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MEASURING THE COST OF CAPITAL IN AN INTERNATIONAL CAPM FRAMEWORK

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    Acknowledgements: The authors would like to thank Justin Pettit of Stern Stewart for his useful comments on an earlier draft of this paper.

Abstract

This paper can be viewed as extending the traditional CAPM framework in two important ways. The first expands the concept of the market portfolio to include international securities. The second extends the definition of systematic risk to include currency risk.

What becomes clear in estimating the cost of capital for an international asset is that both extensions have become necessary if the traditional CAPM is to remain relevant. International markets have become increasingly integrated over the past two decades and so all assets might now be considered “international” and priced accordingly. The inclusion of the currency risk factor is not an ad hoc addition to the CAPM but rather results quite naturally from the fact that foreign returns need to be converted into a domestic currency.

Based on an examination of 18 companies, the article shows that the use of a broader market portfolio will tend to lower the estimated cost of capital for most firms, but in some cases could actually raise it. (In the case of Singapore Airlines, for example, the currency risk factor adds substantially to the cost of capital, while materially reducing it in the case of Nestlé.) Using a simple regression, the authors also attempt to show how the specifics of a particular company—for example, the currencies that are part of their cost/ revenue structure—determine the impact of currency risk on the cost of capital.

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