International Financial Management

A manager should allocate capital to an investment project when the present value of the net cash flows generated by the project exceeds the current investment outlay. Applying this net present value principle requires a discount rate. It is one of the hallmarks of modern finance that this discount rate – the cost of equity capital – is set by investors in the capital markets. When investors finance a firm by purchasing its equity shares, they forgo the opportunity to invest in the equities of many other firms. Investors therefore demand to be compensated for the opportunity cost of their investment with an appropriate expected rate of return. Consequently, the manager of a firm in a capital budgeting situation should set the discount rate for a project to be the expected return for the firm's investors as if they were investing directly in that project.

Chapter 11 showed that the international bond market sets the cost of a company's debt equal to the risk-free (government) interest rate on bonds plus a risk premium to compensate for the possibility that the company may default on the debt. The appropriate rate for discounting the equity cash flows of any project similarly depends on how investors in the firm view the riskiness of the cash flows from that particular project. However, thinking about equity risk in increasingly global equity markets is difficult because there are many more factors involved.

How, then, do investors determine the riskiness of an investment, and how do managers know the required rate of return on a risky investment? Unfortunately, there are no easy answers to these questions, and there are competing theories. This chapter develops the theories necessary to determine the cost of equity capital. It then demonstrates how these theories apply in an international context. Because investors set the cost of equity capital, we start with a detour through the fascinating world of international investing and the theory of optimal portfolio choice. The idea of portfolio diversification figures prominently, and we will argue that international diversification is highly desirable. Blackrock, the world's largest asset manager with over $4 trillion has this advice on its iShares website: “Investing internationally can help diversify your investments to help reduce risk, while also potentially delivering long-term returns.”

Let's explore why they think this.