INTERNATIONAL
FINANCIAL
MANAGEMENT
EUN / RESNICK
Second Edition
16Chapter SixteenInternational Capital Structure and the Cost of Capital
Chapter Objective:
This chapter discusses the cost of capital for the
multinational firm.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-1
Chapter Outline
? Cost of Capital
? Cost of Capital in Segmented vs,Integrated
Markets
? Does the Cost of Capital Differ Among Countries?
? Cross-Border Listings of Stocks
? Capital Asset Pricing Under Cross-Listings
? The Effect of Foreign Equity Ownership
Restrictions
? The Financial Structure of Subsidiaries.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-2
Cost of Capital
? The cost of capital is the minimum rate of return
an investment project must generate in order to
pay its financing costs.
? For a levered firm,the financing costs can be
represented by the weighted average cost of
capital.
iτλKλK l )1()1( ????
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-3
Weighted Average Cost of Capital
Where
K = weighted average cost of capital
Kl = cost of equity capital for a levered firm
i = pretax cost of debt
? = debt to total market value ratio
iτλKλK l )1()1( ????
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-4
The Firm’s Investment Decision and
the Cost of Capital
? A firm that can reduce its
cost of capital will
increase the profitable
capital expenditures that
the firm can take on and
increase the wealth of the
shareholders.
? Internationalizing the
firm’s cost of capital is
one such policy,Investment ($)
IRR
K global
K local
Ilocal Iglobal
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-5
Cost of Capital in Segmented vs,
Integrated Markets
? The cost of equity capital (Ke) of a firm is the
expected return on the firm’s stock that investors
require.
? This return is frequently estimated using the
Capital Asset Pricing Model (CAPM):
)( fMifi RRβRR ???
)V a r (
),C o v (
M
Mi
i R
RRβ ?where
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-6
Cost of Capital in Segmented vs,
Integrated Markets
If capital markets are segmented,then investors can only
invest domestically,This means that the market portfolio
(M) in the CAPM formula would be the domestic portfolio
instead of the world portfolio.
)( fUSUSifi RRβRR ???
versus
)( fWWifi RRβRR ???
Clearly integration or segmentation of international financial
markets has major implications for determining the cost of
capital.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-7
Does the Cost of Capital
Differ among Countries?
? There do appear to be differences in the cost of
capital in different countries.
? When markets are imperfect,international
financing can lower the firm’s cost of capital.
? One way to achieve this is to internationalize the
firm’s ownership structure.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-8
Real After-Tax Cost of Funds
Source,Robert McCauley and Steven Zimmer,“Exchange Rates and International Differences in the Cost of Capital” in Y,
Amihud and R,Levich,Exchange Rates and Corporate Performance (Burr Ridge,Ill; Irwin 1994).
77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92
8
6
4
2
0
-2
U.S.
UK
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-9
Cross-Border Listings of Stocks
? Cross-border listings of stocks have become quite
popular among major corporations.
? The largest contingent of foreign stocks are listed
on the London Stock Exchange.
? U.S,exchanges attracted the next largest
contingent of foreign stocks.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-10
Cross-Border Listings of Stocks
Cross-border listings of stocks benefit a company in the
following ways.
1,The company can expand its potential investor base,which will
lead to a higher stock price and lower cost of capital.
2,Cross-listing creates a secondary market for the company’s
shares,which facilitates raising new capital in foreign markets.
3,Cross-listing can enhance the liquidity of the company’s stock.
4,Cross-listing enhances the visibility of the company’s name and
its products in foreign marketplaces.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-11
Cross-Border Listings of Stocks
Cross-border listings of stocks do carry costs.
1,It can be costly to meet the disclosure and listing
requirements imposed by the foreign exchange and
regulatory authorities.
2,Once a company’s stock is traded in overseas markets,
there can be volatility spillover from these markets.
3,Once a company’s stock is make available to
foreigners,they might acquire a controlling interest
and challenge the domestic control of the company.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-12
Cross-Border Listings of Stocks
On average,cross-border listings of stocks appears
to be a profitable decision.
The benefits outweigh the costs.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-13
Capital Asset Pricing
Under Cross-Listings
Recall the definition of beta:
)( fMifi RRβRR ???
)V a r (
),C o v (
M
Mi
i R
RRβ ?
We can recalibrate the CAPM formula
)V a r (
),C o v ()(
M
Mi
fMfi R
RRRRRR ???
As:
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-14
Capital Asset Pricing
Under Cross-Listings
We can develop a measure of aggregate risk aversion,AM
)V a r (
),C o v ()(
M
Mi
fMfi R
RRRRRR ???
)V a r (
)(
M
fMM
R
RR
MA
?
?
),C o v ( MiMfi RRMARR ??
We can restate the CAPM using AM
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-15
Capital Asset Pricing
Under Cross-Listings
This equation indicates that,given investors’ aggregate risk-
aversion measure,the expected rate of return on an asset
increases as the asset’s covariance with the market
portfolio increases.
In fully integrated capital markets,each asset will be priced
according to the world systematic risk.
),C o v ( MiMfi RRMARR ??
),C o v ( WiWfi RRWARR ??
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-16
Capital Asset Pricing
Under Cross-Listings
The International Asset Pricing Model (IAPM) above has a
number of implications,
International listing of assets in otherwise segmented markets
directly integrates international capital markets by making
these assets tradable.
Firms with nontradable assets essentially get a free ride from
firms with tradable assets in the sense that the former
indirectly benefit from international integration in terms of
a lower cost of capital.
),C o v ( WiWfi RRWARR ??
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-17
The Effect of Foreign Equity
Ownership Restrictions
? While companies have incentives to
internationalize their ownership structure to lower
the cost of capital and increase market share,they
may be concerned with the possible loss of
corporate control to foreigners.
? In some countries,there are legal restrictions on
the percentage of a firm that foreigners can own.
? These restrictions are imposed as a means of
ensuring domestic control of local firms.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-18
The Financial Structure
of Subsidiaries.
? There are three different approaches to
determining the subsidiary’s financial structure.
1,Conform to the parent company's norm.
2,Conform to the local norm of the country where
the subsidiary operates.
3,Vary judiciously to capitalize on opportunities to
lower taxes,reduce financing costs and risk,and
take advantage of various market imperfections.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-19
The Financial Structure
of Subsidiaries.
? In addition to taxes,political risk should be
given due consideration in the choice of a
subsidiary’s financial structure.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-20
End Chapter Sixteen
FINANCIAL
MANAGEMENT
EUN / RESNICK
Second Edition
16Chapter SixteenInternational Capital Structure and the Cost of Capital
Chapter Objective:
This chapter discusses the cost of capital for the
multinational firm.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-1
Chapter Outline
? Cost of Capital
? Cost of Capital in Segmented vs,Integrated
Markets
? Does the Cost of Capital Differ Among Countries?
? Cross-Border Listings of Stocks
? Capital Asset Pricing Under Cross-Listings
? The Effect of Foreign Equity Ownership
Restrictions
? The Financial Structure of Subsidiaries.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-2
Cost of Capital
? The cost of capital is the minimum rate of return
an investment project must generate in order to
pay its financing costs.
? For a levered firm,the financing costs can be
represented by the weighted average cost of
capital.
iτλKλK l )1()1( ????
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-3
Weighted Average Cost of Capital
Where
K = weighted average cost of capital
Kl = cost of equity capital for a levered firm
i = pretax cost of debt
? = debt to total market value ratio
iτλKλK l )1()1( ????
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-4
The Firm’s Investment Decision and
the Cost of Capital
? A firm that can reduce its
cost of capital will
increase the profitable
capital expenditures that
the firm can take on and
increase the wealth of the
shareholders.
? Internationalizing the
firm’s cost of capital is
one such policy,Investment ($)
IRR
K global
K local
Ilocal Iglobal
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-5
Cost of Capital in Segmented vs,
Integrated Markets
? The cost of equity capital (Ke) of a firm is the
expected return on the firm’s stock that investors
require.
? This return is frequently estimated using the
Capital Asset Pricing Model (CAPM):
)( fMifi RRβRR ???
)V a r (
),C o v (
M
Mi
i R
RRβ ?where
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-6
Cost of Capital in Segmented vs,
Integrated Markets
If capital markets are segmented,then investors can only
invest domestically,This means that the market portfolio
(M) in the CAPM formula would be the domestic portfolio
instead of the world portfolio.
)( fUSUSifi RRβRR ???
versus
)( fWWifi RRβRR ???
Clearly integration or segmentation of international financial
markets has major implications for determining the cost of
capital.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-7
Does the Cost of Capital
Differ among Countries?
? There do appear to be differences in the cost of
capital in different countries.
? When markets are imperfect,international
financing can lower the firm’s cost of capital.
? One way to achieve this is to internationalize the
firm’s ownership structure.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-8
Real After-Tax Cost of Funds
Source,Robert McCauley and Steven Zimmer,“Exchange Rates and International Differences in the Cost of Capital” in Y,
Amihud and R,Levich,Exchange Rates and Corporate Performance (Burr Ridge,Ill; Irwin 1994).
77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92
8
6
4
2
0
-2
U.S.
UK
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-9
Cross-Border Listings of Stocks
? Cross-border listings of stocks have become quite
popular among major corporations.
? The largest contingent of foreign stocks are listed
on the London Stock Exchange.
? U.S,exchanges attracted the next largest
contingent of foreign stocks.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-10
Cross-Border Listings of Stocks
Cross-border listings of stocks benefit a company in the
following ways.
1,The company can expand its potential investor base,which will
lead to a higher stock price and lower cost of capital.
2,Cross-listing creates a secondary market for the company’s
shares,which facilitates raising new capital in foreign markets.
3,Cross-listing can enhance the liquidity of the company’s stock.
4,Cross-listing enhances the visibility of the company’s name and
its products in foreign marketplaces.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-11
Cross-Border Listings of Stocks
Cross-border listings of stocks do carry costs.
1,It can be costly to meet the disclosure and listing
requirements imposed by the foreign exchange and
regulatory authorities.
2,Once a company’s stock is traded in overseas markets,
there can be volatility spillover from these markets.
3,Once a company’s stock is make available to
foreigners,they might acquire a controlling interest
and challenge the domestic control of the company.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-12
Cross-Border Listings of Stocks
On average,cross-border listings of stocks appears
to be a profitable decision.
The benefits outweigh the costs.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-13
Capital Asset Pricing
Under Cross-Listings
Recall the definition of beta:
)( fMifi RRβRR ???
)V a r (
),C o v (
M
Mi
i R
RRβ ?
We can recalibrate the CAPM formula
)V a r (
),C o v ()(
M
Mi
fMfi R
RRRRRR ???
As:
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-14
Capital Asset Pricing
Under Cross-Listings
We can develop a measure of aggregate risk aversion,AM
)V a r (
),C o v ()(
M
Mi
fMfi R
RRRRRR ???
)V a r (
)(
M
fMM
R
RR
MA
?
?
),C o v ( MiMfi RRMARR ??
We can restate the CAPM using AM
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-15
Capital Asset Pricing
Under Cross-Listings
This equation indicates that,given investors’ aggregate risk-
aversion measure,the expected rate of return on an asset
increases as the asset’s covariance with the market
portfolio increases.
In fully integrated capital markets,each asset will be priced
according to the world systematic risk.
),C o v ( MiMfi RRMARR ??
),C o v ( WiWfi RRWARR ??
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-16
Capital Asset Pricing
Under Cross-Listings
The International Asset Pricing Model (IAPM) above has a
number of implications,
International listing of assets in otherwise segmented markets
directly integrates international capital markets by making
these assets tradable.
Firms with nontradable assets essentially get a free ride from
firms with tradable assets in the sense that the former
indirectly benefit from international integration in terms of
a lower cost of capital.
),C o v ( WiWfi RRWARR ??
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-17
The Effect of Foreign Equity
Ownership Restrictions
? While companies have incentives to
internationalize their ownership structure to lower
the cost of capital and increase market share,they
may be concerned with the possible loss of
corporate control to foreigners.
? In some countries,there are legal restrictions on
the percentage of a firm that foreigners can own.
? These restrictions are imposed as a means of
ensuring domestic control of local firms.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-18
The Financial Structure
of Subsidiaries.
? There are three different approaches to
determining the subsidiary’s financial structure.
1,Conform to the parent company's norm.
2,Conform to the local norm of the country where
the subsidiary operates.
3,Vary judiciously to capitalize on opportunities to
lower taxes,reduce financing costs and risk,and
take advantage of various market imperfections.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-19
The Financial Structure
of Subsidiaries.
? In addition to taxes,political risk should be
given due consideration in the choice of a
subsidiary’s financial structure.
McGraw-Hill/Irwin Copyright ? 2001 by The McGraw-Hill Companies,Inc,All rights
reserved,
16-20
End Chapter Sixteen
