TheFirm'sInvestmentDecisionand the Cost of CapitalA firm that can reduce(%) d its cost of capital willincrease the profitablecapital expendituresocalthat the firm can takeon andincrease theglobalwealth of theshareholdersIRRInternationalizing thefirm's cost of capital isInvestmIglobalIyocalone such policy
The Firm’s Investment Decision and the Cost of Capital ❖A firm that can reduce its cost of capital will increase the profitable capital expenditures that the firm can take on and increase the wealth of the shareholders. ❖Internationalizing the firm’s cost of capital is one such policy. Investment ($) K global K local Ilocal Iglobal IRR
Cost ofCapitalinSegmentedvs. Integrated MarketsThe cost of equity capital (K.) of a firm is theexpected return on the firm's stock thatinvestors requireThis return is frequently estimated using theCapital Asset Pricing Model (CAPM):R,= R,+ β(RM- R)Cov(R,R)whereVar(RM
Cost of Capital in Segmented vs. Integrated Markets ❖The cost of equity capital (Ke ) of a firm is the expected return on the firm’s 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 (RM – Rf )
Cost ofCapitalinSegmentedvs. IntegratedMarketsIf capital markets are segmented, then investors canonly invest domestically. This means that the marketportfolio (M) in the CAPM formula would be thedomestic portfolio instead of the world portfolioR,= R,+ β,S(Ru.s. - R)versusR,= R,+ β (Rw- R)Clearly integration or segmentation of international financialmarkets has major implications for determining the cost of capital
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 (RW – Rf ) W
Does theCostofCapitalDiffer among Countries?There do appear to be differences in thecost of capital in different countries.When markets are imperfect, internationalfinancing can lower the firm's cost ofcapital.One way to achieve this is tointernationalize the firm's ownershipstructure
Does the Cost of Capital Differ among Countries? ❖There do appear to be differences in the cost of capital in different countries. ❖When markets are imperfect, international financing can lower the firm’s cost of capital. ❖One way to achieve this is to internationalize the firm’s ownership structure
RealAfter-TaxCostofFunds8U.S.642UK0-279777880 8182838485868788899092Source:RobertMcCauleyandStevenZimmer,"ExchangeRatesandInternational Differences inthein Y.Amihud and R.Levich, Exchange Rates and CorporatePerformance(Burr Ridge,Il: Irwin 1994
Real After-Tax Cost of Funds Source: Robert McCauley and Steven Zimmer, “Exchange Rates and International Differences in the Cost of Capital” in Y. Amihud and R. Levich, Exchange Rates and Corporate Performance (Burr Ridge, Ill; Irwin 1994). 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 8 6 4 2 0 -2 UK U.S