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International Cost of Capital & Capital Budgeting

International Cost of Capital & Capital Budgeting. Cost of Capital(A). 1. What is the Cost of Capital? 2. Why is the Cost of Capital important? 3. How can we calculate the Cost of Capital? 4. What are the negative points for using the dividend growth model? Ke = D/P + g

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International Cost of Capital & Capital Budgeting

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  1. International Cost of Capital & Capital Budgeting

  2. Cost of Capital(A) • 1. What is the Cost of Capital? • 2. Why is the Cost of Capital important? • 3. How can we calculate the Cost of Capital? • 4. What are the negative points for using the dividend growth model? • Ke = D/P + g • Many companies don’t pay dividends • Cost of Equity is very sensitive to the growth rate • No adjustment for risk

  3. Cost of Capital(B) • 5. What is positive about using CAPM? • Beta, β, reflects the risk or uncertainty • And can be raised or lowered based on the riskiness of the project. 6. What is negative about using CAPM? Beta must be estimated and the historical beta may not reflect current circumstances.

  4. Calculating Beta(A) • Beta for corporation ABC is calculated by multiplying the Correlation Coefficient, ρ, between the corporation and the market by the standard deviation, σ, of ABC corporation and then dividing by the standard deviation of the market. • βABC = (ρABC,Market)( σABC) / σMARKET

  5. Calculating Beta(B) • Assume the correlation coefficient, ρ for ABC Corporation and the market is .8, that ABC’s stock standard deviation is 25% , finally, that the standard deviation for the market is 20%. • ABC’s beta can be calculated as 1.00, [(.8 x .25)/.20] • A beta of one means ABC has the same amount of systematic risk as the stock market.

  6. Problems Estimating Foreign Project Discount Rates • 1. Should the corporate proxies be US or local companies to estimate the beta? • 2. Is the relevant portfolio (market) the US market, the local market or the world market? • 3. Should the risk premium (expected return on the market minus the risk free rate) be the US market or the local market? • 4. How should country risk be included? • Adjust the cash flow or the discount rate?

  7. Capital Budgeting • 1. What is Capital Budgeting? • 2. How do we equate Costs and Benefits? • 3. How do we adjust for the difference in time between the cash flows? • 4. Should we use the same discount rate for all future cash flows regardless of their risk?

  8. Traditional Capital Budgeting • 1. The Net Present Value, NPV is calculated by subtracting the present value of the project costs from the present value of the project benefits. • 2. The Weighted Average Cost of Capital, the WACC is used to discount all future cash flows regardless of their inherent certainty or uncertainty. • 3. Use incremental cash flows such are opportunity costs, side effects, good and bad and net working capital. • 4. Ignore sunk costs.

  9. Adjusted Present Value, APV • 1. Adjusted Present Value, APV approach separates the certain cash flows from the uncertain or riskier cash flows. • 2. The risky cash flows, such as OCF and Terminal Value are discounted using an all-equity cost of equity. • 3. The more certain cash flows, such as interest and principle payments and depreciation are discounted using the pre tax cost of debt.

  10. All-Equity Cost of Equity • 1. An unlevered beta is used to calculate the cost of equity. • 2. βunlevered= βlevered / [1 + (1- Tax Rate)D/E] • 3. ABC’s beta is 1.00. Assume the tax rate is 30% and the Debt Equity Ratio is 50%. • 4. ABC’s unlevered beta would be .74. • .74 = 1 /[ 1 + (1-.30)(.50)] • Why is the unlevered beta lower than the levered beta?

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