moffett ppt lect ch12

Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Chapter 12

The Global Cost and Availability of Capital

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 12-2

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

• Compare the weighted average cost of capital for an MNE with its domestic counterpart


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 firm’s ability to compete both internationally and vis-à-vis foreign firms entering its market



• 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



• 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



• 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


Exhibit 12.1 Dimensions of the Cost and Availability of Capital Strategy


V

Dt)1(k

V

Ekk deWACC −+=

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)

Weighted Average Cost of Capital


)kk(k k rfmrfe −+= βWhere

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

Cost of Equity and Debt

• Cost of equity is calculated using the Capital Asset Pricing Model (CAPM)


%28.12k

)40.0)(35.01%(00.8)60.0%(00.17k

WACC

WACC

=−+=

Where

kWACC = weighted average cost of capital

ke = Carlton’s cost of equity is 17.0%

kd = Carlton’s before tax cost of debt is 8.0%

t = tax rate of 35.0%

E/V = equity to value ratio of Carlton is 60.0%

D/V = debt to value ratio of Carlton is 40.0%

Trident’s WACC

• Maria Gonzales, Trident’s CFO, believes that Carlton 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


Exhibit 12.2 Calculation of Trident’s Weighted Average Cost of Capital


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%


Exhibit 12.3 Estimating the Global Cost of Equity for Nestlé (Switzerland)


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


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


Exhibit 12.4 Equity Risk Premiums Around the World, 1990-2002


Exhibit 12.5 Arithmetic Versus Geometric Returns: A Sample Calculation


Exhibit 12.6 Alternative Estimates of Cost of Equity for a Hypothetical U.S Firm Assuming β = 1 and krf = 4%


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


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


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


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


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


Exhibit 12.7 Market Liquidity, Segmentation, and the Marginal Cost of Capital


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


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


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


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


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


Novo Industri A/S

• The Road to Globalization– When Novo’s 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


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 Novo’s 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


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 Novo’s 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


Exhibit 12.8 Novo’s B-Share Prices Compared with Stock Market Indices


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


Exhibit 12.9 The Cost of Capital for MNE and Domestic Counterpart Compared


Exhibit 12.10 Do MNEs Have a Higher or Lower WACC than Their Domestic Counterparts?


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



• 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 firm’s 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



• 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



• 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



• 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