Chapter 11 Global Cost and Availability of Capital

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 and/or segmented capital markets, it can achieve this lower global cost and greater availability of capital by a properly designed and implemented strategy. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 2

Exhibit 11. 1 Dimensions of the Cost and Availability of Capital Strategy Local Market Access Global Market Access Firm-Specific Characteristics Firm’s securities appeal only to domestic investors Firm’s securities appeal to international portfolio investors 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 3

Global Cost and Availability of Capital • A firm that must source its long-term debt and equity in a highly illiquid domestic securities market will probably have a relatively high cost of capital and will face limited availability of such capital which will, in turn, damage the overall competitiveness of the firm. • Firms resident in industrial countries with small capital markets may enjoy an improved availability of funds at a lower cost, but would also benefit from access to highly liquid global markets. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 4

Global Cost and Availability of Capital • Firms resident 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. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 5

Weighted Average Cost of Capital • A firm normally finds its weighted average cost of capital (WACC) by combining the cost of equity with the cost of debt in proportion to the relative weight of each in the firm’s optimal longterm financial structure: k. WACC = ke. E + kd(1 -t)D V Copyright © 2004 Pearson Addison-Wesley. All rights reserved. V 6

Weighted Average Cost of Capital k. WACC = weighted average after-tax cost of capital ke = risk-adjusted cost of equity kd = before-tax cost of debt t = marginal 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’s securities (D+E) Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 7

Weighted Average Cost of Capital • The capital asset pricing model (CAPM) approach is to define the cost of equity for a firm by the following formula: ke = krf + βj(km – krf) Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 8

Weighted Average Cost of Capital ke = expected (required) rate of return on equity krf = rate of interest on risk-free bonds (Treasury bonds, for example) βj = coefficient of systematic risk for the firm km = expected (required) rate of return on the market portfolio of stocks Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 9

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. • The interest costs of different debt components are then averaged (according to their proportion). • The before-tax average, kd, is then adjusted for corporate income taxes by multiplying it by the expression (1 -tax rate), to obtain kd(1 -t), the weighted average after-tax cost of debt. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 10

Weighted Average Cost of Capital • The weighted average cost of capital is normally used as the risk-adjusted discount rate whenever a firm’s new projects are in the same general risk class as its existing projects. • On the other hand, a project-specific required rate of return should be used as the discount rate if a new project differs from existing projects in business or financial risk. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 11

Weighted Average Cost of Capital • In practice, calculating a firm’s equity risk premium is quite controversial. • 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 in its application (especially the equity risk premium). • This risk premium is the average annual return of the market expected by investors over and above riskless debt, the term (km – krf). Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 12

Weighted Average Cost of Capital • While the field of finance does agree that a cost of equity calculation should be forward-looking, practitioners typically use historical evidence as a basis for their forward-looking projections. • The current debate begins with a debate over what actually happened in the past. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 13

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. • To understand the motivation of portfolio investors to purchase and hold foreign securities requires an understanding of the principals of: – Portfolio risk reduction – Portfolio rate of return – Foreign currency risk Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 14

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. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 15

The Demand for Foreign Securities: The Role of International Portfolio Investors • Market liquidity (observed by noting the degree to which a firm can issue a new security without depressing the existing market price) can affect a firm’s cost of capital. • In the domestic case, a firm’s marginal cost of capital will eventually increase as suppliers of capital become saturated with the firm’s securities. • 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 only. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 16

The Demand for Foreign Securities: The Role of International Portfolio Investors • 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 (recall the finance definition of efficiency). • Some capital market imperfections include: – Lack of transparency – Political risks – Corporate governance issues – Regulatory barriers Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 17

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). • In the following exhibit, the marginal 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 gains access to other equity markets. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 18

Exhibit 11. 6 Market Liquidity, Segmentation, and the Marginal Cost of Capital Marginal cost of capital and rate of return (percentage) MCCF MCCD k. D 20% 15% 13% 10% k. F MCCU k. U MRR 10 20 Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 30 40 50 60 Budget (millions of $) 19

Illustrative 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. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 20

Illustrative 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 – Political risk Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 21

Illustrative 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). Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 22

Exhibit 11. 7 Novo’s B-Share Prices Compared with Stock Market Indices Share Price Market Indices Dow Jones Industrial Average (NYSE) Novo B-Shares Financial Times (London) Danish Industry Index 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. 23

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). Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 24

The Cost of Capital for MNEs Compared to Domestic Firms • This relationship lies in the link between the cost of capital, its availability, and the opportunity set of projects. • As the opportunity set of projects increases, the firm will eventually need to increase its capital budget to the point where its marginal cost of capital is increasing. • The optimal capital budget would still be at the point where the rising marginal cost of capital equals the declining rate of return on the opportunity set of projects. • This would be at a higher weighted average cost of capital than would have occurred for a lower level of the optimal capital budget. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 25

Exhibit 11. 8 The Cost of Capital for MNE & Domestic Counterpart Compared Marginal cost of capital and rate of return (percentage) MCCDC 20% MCCMNE 15% 10% MRRMNE 5% MRRDC 100 140 Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 300 350 400 Budget (millions of $) 26

The Cost of Capital for MNEs Compared to Domestic Firms • In conclusion, if both MNEs and domestic firms do actually limit their capital budgets to what can be financed without increasing their MCC, then the empirical findings that MNEs have higher WACC stands. • If the domestic firm has such good growth opportunities that it chooses to undertake growth despite and increasing marginal cost of capital, then the MNE would have a lower WACC. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 27

Exhibit 11. 9 Do MNEs Have a Higher or Lower WACC Than Their Domestic Counterparts? Is MNEwacc > or < Domesticwacc ? k. WACC = ke [ Equity Value ] + kd ( 1 – t ) [ Debt Value ] Empirical studies indicate MNEs have a lower debt/capital ratio than domestic counterparts indicating MNEs have a higher 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. 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. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 28