International Capital Structure and the Cost of Capital Notes

Cost of Capital

• The cost of capital is the minimum rate of return an investment project must generate to cover its financing costs.
• When a firm uses both debt and equity, the weighted average cost of capital (WACC) is used to represent the financing cost.
  • $K = K_l + i(1 - \tau)l$
    • $K$ = weighted average cost of capital
    • $K_l$ = cost of equity capital for a levered firm
    • $i$ = before-tax cost of debt capital (borrowing)
    • $\tau$ = marginal corporate income tax rate
    • $l$ = debt-to-total-market-value ratio

Investment Decision and Cost of Capital

• Investment projects are ranked in descending order based on their Internal Rate of Return (IRR), forming a negatively sloped IRR schedule.
• The optimal capital expenditure is found where the IRR schedule intersects the cost of capital.

Cost of Equity Capital

• The main challenge in calculating a firm's financing cost ($K$) is determining the cost of equity capital ($K_e$).
  • Cost of equity capital represents the expected return on the firm’s stock required by investors.
  • Frequently estimated using the Capital Asset Pricing Model (CAPM).
    • $K<em>e = R</em>f + \beta<em>i (R</em>M - R_f)$
      • $R_f$ is the risk-free interest rate.
      • $R_M$ is the expected return on the market portfolio.
      • $\beta_i$ is the beta, a measure of systematic risk inherent in security $i$.

Cost of Capital in Segmented vs. Integrated Markets

• Cost of capital is likely to vary across countries.
• Lau, Ng, and Zhang (2010) found:
  • A country's cost of capital is strongly related to home bias in portfolio holdings.
  • High home bias hinders global risk sharing, increasing the cost of capital.
  • Reduced home bias and greater global risk sharing would reduce the cost of capital.
  • Accounting transparency also helps reduce the cost of capital.

Cross-Border Listings of Stocks

• Cross-border listings of stocks have become popular among major corporations.
• Benefits:
  • Expands the potential investor base, leading to higher stock prices and a lower cost of capital.
  • Creates a secondary market for the company’s shares, facilitating raising new capital in foreign markets.
  • Enhances the liquidity of the company’s stock.
  • Enhances the visibility of the company’s name and its products in foreign marketplaces.
  • Cross-listed shares may be used as the “acquisition currency” for taking over foreign companies.
  • May improve the company’s corporate governance and transparency.
• Costs:
  • Disclosure and listing requirements imposed by foreign exchanges and regulatory authorities.
  • Controlling insiders may find it difficult to continue deriving private benefits.
  • Volatility spillover from overseas markets.
  • Foreigners might acquire a controlling interest and challenge the domestic control of the company.
• German survey by Glaum and Mandler (1996):
  • One-third of German firms were interested in U.S. listings but viewed the required adaptation of financial statements to US-GAAP as a major obstacle.
  • Daimler, a German firm listed on the NYSE, uses both US-GAAP and German accounting law.
  • Daimler publishes two versions of consolidated financial statements with different reported earnings.
  • In 1993 and 1994, the company’s net earnings were positive by German accounting rules but negative by American rules.

Effect of Foreign Equity Ownership Restrictions

• Companies may be concerned with the possible loss of corporate control to foreigners.
• Governments may impose restrictions on the maximum percentage ownership of local firms by foreigners.
  • For example, in India, Mexico, and Thailand, no more than 49% of outstanding shares of local firms can be purchased by foreigners.
• These restrictions ensure domestic control of local firms, especially those considered strategically important to national interests.
• Pricing-to-Market Phenomenon:
  • Foreign and domestic investors may face different market share prices.
  • Shares can exhibit a dual pricing or pricing-to-market (PTM) phenomenon due to legal restraints imposed on foreigners.
    • Example: Foreigners want to buy 30% of a Korean firm, but due to ownership constraints, they can purchase at most 20%.

Financial Structure of Subsidiaries

• Financial managers of multinational corporations must determine the financial structure of foreign subsidiaries.
• Three approaches:
  • Conform to the parent company’s norm.
  • Conform to the local norm of the country where the subsidiary operates.
  • Vary judiciously to capitalize on opportunities to lower taxes, reduce financing costs and risks, and take advantage of various market imperfections.
• The approach depends on the parent company's responsibility for the subsidiary’s financial obligations.
  • If fully responsible, the independent financial structure of the subsidiary is irrelevant.
  • If the parent is not fully responsible, the subsidiary’s financial structure becomes relevant.