1. Global Cost and Availability of Capital
Chapter 11
Global 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 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

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 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

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 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

5. 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

6. 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)

7. 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

8. 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:

9. 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%

10. 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

11. 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

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 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

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 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

17. 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

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 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

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 decrease
If 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 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

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 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).

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 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

25. 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

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 capital
and rate of return (percentage)
100
140
300
350
400
15%
10% 5%
20%
MCCDC
MRRMNE
MRRDC
MCCMNE

28. 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.