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Firm-Specific Characteristics
Firms securities appeal only
to domestic investors
E
D
ke k d ( 1 t)
V
V
Where
kWACC
ke
kd
t
E
D
V
Cost of Equity
Cost of equity is calculated using the Capital
Asset Pricing Model (CAPM)
ke k rf ( k m k rf )
Where
ke = expected rate of return on equity
krf = risk free rate on bonds
km = expected rate of return on the market
km krf = equity risk premium
= coefficient of firms systematic risk
7
Cost of Debt
The normal calculation for cost of debt is analyzing
the various proportions of debt and their associated
costs for the firm (required returns for investors) and
calculating a before and after tax weighted average
cost of debt
Foreign exchange risk & cost of debt
When a firm issues foreign currency denominated debt,
its effective cost equals the after-tax cost of repayment in
terms of the firms own currency
Example: US firm borrows Sfr1,500,000 for one year at
5.00% p.a.; the franc appreciates from Sfr1.500/$ to
Sfr1.440/$
Initial dollar amount borrowed:
Sfr1,500,000
Sfr1.500/$
= $1,000 ,000
8
Cost of Debt
At the end of the year, the US firm
repays the interest plus principal
Sfr1,500,000 x 1.05
= $1,093 ,750
Sfr1.440/$
Cost of Debt
This total home currency cost is higher than
expected because of the appreciation of the Swiss
franc
This cost is the result of the combined cost of debt
and the percentage change in the foreign currencys
value k $ = 1 + k FC x 1 + s - 1
d
[(
)]
Where
kd$ = Cost of borrowing for US firm in home country
kdFC = Cost of borrowing for US firm in a Foreign Currency
s = Percentage change in spot rate
10
Cost of Debt
The total cost of debt must include
the change in the exchange rate
The percentage change in the dollar
value of the Swiss franc given
indirect quotes is calculated as
FC/$
SFC/$
S
2
1
SFC/$
2
Sfr1.500/$ - Sfr1.440/$
x 100
x 100 4.1667%
Sfr1.440/$
11
WACC
What is the WACC for the following
case:
Risk-free rate of return: 4%, the
expected market return: 11%,
proportion of debt: 40%, cost of debt:
6%,
1.30,
and the tax
k e 0of
.04the
1.3(equity:
0.11 - 0.04
) 0.131
rate:
k 35%.
0.131( 0.60 ) 0.06( 1 - 0.35 )( 0.40 )
WACC
kWACC 0.0942
12
P
0
Geometric Mean
1
T
Pt 1
1 over T years
Pt
1
14
15
Market Segmentation
Capital market segmentation is a market
imperfection caused mainly by government
constraints, institutional practices, and investor
perceptions
The most important imperfections are
Asymmetric information
Lack of transparency
High securities transaction costs
Foreign exchange risks
Political risks
Corporate governance differences
Regulatory barriers
17
Illiquidity
and
Segmentati
on
Escaping
Illiquidity
MCCF
MCCD
kD
20%
15%
13%
10%
kF
MCCU
kU
MRR
10
20
30
40
50
60
Budget
(millions of $)
20
Taxation;
Alternative sets of feasible portfolios;
Financial risk;
Foreign exchange risk, and
Political risk.
Source: Arthur I. Stonehill and Kre B. Dullum, Internationalizing the Cost of Capital: The
Novo Experience and National Policy Implications, London: John Wiley, 1982, p. 73.
23
Reprinted with permission.
The
The
The
The
25
m
where ,
MCCDC
20%
MCCMNE
15%
10%
MRRMNE
5%
MRRDC
100 140
300
350
400
Budget
(millions of $)
27
Equity
Value
kd ( 1 tx )
Debt
Value