Dr. P.V. Viswanath |
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Computing the Cost of Capital for Foreign Projects |
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Traditional Approach to the Cost of capital for domestic projects: The cost of capital or discount rate for a project can be reckoned as: According to the CAPM, the required rate of return on an asset is given
as: In principle, the CAPM applies to all assets, but in practice, it is used to estimate the cost of equity. It is rarely used to estimate the cost of debt because it is very difficult to estimate a beta for debt securities. In practice, the yield-to-maturity is used instead of the required rate of return, for debt securities. Where the bond is not traded, and hence no implied yield-to-maturity can be computed, firm-specific variables, such as interest-coverage ratios are used to generate synthetic bond ratings. Historical relationships between bond-ratings and bond spreads over Treasuries are then used to come to an estimate of the bond's yield-to-maturity. WACC: If the financial structure and risk of a project is the same as
that of the entire firm, then the appropriate discount rate or hurdle
rate for a project is the Weighted Average Cost of Capital (WACC): where If the risk of a project is different, then it should be evaluated using its own beta, and its own target debt-to-assets ratio, etc. Traditional Approach to computing WACC for foreign projects: There are several approaches that can be taken. If the project is a foreign project, and the firm's equity investors are essentially holding a US portfolio, then the beta should be computed for the new project with respect to the US equity index (market portfolio) and the required rate of return should be computed in the same way as above. If the "US" firm's investors are really holding a globally diversified portfolio, or if they are not restricted to the US (and hence, once again, they hold globally diversified portfolios), then it makes sense to compute an equity cost of capital for them by using the global CAPM, i.e. computing the beta for the new project using the global "market" portfolio (and a global risk premium). Cost Differential between domestic projects and foreign projects: Reworking this equation, we find that the WACC for the new project,
kI equals: where Note: The question of how much of the projects funding should be raised domestically and how much locally (i.e. abroad) itself requires to be determined in conjunction with relative costs of financing here and abroad -- this issue is not considered in this section. Approximations to the Traditional Approach: If we assume that the multinational in question is a US multinational
with investors who are globally diversified, then, in principle, the beta
of the foreign subsidiary should be estimated with respect to a global
market portfolio, and a global market risk premium should be used. Proxy Companies
The Relevant Base Portfolio
The Relevant Market Risk Premium Furthermore, a recent study (Koedijk, Kees G. and Mathijs A. van Dijk, “Global Risk Factors and the Cost of Capital,” FAJ, p. 32ff., v. 60, no. 2, March/April 2004) has shown that a cost of capital estimated using a domestic CAPM model is insignificantly different from a cost of capital computed using global risk factors. Summary of the Traditional Approach:
Systematic Risk of Foreign Projects: Foreign projects in non-synchronous economies (i.e. economies that are synchronized with world markets) should be less correlated with domestic markets. As a result of this, it can turn out that LDCs have greater political risk but offer higher probability of diversification benefits, even though this sounds paradoxical. Where there are barriers to international portfolio diversification, corporate international diversification can be beneficial to shareholders, contradicting the general Modigliani-Miller theorem that argues that capital structure is irrelevant because investors can diversify on their own. Hence this should be taken into account in the computation of cost of capital for projects, and will be reflected in such a project's low beta. However, Campbell Harvey argues that it is not enough to look at a country's or a foreign project's beta, because this only deals with contribution to volatility. Whereas skewness may be ignored if we're talking about developed countries, when talking about emerging markets, it is not correct to do so, because the impact of a project on the negative skewness of the equityholder's portfolio could be significant! (View Campbell Harvey's video exploring this issue.) For example, he says that India's beta could be negative, but it would not be appropriate to discount Indian projects at less than the US risk-free rate. As a result, there are ad-hoc methods for adjusting the cost of capital for foreign projects that often go beyond the CAPM in a conceptual or ad-hoc way. The traditional approach effectively ignores country risk premiums, assuming that country risk is diversifiable. However, this may not be the case. In fact, with globalization, cross-market correlations have increased, leading to less diversifiability for country risk. Furthermore, as argued above, vide Campbell Harvey, there may be skewness or catastrophic risk to take into account. Strictly speaking then, considering that investors do not like negative skewness (i.e. the likelihood of catastrophic negative returns), we should augment the CAPM with a skewness term. Each project should then have a co-skewness coefficient, i.e. the extent to which the (negative) skewness of the portfolio would be increased by including that project in the investor's (internationally diversified) portfolio. There would also be a market skewness premium, and the co-skewness coefficient for the project would be multiplied by the market skewness premium; the result would then be added to the CAPM required cost of capital to get a final cost of capital that takes the negative skewness risk of the project. (Campbell, June 2000 JF.) Campbell Harvey argues that this negative skewness risk could be quite large for projects in emerging markets. Often, though, instead of taking the (conceptually correct) approach described above -- viz. computing a skewness premium, various ad hoc adjustments are used. In general, we can use a larger country sovereign spread (explained below) to get a larger cost of capital, or we can use a larger beta-like risk measure.
What is interesting is that all these approaches seem to rely, in one way or the other, on country risk premiums, which have to do with bond risk. Even Campbell Harvey's approach using the empirical relationship between an S&P or other rating and the equity return for the market relies on bond ratings. The rationale underlying this is the comment made earlier (attributed to Campbell Harvey's observation), viz. that the market requires additional compensation for negative skewness risk. Bond returns are clearly asymmetrically related to asset returns because they do not share in upside risk. Hence, there must be a strong correlation between measures of bond risk and skewness risk. This explains why Campbell Harvey found stable relationships between local market returns and measures of bond risk. This also justifies, to some extent, the seeming ad hoc approaches of the investment banks that add the sovereign yield spread for the country to the required rate return of return for projects in a given country -- although the exact size of the adjustment, obviously, is incomplete. Additional ways of estimating and using Country Premiums: Country Premiums may be estimated by looking at the rating assigned to
a country’s sovereign debt. The country risk premium that is obtained can then be used in two ways:
Finally, one could estimate a country risk premium based on the riskiness
of the country relative to a maturity market like the US, and to incorporate
this into the cost of equity of the project. This could be done by taking
the US market risk premium and multiplying it by the ratio of the volatility
of stock returns in the foreign country to the volatility of stock returns
in the US. This would be the country-risk adjusted market risk premium. |
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