IFFM Blog #4: International Cost of Capital

For any firm, securing investors to facilitate global, or even regional, expansion of a business is important. However, the valuation of a company changes when entering a different economy as it is impacted by country-specific risks (Grabowski, 2015) Different country risks will affect a company's International Cost of Capital (Susmel, n.d.), which is the minimum rate of return that is expected in order to draw finance providers into investing in a foreign market. To estimate this, the cost of capital must first be understood.

Cost of Capital, or discount rate, simply refers to the rates of return that persons who are keen on investing should expect from a company (Gallo, 2015). From a firm's perspective, it can also be described as the cost of money a company will need to use so as to achieve financing, or induce individuals to buy and retain shares. The cost of capital may be employed by senior staff in order to assess individual investments (Gallo, 2015). Investors too use it to evaluate equity risks. What is most imperative about this value is that it stipulates the base amount of returns a firm should make from company investments to ensure that finance providers earn, and that the company is able to grow from cash generated.

It should be noted that if the company only uses its current liability and long-term debts to finance its operation, the cost of capital is usually the interest rate on the debt. However, if it only has investors, the cost of capital is the cost of equity. This highlights the two key notions that are cost of debt and cost of equity. Cost of equity can be calculated through the use of two primary models - Gordon Growth Model and Capital Asset Pricing Model. On the other hand, calculating the cost of debt is dependent on its classification into irredeemable trade debt, traded debt or non-traded debt. Cost of equity or cost of debt calculations are useful for smaller enterprises that may rely solely on one type of financing (Peavler, 2016).

However, most of the time, companies utilise a combination of debt and equity to finance its activities, but the cost of capital is non-specific and does not take into account the capital structure of the company (Peavler, 2016). In order to account for this, the Weighted Average Cost of Capital (WACC) formula can be used to estimate the discount rate, as seen below in Figure 1.

Figure 1. General WACC formula

Determining a firm's cost of capital, or WACC for those with a mixed capital structure, is imperative in enticing finance providers to invest in a business. Furthermore, it provides a benchmark in terms of rate of returns so that companies can closely monitor cash generated and ensure that it is sufficient to cover the rate of returns expected by investors, as well as for company growth.

References

Grabowski, R. (2015). International Cost of Capital – How to price international country risk and use the 2015 International Valuation Handbook – Guide to Cost of Capital.

Susmel, R. (n.d.). International Financial Management. [ebook] Houston. Available at: https://www.bauer.uh.edu/rsusmel/4386/11.11%20(ch%2017).pdf [Accessed 1 Feb. 2018].

Gallo, A. (2015). A Refresher on Cost of Capital. [online] Harvard Business Review. Available at: https://hbr.org/2015/04/a-refresher-on-cost-of-capital [Accessed 1 Feb. 2018].

Peavler, R. (2016). What Is the Weighted Average Cost of Capital?. [online] The Balance. Available at: https://www.thebalance.com/calculate-weighted-average-cost-of-capital-393130 [Accessed 1 Feb. 2018].