Chapter 12

1. Chapter 12 The Global Cost and Availability of Capital

2. Global Cost & Availability of Capital: Learning Objectives Examine 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 Explain how the weighted average cost of capital for an MNE compares with its domestic counterpart

3. Financial Globalization and Strategy 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 firm’s ability to compete both internationally and vis-à-vis foreign firms entering its market

4. Financial Globalization and Strategy 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. Financial Globalization and Strategy 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. Financial Globalization and Strategy 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. Exhibit 12.1 Dimensions of the Cost and Availability of Capital Strategy

8. 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)

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 β = coefficient of firm’s 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. The Cost of Capital The key component of CAPM is beta, the measure of systematic risk. Systematic risk is a measure of how the firm’s returns vary with those of the market in which it trades Beta will have a value of less than 1.0 if the firm’s returns are less volatile than the market, 1.0 if the same as the market, or greater than 1.0 if more volatile—or risky—than the market CAPM’s biggest challenge is that the beta used needs to be for the future and not the past International CAPM (ICAPM) assumes that there is a global market in which the firm’s equity trades, and estimates of the firm’s beta keglobal = krfg + βjg (kmg – krfg)

11. Trident’s WACC ke = krf + β(km - krf) = 4.00% + 1.2 (9.00% - 5.00%) = 10.00% kd (1 - t) = 8.00 (1 - 0.35) = 8.00 (0.65) = 5.20% kWACC = ke E /V + kd (1 – t) D/V = 10.00% (.60) + 5.20% (.40) = 8.08%

12. Trident’s WACC keglobal = krfg + βjg (kmg – krfg) = 4.00% + 0.90 (8.00% - 4.00%) = 7.60% kWACCICAPM = keglobalE/V + kd (1 – t)D/V = 7.60% (.60) + 5.20% (.40) = 6.64%

13. Nestlé: An Application of the International CAPM The process of calculating an international WACC differs from a domestic WACC in the selection of the appropriate market portfolio and beta Stulz (1995) suggests using a global portfolio of securities available to investors rather than the world portfolio of all securities (some of which may not be available to investors) when calculating a firm’s international cost of equity The next slide shows the domestic and international risk-free rates, market portfolios, and betas for Nestlé used to calculate required rates of return for equity In this example the domestic required return for Nestlé of 9.4065% differs slightly from Nestlé’s global required return of 9.3840%

14. Exhibit 12.2 The Cost of Equity for Nestlé of Switzerland

15. 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 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

16. Calculating Equity Risk Premia in Practice The field of finance does agree that a cost of equity calculation should be forward-looking, meaning that the inputs to the equation should represent what is expected to happen over the relevant future time horizon As is typically the case, however, practitioners use historical evidence as the basis for their forward-looking projections

17. Exhibit 12.3 Arithmetic Versus Geometric Returns: A Sample Calculation

18. Exhibit 12.4 Alternative Estimates of Cost of Equity for a Hypothetical U.S Firm Assuming β = 1 and krf = 4%

19. Exhibit 12.5 Corporate Cost of Equity and Capital Estimation

20. The Demand for Foreign Securities International portfolio investment and cross-listing of equity shares on foreign markets have become commonplace As both domestic and international portfolio managers are asset allocators, their objective is to maximize a portfolio’s rate of return for a given level of risk, or to minimize risk for a given rate of return International portfolio managers can choose from a larger bundle of assets than portfolio managers limited to domestic-only asset allocations Some important diversification dimensions include diversification by country, geographic region and/or stage of development

21. 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

22. 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 Lack of transparency High securities transaction costs Foreign exchange risks Political risks Corporate governance differences Regulatory barriers

23. 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 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

24. 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

25. Exhibit 12.6 Market Liquidity, Segmentation, and the Marginal Cost of Capital

26. Globalization of Securities Markets During the 1990s, national restrictions on cross-border portfolio investment were gradually eased under pressure from the Organization for Economic Cooperation and Development (OECD) Presently, market segmentation has been significantly reduced, although the liquidity of individual national markets remains limited Significantly higher value accrues to firms that have “imported” an Anglo-American corporate governance system

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. Exhibit 12.7 The Cost of Capital for MNE and Domestic Counterpart Compared

29. Exhibit 12.8 Do MNEs Have a Higher or Lower Cost of Capital Than Their Domestic Counterparts?

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. Increased market liquidity causes the marginal cost of capital line to “flatten out to the right.”This results in the firm being able to raise more capital at the same low marginal cost of capital, and thereby justify investing in more capital projects. The key is to attract international portfolio investors.

32. Summary of Learning Objectives 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 expected return and risk that are traded on other national securities markets. Capital market segmentation is a financial market imperfection caused by government constraints and investor perceptions. The most important imperfections are: 1) asymmetric information 2) transaction costs 3) foreign exchange risk 4) corporate governance differences 5) political risk 6) regulatory barriers

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

34. Summary of Learning Objectives Segmentation results in a higher cost of capital and less availability of capital If a firm is resident in a segmented capital market, it can escape from this market by sourcing its debt and equity abroad The result should be a lower marginal cost of capital, improved liquidity for its shares, and a larger capital budget Whether 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 the optimal capital budget

35. 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