The Cost of Capital for International Firms

An important question for firms with international investments is whether the required return for international projects should be different from that of similar domestic projects.

Lower Cost of Capital from International Firm Diversification In the previous chapter, we expressed some skepticism concerning the benefits of diversification. We can make a stronger case for diversification in international firms than for purely domestic firms. Suppose barriers prevented shareholders in the United States from holding foreign securities; the financial markets of different countries would be segmented. Further suppose that firms in the United States were not subject to the same barriers. In such a case, a firm engaging in international investing could provide indirect diversification for U.S. shareholders that they could not achieve by investing within the United States. This could lead to the lowering of the risk premium on international projects. In general, if the costs of investing abroad are lower for a firm than for its shareholders, there is an advantage to international diversification by firms, and this advantage will be reflected in a lower risk-adjusted discount rate.

Alternatively, if there were no barriers to international investing for shareholders, shareholders could obtain the benefit of international diversification for themselves by buying foreign securities. In this case the project cost of capital for a firm in the United States would not depend on whether the project was in the United States or in a foreign country. In practice, holding foreign securities involves substantial expenses. These expenses include taxes, the costs of obtaining information, and trading costs. This implies that although U.S. investors are free to hold foreign securities, they will not be perfectly internationally diversified.

Ross-Westerfield-Jaffe: VIII. Special Topics

Corporate Finance, Sixth

Edition

32. International Corporate Finance

© The McGraw-Hill Companies, 2002

Chapter 32 International Corporate Finance

Lower Cost of Capital from International Shareholder Diversification Recall our discussion of the CAPM and the market portfolio. Consider the U.S. stock market and a U.S. investor who is not internationally diversified but, instead, is invested only in U.S. stocks. From our previous discussion of diversification, we know this investor would be bearing more risk than if she were able to diversify in the stocks of different countries. Now imagine she can invest in many foreign stocks by diversifying internationally. She should be able to reduce the variance (or standard deviation) of her portfolio significantly.

For this investor, the market-risk premium will be lower than for investors who cannot diversify internationally. In internationally integrated markets, investors with internationally diversified portfolios will measure the risk of an individual stock in terms of a world-market portfolio and global betas. Therefore, the cost of capital of a particular firm will be in terms of a global CAPM, such as where RI is the required return on a stock when markets are global, rF is the risk free rate, Bg is the global beta, and RG is the return on the world-market portfolio. A firm with internationally diversified investors will have a cost of capital with a lower market-risk premium [i.e., E(Rg — rF)] and a global beta when compared to a firm with investors that cannot diversify internationally.

Solnik has presented evidence that suggests that international diversification significantly reduces risk for shareholders.3 He shows that the variance of an internationally diversified portfolio of common stocks is about 33 percent of the variance of individual securities. A diversified portfolio of U.S. stocks will reduce variance by only 50 percent. Table 32.3 shows that a world portfolio has lower risk than a portfolio of stocks within a single country. For example, a citizen of Hong Kong can reduce risk from 12.8 percent to 4.2 percent by investing in a world portfolio. This evidence is consistent with a lower global market-risk premium than is a purely domestic-risk premium. Global betas will be different than purely domestic betas. Stulz has argued that the preceding claim for why internationalization reduces the cost of capital doesn't capture the complete picture. He agrees that the global market-risk premium is likely to be substantially lower than the risk premium for an isolated country. In addition, he argues that global investing is likely to improve corporate governance and reduce agency costs. The argument goes something like this: Firms in countries with less-developed financial markets will need to improve their governance so that they can raise capital in well-developed capital markets such as the U.S. Foreign firms raising capital in the U.S. must appeal to more sophisticated investors and better market architectures with superior monitoring abilities.4 Table 32.3 also shows that the systematic risk of foreign stock investment can be very low, as is the case of Austria, or very high, as is the case of Hong Kong.

Foreign Political Risks Firms may determine that international investments inherently involve more political risk than domestic investments. This extra risk may offset the gains from international diversification. Firms may increase the discount rate to allow for the risk of expropriation and foreign exchange remittance controls.

3B. H. Solnik, "Why Not Diversify Internationally Rather than Domestically?" Financial Analysts Journal (July-August 1974). A recent estimate of the benefits of international diversification can be found in Georgio DeSantis and Bruno Gerard, "International Asset Pricing and Portfolio Diversification with Time-Varying Risk, Journal of Finance 52 (1997). They estimate that an internationally diversified portfolio will reduce standard deviation by 20 percent when compared to investing in U.S. stocks only.

4Rene M. Stulz, "Globalization, Corporate Finance, and the Cost of Capital," Journal of Applied Corporate Finance 12 (1999). See also Ronald M. Schramm and Henry N. Wang, "Measuring the Cost of Capital in an International CAPM Framework," Journal of Corporate Finance 12 (1999) and Thomas I. O'Brian, "The Global CAPM and a Firm's Cost of Capital in Different Currencies," Journal of Corporate Finance 12 (1999).

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