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Summary of the Online Additional Readings of "International Financial Management"
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Summary of the Online Additional Readings of the book "International Financial Management"
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OAR 1: Multinational Costs of Capital and Capital StructureBackground on Costs of Capital
Apart from working capital, a firm’s capital consists of equity and debt.
Profitable investment is where the firm invests in projects that achieve returns greater than that required by
their risk.
NPV calculations are based on the cash flows that the firm hopes to achieve in the future. It is ex ante or before
the event and is calculated as follows:
𝐸(𝐶𝐹 ) 𝐸(𝐶𝐹 ) 𝐸(𝐶𝐹 ) 𝐸(𝐶𝐹 ) 𝐸(𝐶𝐹 ) 𝐸(𝐶𝐹 )
𝑁𝑃𝑉 = −𝐼0 + (1+𝑟)11 + (1+𝑟)22 + (1+𝑟)33 + (1+𝑟)44 + (1+𝑟)55 + ⋯ + (1+𝑟)𝑛𝑛
The firm can be valued as one would value any project. The combined cash flows from each activity or sub-
project should be discounted with an interest rate that includes a premium for the risks of each sub-project.
The overall discount rate to be applied would be the firm’s weighted average cost of capital.
The traditional and more accessible way of valuing the firms is to measure return as dividends and share price
growth and to calculate the weighted average cost of capital by taking a weighted average of the returns
demanded by all the lenders of the firm.
A firm’s weighted average cost of capital can be measured as:
𝐷 𝐸
𝑘𝑐 = ( ) 𝑘𝑑 (1 − 𝑡) + ( ) 𝑘𝑒
𝐷+𝐸 𝐷+𝐸
The ratios reflect the percentage of capital represented by debt and equity, respectively.
Initially, using cheaper fixed interest debt (D) to finance company projects may seem attractive. The drawback
is that the greater the percentage of overall finance in the form of fixed interest debt, the more variable the
prospective returns to shareholders.
Two general exceptions:
• At a very high level of debt there would be a risk of bankruptcy due to non-payment of the interest
charges. So, one would therefore expect to see an increase in the cost of capital at high levels of debt.
• Tax: debt is tax deductible for companies but not for individuals. Moderate levels of debt enable the
company to obtain savings otherwise not accessible to shareholders as individuals.
The firm’s cost of capital initially decreases as the ratio of debt to total capital increases. However, after some
point, the cost of capital rises as the ratio of debt to total capital increases.
→ This suggests that the firm should increase its use of debt financing until the point at which the
bankruptcy probability becomes large enough to offset the tax advantage of using debt.
Cost of Capital for MNCs
Characteristics that differentiate MNCs from domestic firms:
• Size of firm: an MNC that often borrows substantial amounts may receive preferential treatment from
creditors, thereby reducing its cost of capital.
• International diversification: an MNC has a greater opportunity to exploit profitable investment.
• Exposure to exchange rate change: all investments denominated in a foreign currency are unavoidably
exposed to changes in the value of that currency → PPP.
• Access to international capital markets: MNCs are normally able to obtain funds through the
international capital market at a lower cost than that paid by domestic firms.
• Exposure to country risk: an MNC that establishes foreign subsidiaries is subject to the possibility that
a host country government may seize a subsidiary’s assets.
, The International Capital Asset Pricing Model (ICAPM)
The CAPM
The discount (interest) rate that should be applied to the future cash flows of a particular project must reflect
all required returns that cannot be diversified away by holding a portfolio of projects.
• Time preference: on behalf of their shareholders, MNCs need to earn a return in terms of today’s
money to reward investors even if the project is perfectly safe.
• Inflation: investors want savings to keep pace at least with inflation, so they can buy at least the same
goods as could be purchased now.
• That element of project risk that is related to the risk of the market as a whole.
CAPM defines the required return on a project or a share as:
𝑘𝑗 = 𝑅𝑓 + 𝛽𝑗 (𝑅𝑚 − 𝑅𝑓 )
The CAPM suggests that the required return on a firm’s stock is a positive function of:
1. The risk-free rate of interest,
2. The market rate of return, and
3. The stock’s beta → represents the sensitivity of the stock’s returns to market returns.
The overall risk of a project, defined as the variance of returns can therefore be broken down into two elements:
1. Unsystematic variability in cash flows unique to the firm, and
2. Systematic risk.
The ICAPM
The ICAMP extends he analysis of the CAPM to a multimarket, multicurrency scenario.
The risk-free element in the ICAPM is the risk-free rate in the currency in which the overall returns are being
measured. The market return and the sensitivity of the investments to markets returns will remain as an
element in the ICAPM.
→ Additionally, projects will have exposure to non-diversifiable currency risks.
CAPM and ICAPM application issues
• The company has to find a like project of a similar risk class to identify an appropriate beta.
• The problem of meaning: why a beta is particularly high or low or why it changes is not easy to explain.
• The model is not complete.
Implications of the ICAPM and CAPM for an MNC’s risk
Capital asset pricing theory suggests that the cost of capital should be generally lower for MNCs than for
domestic firms. MNCs have a greater opportunity to diversify across different financial markets. The systematic
or non-diversifiable element of their investment should be lower.
→ However, investing abroad is risky, more risky than domestic investment.
Costs of capital across countries
An understanding as to why the cost of capital can vary among countries is relevant for three reasons:
1. It can explain why MNCs based in some countries may have a competitive advantage over others.
2. MNCs may be able to adjust their international operations and sources of funds to capitalize on
differences in the cost of capital among countries.
3. Differences in the costs of each capital component can help explain why MNCs based in some
countries tend to use a more debt-intensive capital structure than MNCs based elsewhere.
Country differences in the cost of debt
The cost of debt for firms is higher in some countries than in others because the corresponding risk-free rate is
higher at a specific point in time or because the risk premium is higher.
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