Chapter Five (17)

International Capital Structure

and the Cost of Capital

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 Chapter Outline
• What is Capital Structure?
• Cost of Capital
• Cost of Capital in Segmented versus Integrated Markets
• Cross-Border Listings of Stocks
• The Effect of Foreign Equity Ownership Restrictions

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 What is Capital Structure?
• Capital Structure: The mix of Debt capital (bonds) & Equity capital
(stocks) the firm uses to finance assets.
• Equity capital and Debt capital are the sources of funds firms use to
finance assets, specifically long-term assets.
• The level of Debt and equity capital may vary over time, but most firms
keep the financing mix close to the Optimal Capital Structure.
• Optimal Capital Structure can result to: Lower Cost of Capital and
Maximize the Firm’s Value (or maximise shareholder’s wealth)
• Most firms set a target (i.e. optimal) percentage for differences in
financing mix.
• For example: if a firm use 50% of Equity capital & 50% debt capital to
finance asset. This is its Optimal Capital Structure.
 What is Capital Structure?

Balance Sheet Equation

Asset = Liabilities + Equity

(Financial Structure)

Optimal Capital Structure

=
Proper mix of Equity Capital
& Debt Capital,
Minimize Firm’s Cost of
Capital,
Maximize Firm’s Value
Exhibit 17.1 Median Debt Ratios of Firms across
Countries

5
 Cost of Capital
Learning Outcome:
• To understand what is cost of capital and Weighted Average
Cost of Capital (WACC)
• To calculate Cost of Debt Capital, Cost of Equity Capital and
WACC
• To understand the advantage of international cost of capital

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 Cost of Capital
• Most firms employ Equity capital & Debt capital as sources of
funds to finance their assets (projects).
• To acquire the funds, the Equity capital (stocks) and Debt
capital (bonds) will be sold to investors in Capital market.
• Hence, the investors who provided the funds expect to receive a
return on their investment.
• Hence, the cost of capital is the minimum rate of return an asset
(project) must generate in order to pay its financing costs.
• A value-maximizing firm try to lower its Cost of Capital. Thus,
Lower Cost of Capital = Higher Firm’s Value

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 Cost of Capital
• A firm that has both Debt capital and Equity capital in its capital
structure, its financing cost (i.e. Cost of Capital) is represented by the
weighted average cost of capital (WACC).
WACC equation:
1 2 Simplified WACC equation:

where, K is weighted average cost

of capital; λ is debt to total market
value ratio; Kl is cost of equity
capital for a levered firm; t is
marginal corporate income tax
rate; and i is pretax cost of debt
Cost of Equity Capital equation:
3 After-tax Cost of Debt Capital 4
equation: ke = krf + B (km – krf)
*k or R
kd after-tax = kd (1 – T) where, krf is return of risk-free asset; B
is beta; and km is equity market return
where, kd is cost of debt before tax;
and T is tax rate Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 17-8
Cost of Capital
 Cost of Capital
• MNCs can reduce the cost of capital A value-maximizing firm
by internationalizing the cost of would undertake an
capital. investment project as long

cost of capital (%)

• Internationalizing cost of capital can as the IRR exceeds the
be done by issuing Debt Capital cost of capital.
(bonds) and Equity Capital (stocks) in
international capital market. K local
• It is cheap to issue Debt capital or
Equity capital in international capital
market.
• A firm that can reduce its cost of K global
capital will increase the profitable
capital expenditures that the firm can IRR
take on and increase the Firm’s value
(wealth of the shareholders).
• Thus, Internationalizing the firm’s cost
of capital is one such policy. Investment ($)
Ilocal Iglobal
Cost of Capital in Segmented v s Integrated
ersu

Markets
• Main difficulty in computing the financing cost (K) of
a firm is related to the cost of equity capital
• Cost of equity capital is the expected return on the
firm’s stock that investors require.
• Frequently estimated using the Capital Asset Pricing
Model (CAPM).
Cost of Capital in Segmented v s Integrated
ersu

Markets
Where,

is the risk-free interest rate.

is the expected return on the market portfolio, the

market-value-weighted portfolio of all assets.

Beta, is a measure of systematic risk inherent in security i,

where systematic risk is the nondiversifiable market risk of an
asset.
Cost of Capital in Segmented versus Integrated Markets

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 Cost of Capital in Segmented versus Integrated Markets
(Continued)
To illustrate Cost of Equity Capital in Segmented Market vs.
Integrated Market (refer textbook)
Cost of Equity Capital (Segmented Cost of Equity Capital (Integrated
Market) Market)
Suppose the domestic U.S. beta of IBM Suppose the domestic world beta of
is 1.0. The expected return on U.S. IBM is 0.8. The expected return on
market portfolio is 12 percent, and the world market portfolio is 12 percent, and
return on the risk-free asset is 6 the return on the risk-free asset is 6
percent. If U.S. capital market is percent. If U.S. capital market is
segmented from the rest of the world. integrated from the rest of the world.
The expected return (Ke) on IBM is: The expected return (Ke) on IBM is:

Relatively low world beta of 0.8, investors would require a lower

return on IBM stock under Integration market than Segmented
market Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved. 17-14
 Cross-Border Listings of Stocks
Benefits from cross-border listings:
• The company can expand its
potential investor base.
• Facilitates raising new capital in
foreign markets.
• Cross-border listings can enhance
the liquidity of the company’s
stock.
• Cross-border listings enhances the
visibility of the company’s name
and its products in foreign
marketplaces.
• Cross listed shares may be used as
the“acquisition currency”for taking
over foreign companies.
• Cross-listing may improve the
company’s corporate governance
and transparency.
Costs from cross-border listings:
• It can be costly to meet the
disclosure and listing
requirements imposed by the
foreign exchange.
• Controlling insiders may find it
difficult to continue to derive private
benefits once the company is
cross-listed on foreign exchanges.
• Company’s stocks are exposed to
the volatility spillover from foreign
markets.
• Foreigners might acquire a
controlling interest in the
company.
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Foreign Firms Listed on the NYSE (selected)

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Foreign Firms Listed on the LSE (selected)

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 The Effect of Foreign Equity Ownership Restrictions

• While companies have incentives to internationalize, they may be

concerned with the possible loss of corporate control to foreigners
– Governments in both developed and developing countries sometimes impose
restrictions on the maximum percentage ownership of local firms by
foreigners
• In countries like India, Mexico, and Thailand, foreigners can purchase no more
than 49% of outstanding shares of local firms
– These restrictions are imposed as a means of ensuring domestic control of
local firms, especially those that are considered strategically important to
national interests

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Restrictions on Equity Ownership by Foreigners: Historical
Examples

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 Exercise Questions
• Suppose that your firm is operating in a segmented capital market. What
actions would you recommend to mitigate the negative effects?
• Explain why and how a firm’s cost of capital may decrease when the firm’s
stock is cross-listed on foreign stock exchanges.
 Exercise Questions
Answer problems 1-3 based on the stock market data given by the following table.

Correlation Coefficients
Telmex Mexico World SD(%) (%)
m
Telmex 1.00 .90 0.60 18 ?
Mexico 1.00 0.75 15 14
World 1.00 10 12

The above table provides the correlations among Telmex, a telephone/communication company located in Mexico,
the Mexico stock market index, and the world market index, together with the standard deviations (SD) of returns
and the expected returns ( ). The risk-free rate is 5%.

1. Compute the domestic country beta of Telmex as well as its world beta. What do these betas measure?
2. Suppose the Mexican stock market is segmented from the rest of the world. Using the CAPM paradigm,
estimate the equity cost of capital of Telmex.
3. Suppose now that Telmex has made its shares tradable internationally via cross-listing on NYSE. Again using
the CAPM paradigm, estimate Telmex’s equity cost of capital. Discuss the possible effects of international pricing
of Telmex shares on the share prices and the firm’s investment decisions.
Exercise Questions