Abstract

This study presents a new methodology for estimating international cost of capital and tests international asset pricing models with these measures.

Issue

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 level 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).

Response

In this study, we develop a practical approach for estimating the international cost of capital and document key determinants of the cross-section of individual firm expected returns in G-7 countries (Canada, France, Germany, Italy, Japan, United Kingdom, and the United States), and. 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 to test international asset pricing models and examine characteristics that explain its cross-sectional variation in an international setting

Impact

We have three major objectives: (a) to provide a comprehensive study of individual firm expected return in an international setting, (b) to devise a practical approach to estimating cost of capital for international investments and (c) to conduct tests of international asset pricing models using our forward looking cost of capital measures.

While there are a number of existing studies that test international asset pricing models, they all use ex post average returns as proxies of expected returns and use portfolios as their basic assets. Our paper is the first to estimate forward-looking cost of capital measures for international firms and conduct asset pricing tests using these measures.

Our results reveal striking country and industry patterns in the implied risk premia. At the country level, we find relatively little cross-sectional variation in the implied risk premia. This suggests that multinational managers might be able to use an aggregate risk premium across the G-7 countries.

At the industry level, we find much more cross-sectional variation in the implied risk premium. Some industries, such as Mining, Metals, Tobacco, Transport Equipment, and Paper, have consistently higher implied risk premia; other industries, such as Real Estate, Food, Publishing, Chemicals, and Retail, have consistently lower risk premia. Furthermore, it is useful to condition on both country and industry membership simultaneously when estimating a firm's cost of capital.

Funding Sources

• Private (e.g., commodity groups, foundations, companies)
• Federal Formula Funds - Research (e.g., Hatch, McIntire-Stennis, Animal Health)

Collaborators

• Charles Lee, Johnson Graduate School of Management
• Bhaskaran Swaminathan, Johnson Graduate School of Management

Key Personnel

• Charles Lee
• Bhaskaran Swaminathan