FIN 350 –

INTERNATIONAL
FINANCE
NISHANT DASS
LECTURE 7:
COST OF CAPITAL;
CAPITAL BUDGETING
 3 FIN 350, Lecture 7

COST OF CAPITAL

Prof. Dass, CMC

 4 FIN 350, Lecture 7

Cost of Capital
› Firms earn a rate of return on their projects

› This project would enhance the firm’s value only if

the rate of return is higher than the cost of capital

› Hence, firms always try to lower their costs of

capital

Prof. Dass, CMC

 5 FIN 350, Lecture 7

Cost of Capital …contd.

› Raising capital internationally is one way of
lowering the overall cost of capital

› Which is why we see firms becoming

“multinational” not only in their business but also
in their financing

Prof. Dass, CMC

 6 FIN 350, Lecture 7

What do we mean by “Cost of

Capital”?
› The cost of capital for a firm with debt and equity
(= levered) is given by the Weighted Average Cost
of Capital

› WACC = (E/V)rE + (D/V)rD(1 – τ)

Prof. Dass, CMC

 7 FIN 350, Lecture 7

Cost of Equity
› The main difficulty in determining the WACC is to
correctly determine the cost of equity

› And, we typically use the CAPM to find the rE

› So, a lot of our discussion would be around equity

markets and, as such, we will often use the CAPM
to discuss “cost of capital”
Prof. Dass, CMC
 8 FIN 350, Lecture 7

In the same vein …

› By “integration of capital markets,” we often mean
integration of equity (stock) markets

› By the way, one way stock markets become

integrated with each other is when firms cross-list
their stock across different stock markets

Prof. Dass, CMC

 9 FIN 350, Lecture 7

International Cost of Capital –

in integrated markets

Prof. Dass, CMC

 10 FIN 350, Lecture 7

CAPM in integrated markets

› In integrated markets, the “market portfolio” for
all countries is the “world portfolio” for all
markets, i.e.,

E(Ri ) - Rf = bW [E(RW ) - Rf ]

Prof. Dass, CMC

 11 FIN 350, Lecture 7

How does market integration help?

› It helps investors diversify their risks

› E.g., an internationally diversified portfolio has a

standard deviation that is significantly smaller than
that of a domestic US portfolio – in fact, nearly
half the risk of a US portfolio

› See Fig. 15.3 (pg. 367, 8th ed.) – shown on next slide

Prof. Dass, CMC

 12 FIN 350, Lecture 7

Eun & Resnick, 8th ed., pg. 367

Prof. Dass, CMC

 13 FIN 350, Lecture 7

How does diversification help?

› Because of better diversification, the market
premium is lower

› I.e., due to diversification, [E(RW) – Rf] in the

world-CAPM is lower than the corresponding
domestic premium

Prof. Dass, CMC

 14 FIN 350, Lecture 7

How else does market integration

help?
› Better diversification lowers the market premium,
which ultimately lowers the firms’ cost of capital

› This “benefit” to firms is confirmed by the

evidence on firms that cross-list
› E.g., foreign firms cross-listed in the US are valued
17% higher than compatriot firms that are not listed

Prof. Dass, CMC

 15 FIN 350, Lecture 7

Why does Cross-listing lower Cost

of Equity?
› Cross-listing helps because of:

› Enhanced demand for shares – price goes up

› Greater liquidity – lower “premium” for illiquidity

› Improved governance

› And, more informational transparency

Prof. Dass, CMC
 16 FIN 350, Lecture 7

Then why don’t all firms cross-list?

› Obviously, there must be costs/disadvantages of
cross-listing, e.g.:
› Disclosure and listing requirements are tedious/costly

› Volatility spillovers from these foreign markets

› Foreigners might acquire a controlling stake

Prof. Dass, CMC

 17 FIN 350, Lecture 7

International Cost of Capital –

in partially-integrated markets

Prof. Dass, CMC

 18 FIN 350, Lecture 7

Integrated Financial Markets

› If all markets were completely integrated, the cost
of capital would be the same across countries

› And firms wouldn’t have to raise capital abroad

› No need to cross-list shares
› No need to issue bonds abroad

Prof. Dass, CMC

 19 FIN 350, Lecture 7

But, markets are only partially

integrated, which means…
› Firms can benefit from:

› Cross-listing their equity

› Issuing Euro-currency bonds instead of domestic

bonds

… and lower their cost of capital

Prof. Dass, CMC
 20 FIN 350, Lecture 7

CAPM in partially-integrated
markets
› Here’s a hybrid CAPM acknowledging that
markets are only partially integrated:

E [Ri ,t ] = rf ,t + lt b i , w (E [Rw,t ] - rf ,t ) + (1 - lt )b i ,l (E [Rl ,t ] - rf ,t )

› where lambda is the degree of integration

(subscript t – can change over time)

Prof. Dass, CMC

 21 FIN 350, Lecture 7

Why are markets only partially

integrated?
› Recall, firms choose not to cross-list their shares
because:
› Disclosure and listing requirements are
tedious/costly

› Volatility spillovers from these foreign markets

› Foreigners might acquire a controlling stake

Prof. Dass, CMC

 22 FIN 350, Lecture 7

There’s another reason

› Governments with protectionist policies often
impose limits on foreign ownership of their
country’s firms

Prof. Dass, CMC

 23 FIN 350, Lecture 7

Restrictions on Foreigners
› Country Restrictions
› Australia 10% in banks, 20% in broadcasting, 50% in mining
› Canada 20% in broadcasting, 25% in banks
› China Only B-shares are accessible; domestic investors get A-shares
› France 20%
› India 49%
› Japan 25–50%; any acquisition of >10% stake must be approved
› Korea 20%
› Spain 0% in defense and media
› Sweden 20% of voting rights and 40% of capital
› Switzerland Only certain class of shares are accessible
› UK Government has veto power on any acquisition by foreigners
Prof. Dass, CMC
 24 FIN 350, Lecture 7

International Cost of Capital –

in segmented markets

Prof. Dass, CMC

 25 FIN 350, Lecture 7

CAPM in segmented markets

› In segmented markets, the “market portfolio” in CAPM is
different for different countries

› Therefore, in segmented markets, the definition of

“systematic” risk changes from market to market

Prof. Dass, CMC

 26 FIN 350, Lecture 7

CAPM in segmented markets

› This means that two companies in different
countries but with identical cash flows will be
valued differently by investors in segmented
markets

› Would you expect the cost of equity to be higher in

integrated markets or segmented markets?
› We already saw – integration lowers cost of capital

Prof. Dass, CMC

 27 FIN 350, Lecture 7

If world markets are segmented,

does CAPM work in all markets?
› CAPM is based on fundamental economic theory,
and should work well in all well-developed stock
markets

› However, using CAPM in completely-segregated

and under-developed markets is tricky

› We could use alternative models to get a ballpark

figure … presented next
Prof. Dass, CMC
 28 FIN 350, Lecture 7

Alternative Ways to calculate the

Cost of Equity in segmented markets
› Sovereign Spread Model (aka “Goldman” model)
› Prevalent among banks and consulting firms

E(Ri ) - Rf = bM [E(RM ) - Rf ] + CRP

CRP = (Sovereign Risk Premium ) - (Credit Risk Premium )

SovRP = (Yield on Sovereign Bonds ) - (Yield on US Treasury Bonds )

æ Yield on US Corporate Bonds that have the same ö

CreditRP = çç ÷÷

Prof. Dass, CMC

è maturity/ratings as Sovereign Bonds ø
- (Yield on US Treasury Bonds )
 29 FIN 350, Lecture 7

Before we start applying Sovereign

Spread Model widely …
› What are the underlying assumptions?

› And what are the problems with this Sovereign

Spread Model?

Prof. Dass, CMC

 30 FIN 350, Lecture 7

Problems with this Sovereign Spread

Model
› Bond spread used for cost of equity

› CRP is same for all companies

› Only possible for those countries that have US$-

denominated Sovereign bonds

› No economic rationale for this ad hoc model!

Prof. Dass, CMC
 31 FIN 350, Lecture 7

Fixing problem #1 with the

Sovereign Spread Model

sequity
E(Ri ) - Rf = biM [E(RM ) - Rf ] + CRP
sdebt
Proposed by Damodaran

Prof. Dass, CMC

 32 FIN 350, Lecture 7

Fixing problem #3 with the

Sovereign Spread Model
› Even if the country doesn’t have bonds, we can
impute a CRP using the country’s credit ratings
and finding other countries that have same ratings
and have a CRP available

Prof. Dass, CMC

 33 FIN 350, Lecture 7

Which risks are we accounting for

with the Country Risk Premium?
› Nationalization
› Contract repudiation
› Taxes and new regulation
› Foreign Exchange controls
› Corruption and bureaucratic inefficiency
› Political unrest/violence

Prof. Dass, CMC

 34 FIN 350, Lecture 7

What happens when a segmented

market integrates with the world?
› Integration means capital starts to flow in/out the
country Anusha Chari and Peter
Blair Henry, JF 2004

› As capital flows in, eventually real interest rates fall

› As a result, expected returns would also fall

› All of which, lowers the cost of capital

Prof. Dass, CMC
 35 FIN 350, Lecture 7

Hurdle rate for a subsidiary

Prof. Dass, CMC

 36 FIN 350, Lecture 7

Hurdle Rates (=WACC) for foreign

subsidiaries
› Start with the PV of a foreign project, as seen by a
US-based company

›PV$ = PVFX x S($/FX)

› (where FX is the foreign currency of the country

where the foreign subsidiary and the project are
based)
Prof. Dass, CMC
 37 FIN 350, Lecture 7

PV$ = PVFX x S($/FX)

› Using DCF, we can rewrite the above equation as:

𝐶𝐹$ 𝐶𝐹"#
= ×𝑆 $/𝐹𝑋
1 + 𝑊𝐴𝐶𝐶$ 1 + 𝑊𝐴𝐶𝐶"#

(assuming that this is a one-year project, with only

one cash flow CF at the end of that year, which can
be discounted as shown above)

Prof. Dass, CMC

 38 FIN 350, Lecture 7

But the CFFX can be hedged

› If we hedge the currency risk of a foreign cash
flow using a Forward contract, we can guarantee
ourselves a fixed cash flow in US$ terms:

› I.e., if CF$ = CFFX x F($/FX), then we can write

the “discounted cash flow” equation shown on the
previous slide

Prof. Dass, CMC

 39 FIN 350, Lecture 7

CF$ = CFFX x F($/FX)

𝐶𝐹$ 𝐶𝐹"#
= ×𝑆 $/𝐹𝑋
1 + 𝑊𝐴𝐶𝐶$ 1 + 𝑊𝐴𝐶𝐶"#

can be re-written as:

𝐶𝐹"# ×𝐹 $/𝐹𝑋 𝐶𝐹"#
= ×𝑆 $/𝐹𝑋
1 + 𝑊𝐴𝐶𝐶$ 1 + 𝑊𝐴𝐶𝐶"#

Let’s cancel CFFX term on both sides to re-write …

Prof. Dass, CMC
 40 FIN 350, Lecture 7

Cancelling the CFFX term

𝐶𝐹"# ×𝐹 $/𝐹𝑋 𝐶𝐹"#
= ×𝑆 $/𝐹𝑋
1 + 𝑊𝐴𝐶𝐶$ 1 + 𝑊𝐴𝐶𝐶"#

will become:

𝐹 $/𝐹𝑋 𝑆 $/𝐹𝑋
=
1 + 𝑊𝐴𝐶𝐶$ 1 + 𝑊𝐴𝐶𝐶"#

Prof. Dass, CMC

 41 FIN 350, Lecture 7

But we have seen F and S together in

IRP before, so …
𝐹 $/𝐹𝑋 𝑆 $/𝐹𝑋
=
1 + 𝑊𝐴𝐶𝐶$ 1 + 𝑊𝐴𝐶𝐶"#

can be re-written as:

𝐹 $/𝐹𝑋 1 + 𝑊𝐴𝐶𝐶$
=
𝑆 $/𝐹𝑋 1 + 𝑊𝐴𝐶𝐶"#

P 1 + 𝑟$
I R 1 + 𝑟"# Prof. Dass, CMC
 42 FIN 350, Lecture 7

Combining the two, we can write:

1 + 𝑟$ 1 + 𝑊𝐴𝐶𝐶$
=
1 + 𝑟"# 1 + 𝑊𝐴𝐶𝐶"#

… which is a mathematically beautiful equation!

Prof. Dass, CMC

 43 FIN 350, Lecture 7

In fact, it may be too beautiful to be

true!!
› It will work only to the extent that IRP works:
› If IRP holds well, then that relationship would hold
equally well
› If IRP doesn’t hold well between $ and FX, then
there’s little hope of that relationship to hold
between the parent company’s WACC and foreign
subsidiary’s WACC

Prof. Dass, CMC

 44 FIN 350, Lecture 7

Hurdle Rates for subsidiaries

› Another underlying assumption there is that the
capital structure of the parent is cloned at the
subsidiary undertaking that foreign project

› Depending on how managers choose the capital

structure of foreign subsidiaries, the subsidiary’s
WACC may be related to the parent’s WACC … or
not!

Prof. Dass, CMC

 45 FIN 350, Lecture 7

CAPITAL BUDGETING

Prof. Dass, CMC

 46 FIN 350, Lecture 7

Capital Budgeting
› This is the culmination of our course because
everything that we do in Corporate Finance is
ultimately about Capital Budgeting

› I.e., finding the “worth” of different projects, and

choosing the best one to invest in – in other words,
it’s about the most optimal capital allocation that
increases firm value

Prof. Dass, CMC

 47 FIN 350, Lecture 7

Earnings …
› … are not what we care about, when valuing a project
(that’s for Accountants to worry about)

› In Finance, we always care more about cash flows

Prof. Dass, CMC

 48 FIN 350, Lecture 7

How do we calculate FCFs?

› Start with after-tax Earnings [EBIT x (1 – τ)]
› Depreciation:
› Add it back because it is not a cash expense
› Capital Expenditure
› Is deducted from CFs when it is incurred instead of
being spread over time as “Depreciation”
› Change in NWC
› Deduct that because increasing working capital, etc.,
is a cash expense
Prof. Dass, CMC
 49 FIN 350, Lecture 7

FCFs
Free Cash Flows t =
(Revenues - Costs - Depreciation ) x (1 - t )
+ Depreciation
- Capital Expenditures
- (NWCt - NWCt -1 )
We can simplify the Depreciation terms …
Prof. Dass, CMC
 50 FIN 350, Lecture 7

This rearrangement of the equation

shows why Depreciation matters

Free Cash Flows =

(Revenues - Costs) x (1 - t ) + (Depreciation ´t )
- Capital Expenditures - (DNWC t )

Prof. Dass, CMC

 51 FIN 350, Lecture 7

Note – Incremental cash flows

› We should always care about incremental cash
flows, when valuing a project

› Not the gross cash flows generated by the project,

but also take into account the cash flows lost due
to this project

Prof. Dass, CMC

 52 FIN 350, Lecture 7

Incremental cash flows

› To identify what are “Incremental cash flows,”
consider the following comparison:
› “The Firm without this Project”
› vs.
› “The Firm with this Project”

Prof. Dass, CMC

 53 FIN 350, Lecture 7

Incremental CFs – an international

example
› Say an MNC has foreign sales affiliate that sells its
products that are manufactured in a third country
› Now the MNC decides to replace the foreign sales
affiliate with a full-fledged subsidiary that
produces the goods itself
› The valuation of this new subsidiary should
account for the sales lost as well as costs saved due
to the closing of the sales affiliate, and should only
use the incremental cash flows

Prof. Dass, CMC

 54 FIN 350, Lecture 7

Project valuation when capital

structure doesn’t change

å (1 + WACC ) + (1 + WACC )
FCFt TVT
NPV = t T
- C0
t =1

Prof. Dass, CMC

 55 FIN 350, Lecture 7

But when capital structure is

changing over time …
We calculate the APV – Adjusted
Present Value – instead of NPV

S
FCFt (Interest Paid )tt
t +S
(1 + runlev ) (1 + rD )t

TVT
+ T - C0
(1 + runlev )
Prof. Dass, CMC
 56 FIN 350, Lecture 7

How do you calculate runlev?

› You could use the βunlev in the CAPM, where βunlev:

E D(1 - t ) Sometimes
(1) -- bunlev = bE + bD
E + D(1 - t ) E + D(1 - t ) assumed to
be zero

› Or, directly calculate the runlev using:

D
rE = runlev + (runlev - rD )(1 - t )
E
› which is obtained by multiplying both sides of (1)
with M.P. and adding rf to both sides
Prof. Dass, CMC
 57 FIN 350, Lecture 7

What are we really doing in APV?

› First, the investment decision – value the firm as if
it were unlevered

› Then, the financing decision – separately adding

the benefits (or even subtracting the costs, if any)
due to leverage

› This is based on the “separation principle” –

investment and financing decisions are separate
issues
Prof. Dass, CMC
 58 FIN 350, Lecture 7

But what’s “International” about it?

› Nothing so far!

› So far, we have only evaluated a project from the

“local” or “domestic” perspective

› But once we know this, “internationalizing” it is easy

Prof. Dass, CMC

 59 FIN 350, Lecture 7

What does “internationalizing”

mean?
› It means that we should be able to value a project
undertaken by a domestic firm in a foreign country

› I.e., value a project for a US firm in US$ when the

project is based in another country/currency

› (Although we discuss the APV model, we could

also have started with the simpler NPV –
internationalizing NPV would work similarly)
Prof. Dass, CMC
 60 FIN 350, Lecture 7

The “international” version of APV

APV = S
[Oper.Profitt (1 - t )] x E(St )
(1 + r )
dom t
unlev

l
a lly
e g DA
+S
[(t Dept ) + (Interest Paid )tt ] x E(St )
(1 + r )
F = IT
B dom t
e rC dE
Op itte debt
re m
+
[TVT ] x E(ST )
- [C x S 0]
(1 + r )
dom T
unlev
0

+ (Value Created from RestFunds) x S 0

+ (ConsLoan )x S 0 -S
(LoanInstall)x E(St )
( dom t
1 + rdebt )
Prof. Dass, CMC
 61 FIN 350, Lecture 7

Comment on Depreciation
› Why is the tax-shield from Depreciation discounted
at rD?

› Because these cash flows are typically not as risky

as the operating cash flows of the firm (assuming
that tax laws are not likely to change suddenly and
radically)

Prof. Dass, CMC

 62 FIN 350, Lecture 7

Comment on Interest Tax Shield

› Should we use the actual debt level or the optimal
“debt capacity” to calculate this interest tax shield?
› Remember, investment and financing decisions are
two separate things
› So, irrespective of how a particular project is
financed, the interest tax shields should be based on
the optimal debt capacity
› (This will also tell us whether we are borrowing at a
sub-optimal level and not fully utilizing the tax shield)

Prof. Dass, CMC

 63 FIN 350, Lecture 7

Comment on Tax Rate, τ

› Usually, the tax codes are structured such that you
would get credit in your home country for taxes
paid in the host country

› As a result, τ should be simply equal to the higher

of the two tax rates

Prof. Dass, CMC

 64 FIN 350, Lecture 7

What are Restricted Funds?

› These are funds that were “tied up” in the foreign
country, and are now “freed” by the new project

› They are only available due to this project, and

would have remained inaccessible (due to, say,
controls on remittance by the foreign government)

› These are going toward paying for part of the cost

C0 for the project
Prof. Dass, CMC
 65 FIN 350, Lecture 7

How do we determine whether these

funds should be counted or not?
› Recall the mantra:

› if the “invest or not” decision does not affect the cash

flows,
› then the cash flows should not affect that decision
either!

› The idea behind “restricted funds” is that these funds

will become available if the project is taken – i.e., the
go/no-go decision “creates” these funds
Prof. Dass, CMC
 66 FIN 350, Lecture 7

What is a Concessionary Loan?

› It is a loan that might be offered by a foreign
government at attractive terms in order to
encourage investment

Prof. Dass, CMC

 67 FIN 350, Lecture 7

What are the Loan Installments

(or Loan Payments)?
› The installments that the parent company is paying
for the “concessionary loan”
› These installments are valued at loan-terms that
the company would have faced otherwise
› (The difference between the “Concessionary Loan”
term and the PV of these loan payments gives us the
$- value of the “subsidy” that the foreign
government is offering, and this subsidy should
rightfully be included in this project’s valuation)
Prof. Dass, CMC
 68 FIN 350, Lecture 7

Once again … the “international”

version of APV is:
APV = S
[Oper.Profitt (1 - t )] x E(St )
(1 + r )
dom t
unlev

+S
[(t Dept ) + (Interest Paid )tt ] x E(St )
(1 + r ) dom t
debt

+
[TVT ] x E(ST )
- [C x S 0]
(1 + r )
dom T
unlev
0

+ (Value Created from RestFunds ) x S 0

+ (ConsLoan )x S 0 - S
(LoanInstall )x E(St )
(
dom t
1 + rdebt )
Prof. Dass, CMC
 69 FIN 350, Lecture 7

Recall the concept of APV

› First, investment decision – value the firm as if it
were unlevered

› Then, financing decision – separately add any

benefits (either due to leverage or otherwise) and
subtract any costs

Prof. Dass, CMC

 70 FIN 350, Lecture 7

But our specific APV formula may

look different
› This simple concept of “separation” makes the
APV very general and easy to modify for our
specific project
› With concessionary loans and
› Restricted funds, etc.

› And recall, APV is applicable when the capital

structure of a firm changes over time – valuation
with WACC is invalid in that case!

Prof. Dass, CMC

 71 FIN 350, Lecture 7

Positive APV
› Is it possible that the project is positive-APV for
the subsidiary while negative-APV for the parent?
› Absolutely!
› Why? Because, for instance:
› Profits cannot be repatriated to the parent’s home
country
› A tax or levy is imposed on any funds repatriated!
› Or simply, the exchange rates are unfavorable,
making the profits look very small in terms of the
parent’s domestic currency
› Etc. Prof. Dass, CMC
 72 FIN 350, Lecture 7

The Centralia Corp. Case (Eun and

Resnick, p.484-5, 9th ed.)

Prof. Dass, CMC