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CHAPTER 17 INTERNATIONAL CAPITAL STRUCTURE AND THE COST OF CAPITAL
ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS
QUESTIONS
1. Suppose that your firm is operating in a segmented capital market. What actions would you
recommend to mitigate the negative effects?
Answer: The best solution for this problem is to cross-list your firm’s stock in overseas markets
2. Explain why and how a firm’s cost of capital may decrease when the firm’s stock is cross-
listed on foreign stock exchanges.
Answer: If a stock becomes internationally tradable upon overseas listing, the required return
on the stock is likely to go down because the shareholder base tends to be expanded across
3. Explain the pricing spill-over effect.
Answer: Suppose a firm operating in a relatively segmented capital market (like China, for
example) decides to cross-list its stock in New York or London. Upon cross-border listing, the
firm’s stock will be priced internationally. In addition, the pricing of remaining purely domestic
4. In what sense do firms with nontradable assets get a free-ride from firms whose securities
are internationally tradable?
Answer: Due to the spillover effect, firms with nontradable securities can benefit in terms of
5. Define and discuss indirect world systematic risk.
Answer: The indirect world systematic risk can be defined as the covariance between a
nontradable asset and the world market portfolio that is induced by tradable assets. In the
6. Discuss how the cost of capital is determined in segmented vs. integrated capital markets.
Answer: In segmented capital markets, the cost of capital will be determined essentially by the
7. Suppose there exists a nontradable asset with a perfect positive correlation with a portfolio T
of tradable assets. How will the nontradable asset be priced?
Answer: The nontradable asset with a perfect positive correlation with portfolio T (for tradable)
8. Discuss what factors motivated Novo Industries to seek U.S. listing of its stock. What lessons
can be derived from Novo’s experiences?
Answer: Novo, a rapidly growing company, was domiciled in a small and segmented Danish
market. This restricted the firm’s ability to raise capital at a competitive rate. As discussed in the
9. Discuss foreign equity ownership restrictions. Why do you think countries impose these
restrictions?
Answer: Many countries restrict the maximum fractional ownership of local firms by foreigners.
10. Explain the pricing-to-market phenomenon.
Answer: The pricing-to-market (PTM) refers to the phenomenon that the same securities are
priced differently for different investors. A well-known example of PTM is provided by Nestle. Up
11. Explain how the premium and discount are determined when assets are priced-to-market.
When would the law of one price prevail in international capital markets even if foreign equity
ownership restrictions are imposed?
Answer: The premium and discount are determined by (i) the severity of restrictions imposed
on foreigners and (ii) foreigners’ ability to mitigate the effect of these restrictions using their own
12. Under what conditions will the foreign subsidiary’s financial structure become relevant?
Answer: The subsidiary’s own financial structure will become relevant when the parent firm is
13. Under what conditions would you recommend that the foreign subsidiary conform to the
local norm of financial structure?
Answer: It may make sense for the subsidiary to confirm to the local norm if the parent is not
PROBLEMS
Answer problems 1-3 based on the stock market data given by the following table.
Correlation Coefficients
Telmex Mexico World SD(%)
R
(%)
Telmex 1.00 .90 0.60 18 ?
Mexico 1.00 0.75 15 14
World 1.00 10 12
The above table provides the correlations among Telmex, a telephone/communication company
located in Mexico, the Mexico stock market index, and the world market index, together with the
standard deviations (SD) of returns and the expected returns (
R
). The risk-free rate is 5%.
1. Compute the domestic country beta of Telmex as well as its world beta. What do these betas
measure?
2. Suppose the Mexican stock market is segmented from the rest of the world. Using the CAPM
paradigm, estimate the equity cost of capital of Telmex.
3. Suppose now that Telmex has made its shares tradable internationally via cross-listing on
NYSE. Again using the CAPM paradigm, estimate Telmex’s equity cost of capital. Discuss the
possible effects of international pricing of Telmex shares on the share prices and the firm’s
investment decisions.
Solutions.
1. The domestic beta,
M
T
, and the world beta,
W
T
, of Telmex can be computed as follows:
1.08
225
243
(15)
.9)(18)(15)(0
22
M
TMMT
2
M
TM
M
T
1.08
100
108
(10)
.6)(18)(10)(0
22
W
TWWT
2
W
TW
W
T
Both the domestic and world beta turn out to be the same. As the market moves by 1%, Telmex
stock return will move by 1.08%
.
2.
%72.14)08.1)(514(5
)(
M
TfMfT RRRR
3.
%56.12)08.1)(512(5
)(
W
TfWfT RRRR
