Title: Global Cost
1 Chapter 11 Global Cost and Availability of
Capital
2Chapter 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
3Global 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
4Global 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
5Global 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
6Global 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
7Global Cost Availability of Capital
8Weighted 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)
9Cost 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
10Tridents 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
11Calculating 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
12Equity Market Risk PremiumsIn Selected
Countries, 1900-2000
13Alternative Estimates of Cost of Equity for a
Hypothetical US Firm
14Link 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
15Market 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
16Effects 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
17Effects 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
18Effects of Market Liquidity Segmentation
19Novo 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
20Novo 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
21Novo 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
22Novo 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
23Novo 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
24Novo 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
25Novo 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
26Novo 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
27Cost 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
28Cost of Capital for MNEsversus Domestic Firms
29Cost of Capital for MNEsversus Domestic Firms
30Summary 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
31Summary 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
32Summary 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
33Summary 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