Week 8 - Cost of Capital for Multinationals Flashcards
What is the formula to compare the costs of equity and debt in a firm’s capital structure? (2)
- Kc = (D/D+E) x Kd x (1-t) + (E/D+E) x Ke
- D - amount of debt, E - equity of the firm, Kd - before tax cost of debt, t - corporate tax rate, Ke - cost of equity
What is the weighted average cost of capital (WACC)?
Evaluates the cost of capital by combining the costs of debt and equity weighted by their respective proportions in the firm’s capital structure
What is the hurdle rate in capital budgeting? (2)
- The minimum required return on a project before it is deemed acceptable
- Typically the risk-free rate plus a risk premium which depends on the project’s risk
What are the two basic questions in finance regarding risk and return? (2)
- How do you measure risk?
- How do you translate this risk measure into a risk premium?
What assumptions does the CAPM make? (6)
- Single period investment horizon
- The marginal investor is fully diversified and receives no reward for unsystematic risk
- No taxes or transaction costs
- Financial markets are efficient
- Investors are rational and use mean-variance optimisation
- Expectations are homogenous, meaning all investors hold the market portfolio
What does CAPM say about the expected return of a security? (2)
E (ri) = Rf + βi x (Rm - Rf)
- Rf - risk-free rate, βi - security’s beta, Rm - expected return on the market
How is βi calculated in CAPM? (3)
βi = Cov(Ri,Rm) / σ^2m
=> Cori,m x σi / σm
- βi - security’s volatility relative to the market, Cov(Ri,Rm) - covariance between the asset’s return and the market return, σm - market’s standard deviation
What is the domestic CAPM? (2)
-Assumes that the market portfolio comprises of assets held by investors within a specific country
- Beta is calculated in relation to the country’s market index
What is the difference between Domestic CAPM and World CAPM? (2)
- Domestic CAPM assumes no international diversification - market portfolio consists of only domestic assets
- World CAPM assumes a globally diversified portfolio - market portfolio consists of international assets
What are the issues with using WCAPM? (2)
- Assumes that all investors (domestic and international) have the same expectations regarding real returns
- Does not hold true due to deviations from PPP and fluctuations in exchange rates
How does the ICAPM account for exchange rate risk?
- Includes terms representing exchange rate risks
- Each currency’s risk exposure is measured in relation to its forward premium and the expected future spot rate
How is the cost of capital estimated in ICAPM framework?
Running a multivariate regression of excess returns on the world market return and relevant currency returns
What is the Intertemporal CAPM (2)
- Incorporates inflation and exchange rate risks into the expected return computation
- Addresses the limitations of WCAPM and incorporates real exchange rate fluctuations into asset pricing
What practical issues arise when using CAPM, WCAPM or ICAPM? (4)
- Determining the risk-free rate
- Defining the appropriate market portfolio
- Calculating beta accurately
- Determining the market risk premium
How is the Market Risk Premium (MRP) estimated? (3)
- Surveys of individual investors, institutional investors and academics
- Historical data by calculating the historical sample mean equity market return
- Forward-looking data derived from market prices, such as options and futures on market indexes
