Ch14 - INSTRUCTORS MANUAL MULTINATIONAL FINANCIAL MANAGEMENT 9TH ED CHAPTER 14 THE COST OF CAPITAL FOR FOREIGN INVESTMENTS KEY POINTS 1 A project's

Info iconThis preview shows pages 1–2. Sign up to view the full content.

View Full Document Right Arrow Icon
INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT , 9TH ED. CHAPTER 14 THE COST OF CAPITAL FOR FOREIGN INVESTMENTS K EY P OINTS 1. A project's cost of capital is a function of the riskiness of the project itself, not the risk of the firm undertaking the project. Thus, if an investment's risk characteristics differ from those of the firm's average investment, it is inappropriate to discount project cash flows at the firm's cost of equity capital. 2. Even if foreign investments are riskier than domestic investments that does not mean that those risks must lead to a higher cost of capital for the former. The basic insight of the capital asset pricing model (CAPM) is that only the systematic component of risk is priced; diversifiable risk must be borne at a zero price. The key question for the MNC is whether systematic risk is measured in the context of a globally-diversified portfolio or only a domestically-diversified portfolio. There is strong evidence that much risk that is systematic from a domestic standpoint is unsystematic from a global stand-point. If risk is measured relative to a domestically-diversified portfolio, then foreign projects probably have lower systematic risk than comparable domestic investments, and so should require lower returns. If risk is measured relative to a globally-diversified portfolio, foreign projects will likely still be less risky than domestic projects and require lower returns. But the gap between the required return on domestic and comparable foreign investments should be less in the second case. The total risk of many foreign investments will probably exceed the total risk of their domestic counterparts. But because of the lower correlation between returns on domestic and foreign projects, foreign investing could still reduce the MNC's total risk. Hence, executives of multinational firms should seriously question the use of a risk premium to account for the added political and economic risks of overseas operations, when evaluating prospective foreign investments. The use of any risk premium ignores the fact that the risk of an overseas investment in the context of the firm's other investments, domestic as well as foreign, will be less than the project's total risk. How much less depends on how highly correlated are the outcomes of the firm's different investments. Some investments, however, are more risk-prone than are others, and these risks must be accounted for. This chapter shows how to adjust project discount rates, using the CAPM, when those additional foreign risks are systematic in nature. Chapter 17 will show how to conduct the necessary risk analysis for foreign investments when the foreign risks are unsystematic (through cash flow adjustments). The chapter also explored the factors that are relevant in determining appropriate parent, affiliate, and worldwide
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Image of page 2
This is the end of the preview. Sign up to access the rest of the document.

This note was uploaded on 12/14/2010 for the course FIN 429 taught by Professor Bahgwat during the Fall '08 term at Grand Valley State University.

Page1 / 9

Ch14 - INSTRUCTORS MANUAL MULTINATIONAL FINANCIAL MANAGEMENT 9TH ED CHAPTER 14 THE COST OF CAPITAL FOR FOREIGN INVESTMENTS KEY POINTS 1 A project's

This preview shows document pages 1 - 2. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online