Chapter 19
Setting the Cost of
International Capital
This chapter deals with how to set the cost of capital, which is the discount rate used
in Capital Budgeting. The chapter title adds one word: international. Note that
what is said to be international iscapital. The title does not say “the international
cost of capital”, as the 1994 book (and many others) did: such a title would have
suggested that there is something like a national cost (for domestic projects, pre-
sumably) and, next to that, an international cost, for transborder investments. No,
there is just one cost of capital, and that capital is international. Shares of large cor-
porations are held by people everywhere; and, equally important, even shareholders
of smaller, more locally held firms still invest part of their wealth in foreign stocks.
This has two implications for the way the cost of capital is to be set. First, man-
agers should ask the question how much risk this project adds to an internationally
diversified portfolio instead of to a local market portfolio (the traditional method),
and set a cost of capital that is commensurate with this international risk. Second,
management has to take into account that the expected return differs depending
on what currency the shareholder uses as the (quasi-)real numeraire; and so does
the risk-free rate that serves as one benchmark item in the model. That is, when
setting the cost of capital, the issue of exchange risk has to be taken into account
too, in the sense of investors having different numeraires in which they are doing,
or supposed to be doing, their optimum-portfolio calculations.
There is a second—and largely independent—issue related to exchange rates: how
do we bring expected cash flows and cost of capital in line with each other. The issue
arises because when, say, an Australian firm invests in India, the expected future
cash flows are normally first expressed in Rupees. Yet, the argument typically goes,
the Australian owners care about Australian Dollars only—we’ll make this argument
more precise as we proceed—and the cost of capital we would estimate is probably
expressed inaud. One cannot discountinrcash flows using anauddiscount rate.
So at one point we need to go frominrtoaud.