Module - 38 International Capital Structure

Size: px

Start display at page:

Download "Module - 38 International Capital Structure"

Stephanie Benson
5 years ago
Views:

1 Module - 38 International Capital Structure Developed by: Dr. A.K.Misra Assistant Professor, Finance Vinod Gupta School of Management Indian Institute of Technology Kharagpur, India arunmisra@vgsom.iitkgp.ernet.in Joint Initiative IITs and IISc Funded by MHRD - 1 -

2 International Capital Structure Learning Objectives: The present session discusses about international capital structure. It outlines the historical developments of capital mobility and put forward various models for estimation of cost of capital when a company s has sourced its capital from international markets. It introduces readers with the International Capital Assets Pricing Model. Highlights & Motivation: In this session, the following details about management of transaction exposure are discussed. Cost of Capital Cost of Capital in Segmented vs. Integrated Markets International Capital Asset Pricing The session would help readers to understand the currency forward, futures and options markets and their applications for hedging currency risk. Joint Initiative IITs and IISc Funded by MHRD - 2 -

3 1. Introduction In continuation to Session-37, this session discusses international capital structure and various methods of estimating the cost of capital including the international Capital Assets Pricing Model. Cross-border listings of stocks benefit a company in the following ways. Expansion of investor base and hence higher stock price and lower capital cost Open secondary markets for company s equity shares and hence create liquidity for existing stocks and room for issuing follow-on equity in foreign markets. Create visibility for the company and at the some enhance corporate governance and public disclosures. Foreign listings of stocks carry costs for the company in the following manner: High disclosures norms of foreign regulatory bodies. Higher cost of market volatility and it may negatively affect the company s domestic operations. Foreign ownership may influence the domestic decisions. However, cross-border listings of stocks appear to be a profitable decision as the benefits are more than the costs. We can now re-state the CAPM in the following manner: β i = Cov(R i,r M ) Var(R M ) R i = R f + βi(r M R f ) R i = R f + (R M R f ) Cov(R i,r M ) Var(R M ) Joint Initiative IITs and IISc Funded by MHRD - 3 -

4 We can develop a measure of aggregate risk aversion, A M and can re-state the CAPM using A M R i = R f + (R M R f ) Cov(R i,r M ) Var(R M ) A M = (R M R f ) Var(R M ) R i = R f + A M (Cov(R i,r M ) 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. R i = R f + A w (Cov(R i,r w ) A w = (R w R f ) Var(R w ) International Asset Pricing Model 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 non-tradable 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. 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. As the world s financial markets continue to integrate, especially through electronic systems, the CAPM must be interpreted in a global sense. We should think in terms of a common risk-return trade-off for all assets in an integrated global financial market. One factor that determines an asset s required rate of return is the global beta. Joint Initiative IITs and IISc Funded by MHRD - 4 -

5 Example If long-term US Treasury bond rate is 6.75%, global beta of 0.15 for the long-term US T-bond and global market risk-premium is 5% in US$, estimate the long-term US$ risk-free interest rate. Answer R i = R f + β i US (R US R f ) where R i :US-Treasury Bond Rate R f :Risk-free Return β i :Systematic Risk (R M R f ): Market Risk Premium Global Market Risk-premium: 4% Risk-free interest rate in US:? US-Treasury Bond rate: 6.75% Bond betas: For US $ T-Bond: % = R f *4% R f = 6.75%-0.15*4% = 5.80% Example Using following information, estimate the WACC for IBM in US$ Out of total debt of US$100 million, it has $50 million US$ yield 8% and US$ 50 million is Yen-denominated debt yield 2% in Yen. Debt represent 25% of IBM s Capital and effective tax shield of IBM is 33% Risk-free rate in US$ is 6% while in Yen it is 2% IBM s equity portfolio beta is 0.85 Global Market Risk-premium is 4% Joint Initiative IITs and IISc Funded by MHRD - 5 -

6 Answer For estimating WACC for IBM in US$ we need to find out the cost of yen-denominated debt in US$, given that its yield in Yen is 2%. The return on Yen-denominated debt to a US investor is equal to the debt s yield in Yen plus the % change in the foreign exchange price of the Yen. Cost of Yen-denominated debt in US$ = Cost of Yen debt in Yen + % change FX value of Yen K d = K d + E(x $/ ) As per Unbiased Interest Rate Parity Hypothesis, the expected change in foreign currency value is the risk-free interest differential between the two countries. Hence, % change FX value of Yen against US$ = Risk-free rate in US( 6%) less Risk-free interest rate in Yen (2%) = 4% Cost of Yen-denominated debt in US$ = K d + E(x $/ ) = 2%+ 4% =6% Estimation of IBM s Cost of Debt Capital K d = Cost of US$ Debt *Weight + Cost of Yen Debt *Weight = 8% *50% + 6%*50% =7% Estimation of IBM s Cost of Equity Capital US R i = R f + β i (R US R f ) where R i :Expected Return from the capital market R f :Risk-free Return β i :Systematic Risk (R M R f ): Market Risk Premium Joint Initiative IITs and IISc Funded by MHRD - 6 -

7 Global Market Risk-premium : 4% Risk-free interest rate in US: 6% Equity betas: IBM: 0.85 R IBM = 6% *4% = 9.40% Estimation of IBM s WACC K w = W d K d (1-t)+W s K s Where K d : Before tax cost of debt : 7% K s : cost of equity : 9.40% t : Effective corporate tax rate: 33% W d : weight for debt capital : 25% W s : Weight for equity capital: 75% References K w = 25%*7%*(1-33%) +75%*9.40% =8.22%, Thomas J.O Brien, Oxford Higher Education, 2edition International Financial Management, P.G.Apte, McGraw-Hill, 5edition Model Questions 1. Compare the US$ cost of capital for Coca-Cola and Kellogg if US$ risk-free interest rate is 5.75%, global risk premium 4% and Coca-Cola & Kellogg s global equity betas in US$ estimated at 0.85 and 1.55 respectively 2. If Colgate-Palmolive s global beta is 1.50, what would be the firm s cost of equity in US$, given US-dollar risk-free rate is 5.60% and global risk premium of 4% in US$? 3. Using following information, estimate the WACC for Sony in US$ Out of total debt of US$100 million, it has $40 million US$ yield 7% and US$ 60 million is Yen-denominated debt yield 1.50% in Yen. Debt represent 35% of Sony s Capital and effective tax shield of Sony is 35% Risk-free rate in US$ is 5.75% while in Yen it is 1.25% Sony s equity portfolio beta is 1.10 Global Market Risk-premium is 4% Joint Initiative IITs and IISc Funded by MHRD - 7 -

8 Answer Question: 2 R i = R f + β i US (R US R f ) R Colgate-Palmolive = 5.60% *4% =11.60% Question: 3 Cost of Yen-denominated debt in US$ = Cost of Yen debt in Yen + % change FX value of Yen K d = K d + E(x $/ ) % change FX value of Yen against US$ 4.50% = Risk-free rate in US( 5.75%) less Risk-free interest rate in Yen (1.25%) = Cost of Yen-denominated debt in US$ = K d + E(x $/ ) = 1.50%+ 4.50% =6% Estimation of Sony s Cost of Debt Capital K d = Cost of US$ Debt *Weight + Cost of Yen Debt *Weight = 6.50% *40% + 6%*60% =6.20% Estimation of Sony s Cost of Equity Capital US R i = R f + β i (R US R f ) where R i :Expected Return from the capital market R f :Risk-free Return β i :Systematic Risk (R M R f ): Market Risk Premium Global Market Risk-premium : 4% Risk-free interest rate in US: 5.75% Joint Initiative IITs and IISc Funded by MHRD - 8 -

9 Equity betas: Sony: 1.10 R IBM = 5.75% *4% = 5.79% Estimation of Sony s WACC K w = W d K d (1-t)+W s K s Where K d : Before tax cost of debt: 6.20% K s : cost of equity: 5.79% t : Effective corporate tax rate: 35% W d : weight for debt capital: 35% W s : Weight for equity capital: 65% K w = 35%*6.20%*(1-35%) +65%*5.79% =5.18% Joint Initiative IITs and IISc Funded by MHRD - 9 -

Module - 40 Evaluation of Foreign Direct Investment

Module - 40 Evaluation of Foreign Direct Investment Developed by: Dr. A.K.Misra Assistant Professor, Finance Vinod Gupta School of Management Indian Institute of Technology Kharagpur, India Email: arunmisra@vgsom.iitkgp.ernet.in