Applying a Domestic- or Foreign-Capital WACC  517 foreign-currency equivalent WACC by adding the inflation-rate differ- ence between the currencies in each year.9 The valuation result can be converted at the spot rate to obtain a value in domestic currency. 2. Foreign-capital WACC. Use a foreign-capital WACC if cross-border busi- nesses are financed and taxed at foreign rates. Discount the foreign cash flows directly at this WACC, and convert the result into domestic cur- rency at the spot rate. Alternatively, you could convert the foreign-capital WACC and cash flows into domestic currency and value the business using the forward-rate approach, which leads to the same result. Note that even when converted into the same currency, the domestic- and foreign-capital WACCs are not equal and therefore generate different valu- ation results. For example, consider a WACC estimate for the valuation of a Mexican subsidiary by its German parent company (Exhibit 27.2). For il- lustration purposes, we assume that the parent and subsidiary have identical business risk (ku = 9.0 percent in euros), tax rates (33 percent), credit quality (kd = 5.0 percent in euros), and target leverage (debt-to-value = 33 percent). The domestic-capital WACC for cash flows in euros is 8.5 percent. When we account for the seven-percentage-point inflation difference between the two currencies, the 8.5 percent WACC is equivalent to 16.0 percent in Mexican pesos. Applying this 16.0 percent WACC assumes that the debt financing and taxation of interest are taking place in euros. 9 That is, by adding to the domestic-capital WACC any forward inflation difference between the domestic and foreign currency, as explained in the first section of this chapter. EXHIBIT 27.2  WACC Measures for Mexican Subsidiary of German Parent Company Cross-border DCF valuation example, % Domestic-capital WACC Foreign-capital WACC Currency for measuring cash flows Euros Mexican pesos Cost of debt (kd) 5.0 12.3 Tax rate on interest 33.0 33.0 Difference from tax deduction of interest in foreign versus domestic currency Debt/(debt + equity) 33.0 33.0 Weighted kd after taxes 1.1 2.7 Unlevered cost of equity (ku) 9.0 16.6 Debt/equity 49.3 49.3 Cost of equity (ke) 11.0 18.7 Equity/(debt + equity) 67.0 67.0 Weighted ke 7.3 12.5 WACC 8.5 15.2 € inflation 1.0 1.0 Peso inflation 8.0 8.0 Equivalent WACC1 (in Mex$) 16.0 (in €) 7.7 1 Equivalent WACC in the other currency after adjusting for the difference in inflation. 518  Cross-Border Valuation The foreign-capital WACC is derived by converting the euro-based cost of debt and unlevered cost of equity into pesos (kd = 12.3 percent, and ku = 16.6 percent). The foreign-capital WACC based on cash flow in pesos amounts to 15.2 percent, equivalent to 7.7 percent in euros. The difference from the domestic-capital WACC stems from the after-tax cost of debt: tax shields are larger when the debt is financed and taxed in a higher-inflation currency, ev- erything else being equal. In practice, financing choices for cross-border business operations are far from straightforward, because companies need to take into account many complicating factors. These include differences in international taxation, the cost of local versus international debt funding, the depth of alternative debt markets, the impact on foreign-currency exposure, and others. How to make such international financing choices is beyond the scope of this book. But you should be careful in properly reflecting the outcome of such financing choices via the cost of capital in cross-border valuations. In practice, a domestic-capi- tal WACC is most common—but beware of exceptions. Incorporating Foreign-Currency Risk in the Valuation Many executives are concerned about the impact that currency fluctuations from foreign investments have on value creation in company results. The ana- lyst community and investors may be wary of the resulting earnings volatility, even though it does not matter for value creation. As a result, many companies still add a premium for currency risk to the cost of capital for foreign invest- ments. This is unnecessary. As we discuss in Appendix G, currency risk pre- miums in the cost of capital—if any—are likely to be small. There should be no difference between the cost of capital for investments in foreign currency and otherwise identical investments in domestic currency (when you apply consistent monetary assumptions). First, price fluctuations tend to mitigate currency fluctuations because of purchasing power parity. Second, currency risk is largely diversifiable for companies and shareholders. Any remaining risk from currency rate changes is best reflected in the cash flow projections for the investment. Keep in mind that nominal currency risk is irrelevant if exchange rates im- mediately adjust to differences in inflation rates. The only relevant currency risk is therefore real currency risk as measured by changes in relative pur- chasing power. For example, if you held $100 million of Brazilian currency in 1994, by 2019 it would be worth about $25 million in U.S. dollars. Yet if you adjust for purchasing power, the value of the currency has fluctuated around the $100 million mark during the 25-year period. Exhibit 27.3 shows the estimated real effective (inflation-adjusted) exchange rate for the Brazilian currency, which has continued to hover around the 1994 level although the nominal exchange rate to the U.S. dollar plummeted.