Global Cost and Availability of Capital Chapter 11 Global Cost and Availability of Capital

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 capital Analyze the linkage between cost and availability of capital Effect of market liquidity and segmentation on the cost of capital Weighted average cost of capital comparison between an MNE and its domestic counterpart

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 capital This in turn will limit the firm’s ability to compete both internationally and firms entering its market If the firm can use the highly liquid international capital markets, its competitiveness can be strengthened

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 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 excessive regulatory control, perceived political risk, anticipated FOREX risk, lack of transparency, asymmetric information, cronyism, insider trading and other market imperfections

Global Cost and Availability of Capital Firm’s securities appeal only to domestic investors Firm’s securities appeal to international portfolio investors Firm-Specific Characteristics Local Market Access Global Market Access Market Liquidity for Firm’s Securities Illiquid domestic securities market and limited international liquidity Highly liquid domestic market and broad international participation Effect of Market Segmentation on Firm’s Securities and Cost of Capital Segmented domestic securities market that prices shares according to domestic standards Access to global securities market that prices shares according to international standards

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 (D+E)

Cost of Equity 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 km – krf = equity risk premium β = coefficient of firm’s systematic risk

Cost of Debt The 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 debt Foreign exchange risk & cost of debt When a firm issues foreign currency denominated debt, its effective cost equals the after-tax cost of repayment in terms of the firm’s own currency Example: 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:

Cost of Debt At the end of the year, the US firm repays the interest plus principal The actual dollar cost of the loan is not the nominal 5.00% paid in Swiss francs, but 9.375%

Cost of Debt This total home currency cost is higher than expected because of the appreciation of the Swiss franc This cost is the result of the combined cost of debt and the percentage change in the foreign currency’s value Where kd$ = Cost of borrowing for US firm in home country kdFC = Cost of borrowing for US firm in a Foreign Currency s = Percentage change in spot rate

Cost of Debt The total cost of debt must include the change in the exchange rate The percentage change in the dollar value of the Swiss franc given indirect quotes is calculated as The total cost is then

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%.

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 risk-free rate 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

Equity Market Risk Premiums In Selected Countries, 1900-2000

Alternative Estimates of Cost of Equity for a Hypothetical US Firm

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 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 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 market imperfection caused mainly by government constraints, institutional practices, and investor perceptions The most important 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 Marginal cost of capital is a dynamic case compared to WACC Marginal return on capital at differing budget levels determined by ranking the potential investments based on NPV or IRR 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

Effects of Market Liquidity & Segmentation Escaping Illiquidity and Segmentation Budget (millions of $) Marginal cost of capital and rate of return (percentage) 10 20 30 40 50 60 20% 15% 13% 10% Escaping Illiquidity MRR MCCF kF MCCU kU kD MCCD

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.

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 securities Few security analysts in Denmark Language and accounting principles Taxation; Alternative sets of feasible portfolios; Financial risk; Foreign exchange risk, and Political 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).

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.

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 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 leading to a constant WACC for a large budget

Some Reality Check It is clear that MNEs can take advantage of higher debt levels because their cash flows are diversified internationally However, MNEs face costs of international diversification: Agency costs Political risk Exchange rate risk Asymmetric information All these factors actually cause MNEs to have lower leverage increasing WACC MNEs usually have lower cost of debt lowering WACC MNEs have higher systematic risk increasing WACC

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

Cost of Capital for MNEs vs. Domestic Firms Budget (millions of $) Marginal cost of capital and rate of return (percentage) 100 140 300 350 400 15% 10% 5% 20% MCCDC MRRMNE MRRDC MCCMNE

Cost of Capital for MNEs versus Domestic Firms [ kWACC = ke Equity Value + 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.