Global Cost

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Chapter 11 Global Cost and Availability of
Capital
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Chapter 11Global Cost Availability of Capital

• Learning Objectives
• Show how a firm headquartered in a country with
  an illiquid and segmented capital market achieves
  a lower global cost of and greater availability
  of capital
• Analyze the linkage between cost and availability
  of capital
• Evaluate the effect of market liquidity and
  segmentation on the cost of capital
• Compare the weighted average cost of capital for
  an MNE with its domestic counterpart

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Global Cost Availability of Capital

• Global integration of capital markets has given
  many firms access to new and cheaper sources of
  funds beyond those available in their home market
• A firm that must source its long-term debt and
  equity in a highly illiquid domestic securities
  market will probably have a relatively high cost
  of capital and will face limited availability of
  such capital
• This in turn will limit the firms ability to
  compete both internationally and vis-à-vis
  foreign firms entering its market

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Global Cost Availability of Capital

• Firms resident in small capital markets often
  source their long-term debt and equity at home in
  these partially-liquid domestic markets
• The costs of funds is slightly better than that
  of illiquid markets, however, if these firms can
  tap the highly liquid international capital
  markets, their competitiveness can be
  strengthened
• Firms resident in segmented capital markets must
  devise a strategy to escape dependence on that
  market for their long-term debt and equity needs

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Global Cost Availability of Capital

• 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 such
  factors as 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 Availability of Capital

• Firms constrained by any of these above
  conditions must develop a strategy to escape
  their own limited capital markets and source some
  of their long-term capital needs abroad

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Global Cost Availability of Capital
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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 (DE)
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Cost of Equity and Debt

• 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 ß
coefficient of firms systematic risk

• The normal calculation for cost of debt is
  analyzing the various proportions of debt and
  their associated interest rates for the firm and
  calculating a before and after tax weighted
  average cost of debt

10
Tridents WACC

• Maria Gonzalez, Tridents CFO, believes that
  Trident has access to global capital markets and
  because it is headquartered in the US, that the
  US should serve as its base for market risk and
  equity risk calculations

Where kWACC weighted average cost of
capital ke Tridents cost of equity is
17.0 kd Tridents before tax cost of
debt is 8.0 t tax rate of 35.0 E/V
equity to value ratio of Trident is
60.0 D/V debt to value ratio of Trident
is 40.0
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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 riskless debt
• Typically, the markets 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 PremiumsIn Selected
Countries, 1900-2000
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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

• 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 the 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 financial market
  imperfection caused mainly by government
  constraints, institutional practices, and
  investor perceptions
• Other imperfections are
• Asymmetric information
• 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
  firms marginal cost of capital
• An MNE has a given marginal return on capital at
  differing budget levels determined by which
  capital projects it can and chooses to take on
• 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
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Novo Industri A/S

• Illustrative case of a Danish multinational that
  sought to internationalize its capital structure
  by accessing foreign capital markets
• Novo Industri is a Danish industrial enzyme and
  pharmaceutical firm
• In 1977 the management sought to tap in to other
  capital markets because the Danish market was
  illiquid and segmented causing Novo to incur a
  higher cost of capital than that of its
  international competitors

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Novo Industri A/S

• The Danish equity markets had at least six
  factors of market segmentation
• Asymmetric information for Danish and foreign
  investors
• Taxation
• Alternative sets of feasible portfolios
• Financial risk
• Foreign exchange risk
• Political risk

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Novo Industri A/S

• Asymmetric information
• Denmark had a regulation that prohibited Danish
  investors from holding foreign private sector
  securities
• This left little incentive for Danish investors
  to seek out new information or follow
  developments in other markets
• Another barrier was the lack of equity analysts
  in Denmark following Danish companies

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Novo Industri A/S

• Taxation
• Danish taxation policy charged a capital gains
  tax of 50 on shares held for over two years
• Shares held for less than two years were taxed at
  a marginal income tax rate as high as 75
• This led to bonds being the security of choice
  among Danes
• Feasible set of portfolios
• Because of the prohibition on foreign security
  ownership, Danish investors had a limited set of
  securities from which to choose
• Danish stocks offered international investors an
  opportunity to diversify, but not the reciprocal
  for Danish investors

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Novo Industri A/S

• Financial, Foreign exchange and political risks
• Danish firms were highly leveraged relative to US
  and UK standards with most debt being short-term
• Foreign investors were subject to foreign
  exchange risk but this was not a big obstacle for
  investment
• Denmark was very stable politically

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Novo Industri A/S

• The Road to Globalization
• When Novos management decided to access foreign
  equity markets in 1977 they had several barriers
  to overcome
• Closing the information gap Novo now needed to
  begin disclosing their financials in accordance
  with international standards
• In 1979 Novo had a successful Eurobond issues
  which lead to more disclosure and international
  recognition among investors

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Novo Industri A/S

• The Road to Globalization
• During 1979, Novo also listed its convertibles on
  the London Stock Exchange (LSE)
• Also during that year there was a big boom in
  biotechnology and Novo went to the US to sell
  investors on their company
• The road show worked and Novos shares on the
  Danish exchange and the LSE rose in price from
  increased demand
• This prompted Novo to consider an equity issue in
  the US

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Novo Industri A/S

• The Road to Globalization
• During the first half of 1981 Novo prepared an
  SEC registration
• Before the offering over 50 of Novos
  shareholders had become foreign investors
• On May 30, 1981 Novo listed in the NYSE and
  although it had lost 10 of its value in
  Copenhagen the previous day, the 61 million
  offering was a success and the share price
  quickly gained all its losses from the previous
  day

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Cost of Capital for MNEs versus Domestic Firms

• Is the WACC or 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

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Cost of Capital for MNEsversus Domestic Firms
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Cost of Capital for MNEsversus Domestic Firms
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Summary of Learning Objectives

• Gaining access to global capital markets should
  allow a firm to lower its cost of capital. A
  firm can improve access to global capital markets
  by increasing the market liquidity of its shares
  and by escaping its home capital market
• The costs and availability of capital is directly
  linked to the degree of market liquidity and
  segmentation. Firms having access to markets
  with high liquidity and low segmentation should
  have a lower cost of capital

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Summary of Learning Objectives

• A firm is able to increase its market liquidity
  by raising debt in the Euromarket, by selling
  issues in individual national markets and by
  tapping capital markets through foreign
  subsidiaries
• This causes the marginal cost of capital to lower
  for a firm and it results in a firms ability to
  raise even more capital
• A national capital market is segmented if the
  required rate of return on securities in that
  market differs from the required rate of return
  on securities of comparable return and risk that
  are traded in other national capital markets

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Summary of Learning Objectives

• The most important imperfections are asymmetric
  information, transaction costs, foreign exchange
  risk, political risk, corporate governance
  differences, and regulatory barriers
• Segmentation results in a higher cost of capital
  and less availability of capital

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Summary of Learning Objectives

• If a firm is resident in a segmented capital
  market, it can still escape from this market by
  sourcing its debts and equity abroad. The result
  should be a lower marginal cost of capital,
  improved liquidity for its securities, and a
  larger capital budget
• Whether or not MNEs have a lower cost of capital
  than their domestic counterparts depends on their
  optimal financial structures, systematic risk,
  availability of capital, and the level of optimal
  capital budget