Cost of Capital for Foreign Investment Flashcards
Why do we need to adjust the various costs and weights of the different cost components using the WACC for foreign project investments?
Both project risk and capital structure can vary between the parent and subsidiary firm.
What is the equity cost of capital?
The equity cost of capital is the minimum rate of return necessary to induce investors to buy or hold the firm’s stock.
What is the model of choice for estimating the cost of equity for foreign projects?
CAPM
How do we go around the problem of the information needed to estimate foreign subsidiary betas directly not necessarily existing?
The only practical way to get around this problem is to find publicly traded firms that share similar business risk and use the average beta unlevered beta.
What are the 4 questions for US MNCs?
- Should the corporate proxies be US or local companies?
- Is the relevant base portfolio against which proxy betas are estimated the U.S. market portfolio, the local portfolio, or the world market portfolio?
- Should the market risk premium be based on the U.S. market or the local market?
- How, if at all, should country risk be incorporated in the cost of capital estimates?
Should the corporate proxies be US or local companies?
Although local companies should provide a better indication of risk, such firms may not exist. By contrast, selecting U.S. proxies ensures that such proxies and their data exist, but their circumstances– and hence their betas– may be quite different from those facing the foreign subsidiaries.
Is the relevant base portfolio against which proxy betas are estimated the U.S. market portfolio, the local portfolio, or the world market portfolio?
Selecting the appropriate portfolio matters because a risk that is systematic in the context of local market portfolio may well be diversifiable in the context of the U.S. or world portfolio. If this is the case, using the local market portfolio to calculate beta would result in a higher required return, and a less desirable project, than if beta were calculated using the U.S. or world market portfolio.
Should the market risk premium be based on the U.S. market or the local market?
One argument in favor of using the local-market risk premium is that is the risk premium demanded by investors on investments in that market. On the other hand, estimates of the local-market risk premium may be subject to a good deal of statistical error. Moreover, such estimates may be irrelevant to the extent that an MNC’s investors are not the same as the investors in the local market.
How, if at all, should country risk be incorporated in the cost of capital estimates?
We add a country risk premium to the discount rate estimated using CAPM. These premiums are often computed from the yield spread on dollar denominated local government bonds vs U.S. Treasury bonds. In principle it should not be a problem if both risk premiums are independent.
True or false: As much as possible, the corporate proxies should be local firms.
True, the returns on an MNC’s local operations are likely to depend in large measure on the evolution of the local economy.
What does that U.S. firms and their returns to proxy for the returns of a foreign project will likely lead to an upward-biased estimate of the risk premium demanded by MNC’s investors mean?
The degree of systematic risk for a foreign project, at least as measured from the perspective of an American investor, may well be lower than the systematic risk of comparable U.S. companies.
What is an alternative to when foreign proxies are not directly available?
Finding a proxy industry in the local market, that is, one whose US industry beta is like that of the project’s US industry beta.
How can we analyse the empirical validity of the approach of finding a proxy industry?
One way to analyse the empirical validity of this approach is to check whether the betas of the two industries (the projects and the proxies) are also similar in other national markets that contain both industries (e.g., Britain, Germany, and Japan).
What is the last alternative (when we can’t use foreign proxies and proxy industry)?
The last alternative is to estimate the foreign’s project beta by computing the US industry beta for the project and multiplying it by the foreign market beta relative to the US index.
What are the assumptions needed for the method of adjusted US industry beta?
- The beta for an industry in the U.S. will have the same relative beta in each foreign market. This means that the project has the same risk relative to the risk of the local market as a comparable project would have in the U.S. market.
- The only correlation with the U.S. market of a foreign company in the project’s industry comes through its correlation with the local market and the local market’s correlation with the U.S. market.
