Multinational Business Finance 723g33 Chap 14 Global Cost and Availability of Capital Multinational Business Finance 723g33

Global Cost and 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 markets. If a firm is located in a country with illiquid, small, and/or segmented capital markets, it can achieve a lower global cost and greater availability of capital by a properly designed and implemented strategy.

Global Cost and Availability of Capital Firms that must finance their long-term debt and equity in a highly illiquid domestic securities market will probably have a relatively high cost of capital and a limited availability of such capital which will, in turn, damage the overall competitiveness of the firm. Firms reside in industrial countries with small capital markets may enjoy an improved availability of funds at a lower cost comparing to the illiquid market, but would also benefit from access to highly liquid global markets.

Segmented Capital Markets Firms reside in countries with 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 in that market differs from the required rate of return on securities of comparable expected return and risk traded on other securities markets.

Exhibit 14.1 Dimensions of the Cost and Availability of Capital Strategy

Weighted Average Cost of Capital Firm´s weighted average cost of capital (WACC) is a weighted average of its cost of equity and cost of debt. The weights are the proportion of the firm´s market value of equity and debt to the market value of the firm: RWACC = ReE + Rd(1-τ)D where V is Market value of the firms Equity plus debt, and E is firms market value of equity and D is its market value of debt. Τ is the tax rate. V

Weighted Average Cost of Capital RWACC = weighted average cost of capital Re = cost of equity Rd = before-tax cost of debt τ = marginal income tax rate* E = market value of the firm’s equity D = market value of the firm’s debt V = total market value of the firm, (D+E) * Due to the tax deductibility of interest payment on debt

The Cost of Equity The cost of equity for a firm is derived from the capital asset pricing model (CAPM) by the following formula: Re = Rrf + βj(Rm – Rrf) Where Re is expected (required) rate of return on equity Rrf is rate of interest on risk-free bonds

Weighted Average Cost of Capital βj = coefficient of systematic risk of the firm Rm = expected (or required) rate of return on the market portfolio.

Weighted Average Cost of Capital The normal procedure for measuring the cost of debt requires a forecast of interest rates for the next few years, the proportions of various classes of debt the firm expects to use, and the corporate income tax rate, τ. The interest costs of different debt components are then averaged (according to their proportion). The before-tax average, kd, is then multiplied by the expression (1-tax rate), to obtain kd(1- τ), the weighted average after-tax cost of debt.

Weighted Average Cost of Capital The weighted average cost of capital is normally used as the discount rate whenever a firm’s new projects are in the same general risk class as its existing projects. if a new project differs from existing projects in business or financial risk, then, a project-specific required rate of return should be used as the discount rate.

Equity Risk Premium Market Risk Premium is the average annual return of the market expected by investors over and above riskless debt, that is, (Rm – Rrf). For example 6,5%-1%=5,5%. While the CAPM is widely accepted as the preferred method of calculating the cost of equity for a firm, there is rising debate over what numerical values should be used, i.e. the equity risk premium. In practice, calculating a firm’s equity risk premium is quite controversial.

portfolio risk reduction; portfolio rate of return, and The Demand for Foreign Securities: The Role of International Portfolio Investors Gradual deregulation of equity markets during the past three decades not only elicited increased competition from domestic players but also opened up markets to foreign competitors. The motivation of portfolio investors to purchase and hold foreign securities : portfolio risk reduction; portfolio rate of return, and foreign currency risk.

The Demand for Foreign Securities: The Role of International Portfolio Investors Both domestic and international portfolio managers are asset allocators whose 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. Since international portfolio managers can choose from a larger bundle of assets than domestic portfolio managers, internationally diversified portfolios often have a higher expected rate of return, and nearly always have a lower level of portfolio risk since national securities markets are imperfectly correlated with one another.

The Demand for Foreign Securities: market liquidity Market liquidity can affect a firm’s cost of capital. In the domestic case, a firm’s marginal cost of capital will eventually increase as the borrowing amount increases. The upward slopping marginal COST curve. In the multinational case, a firm is able to tap many capital markets above and beyond what would have been available in a domestic capital market given that the firm is capable of investment in international setting.

The Demand for Foreign Securities: capital market segmentation Capital market segmentation is caused mainly by: government constraints; institutional practices, and investor perceptions. While there are many imperfections that can affect the efficiency of a national market, these markets can still be relatively efficient in a national context but segmented in an international context.

The Demand for Foreign Securities: Capital market imperfections Some capital market imperfections include: Asymmetric information Lack of transparency High transaction costs Political risks Corporate governance issues Regulatory barriers

The price of debt: interest rate Recall, from Microeconomics theory, that the marginal price of a product equals to its marginal revenue. MR=MC. In a competitive market equilibrium, MR=MC=p The effective interest rate for a firm is the marginal cost of capital. Marginal cost of capital: the interest rate for the borrower to borrow an additional dollar. As opposed to average interest rate of the firm´s all borrowings. The next two slides show lower and lower cost of capital as the firm goes international. KD >KF >KU

The Demand for Foreign Securities: The Role of International Portfolio Investors The degree to which capital markets are illiquid or segmented has an important influence on a firm’s marginal cost of capital (and thus on its weighted average cost of capital). the marginal rate of return on capital at different budget levels is denoted as MRR. If the firm is limited to raising funds in its domestic market, the line MCCD shows the marginal domestic cost of capital. If the firm has additional sources of capital outside the domestic (illiquid) capital market the marginal cost of capital shifts right to MCCF. If the MNE is located in a capital market that is both illiquid and segmented, the line MCCU represents the decreased marginal cost of capital if it subcequently gains access to other equity markets.

Exhibit 14.7 Market Liquidity, Segmentation, and the Marginal Cost of Capital

The Cost of Capital for MNEs Compared to Domestic Firms Determining whether a MNEs cost of capital is higher or lower than a domestic counterpart is a function of the marginal cost of capital, the relative after-tax cost of debt, the optimal debt ratio and the relative cost of equity. While the MNE is supposed to have a lower marginal cost of capital (MCC) than a domestic firm, empirical studies show the opposite (as a result of the additional risks and complexities associated with foreign operations).

The Cost of Capital for MNEs Compared to Domestic Firms This relationship lies in the link between the cost of capital, its availability, and available projects. As available projects increases, the firm will eventually need to increase its capital budget to the point where its marginal cost of capital is increasing. (see the next slide) This would point to a higher weighted average cost of capital than would have been for a lower level of the optimal capital budget. (see next slide)

Exhibit 14.8 The Cost of Capital for MNE and Domestic Counterpart Compared KD2 KMNE KD

Exhibit 14.9 Do MNEs Have a Higher or Lower WACC Than Their Domestic Counterparts?

Mini-Case: 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.

Mini-Case: 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; taxation; alternative sets of feasible portfolios; financial risk; foreign exchange risk, and political risk.

Mini-Case: Novo Industri A/S (Novo) Although Novo’s management wished to escape from the shackles of 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).

Exhibit 1 Novo’s B-Share Prices Compared with Stock Market Indices

Exhibit 14.2 Calculation of Trident’s Weighted Average Cost of Capital

Exhibit 14.3 Estimating the Global Cost of Equity for Nestlé (Switzerland)

Exhibit 14.4 Equity Risk Premiums around the World, 1900–2002

Exhibit 14.5 Arithmetic versus Geometric Returns: A Sample Calculation

Exhibit 14.6 Alternative Estimates of Cost of Equity for a Hypothetical U.S. Firm Assuming β = 1 and krf = 4%