International Finance

1
International Finance

• Chapters 16 and 17
• International Capital Structure and the Cost of
  Capital (16)
• International Capital Budgeting (17)

2
Cost of Capital

• The minimum rate of return which a project must
  generate in order to cover the expectations of
  those who have contributed capital (financed) to
  the firm.
• Hurdle Rate in accepting/rejecting projects.

3
Cost of Capital and Global Firms

• The cost of capital for global firms may be
  affected through two distinct channels
• Global operations may make the firm more or less
  risky and thus affect the expected returns of
  capital contributors.
• Financing the firm globally (taking on a global
  capital structure), especially in lower financing
  cost markets, may affect the firms overall cost
  of capital.

4
Globalizing the Firms Markets

• As a firm moves from a domestic setting to a
  global setting, its cost of capital is likely to
  change as capital contributors view the impact of
  the firms global expansion on the risk level
  of the firm.
• Is the firm taking on more risk?
• Is the firm taking on less risk, or making itself
  less risky as a result of its global expansion?

5
Political Risk and Cost of Capital

• Once a global company has assessed the political
  risk associated with a particular country, it can
  then adjust its project cost of capital to take
  into account this assessment.
• Project (country) cost of capital may be higher
  than the firms purely domestic cost of capital.
• Depends upon the non-domestic environment in
  which the firm engages.

6
Globalizing the Firms Capital Structure

• As global firms take on a global capital
  structure, the next issue is to what extent does
  this global capital structure affect the global
  firms cost of capital?
• Can it source in overseas financial markets where
  financing costs are lower than back home?
• This will lower the firms overall cost of
  capital!

7
Estimating Cost of Capital

• As noted, 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 (using debt) firm, the financing
  costs can be represented by the weighted average
  cost of capital.

8
Weighted Average Cost of Capital
K (1 ?)Kl ?(1 t)i

• 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
• t marginal corporate income tax rate

9
The Firms Investment Decision and the Cost of
Capital

• A firm that can reduce its cost of capital (k)
  will increase the profitable capital expenditures
  that the firm can take on (and can increase the
  wealth of the shareholders).
• Globalizing the firm may be one such policy.
• Markets
• Capital Structure

cost of capital ()
Investment ()
10
Does the Cost of Funds Differ among Countries?

• Answer Yes!
• There are differences in the cost of funds among
  countries.
• Japan versus the rest of the world today (foreign
  bond rates).
• Smaller and less liquid financial markets have
  higher financing costs.
• Segmented markets carry higher financing costs.
• Implications for Global Firms
• Global firms may be able to lower their overall
  cost of capital through a strategy of globalizing
  the firms capital structure.

11
Corporate Bond Rates Large, Liquid Markets, June
19, 2003

• Country Long Term Corporate Bonds
• Australia 6.75
• U.K. 5.93
• Canada 6/15
• Japan 1.88
• Switzerland 2.67
• U.S. 6.09
• Euro Area 4.17
• Source The Economist Magazine

12
10 Year Government Bond RatesJune 19, 2004

• Variations among large liquid markets in rates.
• Japan the lowest!
• Upward trend since last year in these rates.

13
Less Liquid Financial Markets

• Definition An illiquid market is characterized
  by small turnover.
• Difficulties in raising funds, especially large
  offerings.
• Market distortions associated with raising funds.
• Impacts on share prices and interest rates.
• A firm that must source its long-term debt and
  equity in a highly illiquid domestic securities
  market will probably have a relatively higher
  cost of capital and will also face limited
  availability of such capital.
• Strategies need to be designed to allow firms to
  finance in more liquid markets.

14
Small Financial Markets

• Relatively small financial markets have
  difficulty in meeting the large financing needs
  of firms.
• Thus, financing costs are likely to be higher for
  firms financing under such conditions.
• Firms need to develop strategies to allow them to
  finance in larger international markets.

15
Short Term Interest Rates Small, Less Liquid
Markets, June 19, 2004

• Country Short term interest rate (p.a.)
• China 2.85
• India 4.41
• Korea 3.90
• Brazil 15.79
• Mexico 6.54
• South Africa 8.20
• Hungary 11.50
• Turkey 25.26
• United States 1.45

16
Segmented Financial Markets

• Capital markets become segmented because of such
  factors as
• excessive regulatory control,
• perceived political risk,
• anticipated FOREX risk,
• lack of transparency,
• insider trading and other market imperfections.
• Consequence of a segmented market
• the required rate of return on securities will
  be higher than the required rate of return on
  securities of comparable quality traded on other
  securities markets thus, higher cost of capital
  for these markets!
• Firms in segmented capital markets must devise a
  strategy to escape dependence on that market for
  their long-term debt and equity needs.

17
Firm Specific Influences on Financing Options

• Some firms because of their relatively small
  size, short history, and/or appeal may not be
  able to escape their domestic capital markets.
• If constrained to small, less liquid, and/or
  segmented domestic capital markets this will
  result in higher financing costs for these firms.
  may be constrained to their domestic capital
  market.
• These firms will be at a competitive disadvantage
  to others.
• These firms must design strategies to overcome
  their firm specific barriers to global markets.

18
Local Market versus Global Market Access
19
Strategies for Overcoming Small, Less Liquid and
Segmented Markets

• Firms financing in small, less liquid, and/or
  segmented capital markets will do so at
  relatively higher costs.
• Higher interest rates.
• Lower prices for equities.
• What strategies can these firms use to escape
  these markets?
• Cross list equity on the worlds major stock
  exchanges (New York and London).

20
Cross Listing as a Strategy

• What can a firm hope to achieve through cross
  listing?
• Cross listing on major exchange will force the
  firm as it complies with listing requirements to
  increase its level of financial disclosure.
• Firm becomes more transparent.
• Management is more likely to manage in the best
  interest of shareholders.
• Corporate governance improves!

21
Impact of Cross Listing on Cost of Capital

• Cross listing which results in more stringent
  disclosure and better corporate governance, can
  result in lower financing costs.
• Share prices may rise as a result of cross
  listing in New York or London i.e., positive
  revaluation of share price.
• Andrew Karolyi (1996) study cross listing
  resulted in a reduction in the cost of equity
  capital of 114 basis points on average.
• Debt cost will probably also be favorably
  affected!

22
Cost of Capital Differences

• Robert McCauley and Steven Zimmer (1994) study
  offers a direct comparison of the cost of capital
  among four major countries
• United States
• United Kingdom
• Japan
• Germany
• Conclusions There are differences, although
  they may be narrowing.

23
Evidence on Cost of Capital Differences After
Tax Cost of Debt
24
Evidence on Cost of Capital Differences Cost of
Equity
25
Evidence on Cost of Capital Differences After
Tax Cost of Capital
26
Does Cost of Financing Differ Among Financing
Options?

• Answer Yes!
• Eurobond financing is typically lower than
  comparable domestic borrowing.
• Eurobonds are bearer bonds!
• Eurobonds have less regulation.
• Lowers the cost of issuing.
• Implications for Global Firms
• Global firms may be able to lower their overall
  cost of capital through a strategy of utilizing
  lower cost financing options (such as the
  euromarkets).

27
Do Firms in Different Countries have Different
Costs of Capital?

• Answer Historically, yes!
• Japan and German firms typically lower than U.S.
  and U.K. firms (1970s, 1980s and early 1990s)
• Why?
• Firms utilizing different capital structures
  (debt/equity ratios)
• Japans advantage Low cost, long term debt.
• Germanys advantage Low cost, short term debt
  (bank loans).
• However, these costs differences tend to be
  narrowing!
• Probably due to the globalization of U.S. and
  U.K. firms.

28
Evidence on Cost of Capital Differences Debt to
Equity Ratios
29
Cost of Capital for Global versus Domestic Firms

• Question facing Global Firms
• Is the weighted average cost of capital for a
  global firm higher or lower than for its domestic
  counterpart?
• The answer is not simple it is a function of
• The relative cost of equity
• The after-tax cost of debt
• The debt capital ratios

30
Empirical Evidence on Cost of Capital
31
Review of Capital Budgeting

• 1. Identify the SIZE and TIMING of all relevant
  cash flows on a time line.
• 2. Identify the RISKINESS of the cash flows to
  determine the appropriate discount rate (cost of
  capital).
• 3. Find NPV by discounting the cash flows at the
  appropriate discount rate (cost of capital).
• 4. Compare the value of competing cash flow
  streams at the same point in time.

32
International Capital Budgeting

• Capital budgeting for international decision
  makers
• 1. Estimate future cash flows in foreign
  currency.
• 2. Convert to U.S. dollars at the predicted
  exchange rate.
• 3. Calculate NPV using the U.S. cost of capital
  as a benchmark.
• Adjust U.S. cost of capital to account for
  political risk issues.

33
International Capital Budgeting Example
interest rate 3 interest rate 6 Cost of
capital 15
Is this a good investment from the perspective of
the U.S. shareholders?

34
International Capital Budgeting Example
331.60
35
International Capital Budgeting Example
331.60
113.70
CF1 (200)E S1(/) E S1(/) can be
found by using the interest rate differential
(IFE)
.5687/
so CF1 (200)(.5687/) 113.7
36
International Capital Budgeting Example
331.60
113.70
292.60
37
International Capital Budgeting Example
331.60
113.70
292.60
180.70
38
International Capital Budgeting Issues

• Estimating future spot rates for the purpose of
  converting foreign currency earnings to U.S.
  dollar earnings.
• Use parity model (IFE) to estimate future spot
  rate.
• Determining the appropriate cost of capital.
• Begin with home country cost of capital
• This will take into account the impact of a
  globalized capital structure on the firms home
  country cost of capital.
• Adjust home country cost of capital for the
  foreign environments political risk.
• Analyze the foreign project on this basis!