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 G7 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 20% to 30% of the cross-sectional variation in international risk premia. Interestingly, beta measures from various international asset pricing models have little explanatory power, while betas corresponding to empirical size and book-to-market factors do much better. 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, and Marston (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) that 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. 1 Harvey (2001) describes and critically evaluates various approaches used by financial practitioners.