Global Cost of Capital

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Global Cost of Capital

• WACC equitycost of equity debtcost of
  debt
• Cost of equity keD1/P0g
• Cost of debtkd(1-T)
• CAPM Cost of equity kkrf(km-krf)beta

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How to calculate
6(1-30)
41.3(14-4)
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WACC

• To calculate a WACC for a multiple layer
  financing, you need to figure out the amounts of
  each type of financing and therefore its weight
• To do this, they must all be in the same
  currency, so use the exchange rates

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Which pieces?
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What are the components
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Market Liquidity Marginal Cost of Capital (MCC)

• Degree to which a firm can issue new security
  without depressing the existing market price.
• Degree to which a change in price of firms
  securities elicits a substantial order flow
• Eventually, as companys needs expand the
  marginal cost will increase (I.e, the next
  increment will be more expensive)

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The Role of International Capital Markets in
Market Liquidity

• Euromarkets
• Individual capital markets
• Expand the supply of capital for a firm, when
  domestic market is saturated

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Market Segmentation

• A national capital market is considered segmented
  if the required rate of return on securities in
  that market differs from the required rate of
  return on securities of comparable expected
  return and risk that are traded on other national
  securities markets

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Reasons for Market Segmentation

• Information barriers
• Transaction costs
• Foreign exchange risk
• Takeover defenses
• Small country bias
• Political risk
• Regulatory barriers

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Implications

• Marginal cost of capital higher when in
  segmented market lower when integrated markets
• Potential risk reduction because of global beta
  foreign stocks are not closely correlated with US
  stocks.
• FX risk and return in international portfolios
  (return on security, return on currency)

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Cross-listing abroad

• Liquidity of existing shares (ADRs)
• Increased share price
• Liquid secondary market
• Acquisition of local firms
• Visibility, acceptance
• Local management compensation (and global,
  sometimes)
• But some barriers (disclosure, etc.)

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Depositary Receipts

• American Depositary Receipts (occasionally
  referred to as American Drawing Rights in web
  sources)
• Negotiable certificates issued by a US bank to
  represent the underlying stock
• Use eliminates some issues with dividends and
  transfer of ownership

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Financing Considerations

• When companies look for debt financing, they
  always need to look at-quantity of money
  needed-maturity-type of repayment stream
• When a multinational firm looks at debt
  financing, currency denomination arises as
  another issue to consider

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Typically

• Company wants to finance current assets with
  current liabilities and long term assets with
  long term liabilities (maturity matching)
• Depending on how conservative or aggressive a
  firm is, they may finance all or part of
  permanent current assets with long term funds to
  avoid refunding risk

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Adding the Global Dimension

• Operating exposure management may call for
  matching foreign currency assets with foreign
  currency liabilities
• Focus on balance sheet or income statement
  exposure?
• Cash flow should be the focus!
• Effective cost of fx denominated debt includes fx
  risk component (calculation)

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Effective cost

• Foreign Exchange risk can add to the effective
  cost of debt
• Proceeds of loan Calculated at current spot rate
  at the time of borrowing
• Repayment Calculated at ending spot rate
• Kd (1kFd)(1change spot)-1
• change spot (S1-S2)/S2100 (indir)

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To compare financing alternativesover a period
of more than an year

• In order to compare financing alternatives, you
  need to compare the US (parent currency) cash
  flows
• To calculate the effective rate for a multiple
  year period, you need to calculate the IRR
• Remember, a currency weakens IF you can buy more
  of it with 1 and strengthens if you can buy less
  of it with 1

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Pricing Terms Review

• LIBORLondon Interbank Offered Rate deposit rate
  applicable to interbank loans Used as a
  reference rate
• Borrowers usually pay a premium over the base
  rate (LIBOR or other)
• Up front fees are sometimes paid they impact the
  effective cost of the credit (net proceeds less
  than face amount)

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ECP EMTN(Calculate Present Value)

• Euro Commercial Paper market price can be
  calculated as MPFace Value/1(N/360)(Y/100)
  -Ndays remaining to maturity-Yield in annual
  (market)
• Pricing of EMTN is more complex-Present value
  of each payment must be calculated (including
  principal at end)-Days as of payment
  interval-Discount factorannual yield adjusted
  to reflect payment period

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Capital Structure Review

• Cost of capital changes as the amount of debt
  increases as portion of the capital
• Debt capital is generally less expensive than
  equity capital, up to a point where the risk of
  insolvency becomes too high
• Cost of capital for large firms generally lower
  than smaller firms (access)

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Adding the global dimension

• US Multinational firms have lower cost of capital
  than domestic only firms, or multinationals
  domiciled in illiquid markets
• The US MNCs have essentially a flat Marginal Cost
  of Capital curve, while the others face an
  increasing MCC due to lower available supply of
  financing

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Adding the global dimension

• Multinational firms may be in a better position
  to support higher debt due to diversification of
  cash flows
• This assumes that geographic areas are at least
  at different stages of economic cycles
• Given recent and current headlines, do you buy
  this argument or not?

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Hedging Interest Rates

• See table 14.5 for full summary.
• If you have a payment due, you can sell a future.
• If rates go up Futures price falls, short earns
  a profit
• If rates go down Futures price increases, short
  earns a loss
• They offset the changes in the rate.

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Foreign Affiliates

• Foreign direct investment can be political hot
  potato
• Affiliate capital structure can have an impact on
  how the investment is viewed by the host
  country-Debt ratio norms vary-Minimum own
  capital and insolvency (Finland example)
• Localizing financial structures has both
  advantages and disadvantages

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The best course to follow?

• Ultimately, the wealth of the shareholders of the
  multinational firm will likely be maximized by
  borrowing at the lowest effective cost (after
  adjusting for fx risk) to reduce the WACC
• Therefore, paying attention to cosmetics at the
  local level may be suboptimal

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Funding sources for financing Foreign Affiliates

• Internal funds
• Funds from within the corporate
  family-Parent-Sister affiliates-Parent
  guarantees
• Funds from external sources-Parent
  country-Outside parent country-Local (where
  affiliate is)

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Should a company invest abroad?

• Options available to enter a foreign market-100
  DFI in an affiliate-Joint Venture with local
  firm-Exporting-Licensing-Management contracts

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Strategic motives

• New markets for products
• Cheap or hard to transport raw materials
• Production efficiency where a factor of
  production is cheaper
• Access to technology/expertise-foreigners coming
  to US-what about US firms in Russia, India?
• Political safety

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Capital Budgeting

• Identify investment outlays-purchase,
  transportation, installation of
  equipment-increases in working capital
• Identify annual cash flows-any relevant cash
  flow, positive or negative, due to decision to go
  ahead with this project, including opportunity
  costs-do not consider sunk costs
• Identify terminal cash flows-salvage value of
  equipment/operation-recovery of working capital
• Discounted cash flow/discount rate

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Adding the global dimension

• Parent cash flows (even though financial)
• Project cash flows (operational)
• Affiliate to affiliate opportunity costs
• Tax, political, legal constraints
• Ways to reposition funds
• Inflation differences and FX fluctuations
• Segmented market opportunity
• Tax and other incentives, political risk

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Project Point of View

• In local currency
• Does project meet criteria from a local
  company/market perspective-is return competitive
  with local investor expectations/minimum (govt
  bonds)
• ..from a parent perspective, what influences
  shareholder value..? Cash flow!

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Repatriation Flows

• Dividends - as return on capital investment
• Principal and interest - as payment for borrowed
  funds
• Intra-firm sales (transfer pricing) or products
  and services
• Royalties and license fees

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Repatriation Flows and Taxes

• Dividends distributed after tax, as in the US
• Interest payments before tax, as in the US
• Transfer prices may lower foreign tax liability,
  but remember the issues
• Royalties and license fees reduces foreign tax
  liabilities
• Tax gross up for tax calculations?
• Blocked funds?
• Adjust cash flows for higher risk?

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Capital Budgeting Process

• 1. Define the cash flows for foreign operation
  for periods 0 through n a) Initial /Investment/
  Outlayb) Annual Cash Flows (Rev, Cost, Depr,
  Taxes, Add Back Depr)c) Terminal Cash Flow
• Notesa) Working Capital increase in initial
  outlayb) You depreciate cost

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Capital Budgeting Process

• 2. Determine Annual Cash Flows to Parenta)
  Dividend (Net Income? Net Income plus
  Depreciation? Restrictions?)b) Other
• 3. Translate to Parent Currency at rates
  applicable rates (can do at different points in
  the process but must do before take PV)

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Capital Budgeting Process

• 4. Determine Terminal Cash flow (yr n)a) Sales
  proceeds (if you sell for book value, after tax
  issame as before tax) or PENet Income in
  Yrnb) Infinite stream of dividendsc) Working
  capital recovery
• 5. Determine Value and of delayed repatriation
  of Blocked Funds in yr n a) Reinvest (calculate
  FV at year n of each years)b) Calculate Present
  value of FV
• 6. Calculate sum of all Present Values

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When Calculating Cash Flows

• Often you need to calculate Revenues based on
  units and price. Both may change over the time
  frame.
• Unit cost may also be given and needs to be
  multiplied by volume
• A dividend to the parent may be the only parent
  cash flow

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Example - Assumptions
We use these assumptions to build an income
statement and cashflow to the parent
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Example Income Statement and Cash flow to parent
Units Price
Units cost
80 0f NI
Last Div/ 20
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Another Example(In class if time)
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