Presentation on theme: "Global Cost and Availability of Capital"— Presentation transcript:
1 Global Cost and Availability of Capital Chapter 11Global Cost and Availability of Capital
2 Global Cost and Availability of Capital How a firm headquartered in a country with an illiquid and segmented capital market achieves a lower global cost and greater availability of capitalAnalyze the linkage between cost and availability of capitalEffect of market liquidity and segmentation on the cost of capitalWeighted average cost of capital comparison between an MNE and its domestic counterpart
3 Global Cost and Availability of Capital Financing a firm in a highly illiquid domestic securities market will probably increase the cost of capital and limit the availability of capitalThis in turn will limit the firm’s ability to compete both internationally and firms entering its marketIf the firm can use the highly liquid international capital markets, its competitiveness can be strengthened
4 Global Cost and Availability of Capital Firms in segmented capital markets must devise a strategy to escape dependence on that market for their long-term debt and equity needsA 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 marketsCapital markets become segmented because of excessive regulatory control, perceived political risk, anticipated FOREX risk, lack of transparency, asymmetric information, cronyism, insider trading and other market imperfections
5 Global Cost and Availability of Capital Firm’s securities appeal onlyto domestic investorsFirm’s securities appeal tointernational portfolio investorsFirm-Specific CharacteristicsLocal Market AccessGlobal Market AccessMarket Liquidity for Firm’s SecuritiesIlliquid domestic securities marketand limited international liquidityHighly liquid domestic market andbroad international participationEffect of Market Segmentation on Firm’s Securities and Cost of CapitalSegmented domestic securitiesmarket that prices sharesaccording to domestic standardsAccess to global securities marketthat prices shares according tointernational standards
6 Weighted Average Cost of Capital WherekWACC = weighted average cost of capitalke = risk adjusted cost of equitykd = before tax cost of debtt = tax rateE = market value of equityD = market value of debtV = market value of firm (D+E)
7 Cost of EquityCost of equity is calculated using the Capital Asset Pricing Model (CAPM)Whereke = expected rate of return on equitykrf = risk free rate on bondskm = expected rate of return on the marketkm – krf = equity risk premiumβ = coefficient of firm’s systematic risk
8 Cost of DebtThe normal calculation for cost of debt is analyzing the various proportions of debt and their associated costs for the firm (required returns for investors) and calculating a before and after tax weighted average cost of debtForeign exchange risk & cost of debtWhen a firm issues foreign currency denominated debt, its effective cost equals the after-tax cost of repayment in terms of the firm’s own currencyExample: US firm borrows Sfr1,500,000 for one year at 5.00% p.a.; the franc appreciates from Sfr1.500/$ to Sfr1.440/$Initial dollar amount borrowed:
9 Cost of DebtAt the end of the year, the US firm repays the interest plus principalThe actual dollar cost of the loan is not the nominal 5.00% paid in Swiss francs, but 9.375%
10 Cost of DebtThis total home currency cost is higher than expected because of the appreciation of the Swiss francThis cost is the result of the combined cost of debt and the percentage change in the foreign currency’s valueWherekd$ = Cost of borrowing for US firm in home countrykdFC = Cost of borrowing for US firm in a Foreign Currencys = Percentage change in spot rate
11 Cost of DebtThe total cost of debt must include the change in the exchange rateThe percentage change in the dollar value of the Swiss franc given indirect quotes is calculated asThe total cost is then
12 WACC What is the WACC for the following case: Risk-free rate of return: 4%, the expected market return: 11%, proportion of debt: 40%, cost of debt: 6%, β of the equity: 1.30, and the tax rate: 35%.
13 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 premiumThe equity risk premium is the expected average annual return on the market above risk-free rateTypically, 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
14 Equity Market Risk Premiums In Selected Countries, 1900-2000
15 Alternative Estimates of Cost of Equity for a Hypothetical US Firm
16 Link between Cost & Availability of Capital (Liquidity) 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 pricesIn 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 marketIn 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
17 Market SegmentationCapital market segmentation is a market imperfection caused mainly by government constraints, institutional practices, and investor perceptionsThe most important imperfections areAsymmetric informationLack of transparencyHigh securities transaction costsForeign exchange risksPolitical risksCorporate governance differencesRegulatory barriers
18 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 capitalMarginal cost of capital is a dynamic case compared to WACCMarginal return on capital at differing budget levels determined by ranking the potential investments based on NPV or IRRIf the firm is limited to raising funds in its domestic market, it has domestic marginal cost of capital at various budget levels
19 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 decreaseIf the MNE has unlimited access to capital both domestic and abroad, then its marginal cost of capital decreases even further
20 Effects of Market Liquidity & Segmentation Escaping Illiquidity and SegmentationBudget(millions of $)Marginal cost of capitaland rate of return (percentage)10203040506020%15%13%10%Escaping IlliquidityMRRMCCFkFMCCUkUkDMCCD
21 Novo Industri A/S (Novo) Novo is a Danish multinational firm.The company’s management decided to “internationalize” the firm’s capital structure and sources of funds.This was based on the observation that the Danish securities market was both illiquid and segmented from other capital markets (at the time).Management realized that the company’s projected growth opportunities required raising capital beyond what could be raised in the domestic market alone.
22 Novo Industri A/S (Novo) Six characteristics of the Danish equity market were responsible for market segmentation:Asymmetric information base of Danish and foreign investors;Danish investors could not own foreign securitiesFew security analysts in DenmarkLanguage and accounting principlesTaxation;Alternative sets of feasible portfolios;Financial risk;Foreign exchange risk, andPolitical risk.Although Novo’s management wished to escape from the Denmark’s segmented and illiquid capital market, many barriers had to be overcome.These barriers included closing the information gap between the capital markets and the company itself and executing a share offering in the US (which required resolving additional barriers imposed by the government of Denmark on securities issuances).
23 Novo Industri A/S (Novo) Source: Arthur I. Stonehill and Kåre B. Dullum, Internationalizing the Cost of Capital: The Novo Experience and National Policy Implications, London: John Wiley, 1982, p. 73. Reprinted with permission.
24 Cost of Capital for MNEs vs. Domestic Firms Is the WACC for an MNE higher or lower than for its domestic counterpart?The answer is a function ofThe marginal cost of capitalThe after-tax cost of debtThe optimal debt ratioThe relative cost of equityAn MNE should have a lower cost of capital because it has access to a global cost and availability of capitalThis availability and cost allows the MNE more optimality in capital projects and budgets compared to its domestic counterpart leading to a constant WACC for a large budget
25 Some Reality CheckIt is clear that MNEs can take advantage of higher debt levels because their cash flows are diversified internationallyHowever, MNEs face costs of international diversification:Agency costsPolitical riskExchange rate riskAsymmetric informationAll these factors actually cause MNEs to have lower leverage increasing WACCMNEs usually have lower cost of debt lowering WACCMNEs have higher systematic risk increasing WACC
26 Some Reality Check Components of β Benefits of diversification is a lower correlation between the security j and the market, however, increased standard deviation of security j leads to a higher beta or systematic risk
27 Cost of Capital for MNEs vs. Domestic Firms Budget(millions of $)Marginal cost of capitaland rate of return (percentage)10014030035040015%10%5%20%MCCDCMRRMNEMRRDCMCCMNE
28 Cost of Capital for MNEs versus Domestic Firms [kWACC = keEquityValue+ kd ( 1 – tx )Debt]Is MNEwacc > or < Domesticwacc ?The cost of equity required by investors is higher for multinational firms than for domestic firms. Possible explanations are higher levels of political risk, foreign exchange risk, and higher agency costs of doing business in a multinational managerial environment. However, at relatively high levels of the optimal capital budget, the MNE would have a lower cost of capital.And indications are that MNEs have a lower average cost of debt than domestic counterparts, indicating MNEs have a lower cost of capital.Empirical studies indicate MNEs have a lower debt/capital ratio than domestic counterparts indicating MNEs have a higher cost of capital.