PDF Ebook The Cross-Section of International Cost of Capital
This study presents a new methodology for estimating international cost of capital. Using a discounted cash flow model, we estimate market implied risk premia for firms in the G-7 countries during the 1990 to 2000 time period. We find that the average risk premia in G-7 countries typically fall within a narrow range of 2% to 4%, and that risk premia are consistently higher for some countries and industries. Variables most useful in explaining cross-sectional variation in implied risk premia are return volatility, size, B/M ratio, analyst growth forecast, and lagged industry-country risk premia. Together, these variables explain about 20% to 30% of the cross-sectional variation in international risk premia. Interestingly, beta risk measures nominated by a variety of international asset pricing models have little explanatory power.
How should a multinational manager estimate the cost of capital for an investment in a foreign country? What asset pricing model should she use? Should it be a single-factor or a multi-factor model? Does it really matter? What evidence is there to support one approach versus another? The finance literature offers surprisingly few definitive answers to these important practical questions.
To some extent these issues are not unique to the international context. Practical issues concerning the usefulness of firm betas and the noisy nature of factor risk premia estimates exist in domestic settings (e.g., see Fama and French (1997)). But, these problems assume a greater layer of complexity in the international context, because cross-border differences in legal and regulatory structure, accounting standards, and government policies give rise to a further decision: whether to use a domestic asset pricing model (DAPM) or an international asset pricing model (IAPM).
Opinions vary on this matter. Some finance textbooks (e.g., Shapiro (2002)) recommend an international CAPM (ICAPM) derived under the assumption of integrated financial and consumption goods markets. Other influential references (e.g., Bodnar, Dumas, andMarston (2002)) recommend the use of multi-factor international asset pricing models that capture additional dimensions of risk other than the world market risk. In practice, a variety of ad hoc approaches are used, many of which have questionable theoretical and empirical validity (see Harvey (2001).
Most theoretical work in international finance (e.g., Solnik (1974), Sercu (1980), Stulz (1981), and Adler and Dumas (1983)) favor the use of multi factor models. In these models, deviations from purchasing power parity (PPP) give rise to additional priced factors associated with exchange rate risks. As an excellent example of this genre, Stulz (1981) develops an international consumption CAPM (ICCAPM) which obtains as special cases various single and multi-factor international asset pricing models. Unfortunately, empirical implementations of international consumption CAPM (ICCAPM) are difficult because of the noisy nature of consumption data. Existing empirical work tends to support a multifactor IAPM over ICAPM (see Korajczyk and Viallet (1989), Ferson and Harvey (1993), Dumas and Solnik (1995) and Zhang (2003)). However, as Karolyi and Stulz (2002) point out: “the literature has provided clear evidence that national market risk premia are determined internationally, but less clear evidence that international factors affect the cross-section of expected returns.”
In this study, we document key determinants of the cross-section of expected returns in G-7 countries (Canada, France, Germany, Italy, Japan, UK, and US), and develop a practical approach for estimating the international cost of capital. Unlike the existing literature, which uses risk premia estimated from ex post average returns to test the validity of various international asset pricing models, we use forward-looking risk premium measures estimated from current stock prices and forecasts of future cash flows. As Elton (1999) and Gebhardt, Lee, and Swaminathan (2001) (GLS henceforth) observe, ex post average returns can be a poor proxy for expected returns in the cross-section. We use an implied cost of capital as our proxy for expected returns, and examine characteristics that explain its cross-sectional variation in an international setting.
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PDF Ebook The Cross-Section of International Cost of Capital
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