Global Financial Structure

1
Global Financial Structure

• P.V. Viswanath
• International Corporate Finance

2
The cost of staying domestic

• Firms that are forced to source their long-term
  debt and equity in a highly illiquid domestic
  securities market will have
• a relatively high cost of capital and
• limited availability of capital.

3
Dimensions of Cost and Availability
4
Segmented Capital Markets

• Capital Markets become segmented because of
  market imperfections, such as
• Regulatory Controls
• Perceived Political Risk
• Foreign Exchange Risk
• Lack of Transparency
• Asymmetric Information
• Cronyism
• Insider Trading

5
Estimating the Global Cost of Equity for Nestlé
in Swiss Francs
Question Would an MNE with access to global
capital always have a lower cost of capital than
if it were restricted to domestic sources?
6
Market Segmentation and Market Efficiency

• A 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 risk that are traded on other national
  securities markets.
• A market is efficient if security prices in that
  market reflect all available information.
• Although segmented markets are likely to be
  inefficient, the two concepts are independent.
  If security prices in a segmented market reflect
  all relevant local information, that market would
  indeed be efficient. However, foreign investors
  would not be participants in such a market.

7
Global Sourcing and Lower Capital Costs

• Local capital markets are likely to be smaller.
  Hence, a firm that begins with a domestic capital
  market and is forced to raised its capital
  locally will, after a while, find that it has to
  pay a high price for its capital needs.
• If it can access global markets, it can raise
  funds at a cheaper rate for those additional
  capital needs.

8
Global Sourcing and Lower Capital Costs
Marginal Return on Investments
Local Marginal Cost of Capital
Cost of Capital
C
Global Marginal Cost of Capital
B
A
Budget
9
Global Sourcing and Lower Capital Costs

• However, this cannot be guaranteed once the
  domestic capital market becomes completely
  integrated into the global market.
• If investors in the domestic market do not have
  access to a global market as well, they are
  essentially forced to invest locally and may be
  satisfied with a lower rate of return.
• Hence it may be optimal for the global firm to
  tap the cheaper local markets for its initial
  capital requirements, and go global only once its
  needs get so great that it would be very
  expensive to continue to use local markets

10
Global Sourcing and Lower Capital Costs

• Once the domestic market becomes completely
  integrated into global markets, investors will
  demand the higher rates of return that may be
  available in global markets. This would rob the
  firm of the originally available bargain sources
  of capital.
• Local business may be hurt, especially those with
  monopolies, along with their owners and
  employees. However, local investors will be
  better off.

11
Global Sourcing and the Price of Risk
The slope of a markets capital allocation line
represent the reward to risk ratio in that market
Global Efficient Frontier
Expected Returns
Domestic Efficient Frontier
Standard Deviation of Returns
12
Global Sourcing and the Price of Risk
The price of risk for the firm with global
options can be lower at higher risk levels
Global Efficient Frontier
Expected Returns
Domestic Efficient Frontier
Standard Deviation of Returns
13
Global Sourcing and Investment Choices

• If a firm has access to global sources of
  capital, it can make different decisions
  regarding the choice of projects and their
  riskiness
• It can also make different decisions regarding
  capital structure. For example,
• If it can sell off its assets in more liquid
  markets, its bankruptcy costs would be lower.
• If it can reorganize cheaper, its bankruptcy
  costs would be lower.
• If debt is cheaper relative to equity in global
  markets
• In such a case, the firm would choose more debt.