International Financial Management

INTERNATIONAL CAPITAL STRUCTURE AND

THE COST OF CAPITAL
 Chapter Outline
Cost of Capital
Cost of Capital in Segmented versus Integrated Markets
Does the Cost of Capital Differ among Countries?
Cross-Border Listings of Stocks
Capital Asset Pricing under Cross-Listings
The Effect of Foreign Equity Ownership Restrictions
The Financial Structure of Subsidiaries

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 Cost of Capital
The cost of capital is the minimum rate of return an investment
project must generate in order to pay its financing costs
When a firm has both debt and equity in its capital structure, its
financing cost can be represented by the weighted average
cost of capital:

K = Weighted average cost of capital

Kl = Cost of equity capital for a levered firm
I = Before-tax cost of debt capital (that is, borrowing)
= Marginal corporate income tax rate
= Debt-to-total-market-value ratio
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EXHIBIT 17.1 Median Debt Ratios of Firms across Countries

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 The Firm’s Investment Decision and the Cost of
Capital
When all the investment
projects under
consideration are ranked
in descending order in
terms of the IRR, the
firm will face a
negatively sloped IRR
schedule

Optimal capital
expenditure will then be
determined at the point
where the IRR schedule
intersects the cost of
capital
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 Cost of Capital in Segmented versus Integrated
Markets 1

Main difficulty in computing the financing cost (K) of a firm

is related to the cost of equity capital (Ke)
• 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).

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 Cost of Capital in Segmented versus Integrated
Markets 2

Where
Rf is the risk-free interest rate

RM is the expected return on the market portfolio, the

market-value-weighted portfolio of all assets
Beta, βi, is a measure of systematic risk inherent in security
i, where systematic risk is the nondiversifiable market risk
of an asset
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 Does the Cost of Capital Differ among Countries?

Cost of capital is likely to vary across countries

Lau, Ng, and Zhang (2010) find the following:
• Cost of capital of a country is strongly related to the
home bias in portfolio holdings.
• When a country exhibits a high degree of home bias, as Peru
does, the global risk sharing is hampered, thereby increasing the
cost of capital for the country.
• Reduced home bias and greater global risk sharing
would help reduce the cost of capital.
• Accounting transparency also helps reduce the cost of
capital.
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EXHIBIT 17.4 Implied Cost of Capital versus Home Bias

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 Cross-Border Listings of Stocks 1
Cross-border listings of stocks have become quite popular among major
corporations
Benefits of cross-border listings:
1. Company can expand its potential investor base, which will lead to a
higher stock price and a lower cost of capital.
2. Creates a secondary market for the company’s shares, which
facilitates raising new capital in foreign markets.
3. Can enhance the liquidity of the company’s stock.
4. Enhances the visibility of the company’s name and its products in
foreign marketplaces.
5. Cross-listed shares may be used as the “acquisition currency” for
taking over foreign companies.
6. May improve the company’s corporate governance and
transparency.
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 Cross-Border Listings of Stocks 2

Costs of cross-border listings:

1. Disclosure and listing requirements imposed by the
foreign exchange and regulatory authorities.
2. Controlling insiders may find it difficult to continue to
derive private benefits once the company is cross-listed
on foreign exchanges.
3. Once a company’s stock is traded in overseas markets,
there can be volatility spillover from those markets.
4. Once a company’s stock is made available to foreigners,
they might acquire a controlling interest and challenge
the domestic control of the company.

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 EXHIBIT 17.8 Foreign Firms Listed on the N Y S E (selected)
Australia BHP Billiton James Hardie Industries, Westpac Banking
Brazil Banco Bradesco, Embraer, Petrobras, Telebras, Vale
Canada Barrick Gold, Canadian Pacific Railways, Domtar, IMAX, R BC, Thomson Reuters, Toronto
Dominion Bank
Chile Banco de Chile, LAN Airlines, Enersis Chile
China China Eastern Airlines, China Life Insurance, Huaneng Power, Petro China, China Mobile,
TAL Education
Finland Nokia Corp
France Constellium, Orange, Sanofi-Aventis, Sequans Communications, Total
Germany Deutsche Bank, Orion Engineered Carbons, SAP, Voxeljet
India ICICI Bank, Infosys, Tata Motors, Wipro
Israel Cellcom Israel, Israel Chemicals, Teva Pharmaceutical
Italy ENI, Ferrari, Natuzzi, Telecom Italia
Japan Line, Orix, Sony, Toyota Motors
Korea Korea Electric Power, Korea Telecom, Pohang Iron & Steel, S K Telecom, K B Financial
Mexico Cemex, Grupo Simec, Grupo Televisa, America Mobil
Netherlands Aegon, AerCap Holdings, Core Laboratories
Norway DHT Hldgs, SeaDrill, Statoil
South Africa Anglo Gold Ashanti, Gold Fields, Sasol
Spain Banco Santander, Telefonica
Switzerland ABB, Credit Suisse, Novartis, Union Bank of Switzerland
United Kingdom Barclays, British Petroleum, Diageo, GlaxoSmithKIine, H SBC, Lloyds, Prudential, Royal
Bank of Scotland, Royal Dutch Shell

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 EXHIBIT 17.9 Foreign Firms Listed on the L S E (selected)
Australia Base Resources, Ironridge Resources, Prairie Mining, South32
Canada Canadian General Investments, Entertainment One, Falcon Oil and Gas, Republic
Goldfields
China Air China, China Petroleum and Chemical, Datang Inti Power Generation, Zhejiang
Expressway
Egypt Commercial International Bank, Orascom Investment Holding, Telecom Egypt
France Compagnie De Saint-Gobain, Novacyt, Total
Germany BASF, Commerzbank, Tui
India Mahindra and Mahindra, Reliance Industries, State Bank of India, Steel Authority of
India, Tata Power
Ireland Abbey Pic, Bank of Ireland, Kingspan Group, Ryanair Holdings
Israel Amiad Water Systems, B.S.D. Crown, Taptica International
japan ANA, Mitsubishi Electric, Ricoh, Toyota Motors, Konami Holdings
Korea Hyundai Motor, L G Electronics, Samsung Electronics, S K Telecom
Netherlands European Asset Trust, Plaza Centers, Rhi Magnesita
Pakistan Lucky Cement, Oil and Gas Development, United Bank
Poland Bank Pekao, Work Service
Russia Gazprom, Lukoil, Sberbank, Severstal, Rosneft
South Africa Naspers, Stilfontein Gold Mining, Tongaat Hulett
Spain Banco Santander, International Consolidated Airlines, Telefonica
Taiwan Acer, Evergreen Marine, Hon Hai Precision Industry
Turkey Turkiye Garanti Bankasi, Turkiye Is Bankasi, Yapi Ve Kredi Bankasi
United States Boeing, General Electric, Honeywell, I BM, Marsh and McLennan, Unisys

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 Cross-Border Listings of Stocks 3

German survey by Glaum and Mandler (1996)

• One-third of the German sample firms are interested in
U.S. listings, but view the required adaptation of
financial statements to US-GAAP as a major obstacle.
• Daimler, a German firm listed on the NYSE, employs
US-GAAP as well as German accounting law and
publishes two versions of consolidated financial
statements with different reported earnings.
• Company’s net earnings were positive by German accounting
rules but negative by American rules in 1993 and 1994.

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EXHIBIT 17.10 Daimler’s Net Profit/Loss (D M bn): German
versus American Accounting Rules

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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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 EXHIBIT 17.11 Restrictions on Equity Ownership by
Foreigners: Historical Examples

Country Restrictions on Foreigners

Australia 10% in banks, 20% in broadcasting, and 50% in new mining ventures.
Canada 20% in broadcasting, and 25% in bank/insurance companies.
China Foreigners are restricted to B shares; locals are eligible for A shares.
France Limited to 20%.
India Limited to 49%.
Indonesia Limited to 49%.
Mexico Limited to 49%.
Maximum of 25 to 50% for several major firms; acquisition of over 10% of a single firm
Japan
subject to approval of the Ministry of Finance.
Korea Limited to 20%.
Malaysia 20% in banks and 30% in natural resources.
0% in pulp, paper, and mining, 10% in banks, 20% in industrial and oil shares, and 50%
Norway
in shipping companies.
Spain 0% in defense industries and mass media. Limited to 50% for other firms.
Sweden 20% of voting shares and 40% of total equity capital.
Switzerland Foreigners can be restricted to bearer shares.
U.K. Government retains the veto power over any foreign takeover of British firms.

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 Pricing-to-Market Phenomenon
Suppose foreigners would like to buy 30% of a Korean firm,
but because of ownership constraints imposed on
foreigners, they can purchase at most 20%
• Because this constraint is effective in limiting desired
foreign ownership, foreign and domestic investors may
face different market share prices.
• Shares can exhibit a dual pricing or pricing-to-market
(PTM) phenomenon due to legal restraints imposed on
foreigners.

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 The Financial Structure of Subsidiaries 1

One of the problems faced by financial managers of

multinational corporations is how to determine the financial
structure of foreign subsidiaries
Three approaches to determining the subsidiary’s financial
structure:
1. Conform to the parent company’s norm.
2. Conform to the local norm of the country where the
subsidiary operates.
3. Vary judiciously to capitalize on opportunities to lower
taxes, reduce financing costs and risks, and take
advantage of various market imperfections.
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 The Financial Structure of Subsidiaries 2

Which approach to take depends on whether and to what

extent the parent company is responsible for the
subsidiary’s financial obligations
• If fully responsible, independent financial structure of the
subsidiary is irrelevant.
• If parent is not fully responsible, subsidiary’s financial
structure becomes quite relevant.

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