international treasury management: understanding the cost of capital

Stephen R. Goldberg, Joseph H. Godwin, andJonathan E. Duchac

The cost of capitalis an importantconcept to inter-

national treasury man-agement because itplays a key role inevaluating prospectiveinvestments, the firmitself, and the perform-ance of both manage-ment and the company.In this article, we firstdiscuss the general concept ofcost of capital and how it isdetermined. We then look atissues related to multinationalcompanies and discuss determi-nation of cost of capital for for-eign projects or affiliates.

WHAT IS COST OF CAPITAL?

In its simplest terms, cost ofcapital is the minimum accept-able return on investment. It isan opportunity cost equal to thetotal return that a company’sinvestors could expect to earn byinvesting in a portfolio of stocksand bonds of comparable risk.Cost of capital is specific to anyfirm and is the rate that deter-mines the value of the firm. It isthe rate that should be used todiscount projected cash flows ofpotential projects to present

value. If a firm earns a returngreater than its cost of capital, itis creating value for owners.Conversely, if a firm earns areturn less than its cost of capi-tal, it is destroying value. Inother words, the cost of capital isthe rate of return that the marketuses to discount future cashflows of the firm to presentvalue to determine the value ofthe firm.

The cost of capital is the dis-count rate that fulfills the fol-lowing equation:

V = X / c (1)

where V is the market value ofthe firm and X is the averageafter-tax cash flow. The value crepresents a weighted averageof the required rate of return ofthe individual sources offinancing, with each type of

financing given itsproportionate weightin the firm’s long-runtarget capital struc-ture.1 Using c as thediscount rates for newprojects ensures thevalue of owners’ equi-ty will be maximized.A lower rate wouldencourage the firm toaccept projects that

are not in the shareholders’ bestinterests. A higher rate wouldresult in turning down projectsthat would increase the value ofshareholders’ interests. Exhibit1 summarizes the uses of thecost of capital.

Since firms employ multiplesources of capital, the rate usedto evaluate projects should be aweighted average cost of capital.Firm i’s weighted average cost ofcapital,2 c, is

c = ce (E / V) + cd (1 – t) (D / V) (2)

where ce is the risk-adjusted costof equity; cd is the before-taxcost of debt; D, E, and V are themarket values of the firm’s debt,equity, and total securities,respectively. The total value ofthe firm (V) equals the marketvalues of debt (D) plus equity

Cost of capital is an important concept for inter-national treasury management. It plays a key rolein evaluating prospective investments, the firmitself, and the performance of both managementand the company. The authors explain what costof capital is, how you determine it, and someimplications for U.S. multinational firms.

© 2001 John Wiley & Sons, Inc.

International Treasury Management:Understanding the Cost of Capital

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13© 2001 John Wiley & Sons, Inc.

(E) securities. Thus, E/V (D/V)is the proportion of equity (debt)securities in the firm’s capitalstructure. Each type of financingwould be represented by a sepa-rate term in equation (2). Thus, afirm could additionally have pre-ferred stock, and several differ-ent sources of debt.

This cost of capital, c, is thenused for the total firm for the pur-poses indicated in Exhibit 1. Thevalue ce is the required rate ofreturn on the firm’s stock giventhe firm’s particular target debtratio. The firm’s historical debt-to-equity ratio is not relevant. Theweights must be marginal ratesthat reflect the firm’s target capi-tal structure, which is the propor-tions of debt and equity the firmplans to use in the future.

In determining cost of capi-tal, the firm should use its long-run optimal financial structureand ignore temporary deviations.Firms ordinarily do not issuebonds (or other debt) and sharesevery year. New capital tends tobe raised in lumps. Consider afirm that raises capital every twoyears by alternatively issuingnew shares and bonds. If theactual proportion of debt andshares are used in years afterdebt is issued, the weighted aver-age cost of capital may be con-siderably lower than in years

after shares are issued. This mayresult in projects with a returnexpected to exceed the long-runcost of capital being rejected inyears when new shares areissued, and projects with a returnexpected to be below the long-run cost of capital being accept-ed in years when new debt isissued.

In determining the cost ofcapital, market values—not bookvalues—should be used for bothdebt and equity. Although mar-ket values are the only conceptu-ally correct values, it would beuneconomical and impractical torevise the calculation of cost ofcapital every time market priceschange. A compromise withreality is to use average marketprices or trends and ignore tem-porary deviations around thetrend line.

The discussion in this articleassumes that a firm participatesin only one industry and, there-fore, only one cost of capital isappropriate for the firm. If afirm participates in more thanone industry, a separate determi-nation of cost of capital shouldbe made for each industry.3 Thisviews the firm as a portfolio ofinvestments with the overall costof capital of the firm equal to ablend of the costs of capital ofits various businesses.

The following sections dis-cuss determination of the costsof debt (cd), preferred stock (cp)and common stock (ce), respec-tively.

COST OF DEBT

The cost of debt is the rate acompany would have to pay inthe current market to obtain newlong-term debt. The best indica-tion of this rate is the prevailingyield to maturity on the firm’sown outstanding and publiclytraded debt. In the absence of aquote for its bonds, the borrow-ing rate could be approximatedby a sample of companies withthe same bond rating. If a creditrating is not available, a ratingcan be estimated from modelsthat attempt to mimic ratingagencies. If no market price isavailable on debt, the marketprice can be estimated by dis-counting cash (interest and prin-cipal) payments of the debt topresent value using the interestrate corresponding to the debtrating. Exhibit 2 summarizes thedetermination of the cost ofdebt.

COST OF PREFERRED STOCK

If preferred stock is notcallable or convertible then thecost of preferred stock can beestimated by dividing the annualdividends by the current stockprice (see Exhibit 3). If the stockis callable or convertible, valua-tion of the option feature com-plicates determination of thecost.

COST OF COMMON STOCK

According to the capitalasset pricing model (CAPM), anequilibrium relationship existsbetween an asset’s requiredreturn and its associated risk:

14 The Journal of Corporate Accounting & Finance


Uses of Cost of Capital by Company Management

1. Discount rate to determine present value of projected cash flows.2. Hurdle rate for accepting new projects.3. Capital charge rate to calculate economic profit or value added.4. Benchmark for assessing rates of return on capital employed.

Exhibit 1

ri = rf + βi (rm – rf) (3)

where ri is the equilibriumexpected return for asset i; rf isthe rate of return on a risk-freeasset, measured as, say, the yieldon a ten-year U.S. governmenttreasury bond; rm is the expectedreturn on the market portfolioconsisting of all risky assets; andβi is the systematic risk of asset imeasured as Cov(ri, rm)/ �2 (rm).Cov(ri, rm) is the covariance

between returns on security i andthe market portfolio. The value�2 (rm) is the variance of returnson the market portfolio. Asset iis any asset such as a share ofcommon stock or a bond issuedby a firm.

CAPM assumes that pricesare set by intelligent, risk-averseinvestors who fully diversify theirrisks so that only risk that cannotbe diversified away will berewarded with a risk premium.

The risk premi-um associatedwith asset i is βi

(rm – rf). βi isthe systematicor non-diversifi-able risk of theasset. βi meas-ures the correla-tion betweenreturns on a particular assetand returns onthe market port-folio.

A regres-sion equationused to estimatebeta is

Company return = a + b (marketindex) + c (4)

Regression coefficient, b, isthe estimated beta. Historicaldata are used for, say, a 60-month period. The market indexmight be represented by the S&P500 and the risk-free interestrate might be the yield on ten-year Treasury bonds. Thisapproach assumes that there isno reason to believe this relationshould change. Factors thataffect beta and the cost of capitalare indicated in Exhibit 4. If anew investment changes any ofthe factors in Exhibit 4, theinvestment could change thebeta, or risk of the firm, and thecost of capital.

Beta measures the extent towhich adding an individual com-pany’s shares to an already well-diversified portfolio will amplifyor dampen the expected variabil-ity of the portfolio’s return. Abeta of greater (less) than oneindicates that a firm’s marketprice changes exaggerate (damp-en) relative to the overall market.A beta of one indicates that theamplitude of changes in a firm’sshare price generally match themarket as a whole. Beta does notmeasure the total risk entailed inpurchasing a single company’sshares. Rather, it measures onlythat portion of the risk that can-not be diversified away. Whilemanagers are likely to be goodjudges of total risk of a compa-ny, they are likely to be poorjudges of the risk that matters toinvestors, and therefore the costof capital. One implication ofCAPM is that corporate diversi-fication is redundant to personalportfolio diversification. Exhibit5 summarizes the CAPMapproach and indicates thatcovariance of the returns of asecurity with market returns isan important measure of risk.

November/December 2001 15


Pre-Tax Cost of Debt (Cd)

P0 = ∑nt=1 [(It / (1 + cd)t) + Pn / (1 + cd)n]

Definition of symbols:cd = pre-tax cost of debt determined by solving the equationP0 = current price of bondPn = maturity value of bondI = interest payment

(If bond is not sold at par, some adjustment should be made to the formula.)

Exhibit 2

Cost of Preferred Stock

cp = d / P0

Definition of symbols:cp = the after-tax cost of preferred stockP0 = the current price of the preferred stockd = annual dividend payment

Exhibit 3

MARKET LIQUIDITY AND MAR-KET SEGMENTATION

Two factors identified inExhibit 4 that affect the cost ofcapital are market liquidity andthe effect of market segmenta-tion on the firm’s shares. Equityand debt capital may not beavailable at the same rate ofreturn as the capital budgetexpands for firms in illiquid orsegmented emerging capitalmarkets; small domestic firms;or family-owned firms in anycapital market.

Market liquidity is looselydefined as the degree to which afirm can issue new securitieswithout depressing the existingmarket price, as well as thedegree to which a change inprice of its securities results in asubstantial order flow. A firmshould expand its capital in the

same proportions as its optimalcapital structure. In general, as afirm’s capital increases, eventu-ally its marginal cost of capitalincreases. In the long run thismay not be a limitation depend-ing on market liquidity.

Multinationals can improvemarket liquidity by raising fundsin Euromarkets (money, bond,and equity), by issuing securitiesdirectly in various national secu-rity markets, and by having sub-sidiaries raise capital in theirlocal national markets.

Market segmentation occurswhen the required rate of returnon securities in a national capi-tal market differs from therequired rate of return on securi-ties of comparable expectedreturn and risk that are traded onother national securities mar-kets. Exhibit 6 lists factors thatcould cause market segmenta-

tion. If all security markets werefully integrated, securities ofcomparable expected return andrisk should have the samerequired rate of return afteradjusting for exchange rate andpolitical risks. A market is effi-cient if security prices in thatmarket reflect all availableinformation and adjust quicklyto any new information. Anational securities market canbe efficient domestically andstill segmented internationally.The price of an individual secu-rity reflects its intrinsic value,and price fluctuations are ran-dom walks around this value.

An efficient national capitalmarket might correctly price allsecurities traded in that marketon the basis of informationavailable to the market. If thatmarket were segmented, foreigninvestors would not be partici-pants. Therefore, securities in asegmented market would bepriced on the basis of domesticrather than international stan-dards.

Availability and cost of capi-tal depend on whether a firm cangain liquidity for its debt andequity securities and a price forthose securities based on interna-tional rather than national stan-dards. A domestic firm in anilliquid or segmented nationalmarket must define a strategy toattract international portfolioinvestors and decrease the firm’scost of capital.

The firm’s marginal cost ofcapital decreases as the firmexpands its sources of capitalfrom a segmented national capi-tal market to the use of interna-tional sources of capital and tosourcing of capital on an inte-grated (i.e., unsegmented) capi-tal market. This lower cost ofcapital results from greater avail-ability of capital and internation-al pricing of a firm’s securities.



Factors Affecting Cost of Capital

1. Firm-Specific Characteristics1.1. Risk characteristics of domestic market and firm-specific industry1.2. Firm’s securities appeal to domestic investors1.3. Firm’s securities appeal to international portfolio investors1.4. Firm’s capital structure

2. Market Liquidity for Firm’s Securities2.1. Illiquid domestic securities market and limited international liquidity2.2. Highly liquid domestic market and broad internationalparticipation

3. Effect of Market Segmentation on Firm’s Securities3.1. Segmented domestic securities market that prices shares according to domestic standards3.2. Access to global securities market that prices sharesaccording to international standards

Exhibit 4

COST OF CAPITAL OF A MULTI-NATIONAL VERSUS A DOMES-TIC COMPANY

Whether or not the weightedaverage cost of capital for amultinational is higher or lowerthan a domestic companydepends on the relative after-taxcost of debt, the optimal debtratio, and the relative cost ofequity. Generally, a multinationalhas greater availability of capitalsince it can access capital mar-kets other than its domestic mar-ket. Also, a multinational’s mar-ginal cost of capital, incomparison with a domesticcounterpart’s marginal cost ofcapital, tends to be constant forgreater ranges of capitaldemand.

Is systematic risk and cost ofcapital greater or lesser for amultinational than for a domesticfirm? The traditional argument isthat a multinational should beable to reduce cash flow vari-ability because cash flows andreturns are more diversifiedinternationally. Reduced vari-ability of cash flows shouldresult in higher debt capacityand lower systematic risk andcost of capital. However, Eite-man et al. (2001) comment thatrecent studies find that U.S.-based multinationals have higherweighted average costs of capitalthan domestic firms. One expla-nation is that beta could increaseif the decrease in the correlationbetween a firm’s returns and themarket’s returns is more than

offset by an increase in the vari-ance of the firm’s returns. Thisis consistent with the observa-tion that many multinationalsuse a higher hurdle rate to dis-count expected foreign projectcash flows. They are acceptingprojects that they consider riski-er than domestic projects, poten-tially increasing their systematicrisk. Multinationals need to earna higher rate of return than theirdomestic counterpart to maintaintheir market value.

Eiteman et al. (2001) pro-vide an additional argument toexplain this contradiction by thelinkage between cost of capital,its availability, and the opportu-nity set of available projects. Asthe opportunity set of projectsincreases, eventually the firmneeds to increase its capitalbudget to the point where itsmarginal cost of capital equalsthe declining rate of return onthe opportunity set of projects.This is at a higher weighted-average cost of capital thanwould have occurred for a lowerlevel of the optimal capitalbudget.

CHOICE OF MARKET INDEXAND RISK PREMIUM.

In this section, we discusstwo issues. First, in estimatingbeta, should we use a U.S. orworld market index? Second, todetermine the cost of capital,should we use a risk premiumbased on the world market or theU.S. market?

Risk that is systematic in thecontext of the local market maybe diversifiable in the context ofthe world or U.S. portfolio. Ifthis is the case, using the localmarket portfolio may result in ahigher beta and higher desiredreturn. The appropriate marketportfolio to use in determiningbeta depends on one’s view of



Cost of EquityCAPM Approach

ce = rf + β (rm – rf)

Definition of symbols:ce = the after-tax cost of common stockrf = the risk-free interest rate, sometimes estimated by the yield of ten-year Treasury bondsrm = expected market rate of return, sometimes measured as theweighted average return on the S&P 500(rm – rf) = the difference between the risk-free interest rate and expect-ed market rate of return, estimated by historical relationships; the differ-ence is approximately 5 percentβ = measure of firm i’s risk versus that of the market = Cov(ri, rm) / �2

(rm), sometimes estimated as the regression coefficient of regressing thereturns of a common stock of a company on total market returns for a60-month periodCov(ri, rm) = the covariance between returns on security i and the marketportfolio�2 (rm) = the variance of returns on the market portfolio

Exhibit 5

world capital markets. If capitalmarkets are globally integrated,then the world portfolio shouldbe used. If capital markets arenot integrated but completelysegmented, then the domesticmarket portfolio should be used.The test of capital market inte-gration is whether or not assetsare priced in a common context.If capital markets are integrated,then security prices offer allinvestors worldwide the sametrade-off between systematic riskand expected return.

Capital markets probably liesomewhere between fully inte-grated and totally segmented.Our knowledge and technologyare such that it is not within ourpower to determine the relevantmarket portfolio and hence thecorrect beta to use for projectevaluation (for both foreign anddomestic purposes). Shapiro(1999) recommends that U.S.multinationals use the U.S. mar-

ket portfolio for two reasons.First, it ensures comparabilitybetween evaluation of both for-eign and domestic investments.Second, the relatively smallamount of international diversi-fication by U.S. investors sug-gests that the relevant portfoliofrom their point of view is theU.S. market portfolio.

The second issue is shouldthe market risk premium bebased on the U.S. or local marketrisk premium? The local marketrisk premium is the premiumdemanded by investors in thelocal market. Estimates of thelocal market risk premium maybe subject to considerable statis-tical error. Also, the local riskpremium may be irrelevant sincethe multinationals’ investors arenot the same as the investors inthe local market.

For several reasons, the rec-ommended risk premium to beused is the U.S. market risk pre-

mium. First, the U.S. marketrisk premium is the premiumlikely to be demanded by a U.S.company’s mostly Americaninvestors. Second, this is consis-tent with the recommendationthat the betas of foreign sub-sidiaries be estimated relative tothe U.S. market. Using the U.S.market risk premium ensuresconsistency between the meas-ure of systematic risk and theprice per unit of risk. Third, thequality, quantity, and length ofU.S. capital market data are byfar the best in the world. Thisincreases the statistical validityof the estimated market risk pre-mium.

COST OF CAPITAL FOR A FOR-EIGN (LOCAL) PROJECT

The firm can be viewed as aportfolio of projects. The valueof the firm is equal to the sumof the values of the individualprojects making up the portfo-lio. The cost of capital is a func-tion of the projects in which itengages. Total firm cost of capi-tal is a blending of the cost ofcapital of the projects undertak-en. The cost of capital for thefirm as a whole can be used tovalue the stream of future equitycash flows to set a price on thefirm’s equity shares. It shouldnot be used as a measure of therequired return on equity invest-ments in future projects unlessthese projects are of similarnature to the average of thosealready being undertaken by thefirm.

Unless the financial struc-tures and commercial risks arethe same for all projects, the useof a single overall cost of capitalcould lead to incorrect valuation.Different discount rates shouldbe used to value projects that areexpected to change the risk com-plexion of the firm.



Factors That Cause Segmented Markets

1. Regulatory controls2. Perceived political risk3. Foreign exchange risk4. Lack of transparency5. Asymmetric information6. Transaction costs7. Takeover defenses8. Small-country bias9. Cronyism

10. Insider trading11. Tax differences12. Language13. Accounting principles14. Other market imperfections

Exhibit 6

Exhibit 7 identifies threeissues related to estimating betafor a foreign subsidiary. The lasttwo issues, choice of worldindex and determination of mar-ket risk premium, were dis-cussed in an earlier section.Since U.S. investors are the pri-mary investors in most U.S.multinationals, the suggestion isto use U.S. market data to deter-mine both (1) the beta of thefirm or project and (2) the mar-ket risk premium to be used forthe cost of capital.

The information needed toestimate foreign project betas,past or estimated future foreignsubsidiary and market returns,generally does not exist. Theonly practical way to get aroundthis problem is to find publiclytraded companies that share sim-ilar risk characteristics and usethe average beta for the portfolioof corporate surrogates to proxyfor the subsidiary’s beta.

The first issue is should thecorporate proxies that are usedto estimate beta be U.S. or local(i.e., foreign) companies? Oftenlocal proxies do not exist. U.S.proxies may exist but their cir-cumstances and hence betas maydiffer. For several reasons, cor-porate proxies should be local

companies as much as possible.First, local operations are likelyto depend on the local economy.Thus, the timing and magnitudeof these returns are likely to dif-fer from those generated bycomparable U.S. companies. Theresult is that the degree of sys-tematic risk for a foreign opera-tion, from the perspective of aU.S. investor, may be lower thanit is for comparable U.S. compa-nies. Using U.S. companies toproxy may lead to an upwardbias in the estimate of beta.Shapiro (1999) demonstratesthis bias by computing the betaof a fully diversified investmentin three different countries fromthe perspective of a U.S.investor. Indices of countryreturns were regressed on theU.S. market return index to esti-mate beta. Although standarddeviation of returns was consid-erably greater for the markets inAustralia, Hong Kong, and Sin-gapore relative to the UnitedStates, the betas of these foreignmarkets relative to the U.S. mar-ket were all less than 0.5.Although total risk and unsys-tematic risk were greater than afully diversified U.S. invest-ment, systematic risk was clear-ly lower.

After reasonable proxies areidentified, beta is estimatedusing historical data by regress-ing the proxies’ returns on theU.S. market index. The betasdetermined by this regression aremeasures of the systematic riskof levered comparison compa-nies. To determine the appropri-ate beta you have to un-lever thebetas of the comparison compa-nies and then re-lever using thetarget capital structure of theaffiliate being analyzed. The fol-lowing equations can be used asan approximation to un-lever thecomparison company and then tore-lever for the affiliate.

βL = [1+ (1–T)(D/E)] βU (5a)βU = [1+ (1–T)(D/E)] / βL (5b)

where βL is levered equity beta.T is the marginal corporate taxrate. D/E is the target debt-to-equity ratio for the affiliate, esti-mated in terms of market value.βU is the un-levered equity beta.To convert the proxy’s leveredbeta to an un-levered beta, theproxy’s tax rate and debt-to-equi-ty ratio would be used. Then toconvert the resulting un-leveredbeta to a levered beta, the affili-ate’s marginal tax rate and targetdebt-to-equity ratio would beused.

A second alternative is tofind a proxy industry in the localmarket whose industry beta issimilar to that of the project’sU.S. industry beta. To check thevalidity of the approach is toexamine whether the betas of thetwo industries (the project’s andthe proxy’s) are also similar inother national markets that con-tain both industries.

The least preferred approachis to estimate the foreign pro-ject’s beta, βFORSUB, by computingthe U.S. industry beta for theproject, βUSPROXY, and multiplyingit by the un-levered foreign mar-



Issues Related to Estimating Foreign Subsidiary’s Betas

1. Choice of proxies:a. Local companiesb. Local industryc. Adjusted U.S. industry

2. U.S., local, or world market index3. U.S. or local market risk premium

Exhibit 7

ket beta relative to the U.S.index, βFORMARKET.

βFORSUB = βUSPROXY �βFORMARKET

Implicit in this approach aretwo questionable assumptions.First, the beta for an industry inthe United States will be thesame as the beta for that industryin each foreign market. Second,the only correlation with theU.S. market of a foreign compa-ny in the project’s industrycomes through its correlationwith the local market and thelocal market’s correlation withthe U.S. market. For example,contrary to this assumption, anoil firm could have a low corre-lation in the local market but ahigh correlation with the U.S.market. However, to the extentthat returns for a foreign projectdepend largely on the local econ-omy, these two assumptions maybe an appropriate compromise.

For countries where there isno historical stock market datafor estimating the market beta, aclosed end country fund that istraded in the United States (or

elsewhere) may be used to esti-mate the country beta. Anotherpossibility is to compute GNPcorrelations.

An additional approach toestimating beta is suggested byCopeland et al. (2000). Prepare alist of industries and their betas.Have three to five managers of afirm or project select the indus-try with risk closest to the firm(or project). Use the beta of theselected industry.

In summary, it is recommend-ed that the cost of equity capitalfor a foreign subsidiary be esti-mated by finding a proxy portfo-lio in the country in which thatsub operates and calculates itsbeta relative to the U.S. market.That beta should then be multi-plied by the risk premium for theU.S. market. This estimated equityrisk premium would then beadded to the U.S. (parent’s) nomi-nal risk free rate to compute adollar cost of equity capital.

FOREIGN AFFILIATE DEBTSTRUCTURE

An objective of multination-als should be minimizing the

cost of capital for a given levelof business risk and capitalbudget. Therefore, the financialstructure of each affiliate is rele-vant only to the extent that itaffects this overall goal, asopposed to having an objectiveof minimizing its own independ-ent cost of capital. Internationalstudies have concluded thatcountry-specific environmentalvariables (see Exhibit 8) influ-ence foreign affiliate debt ratios.

Eiteman et al. (2001) sug-gests that a multinational shouldfollow a policy of borrowing atlowest cost, after adjusting forforeign exchange risk, anywherein the world without regard tothe impact on any particularaffiliate’s financial structure.This assumes compliance withlocal regulations. Both the multi-national and local affiliatesshould attempt to minimize theiroverall weighted average cost ofcapital. If debt is available to aforeign affiliate at equal cost tothat which could be raised else-where, after adjusting for foreignexchange risk, then localizingthe foreign affiliates financestructure should incur no penaltyand potentially allow someadvantages. If a foreign affiliatehas access to subsidized lower-cost foreign debt, the multina-tional should borrow all that itcan through the foreign affiliate.If conforming to debt norms ofthe host country does not requirea cost penalty but merelyreplaces debt in one affiliate bydebt in another, advantages canbe realized. The advantagesinclude better relations withhost-country authorities and bet-ter performance evaluation ofthe foreign affiliate.

DETERMINING VALUE

A firm’s cost of capital is theopportunity cost of investing in a



Country-Specific Determinants of Debt Ratios

1. Historical development2. Taxation3. Corporate governance4. Bank influence5. Existence of viable corporate bond market6. Attitude toward risk7. Government regulation8. Availability of capital9. Agency costs

Exhibit 8

firm as opposed to alternativeequally risky investments. It isthis rate that the market uses todiscount future cash flows of thefirm to present value to deter-mine the value of the firm. It isequal to the weighted-average-after-tax cost of the firm’s vari-ous sources of capital. Under theCAPM, the cost of equity isequal to the risk-free rate ofinterest plus a risk premiumequal to a firm specific measureof risk, beta, multiplied by thedifference between the risk-freeinterest rate and the expectedaverage market return. For a U.S.multinational, we recommended

using the U.S. market index tocompute beta for both the parentcompany and for foreign proj-ects. In addition, the risk premi-um should be based on U.S.rates of return and not global orlocal (foreign) market. Also, thecost of capital should be com-puted separately for each foreignproject.

REFERENCES

Copeland, T., Koller, T., & Murrin, J. (2000).Valuation, measuring and managing thevalue of companies (3rd ed.). NewYork: John Wiley & Sons Inc.

Eiteman, D.K., Stonehill, A.I., & Moffett,M.H. (2001). Multinational business

finance (9th ed.). Reading, MA: Addi-son Wesley Longman.

Shapiro, A.C. (1999). Multinational finan-cial management (6th ed.). New York:John Wiley & Sons.

Stewart, G.B., III. (1991). The quest forvalue. New York: Harper Business.

NOTES

1. Capital structure defines the break-down of capital among equity securi-ties and various forms of debt.

2. All terms are firm specific except forthe market return (rm) and the risk freereturn (rf). However, for most of theremainder of the article, we drop thesubscript indicating firm i.

3. Each industry has its own risk, and,therefore, cost of capital and capitalstructure.



Stephen R. Goldberg, Ph.D., CPA, and Joseph H. Godwin, Ph.D., CPA, are professors of accounting at theSeidman School of Business at Grand Valley State University. Jonathan E. Duchac, Ph.D., CPA, is an asso-ciate professor at the Calloway School of Business and Accountancy at Wake Forest University. Godwinserved as the 1998–1999 academic fellow in the Office of The Chief Accountant of the U.S. Securities andExchange Commission. Duchac has served as an executive vice president in the Accounting Policy Groupof Merrill Lynch. All of the authors have previously published articles on financial accounting, internation-al reporting, and performance measurement topics.

international treasury management: understanding the cost of capital

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