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

size factor

whether a firm is small or large and how this size provides an estimate of the cost of equity

value factor

whether a firm has growth or value and how this firm characteristic provides an estimate of the cost of equity

LO-5

Discuss how exchange rate risk affects firms’ cash flows and its impact on stock returns. Rit = Rft + bi(Rmt − Rft) + bi g (Rgt − Rft)

where

Rgt = the one-month return on a global market index (e.g., the Dow Jones world index of stocks)

βi g = the global beta risk measure for the stock and other terms as before.

Now the firm’s stock has both domestic and global beta risk measures. Extending the previous U.S. MNC example, given that average Rmt = 10 percent, Rgt = 11 percent, average Rft = 5 percent, bi = 0.80, and βi g = 1.00, the cost of equity equals 15 percent computed as 5 + 0.80(10 − 5) + 1.00(11−5). In general, MNCs should use the ICAPM to estimate their cost of equity, while domestic firms with little or no international business activity should apply the CAPM.

It should be mentioned that the CAPM and ICAPM models have been the subject of controversy for the past two decades. Extensive tests by Fama and French7 have shown that estimates of the cost of equity can be improved by adding two other variables to these models: 1) the return on a portfolio of small firm stocks minus the return on a portfolio of large firm stocks (SMB), and 2) the return on a portfolio of high book-equity to market-equity ratio stocks minus the return on a portfolio of low book-equity to market-equity ratio stocks (HML). These size and value factors, respectively, may increase the explanatory power of the CAPM and ICAPM and, therefore, improve estimates of the cost of equity.8 In the context of the CAPM, Fama and French propose the following cost of equity formula:

(Rit − Rft)t = a+ bi(Rmt − Rft) + bsSMBt + bvHMLt.

In the previous example with Rmt = 10 percent, average Rft = 5 percent, and βi = 0.80, if we further assume that SMB = 2 percent, HML = 1 percent, βs = 0.50, and βv = 0.30, then the cost of equity equals 10.3 percent computed as 5 + 0.80(10 − 5) + 0.50(2) + 0.30(1). A similar adjustment can be made to the ICAPM for MNCs facing integrated financial markets.

In sum, the cost of equity can be computed via either the CAPM for domestic firms or the ICAPM for MNCs. The Fama and French size and value factors can be added to these models to help improve their accuracy. The weighted average cost of equity and debt is the cost of capital used in discounting investment projects by the firm. The lower the cost of capital, the higher the NPVs of investment projects. In turn, the value of the firm is increased by more positive NPV projects. MNCs have an advantage over domestic firms in their ability to tap global financial markets in search of the lowest costs of equity and debt.

Reality Che C k lO-4

Refer again to the example in Exhibit 14.7 and recompute the NPV in dollars for the U.S. firm. Assume that the euro increases in value over time. Insert some hypothetical EUR-to-USD exchange rates. How did the NPV in dollars change?

14-5 Currency Risk and Stock Valuation

Foreign sales of firms will decline due to local currency appreciation. Import costs can rise when local currency depreciates. Of course, these export or import cash flow effects increase as currency movements become larger in magnitude. Suppliers and buyers that are affected by exchange rate risk can affect domestic firms with no export or import business.