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Global Cost

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Title: Global Cost


1
Chapter 11 Global Cost and Availability of
Capital
2
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

3
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

4
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

5
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

6
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

7
Global Cost Availability of Capital
8
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)
9
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
11
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

12
Equity Market Risk PremiumsIn Selected
Countries, 1900-2000
13
Alternative Estimates of Cost of Equity for a
Hypothetical US Firm
14
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

15
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

16
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

17
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

18
Effects of Market Liquidity Segmentation
19
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

20
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

21
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

22
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

23
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

24
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

25
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

26
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

27
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

28
Cost of Capital for MNEsversus Domestic Firms
29
Cost of Capital for MNEsversus Domestic Firms
30
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

31
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

32
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

33
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
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