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Chapter 11

Global Cost and Availability of Capital

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Global Cost and Availability of Capital

• How a firm headquartered in a country with an illiquid and segmented capital market achieves a lower global cost and greater availability of capital

• Analyze the linkage between cost and availability of capital

• Effect of market liquidity and segmentation on the cost of capital

• Weighted average cost of capital comparison between an MNE and its domestic counterpart

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Global Cost and Availability of Capital

• Financing a firm in a highly illiquid domestic securities market will probably increase the cost of capital and limit the availability of capital

• This in turn will limit the firm’s ability to compete both internationally and firms entering its market

• If the firm can use the highly liquid international capital markets, its competitiveness can be strengthened

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Global Cost and Availability of Capital

• Firms in segmented capital markets must devise a strategy to escape dependence on that market for their long-term debt and equity needs

• A national capital market is segmented if the required rate of return on securities differs from the required rate of return on securities of comparable expected return and risk traded on other securities markets

• Capital markets become segmented because of excessive regulatory control, perceived political risk, anticipated FOREX risk, lack of transparency, asymmetric information, cronyism, insider trading and other market imperfections

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Global Cost and Availability of Capital

Market Liquidity for Firm’s Securities

Illiquid domestic securities marketand limited international liquidity

Highly liquid domestic market andbroad international participation

Effect of Market Segmentation on Firm’s Securities and Cost of Capital

Segmented domestic securitiesmarket that prices sharesaccording to domestic standards

Access to global securities marketthat prices shares according tointernational standards

Firm’s securities appeal onlyto domestic investors

Firm’s securities appeal tointernational portfolio investors

Firm-Specific Characteristics

Local Market Access Global Market Access

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Weighted Average Cost of Capital

• Where– kWACC = weighted average cost of capital

– ke = risk adjusted cost of equity

– kd = before tax cost of debt– t = tax rate– E = market value of equity– D = market value of debt– V = market value of firm (D+E)

V

Dt)(k

V

Ekk deWACC 1

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Cost of Equity

• Cost of equity is calculated using the Capital Asset Pricing Model (CAPM)

• Where– ke = expected rate of return on equity

– krf = risk free rate on bonds

– km = expected rate of return on the market

– km – krf = equity risk premium– β = coefficient of firm’s systematic risk

)kk(k k rfmrfe

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Cost of Debt

• The normal calculation for cost of debt is analyzing the various proportions of debt and their associated costs for the firm (required returns for investors) and calculating a before and after tax weighted average cost of debt

• Foreign exchange risk & cost of debt– When a firm issues foreign currency denominated debt, its

effective cost equals the after-tax cost of repayment in terms of the firm’s own currency

– Example: US firm borrows Sfr1,500,000 for one year at 5.00% p.a.; the franc appreciates from Sfr1.500/$ to Sfr1.440/$• Initial dollar amount borrowed:

000,000,1$Sfr1.500/$

00Sfr1,500,0=

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Cost of Debt

• At the end of the year, the US firm repays the interest plus principal

• The actual dollar cost of the loan is not the nominal 5.00% paid in Swiss francs, but 9.375%

750,093,1$Sfr1.440/$

1.05 x 00Sfr1,500,0=

09375.1000,000,1

$1,093,750=

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Cost of Debt

• This total home currency cost is higher than expected because of the appreciation of the Swiss franc

• This cost is the result of the combined cost of debt and the percentage change in the foreign currency’s value

• Where– kd

$ = Cost of borrowing for US firm in home country

– kdFC = Cost of borrowing for US firm in a Foreign Currency

– s = Percentage change in spot rate

( ) ( )[ ] 1s1 x k1k FCd

$d -++=

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Cost of Debt

• The total cost of debt must include the change in the exchange rate

• The percentage change in the dollar value of the Swiss franc given indirect quotes is calculated as

• The total cost is then

4.1667% 100 x Sfr1.440/$

Sfr1.440/$ - Sfr1.500/$ 100 x

S

S-SFC/$

FC/$2

FC/$

2

1

( ) ( )[ ] 09375.01041667.01 x 05.1k $d =-++=

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WACC

• What is the WACC for the following case:• Risk-free rate of return: 4%, the expected

market return: 11%, proportion of debt: 40%, cost of debt: 6%, β of the equity: 1.30, and the tax rate: 35%.

09420

400350-10606001310

1310040-11031040

.k

).)(.(.).(.k

.)..(..k

WACC

WACC

e

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Calculating Equity Risk Premia in Practice

• Using CAPM, there is rising debate over what numerical values should be used in its application, especially the equity risk premium– The equity risk premium is the expected average

annual return on the market above risk-free rate– Typically, the market’s return is calculated on a

historical basis yet others feel that the number should be forward looking since it is being used to calculate expected returns

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Equity Market Risk Premiums In Selected Countries, 1900-2000

1

1

1

0

TT

t

1t

P

P MeanGeometric

years T over P

P of Average MeanArithmetic

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Alternative Estimates of Cost of Equity for a Hypothetical US Firm

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Link between Cost & Availability of Capital (Liquidity)

• Although no consensus exists on the definition of market liquidity, market liquidity can be observed by noting the degree to which a firm can issue new securities without depressing existing market prices

• In a domestic case, the underlying assumption is that total availability of capital at anytime for a firm is determined by supply and demand within its domestic market

• In the multinational case, a firm is able to improve market liquidity by raising funds in the Euromarkets, by selling securities abroad, and by tapping local capital markets

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Market Segmentation

• Capital market segmentation is a market imperfection caused mainly by government constraints, institutional practices, and investor perceptions

• The most important imperfections are– Asymmetric information– Lack of transparency– High securities transaction costs– Foreign exchange risks– Political risks– Corporate governance differences– Regulatory barriers

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Effects of Market Liquidity & Segmentation

• The degree to which capital markets are illiquid or segmented has an important influence on a firm’s marginal cost of capital

• Marginal cost of capital is a dynamic case compared to WACC

• Marginal return on capital at differing budget levels determined by ranking the potential investments based on NPV or IRR

• If the firm is limited to raising funds in its domestic market, it has domestic marginal cost of capital at various budget levels

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Effects of Market Liquidity & Segmentation

• If an MNE has access to additional sources of capital outside its domestic market, its marginal cost of capital can decrease

• If the MNE has unlimited access to capital both domestic and abroad, then its marginal cost of capital decreases even further

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Effects of Market Liquidity & Segmentation

Budget(millions of $)

Marginal cost of capitaland rate of return (percentage)

10 20 30 40 50 60

20%15%13%10%

MRR

MCCF

kF

MCCU

kU

kD

MCCD

Escaping Illiquidity

Escaping Illiquidity and Segmentation

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Novo Industri A/S (Novo)

• Novo is a Danish multinational firm.• The company’s management decided to

“internationalize” the firm’s capital structure and sources of funds.

• This was based on the observation that the Danish securities market was both illiquid and segmented from other capital markets (at the time).

• Management realized that the company’s projected growth opportunities required raising capital beyond what could be raised in the domestic market alone.

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Novo Industri A/S (Novo)• Six characteristics of the Danish equity market were responsible for market

segmentation:– Asymmetric information base of Danish and foreign investors;

• Danish investors could not own foreign securities• Few security analysts in Denmark• Language and accounting principles

– Taxation;– Alternative sets of feasible portfolios;– Financial risk;– Foreign exchange risk, and– Political risk.

• Although Novo’s management wished to escape from the Denmark’s segmented and illiquid capital market, many barriers had to be overcome.

• These barriers included closing the information gap between the capital markets and the company itself and executing a share offering in the US (which required resolving additional barriers imposed by the government of Denmark on securities issuances).

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Novo Industri A/S (Novo)

• Source: Arthur I. Stonehill and Kåre B. Dullum, Internationalizing the Cost of Capital: The Novo Experience and National Policy Implications, London: John Wiley, 1982, p. 73. Reprinted with permission.

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77.1 77.2 77.3 77.4 78.1 78.2 78.3 78.4 79.1 79.2 79.3 79.4 80.1 80.2 80.3 80.4 81.1 81.2 81.3 81.4 82.1 81.2

Time

Sh

are

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ce

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200

400

600

800

1000

1200

Mar

ket

In

dic

es

Novo-B Shares Danish Industry DJIA (NYSE) FT (London)

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Cost of Capital for MNEs vs. Domestic Firms

• Is the WACC for an MNE higher or lower than for its domestic counterpart?– The answer is a function of

• The marginal cost of capital• The after-tax cost of debt• The optimal debt ratio• The relative cost of equity

• An MNE should have a lower cost of capital because it has access to a global cost and availability of capital

• This availability and cost allows the MNE more optimality in capital projects and budgets compared to its domestic counterpart leading to a constant WACC for a large budget

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Some Reality Check

• It is clear that MNEs can take advantage of higher debt levels because their cash flows are diversified internationally

• However, MNEs face costs of international diversification:– Agency costs– Political risk– Exchange rate risk– Asymmetric information

• All these factors actually cause MNEs to have lower leverage increasing WACC

• MNEs usually have lower cost of debt lowering WACC• MNEs have higher systematic risk increasing WACC

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Some Reality Check

• Components of β

• Benefits of diversification is a lower correlation between the security j and the market, however, increased standard deviation of security j leads to a higher beta or systematic risk

m market, the of deviation standardthe

j security of deviation standardthe

m market, the andj security between ncorrelatio the

,where

m

j

jm

m

jjm

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Cost of Capital for MNEs vs. Domestic Firms

Budget(millions of $)

Marginal cost of capitaland rate of return (percentage)

100 140 300 350 400

15%

10%

5%

20%

MCCDC

MRRDC

MRRMNE

MCCMNE

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Cost of Capital for MNEs versus Domestic Firms

Empirical studies indicate MNEs have a lower debt/capital ratio than domestic counterparts indicating MNEs have a higher cost of capital.

The cost of equity required by investors is higher for multinational firms than for domestic firms. Possible explanations are higher levels of political risk, foreign exchange risk, and higher agency costs of doing business in a multinational managerial environment. However, at relatively high levels of the optimal capital budget, the MNE would have a lower cost of capital.

[kWACC = ke Equity

Value+ kd ( 1 – tx )

Debt

Value[ ]]Is MNEwacc > or < Domesticwacc ?

And indications are that MNEs have a lower average cost of debt than domestic counterparts, indicating MNEs have a lower cost of capital.