A Critical Essay on International Finance

This essay evaluates the application of CAPM model in assessing the cost of capital for a foreign project. It discusses the factors that influence the cost of capital for multinational projects and how the CAPM model can be used to analyze the risk and return of a foreign project.

A Critical Essay on International Finance
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Introduction
The business companies emphasize on seeking growth and expansion by continually
investing in new markets and thereby realizing increased revenues and profits. The multinational
companies conduct their operations on a global platform and as such have to undertake decisions
by investing in local or foreign countries. The multinational firm acquires the capital or funds
required to make such investment either from debt or equity resources. The value delivered by a
multinational project is dependent on the expected cash flows and also on the cost of the funds.
The cost of capital acquired is an important aspect in determination of the investment decisions
undertaken by a multinational firm. However, determination of the cost of capital is also
dependent on the characteristics of the investment. The higher is the risk associated with the
investment the greater is the cost of capital and this can be adequately measured by the use of
Capital Asset Pricing Model (CAPM) (Somanath, 2011). In this context, this essay has been
developed for evaluating the application of CAPM model in assessing the cost of capital for a
foreign project.
Literature Review on Critical Evaluation of Capital Asset Pricing Model (CAPM) for
reviewing Cost of Capital for Foreign Projects (Required rate of return is also referred as
cost of capital)
According to information realised from BPP Learning Media (2017), the cost of capital is
the weighted average of the costs that are incurred in acquiring funds for carrying out an
investment that includes both debt and equity sources of finance. The cost of equity is related
with the risk that is undertaken by the equity investors while investing and cost of debt is the risk
perceived by the lenders at the time of investing in a capital project. The relative weight of each
of the component sources of finance reflects their proportion used in financing an investment.
The business firms tend to develop a capital structure that intends to reduce the cost of capital
and maximize the required rate of returns. The cost of capital can be stated as the rate that must
be realized for satisfying the required rate of return on an investment. It has a large impact on the
value of an investment and is used by business managers for selecting an investment option that
is able to provide maximum profits in the future context. For example, if there are two
investment options having same returns, then the option having lower cost of capital will be
selected for investment purpose as it will provide higher profits (BPP Learning Media, 2017).
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According to Park and Matunhire (2011), the cost of capital for domestic projects is
significantly different from that of international projects due to impact of external environmental
factors such as economic, political, legal or technological. The different countries possess
different business environments and thus the required rate of return varies in carrying out
projects in a domestic or global environment. The difference in inherent risks for the firm of each
country is responsible for realizing varying returns for specific projects being carried out by a
multinational firm in different countries. This requires a multinational firm to evaluate the
required rate of return for specific projects as the use of a single rate of return for all the projects
carried out by an international firm can result in providing incorrect results till they are having
similar cost structures and commercial risks. As such, it can be said that it is highly important for
a multinational firm to evaluate whether the rate of return to be realized by a foreign project is
same that of domestic project (Park and Matunhire, 2011). The major factors that are responsible
for causing the difference between costs of capital for multinational projects as compared to the
domestic projects undertaken by an international firm can be discussed as follows:
Size of Project: The projects that are carried out in an international context are bigger in size as
compared with that carried out in domestic environment. The international projects are bigger in
size as therefore borrow higher amount of funds to achieve their determined goals or objectives.
As such, the international projects are often associated with higher risk as compared with
domestic projects due to their higher cost of capital.
Foreign Exchange Risk: The cash flows to be realized from an international project are also
largely impacted by the fluctuations in the exchange rate. This can lead to increasing the risk for
shareholders and lenders who are investing within the project thus leading to its higher cost of
capital. However, it is not always the case that the fluctuations in the exchange rate can result in
negatively impacting the cash flows of multinational corporations. The movement of currency in
a positive manner can help in gaining larger returns from an investment (Gaspar and Arreola-
Risa, 2013).
Increased availability of funds from international markets: The international projects of a
MNC are carried out in a global context and thus are exposed to global investors which make its
relatively easy for a multinational firm to gain funds at a lower cost of capital as compared to the
domestic projects. The subsidiaries of a multinational firm can obtain funds at a lower rate of
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interest in a foreign country and this may impact the profitability of a project carried out in that
country as compared with the domestic country (Butler, 2016).
Impact of Diversification: The multinational corporations by conducting their operations in a
global context can achieve stability over their cash flows. The foreign projects of a global firm
that are carried out in different countries enable it to acquire funds from all over the world. As
such, the foreign projects carried out by a MNC can enable a multinational firm to achieve
diversification and thus reducing the risk related with investment and thereby decreasing the cost
of capital (Ehrhardt and Brigham, 2013).
Country Specific Risk: The risk associated with a foreign project of a multinational firm is
significantly impacted by the risks that are associated with specific country. The specific risk
such as political or economic may have an impact on the cash flows to be realized from a foreign
project of a multinational firm. The higher the risk associated with a specific country in terms of
its external environment the higher is the cost of capital.
Tax advantages: The multinational firms generally tend to select a foreign country for caring
out their operations where they can gain tax advantage. This enables a multinational firm to
reduce their costs of capital as compared to carrying the operations within a domestic firm
(Brigham and Ehrhardt, 2016).
Thus, all these factors are responsible for influencing the cost of a capital for a foreign
project that is undertaken by multinational firm and thus impacting its required rate of return
which is quite different in comparison to its project carried out in a domestic country.
Nhleko and Musingwini (2016) stated that the Capital Asset Pricing Model (CAPM) is
generally used for determining the risk and return relation in context of an investment incurred.
The CAPM model has been developed for depicting the relation between the risk and returns
associated with a potential investment. The model is used for calculation of the required rate of
return for capital investments. It provides a methodology for quantifying risk and transferring the
risk into estimates of expected return on equity. The model has stated that an investor will
demand higher profitability of the risk associated with a project is higher. As such, according to
the model a project that is having more risk is also associated with providing larger return to an
investor. The CPAM mole can be largely used for estimating the required rate of return which is
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equal to the cost of equity capital. The model can be largely used for assessing the required rate
of return of multinational corporations in comparison to that of domestic firms (Nhleko and
Musingwini, 2016). The formula stated by the CAPM model for analyzing the cost of equity can
be stated as follows:
ke = R f +  ( R m – R f )
where ‘ke’ is equal to the required rate of return on a stock
‘R f’ indicates the risk-free rate of return
‘Rm’ is the rate of return to be realized from market
‘’ is the beta of stock
As per Da, Guo and Jagannathan (2012), Beta ‘’ represent the sensitivity of returns to be
realized in context of the market conditions. Thus, a multinational firm can evaluate the risk
associated with its foreign project easily by the use of CAPM model. The beta factor provided by
the CAPM model denotes systematic risk that is risk associated with an investment on the basis
of fluctuations in the market conditions. Beta can be used for representing the sensitivity of the
project cash flows in relation to market conditions. The lower is the beta, lower is the systematic
risk and this significantly leads to decline in the required rate of return of a foreign project. Thus,
CAPM model can be used to analyze the potential risk and return associated with a foreign
project of a multinational firm by assessing of beta factor. The MNCs that are able to reduce beta
factor associated within an investment are able to considerable lower the required rate of return
of a project (Da, Guo and Jagannathan, 2012).
As per the views of Liu, Whited and Zhang (2009), the return on equity as per the CAPM
model can be measured on the basis of calculation on an interest free rate in addition to a
premium that reflects the risk associated with a firm. The risk free interest varies from one
country to other and thus significantly can result in causing difference in the cost of equity
related within an investment. The difference in risk free rate between a foreign project and a
domestic project carried by a multinational firm can occur on the basis of factors that impact
supply and demand. The major factors that impact the supply of fund within a foreign project are
tax laws, demographics, and monetary policy and economic conditions. The risk premium
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represents the risk on the debt that is used for compensating the lenders for investing in a higher
risk project. The risk premium varies in proportion to the economic conditions, degree of
leverage and support of the government. As such, the cost of debt can be determined on the basis
of risk-free interest rate of the borrowed currency and risk premium required by the creditor in
the foreign country. On the other hand, the risk-free rate can be defined on the basis of supply
and demand factors. Thus, CAPM model can easily help in assessing the cost of debt and equity
related with a foreign project and thus estimating its required rate of return. It can thus help the
business managers of a multinational firm to evaluate the cost of capital of a foreign project and
thus taking accurate decisions relation to investing within a foreign or hoe country for realizing
larger returns (Liu, Whited and Zhang, 2009).
Analysis
The required rate of return is estimated through use of capital asset pricing model and this
model has three main components that can be impacted with change of location of project
(Domestic Country to any other country). For example, market returns in United Kingdom will
not the same as in Australia or any other country. It is because market return is highly dependent
upon the investor’s perspective, economy position, inflation level, and other environmental
factors of the particular company (Reilly and Brown, 2011). Similarly, beta will also change with
the change of location of project as beta is dependent upon the relation of return of individual
stock and return provided by market index of country in which project has been established.
Lastly, it is important to consider the risk free rate of return as the yield of treasury bonds issued
by the government of such country in project is being established. So, according to the CAPM
model, required rate of return cannot be same in any foreign country as compare domestic
country. In order to understand this through use of specific country example, it has been assumed
that domestic country is United Kingdom and project has been established in Australia (Moles
and Kidwekk, 2011).
Example: Let us assume that project that company is considering is related to the sale of goods
and services in retail sector. So it is important to take beta of company in Australia that deals in
retail sector. Therefore, beta of Wesfarmers (Australia entity dealing retail sector) has been
taken. Beta of domestic company is taken of Tesco Company. Details to calculate the required
rate of return through using the CAPM model has been shown in below table.
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Components Domestic Country Foreign Country
UK Australia
Risk free rate of return 1.07% 1.65%
Beta 1.17 1.03
Market Premium (Assumed) 7.5% 8.50%
Required rate of return using CAPM 9.85% 10.40%
Source of Beta
(Domestic) https://markets.ft.com/data/equities/tearsheet/summary?s=TSCO:LSE
Source of Beta
(Foreign) https://au.finance.yahoo.com/quote/WES.AX/
Source of Risk free
rate of return
(Domestic)
https://www.bloomberg.com/markets/rates-bonds/government-
bonds/uk
Source of Risk free
rate of return (Foreign) http://www.worldgovernmentbonds.com/country/australia/
So, it is proved that required rate of return for the foreign project will be country specific
and it cannot same as domestic project.
Future Outlook
The use of project specific risk allows the company to analyse the project in more
accurate way and also helps to attain the discount rate required for investment appraisal purpose.
Conclusion
It can be stated on the basis of overall discussion held within the essay that cost of capital
for a foreign project is different from that carried out in a domestic context for a multinational
firm. This is largely due to the influence of business environment in a foreign country which may
result in impacting the rate of return of projects carried out by a multinational firm in different
countries. The report has identified the factor that is responsible for causing difference within the
cost of capital in a foreign and home country. The CAPM model can be used for determining the
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potential returns to be realized from a foreign project in comparison to the significant risk
associated with it. The model can be used to estimate the required rate of return on equity by
valuation of the beta factor, risk-free rate and risk premium.
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References
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