Estimating the Cost of Capital  515
currency should equal the U.S. dollar risk-free return and the change in the 
exchange rate:
1
1
1
+
(
) =
+
(
)
−
r
r
X
X
f t
A
f t
t
t
,
,
$
                    (27.1)
where  rf t,
$ = risk-free rate in U.S. dollars
Xt = exchange rate at time t of currency A expressed in U.S. dollars
If risk-free rates across currencies are tied to changes in exchange rates in 
this way, beta estimates based on excess returns will be the same whether we 
use U.S. dollars, Swiss francs, or any other currency. In practice, the relations 
will not hold perfectly. To avoid any differences in beta estimates, we recom-
mend using a synthetic risk-free rate for each currency when calculating a 
stock’s excess returns, based on the U.S. risk-free rate and the U.S. dollar ex-
change rate as defined in Equation 27.1.
Local CAPM  We recommend using a local CAPM for investors and compa-
nies facing restrictions to investing abroad. In that case, the local market port-
folio is the right reference to estimate the cost of capital. As a result, valuations 
in such restricted markets can be out of line with those in global markets—
which is what we have encountered in the past for valuations in, for example, 
the Indian and some Asian stock markets. The local CAPM is similar to the 
model described in Chapter 15 but stated in terms of a local risk-free rate, a 
risk premium of the local market portfolio over that risk-free rate, and a local 
beta measured against that same local market portfolio:
E r
r
E r
r
j
f L
j L
L
f L
( ) =
+
( ) −


,
,
,
β
where    rj = return for asset j
 rf,L = local risk-free rate
βj L
, = local beta of asset j versus local market portfolio L
rL = return for local market portfolio L
Some practitioners and academic researchers propose always using a local 
CAPM, regardless of any investment restrictions for investors and compa-
nies.5 Interestingly enough, empirical research finds that the local and global 
CAPM generate similar results for well-integrated markets (which is in line 
5 See, for example, R. Stulz, “The Cost of Capital in Internationally Integrated Markets: The Case of 
Nestlé,” European Financial Management 1, no. 1 (1995): 11–22.

516  Cross-Border Valuation
with theoretical predictions, as explained in Appendix G). For the United 
States, United Kingdom, Germany, France, and smaller economies such as 
the Netherlands and Switzerland, cost of capital estimates from a local and a 
global CAPM are very close to each other.6
Nevertheless, we don’t recommend the local CAPM approach for integrated 
markets, for several reasons. When applying the local CAPM for investments 
in different countries, you need to estimate the local market risk premium and 
beta for each of these countries instead of only the global market risk premium 
when applying the global CAPM. Using a local CAPM also means you cannot 
make a straightforward estimate of a company’s beta based on the average of 
the estimated betas for a sample of industry peers. In Chapter 15, we recom-
mend estimating an industry average beta to reduce its standard error, but if 
the peers are in different countries, their local betas are not directly compa-
rable. Finally, local risk premiums are typically less stable over time than their 
aggregate, the global risk premium. See Appendix G for more detail.
Applying a Domestic- or Foreign-Capital WACC
When cash flows and cost of capital are estimated in a consistent manner, the 
currency in which the cash flows are denominated will not affect the valua-
tion. This holds regardless of whether you are using the enterprise DCF ap-
proach, the adjusted present value (APV) approach, or the cash-flow-to-equity 
approach.
But you should be aware of some implicit assumptions made when ap-
plying the enterprise DCF approach with a weighted average cost of capital 
(WACC) for cross-border valuations. As explained in Chapter 15, the WACC 
automatically accounts for the value of interest tax shields in your valuation 
of free cash flows. When you translate a WACC from one currency into an-
other, you also translate the implied interest tax shields—and the underlying 
assumptions on debt financing and taxation.7 As a result, there are two basic 
choices in applying WACC in cross-border valuations:
1. Domestic-capital WACC. Use a domestic-capital WACC if the cross-bor-
der business is financed and taxed at domestic interest and tax rates. 
As international companies tend to borrow in their parent country at 
parent company currencies, this is the most common approach.8 To 
discount foreign cash flows, convert the domestic-capital WACC into a 
6 R. Harris, F. Marston, D. Mishra, and T. O’Brien, “Ex-Ante Cost of Equity Estimates of S&P 500 Firms: 
The Choice between Domestic and Global CAPM,” Financial Management 32, no. 3 (2003): 51–66.
7 This assumption concerns only the taxation of interest charges, not the foreign operating tax rate.
8 As always, account for the riskiness of the cross-border business in the WACC via the unlevered beta.