International Cost of Capital and Capital Structure Notes

International Cost of Capital and Capital Structure

  • This lecture covers international cost of capital and capital structure, as detailed in Chapter 17.
  • The cost of capital is a fundamental concept often reviewed in corporate finance courses.

Modern Portfolio Theory Review

  • The textbook uses different notation compared to others.

  • Typical formula for cost of capital: weight of debt * (1 - tax rate) * cost of debt + weight of equity * cost of equity.

  • The presented notation uses Lambda ($\Lambda$) for the debt-to-market value ratio and $K_L$ for the cost of equity in a levered firm.

  • Firms can be unlevered (without leverage), where the debt component is zero.

  • Debt capital is multiplied by (1 - tax rate) * $I$, where $I$ is the before-tax cost of debt capital.

  • It's crucial to recognize whether the cost of debt is before or after tax, especially for test questions.

  • Formula:

    WACC = (1 - \Lambda) * K_L + \Lambda * (1 - \tau) * I

Capital Structure

  • Capital structure is management's choice, specifically the financial manager's decision.
  • It involves selecting the mix of borrowed money (debt) relative to equity.
  • Borrowing money introduces financial risk because debt must be repaid.
  • If a business slows down and cannot pay its debts, it faces financial distress.
  • External forces, like banks, can limit borrowing amounts.
  • Rating agencies also influence borrowing capacity.
  • Debt-to-capital ratios vary across countries.
  • South Korea tends to have a high debt-to-capital ratio, while the US is on the lower end.
  • The US has large, developed public equity markets, offering abundant access to equities for individuals and institutional investors.

Debt vs. Equity Financing

  • Businesses often prefer raising debt over equity because equity is more expensive.
  • The condition of equity markets in a country influences the prevalence of debt usage.
  • Traditional bank financing plays a role, especially when banks have close relationships with businesses.
  • Many businesses, mainly in Japan and Korea, are part of larger conglomerates (Keiretsu or Chaebols) with financial institution partners and family companies.
  • These factors explain why certain countries rely more on debt financing.

Investment Decisions and Cost of Capital

  • Businesses make investment decisions to increase shareholder wealth.
  • They invest in projects with a return exceeding their cost of capital.
  • Earnings should exceed costs.
  • Projects must have a return that exceeds their cost.
  • Accurately measuring the cost of capital is crucial for project selection.
  • Approaches like Net Present Value (NPV), where the present value of cash inflows exceeds cash outflows, are used.
  • Internal Rate of Return (IRR) solves for the rate.
  • Businesses may have multiple acceptable projects given their cost of capital.
  • As more projects are undertaken, the IRR tends to decrease.
  • Firms select projects based on available capital.
  • Projects are accepted as long as the return is equal to or greater than the weighted average cost of capital (WACC).
  • Projects are ranked in descending order by their internal rate of return.
  • The optimal capital expenditure occurs where the investment opportunities intersect with the available capital.
  • Optimal capital structure: expenditure where schedules intersect.

Cost of Equity

  • The main challenge in computing a firm's financing cost is determining the cost of equity ($K_E$).
  • Lowering the cost of capital enables businesses to accept more projects.
  • Cost of equity capital is the expected return on the firm's stock required by investors.

Capital Asset Pricing Model (CAPM)

  • When making investment decisions, businesses evaluate the capital cost against the project's return.

  • Cost of debt is relatively straightforward to calculate by asking banks or examining bond yields.

  • Cost of equity is more complicated, even without issuing new stock, as shareholders expect a return based on perceived risk.

  • The Capital Asset Pricing Model (CAPM) is used to determine the cost of equity.

  • It uses a single factor: market risk.

  • The factor is beta multiplied by market risk.

  • CAPM provides an estimate of the cost of equity capital:

    Cost of Equity = Risk-Free Rate + \beta * (Market Return - Risk-Free Rate)

  • The model, which won a Nobel Prize, suggests return is a function of risk.

  • Higher risk demands a higher required return from shareholders; otherwise, the stock price decreases.

  • Investors price in risk by discounting future expectations.

CAPM Components

  • Investors can achieve a risk-free return by investing in government bonds.
  • The risk-free rate is the minimum required return on equity.
  • The market portfolio comprises a diversified portfolio representing the overall market, containing only systematic risk.
  • The equity market risk premium is the difference between the market return and the risk-free rate.
  • It represents the excess return required for investing in the stock market.
  • Investors need to receive the risk-free return plus the excess return for investing in the stock market rather than risk-free assets.
  • Beta ($\beta$) measures the correlation and sensitivity of individual equity returns to market changes.
  • A high beta indicates greater systematic risk and sensitivity to market swings.
  • For example, with a market swing of 5%, an asset with a beta of 1 will change by 5%, while a beta of 1.5 will change by 7.5%.

Beta and Industry Sensitivity

  • Certain industries have high betas, such as airlines, due to their sensitivity to economic conditions and business cycles.
  • Food and beverage industries have lower sensitivity, as consumption remains relatively constant.
  • Consumer durables are more sensitive than consumer non-durables.
  • Systematic risk is inherent in a security.
  • Systematic risk is the non-diversifiable market risk of an asset.
  • Diversifiable risk can be mitigated by adding the asset to a portfolio.
  • Beta measures an asset's systematic risk, reflecting its sensitivity to market movements.
  • Beta measures the correlation between returns on a stock and market returns over time.

Equity Market Risk Premium

  • The equity market risk premium can be forward-looking.
  • It can be determined by examining the index price and using a dividend discount model.
  • Typically, historical data over several years (75-100 years) is used.
  • Risk-free rate can be obtained from sources like Bloomberg.

Market Return Considerations

  • Market return is based on the stock market, where participants diversify their portfolios.
  • The market has a limited universe, consisting of 500 or thousands of stocks.
  • Returns vary from country to country based on market conditions.
  • Global markets are possible, but some countries are not open.

Home Bias

  • Lau and Zhang's study examines home bias.
  • Integrated markets, where managers can invest in and out, have a lower cost of capital due to the influence of multiple investors.
  • Greater diversification lowers risk by allowing investments in emerging markets and other countries.
  • Countries with high home bias, restrict foreign investment.
  • Limited global risk sharing increases the cost of capital.
  • A broader investor base leads to a greater tolerance for risk.
  • Reduced home bias and greater global risk sharing helps reduce the cost of capital

Accounting Transparency

  • Accounting transparency reduces perceived risk.
  • Reliable accounting systems, frequent disclosures, and reliable auditors are crucial.
  • Uncertainty increases risk.

Financial Market Uncertainty

  • Financial markets are influenced by the uncertainty of factors like tariffs.
  • Market responds to understanding what's going to happen.
  • Fluctuating policies and negotiations create hesitancy to invest.

Retail Investors and Market Support

  • Retail investors are currently supporting the stock market.
  • Institutional investors are more cautious and leveraged.
  • Retail investors have long-term experience and look for buying opportunities.
  • Belief that markets eventually recover encourages buying during downturns.

Home Bias and Cost of Capital: Empirical Evidence

  • Home bias is plotted against the implied cost of capital.
  • More segmented financial markets have a greater cost of capital.
  • The intuition is that there is insufficient risk sharing with outsiders.

Cross-Border Listings

  • Stocks can be listed cross-border.
  • This expands the potential investment base, leading to higher stock prices.
  • Foreigners own 30% of US equities.
  • Benefits include:
    • Creating a secondary market enhances the liquidity of the stock.
    • More people will buy it when you are trying to sell.
    • Greater visibility in the marketplace.
    • May be used as acquisition currency for takeover of foreign companies.
    • Improved corporate governance and transparency through disclosure requirements.
  • Downsides include:
    • Disclosure requirements imposed by foreign exchanges and regulatory authorities.
    • Difficulty to continue private benefits when cross-listed on foreign exchanges.
    • Volatility spillover.

Depository Receipts

  • Listings exist where Microsoft has shares listed in Argentina.

  • Overseas markets trade US Companies even after the US market closes through depository receipts.

  • Foreign companies use depository receipts in the United States.

  • Shares are bought and placed in a bank (depository), which issues receipts that trade in the local market.

  • For example, Microsoft shares trade in Argentina, denominated in pesos.

  • Without depository receipt:

    • Chilean investor wanting to buy IBM shares would ordinarily:
      • Convert pesos to dollars.
      • Find a US broker.
      • Buy dollar-denominated stock.
      • Convert dollars back to pesos when selling.
      • Convert dividends paid in dollars into pesos, too.

  • With depository receipt:

    • American Depository Receipts (ADRs) trade on the Chilean exchange.
    • They can buy and sell them over their own exchange with the broker and they're peso denominated.
    • Whenever IBM pays a dividend, they will pay the dividend in dollars to the custodian, the agent, the bank that handles that for them.
    • The custodian then pays the shareholders
    • The receipts are held in a vault backing up these receipts.
    • It is possible to convert the receipts to actual stock.
    • They can turn those over and get the stock in them, but they sell the stock outside the country.

  • U.S. companies can have investors everywhere in the world.

  • They can list on the local exchange directly or through depository receipts.

  • Examples: Cemex (Mexican company) and Deutsche Bank have ADRs trading in US dollars.

  • This is more convenient than finding a broker and trading on the original exchange.

  • Once a company's stock is traded over these markets, it can be volatility spilled. We saw that once somebody stock is made available to foreigners, they can be acquired by a foreigner because they.

Anheuser Busch Acquisition

  • Example of Anheuser Busch being acquired by foreign companies.
  • Management initially resisted the takeover in 2007.
  • InBev offered an amount above that and immediately the management said.
  • Management presented a plan to raise the company's value to $54 by cost-cutting and product line reduction.
  • Shareholders questioned why management hadn't implemented the plan already.
  • Eventually, InBev acquired Anheuser Busch.

Foreign Firms Listed on Exchanges

  • Companies like Cemex and Grupo Televisa loosen on the New York Stock Exchange.
  • American Mobile is the big mobile phone company there used to.
  • Satellite is a pharmaceutical, French course, and Nokia.
  • Embraer is an aircraft manufacturer.
  • Petrobras is the Brazilian oil company.
  • Telefonica is a big communication company in Spain and Novartis is a pharmaceuticals.
  • Foreign firms also trade on the London Stock Exchange.
  • US companies such as Boeing and GE will trade in on the London exchange.

Stock Listings on Global Exchanges

  • Alphabet Inc. (Google) stock listings across different global exchanges.
  • Prices are shown in local currencies like Mexican pesos and Chilean pesos.
  • Investors can purchase depository receipts on local exchanges using their local currency

Depository Receipts (Detailed Example)

  • Mexican investor wants to invest in Google.
  • They can purchase depository receipts on the Bolsa Mexicana de Valores (Mexican Stock Exchange).
  • The price is stated in Mexican pesos, converted from the dollar price.
  • This process allows investors to invest in foreign companies using their local currency.
  • Shareholders get those.

Currency Denomination and Trading Locations

  • Different trading locations and currency denominations for Google stock.
  • Euros, U.S. dollars, Mexican pesos, and Chilean pesos.
  • Indicators: price in euro or dollar, and UN don't is trades on New York.

Depository Receipts: Bundling and Value

  • Depository receipts can include multiple shares.
  • Done when currencies have low value and share prices are low.
  • Example: CDEAR (Argentina) and Brazilian exchanges.

Global Google Investment

  • Find investors Chile, Argentina, Mexico, Canada, everywhere on those by doing the deposit card receipts on those changes more.

Arbitrage

  • Arbitrage prevents mispricing when arbitrage sells on one exchanges to buy on another.
  • FX arbitrage is a real practice that depends of the exchange.
  • If the exchange rate is not pricing through the exchange rate property. The one that is buying more is the arbitrage.

German Survey (1996)

  • One-third of German firms were interested in US listings.
  • They considered the adaptation of financial statements( the accountants to everything in US staff having audited to USDA app.) an obstacle.
  • Daimler the German firm listed in New York, employs GAAP as well as German accounting law and publishes 2 versions with different reported earnings.
  • They use the local international accounting standard for then, and they'll have different earnings.

Accounting Standards: Rule-Based vs. Flexible

  • Inventory treatment and reserves.
  • Positive earnings in German accounting rules, but negative under US GAAP in 1993 and 1994.
  • German accounting rules allowed for more aggressive earnings smoothing through inventory reserves.
  • Accounting is rule based but you can't take it if it isn't really an expense.

Foreign Equity Ownership Restrictions

  • Governments prevent residents from investing abroad and foreigners from investing and in their country.
  • In India, Mexico, and Thailand, foreigners can purchase no more than 49% of outstanding shares of local firms
  • A shares, which only Chinese can own, which eventually foreign owned the Asian.
  • They wanted Mr. control of local firms.
  • Those are strategically important to national interests.
  • For example in Mexico, foreigners can on paper wait.

Ownership Restrictions by Country

  • Mexico
    • Pulp and paper
  • Spain
    • Defense
    • Mass media
  • US
    • Foreign airlines

Market Segmentation and Dual Pricing

  • Due to ownership constraints on both of foreigners, they can purchase 20% of limiting desired foreign ownerships, foreign and domestic investors may face different market share prices.
  • Shares can exhibit a dual price to market phenomenon because there are more shares available for domestic sellers shares.

Determining Financial Structure: Subsidiary Management

  • Multinational companies make this decision (parent v. subsidiary).
  • A company can set whatever financial structure for their wholly owned subsidiary regardless of external norms or rules.
  • The parent company can have their own rules.
  • Some companies make the decision that if I've got a subsidiary that is not not generating the cash sufficient to support external debt, where banks wouldn't lend to them because of not enough cash flow, then we're going to fully capitalize because we're going to measure their performance based on the Cost of equity, which means it's a higher cost.

Internal vs. External Norms

  • Very judiciously to capitalize opportunities to lower taxes, reduce financing costs and risk and take advantage of various market imperfections.
  • They can also overcapitalize.

Restrictions

  • Government does not allow the intercompany loans because of the reduce tax liability to the government.

Tax System

  • A lot of internal.
  • Because our tax people tell US capital ID's debt, we have a rule to make a Mark's length.
  • We look at the local risk free rate, we go get the credit default swap to get a default risk premium and we might have to get a country to fall risk premium and then we put a charge.
  • Then we put it on a Bloomberg screen graph. So in the auditors the authorities come, they say, OK, this subsidiary, you've lent the money.
  • For Canadian transaction they may say, you get a dividend.

Parent Company Responsibility

  • It depends on whether or to what extent parent company is responsible for their financial obligations. If they're fully responsible independent financial structure of the subsidiary is irrelevant
  • If not, then subsidiary has to be making those decisions because they're the ones that are following the money.
  • The more open the market, the cheaper the equity.