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INTERNATIONAL
FINANCIAL
MANAGEMENT
EUN / RESNICK
Fifth Edition
Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
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Fifth Edition
Chapter Objective:This chapter discusses the cost of capital for the
multinational firm.
17Chapter SeventeenInternational Capital
Structure and the Costof Capital
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Cost of Capital
Cost of Capital in Segmented vs. Integrated Markets
Does the Cost of Capital Differ Among Countries?
Cross-Border Listings of Stocks
Capital Asset Pricing Under Cross-Listings
The Effect of Foreign Equity Ownership Restrictions
The Financial Structure of Subsidiaries.
Chapter Outline
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Weighted Average Cost of Capital
Where
K= weighted average cost of capital
Kl = cost of equity capital for a levered firm
i = pretax cost of debt
= debt to total market value ratio
t= marginal corporate income tax rate
K= (1)Kl + (1t)i
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The Firms Investment Decision and
the Cost of Capital
A firm that can reduce its
cost of capital will
increase the profitable
capital expenditures thatthe firm can take on and
increase the wealth of the
shareholders.
Internationalizing thefirms cost of capital is
one such policy.Investment ($)
Kglobal
Klocal
Ilocal Iglobal
IRR
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Cost of Capital in Segmented vs.Integrated Markets
The cost of equity capital (Ke) of a firm is the
expected return on the firms stock that investors
require.
This return is frequently estimated using the
Capital Asset Pricing Model (CAPM):
where bi=Cov(Ri ,RM)
Var(RM)
Ri =Rf+ bi(RMRf)
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Cost of Capital in Segmented vs.Integrated Markets
If capital markets are segmented, then investors can only
invest domestically. This means that the market portfolio
(M) in the CAPM formula would be the domestic portfolio
instead of the world portfolio.
versus
Clearly integration or segmentation of international financial
markets has major implications for determining the cost of
capital.
Ri =Rf+ bi (RU.S.Rf)U.S.
Ri =Rf+ bi (RWRf)
W
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Cross-Border Listings of Stocks
Cross-border listings of stocks do carry costs.
1. It can be costly to meet the disclosure and listing
requirements imposed by the foreign exchange and
regulatory authorities.2. Once a companys stock is traded in overseas
markets, there can be volatility spillover from these
markets.
3. Once a companys stock is make available toforeigners, they might acquire a controlling interest
and challenge the domestic control of the company.
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Cross-Border Listings of Stocks
On average, cross-border listings of stocks appears
to be a profitable decision.
The benefits outweigh the costs.
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Foreign Firms Listed on the NYSE (Selected)Japan Canon, Honda Motor, Japan Air Lines, Kubota,
Mizuho Financial, NTT Docomo, Sony, Toyota MotorKorea Korea Electric Power, Korea Telecom, Pohang Iron &
Steel, SK Telecom
Mexico Cemex, Empresas ICA, Grupo Televisa, Telefonos de
Mexico, Vitro
Netherlands Aegon, Arcelor Mittal, Royal Dutch Shell, Unilever,
ABN Amro Holdings, ING
Russia Mechel OAO, Rostelecom, Vimpel-Communications
South Africa ASA, Gold Fields, SasolSpain Banco Santander, BBVA, Repsol, Telefonica
United
Kingdom
Barclays, BP, Beazer, Cadbury Schweppes,
GlaxoSmithKlein, HSBC, Lloyds, Prudential, Royal Bank
of Scotland Vodafone17-15
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Capital Asset PricingUnder Cross-Listings
Recall the definition of beta:
We can recalibrate the CAPM formula
As:
bi=Cov(Ri ,RM)
Var(RM)
Ri =Rf+ bi(RMRf)
Ri =Rf+ (RMRf) Cov(Ri ,RM)
Var(RM)
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Capital Asset PricingUnder Cross-Listings
We can develop a measure of aggregate risk aversion,AM
We can restate the CAPM usingAM
Ri =Rf+ (RMRf) Cov(Ri ,RM)
Var(RM)
AMM =(RMRf)
Var(RM
)
Ri =Rf+AMMCov(Ri ,RM)
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C i l A P i i
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Capital Asset PricingUnder Cross-Listings
This equation indicates that, given investors aggregate risk-
aversion measure, the expected rate of return on an asset
increases as the assets covariance with the market
portfolio increases.
In fully integrated capital markets, each asset will be priced
according to the worldsystematic risk.
Ri =Rf+AMMCov(Ri ,RM)
Ri =Rf+AWWCov(Ri ,RW)
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C it l A t P i i
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Capital Asset PricingUnder Cross-Listings
The International Asset Pricing Model (IAPM) above has anumber of implications.
International listing of assets in otherwise segmented marketsdirectly integrates international capital markets by makingthese assets tradable.
Firms with nontradable assets essentially get a free ride from
firms with tradable assets in the sense that the formerindirectly benefit from international integration in terms ofa lower cost of capital.
Ri =Rf+AWWCov(Ri ,RW)
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Th Eff t f F i E it
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The Effect of Foreign EquityOwnership Restrictions
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 ofcorporate 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.
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Pricing-to-Market Phenomenon
Suppose foreigners, if allowed, would like to buy30 percent of a Korean firm.
But they are constrained by ownership constraints
imposed on foreigners to purchase at most 20percent.
Because this constraint is effective in limitingdesired foreign ownership, foreign and domestic
investors many face different market share prices. This dual pricing is the pricing-to-market
phenomenon.
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Asset Pricing under Foreign Ownership
Restrictions
An interesting outcome is that the firms cost of
capital depends on which investors, domestic or
foreign, supply capital.
The implication is that a firm can reduce its costof capital by internationalizing its ownership
structure.
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A E l f F i O hi
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An Example of Foreign Ownership
Restrictions: Nestl
Following this, the price spread between the two types of
shares narrowed dramatically.
This implies that there was a major transfer of wealth from
foreign shareholders to Swiss shareholders.
The price of bearer shares declined about 25 percent.
The price of registered shares rose by about 35 percent.
Because registered shares represented about two-thirds of
the market capitalization, the total value of Nestlincreased substantially when it internationalized its
ownership structure.
Nestls cost of capital therefore declined.
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An Example of Foreign Ownership
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An Example of Foreign OwnershipRestrictions: Nestl
Foreigners holding Nestl bearer shares were
exposed to political risk in a country that is
widely viewed as a haven from such risk.
The Nestl episode illustrates
The importance of considering market imperfections.
The peril of political risk.
The benefits to the firm of internationalizing itsownership structure.
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The Financial Structure
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The Financial Structureof Subsidiaries.
In addition to taxes, political risk should be
given due consideration in the choice of a
subsidiarys financial structure.
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