1. Corporate Finance MLI28C060
Capital structure I: Financial instruments and capital structure
Lecture 4
Thursday 13 October 2016

2. I. Implications for firm from International versus domestic capital raising

3. Figure: Dimensions of the Cost and Availability of Capital Strategy

4. International Diversification and Risk Portfolio Risk reduction
The case for international diversification of portfolios can be decomposed into two components,
the potential risk reduction benefits of holding international securities.
The potential added foreign exchange risk.
Portfolio beta
A measure of portfolio risk
The ratio of the variance of a portfolio’s return relative to the variance of the market return
A fully diversified domestic portfolio have a beta of 1.0

5. International Diversification and Risk
Portfolio Risk reduction

6. International Diversification and Risk
The total risk of a portfolio is composed of
systematic risk (the market) and
unsystematic risk (the individual securities).
Increasing the number of securities in the portfolio reduces the unsystematic risk component

7. International Diversification and Risk

8. Internationalizing the Domestic Portfolio
The optimal domestic portfolio
Risk-averse typical investor is in search of a portfolio that maximises expected portfolio return per unit of expected portfolio risk.
The domestic investor may choose among a set of individual securities in the domestic market.
The near-infinite set of portfolio combinations of domestic securities form the domestic portfolio opportunity set
The set of portfolios along the extreme left edge of the set is termed the efficient frontier which represents the optimal portfolios of securities that possess the minimum expected risk for each level of expected portfolio return.

9. Internationalizing the Domestic Portfolio
The optimal domestic portfolio

10. Internationalizing the Domestic Portfolio
The optimal domestic portfolio [above slide]
The minimum risk domestic portfolio (MRDP) is the portfolio with the minimum risk
The individual investor will search out the optimal domestic portfolio (DP), which combines the risk-free asset and a portfolio of domestic securities found on the efficient frontier.
He or she begins with the risk-free asset (Rf) and moves out along the security market line until reaching portfolio DP.
This portfolio (DP) is defined as the optimal domestic portfolio

11. International Diversification and Risk
The internationally diversified portfolio opportunity set shifts leftward of the purely domestic opportunity set.

12. International Diversification and Risk

13. International Diversification and Risk
The internationally diversified portfolio opportunity set is of lower expected risk than comparable domestic portfolios.
The gains arise from the introduction of additional securities and/or portfolios that are of less than perfect correlation with the securities and portfolios within the domestic opportunity set.

14. International Diversification and Risk

15. International Diversification and Risk
The optimal international portfolio (IP) [above slide]
The investor can choose an optimal portfolio that combines the same risk-free asset with a portfolio from the efficient frontier of the internationally diversified portfolio opportunity set.
The IP is found by locating that point on the capital market line which extends from the risk-free asset return of Rf to a point of tangency along the internationally diversified efficient frontier.
IP offers higher expected portfolio return with a lower portfolio risk compared to the domestic portfolio alone.

16. International Diversification and Risk
Calculation of portfolio risk and return
An investor can reduce investment risk by
holding risky assets in a portfolio.
as long as the asset returns are not perfectly positively correlated, the investor can reduce risk, because some of the fluctuations of the asset returns will offset each other.
An example
Ausdrill’s Chief Financial Officer, Caitlin, is considering investing Ausdrill’s marketable securities in two different risky assets: an index of the Australian equity markets and an index of the German equity markets. The two equities are characterised by the following expected returns and expected risks.

17. International Diversification and Risk
Calculation of portfolio risk and return
An example
The expected return of the portfolio

18. International Diversification and Risk
Calculation of portfolio risk and return
An example
The standard deviation of the portfolio’s expected return

19. International Diversification and Risk
Calculation of portfolio risk and return
An example

20. International Diversification and Risk
Calculation of portfolio risk and return
Multiple-asset model

21. II. Capital raising from two points of view: that of capital issuer (firm) and investor

22. From investor’s point of view

23. National Markets and Asset Performance
The true benefits of global diversification arise from the fact that the returns of different stock markets around the world are not perfectly positively correlated.
Fact is
Different industrial structures in different countries, and
Different economies do not exactly follow the same business cycle.

24. National Markets and Asset Performance

25. National Markets and Asset Performance

26. From capital raiser (firm)’s point of view

27. The Firm’s Investment Decision and the Cost of Capital
A firm that can reduce its cost of capital will increase the profitable capital expenditures that the firm can take on and increase the wealth of the shareholders.
Internationalizing the firm’s cost of capital is one such policy.
IRR
cost of capital (%)
K local
Ilocal
K global
Iglobal
Investment ($)

28. Does the Cost of Capital Differ among Countries?
There do appear to be differences in the cost of capital in different countries.
When markets are imperfect, international financing can lower the firm’s cost of capital.
One way to achieve this is to internationalize the firm’s ownership structure.

29. Preliminary Note: The difference between stock price and total return

30. III. Introduction of capital asset pricing model (CAPM) and its international counterpart (ICAPM) in equity valuation

31. Cost of Capital in Segmented vs. Integrated Markets
The cost of equity capital (Ke) of a firm is the expected return on the firm’s stock that investors require.
This return is frequently estimated using the Capital Asset Pricing Model (CAPM):
Ri = Rf + bi(RM – Rf)
where
bi=
Cov(Ri , RM)
Var(RM)

32. Cost of Capital in Segmented vs. Integrated Markets
If capital markets are segmented, then investors can only invest domestically. This means that the market portfolio (M) in the CAPM formula would be the domestic portfolio instead of the world portfolio.
Ri = Rf + bi (RU.S. – Rf)
U.S.
versus
Ri = Rf + bi (RW – Rf) W
Clearly integration or segmentation of international financial markets has major implications for determining the cost of capital.

33. 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

34. Worked Example: 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
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%

35. 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 % differs slightly from Nestlé’s global required return of %

36. Figure: Estimating the Global Cost of Equity for Nestlé (Switzerland)

37. 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

38. 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

39. Figure: Equity Risk Premiums Around the World, 1990-2002

40. 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

41. 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

42. 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