M u l t i n a t i o n al C a p i t al B u dge t i n g
357
14-4b The Cost of Capital: Domestic Versus Global The cost of capital is the required rate of return demanded by stock and bond investors. In the above NPV analyses, the cost of capital was the discount rate assumed to be 15 percent. The following well-known formula can be used to compute the weighted average cost of capital for a firm: K = (Equity/Total Market Value) R + (Debt/Total Market Value) (1 − Tax Rate) I where
Equity = market value of common and preferred stock outstanding Debt = market value of long-term debt outstanding R = cost of equity or required rate of return of equity holders I = before-tax cost of debt or interest rate Tax Rate = marginal tax rate of the firm Total Market Value = Equity + Debt.
The costs of equity R and the cost of debt I increase as the debt, or financial leverage, of the firm increases due to increased bankruptcy risk. Notice that higher taxes can reduce the cost of capital, or K, due to higher interest deductions on debt payments. If firms can reduce their cost of capital by lowering costs of equity and debt, changes in the combination of debt and equity they use (i.e., capital structure), or tax management, they can increase the value of NPVs on investment projects. In the above example, lowering the cost of capital below 15 percent would increase the NPV on the German computer chip subsidiary. The cost of debt is readily measured by calculating a weighted average of different interest rates paid by the firm on sources of long-term borrowings. MNCs are able to borrow beyond domestic borders in international capital markets and thereby minimize their cost of debt. International banks and bond markets increase access to loanable funds at competitive interest rates. The cost of equity is more difficult to estimate. The Capital Asset Pricing Model5 (CAPM) is a well-known approach to estimating the cost of domestic equity. The CAPM is written as follows: Rit = Rft + βi(Rmt − Rft), where Rit = the one-month return on stock i in month t Rmt = the one-month return on a domestic market index (e.g., the S&P 500 index of the 500 largest U.S. firms) Rft = the one-month riskless rate of return (e.g., the U.S. Treasury bill rate) βi = the domestic beta risk measure for the stock. As an example, given average Rmt = 10 percent, average Rft = 5 percent, and bi = 0.80, the cost of equity equals 9 percent computed as 5 + 0.80(10 − 5). The beta risk measure is less than one, which implies that the stock has lower risk than the market index. Firms with lower betas will have lower costs of equity than higher beta firms. One problem in estimating the cost of equity is whether the stock’s equity market is domestic or global. If investors in the domestic market set the price of the stock, a segmented market for the stock exists, and the CAPM is an appropriate way to measure the cost of equity. However, if international investors set the stock price, then an integrated market exists, such that the CAPM is inappropriate. Internationally integrated equity markets require the use of the International CAPM6 (ICAPM) to estimate the cost of equity. The ICAPM can be written as follows:
cost of capital
the required rate of return demanded by stock and bond investors and is used in net present value capital budgeting analyses as the discount rate
weighted average cost of capital the sum of the costs of equity and debt weighted by the amount of financing from these two capital sources
cost of debt
the weighted average of different interest rates paid on longterm borrowings
cost of equity
the required rate of return by stockholders in a firm and is estimated by means of the Capital Asset Pricing Model (CAPM)
beta risk
a measurement of the general market risk of a stock in the Capital Asset Pricing Model (CAPM)
international CAPM (ICAPM)
an asset pricing model that includes both domestic and global market factors to estimate the cost of equity or required rate of return on stocks
Copyright 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.