International Capital Structure INTERNATIONAL 16 And The .

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Chapter Sixteen16International Capital StructureINTERNATIONALand the Cost of CapitalFINANCIALMANAGEMENTChapter Objective:This chapter discusses the cost of capital for themultinational firm.EUN / RESNICKSecond Edition

Chapter Outline Cost of CapitalCost of Capital in Segmented vs. IntegratedMarketsDoes the Cost of Capital Differ Among Countries?Cross-Border Listings of StocksCapital Asset Pricing Under Cross-ListingsThe Effect of Foreign Equity OwnershipRestrictionsThe Financial Structure of ht 2001 by The McGraw-Hill Companies, Inc. All rights

Cost of Capital The cost of capital is the minimum rate of returnan investment project must generate in order topay its financing costs.For a levered firm, the financing costs can berepresented by the weighted average cost ofcapital.McGraw-Hill/Irwinreserved.16-2Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Weighted Average Cost of CapitalWhereK weighted average cost of capitalKl cost of equity capital for a levered firmi pretax cost of debtλ debt to total market value ratioMcGraw-Hill/Irwinreserved.16-3Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

The Firm’s Investment Decision andthe Cost of Capital A firm that can reduce itscost of capital willincrease the profitablecapital expenditures thatthe firm can take on andincrease the wealth of theshareholders.Internationalizing thefirm’s cost of capital isone such policy.McGraw-Hill/Irwinreserved.16-4K localK globalIRRIlocal IglobalInvestment ( )Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Cost of Capital in Segmented vs.Integrated Markets The cost of equity capital (Ke) of a firm is theexpected return on the firm’s stock that investorsrequire.This return is frequently estimated using theCapital Asset Pricing Model t 2001 by The McGraw-Hill Companies, Inc. All rights

Cost of Capital in Segmented vs.Integrated MarketsIf capital markets are segmented, then investors can onlyinvest domestically. This means that the market portfolio(M) in the CAPM formula would be the domestic portfolioinstead of the world portfolio.versusClearly integration or segmentation of international financialmarkets has major implications for determining the cost ofcapital.McGraw-Hill/Irwinreserved.16-6Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Does the Cost of CapitalDiffer among Countries? There do appear to be differences in the cost ofcapital in different countries.When markets are imperfect, internationalfinancing can lower the firm’s cost of capital.One way to achieve this is to internationalize thefirm’s ownership structure.McGraw-Hill/Irwinreserved.16-7Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Real After-Tax Cost of Funds8U.S.642UK0-277787980 818283 84858687888990 9192Source: 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).McGraw-Hill/Irwinreserved.16-8Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Cross-Border Listings of Stocks Cross-border listings of stocks have become quitepopular among major corporations.The largest contingent of foreign stocks are listedon the London Stock Exchange.U.S. exchanges attracted the next largestcontingent of foreign stocks.McGraw-Hill/Irwinreserved.16-9Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Cross-Border Listings of StocksCross-border listings of stocks benefit a company in thefollowing ways.1.2.3.4.The company can expand its potential investor base, which willlead to a higher stock price and lower cost of capital.Cross-listing creates a secondary market for the company’sshares, which facilitates raising new capital in foreign markets.Cross-listing can enhance the liquidity of the company’s stock.Cross-listing enhances the visibility of the company’s name andits products in foreign ght 2001 by The McGraw-Hill Companies, Inc. All rights

Cross-Border Listings of StocksCross-border listings of stocks do carry costs.1.2.3.It can be costly to meet the disclosure and listingrequirements imposed by the foreign exchange andregulatory authorities.Once a company’s stock is traded in overseas markets,there can be volatility spillover from these markets.Once a company’s stock is make available toforeigners, they might acquire a controlling interestand challenge the domestic control of the company.McGraw-Hill/Irwinreserved.16-11Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Cross-Border Listings of StocksOn average, cross-border listings of stocks appearsto be a profitable decision.The benefits outweigh the costs.McGraw-Hill/Irwinreserved.16-12Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Capital Asset PricingUnder Cross-ListingsRecall the definition of beta:We can recalibrate the CAPM formulaAs:McGraw-Hill/Irwinreserved.16-13Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Capital Asset PricingUnder Cross-ListingsWe can develop a measure of aggregate risk aversion, AMWe can restate the CAPM using AMMcGraw-Hill/Irwinreserved.16-14Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Capital Asset PricingUnder Cross-ListingsThis equation indicates that, given investors’ aggregate riskaversion measure, the expected rate of return on an assetincreases as the asset’s covariance with the marketportfolio increases.In fully integrated capital markets, each asset will be pricedaccording to the world systematic risk.McGraw-Hill/Irwinreserved.16-15Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

Capital Asset PricingUnder Cross-ListingsThe International Asset Pricing Model (IAPM) above has anumber of implications.International listing of assets in otherwise segmented marketsdirectly integrates international capital markets by makingthese assets tradable.Firms with nontradable assets essentially get a free ride fromfirms with tradable assets in the sense that the formerindirectly benefit from international integration in terms ofa lower cost of capital.McGraw-Hill/Irwinreserved.16-16Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

The Effect of Foreign EquityOwnership Restrictions While companies have incentives tointernationalize their ownership structure to lowerthe cost of capital and increase market share, theymay be concerned with the possible loss ofcorporate control to foreigners.In some countries, there are legal restrictions onthe percentage of a firm that foreigners can own.These restrictions are imposed as a means ofensuring domestic control of local firms.McGraw-Hill/Irwinreserved.16-17Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

The Financial Structureof Subsidiaries. 1.2.3.There are three different approaches todetermining the subsidiary’s financial structure.Conform to the parent company's norm.Conform to the local norm of the country wherethe subsidiary operates.Vary judiciously to capitalize on opportunities tolower taxes, reduce financing costs and risk, andtake advantage of various market ight 2001 by The McGraw-Hill Companies, Inc. All rights

The Financial Structureof Subsidiaries. In addition to taxes, political risk should begiven due consideration in the choice of asubsidiary’s financial structure.McGraw-Hill/Irwinreserved.16-19Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

End Chapter SixteenMcGraw-Hill/Irwinreserved.16-20Copyright 2001 by The McGraw-Hill Companies, Inc. All rights

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. versus Clearly integration or segmentation of international financial markets has major implications for determining the .

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