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4079 Chapter 11 N

The document discusses how global integration of capital markets has given firms access to cheaper sources of funding. It explains that sourcing funds globally can help firms in countries with illiquid or segmented capital markets reduce their cost of capital and increase access to funds. However, a firm's ability to raise funds globally depends on its characteristics and the liquidity of its shares on international markets. The document also examines methods for estimating a firm's weighted average cost of capital.

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59 views15 pages

4079 Chapter 11 N

The document discusses how global integration of capital markets has given firms access to cheaper sources of funding. It explains that sourcing funds globally can help firms in countries with illiquid or segmented capital markets reduce their cost of capital and increase access to funds. However, a firm's ability to raise funds globally depends on its characteristics and the liquidity of its shares on international markets. The document also examines methods for estimating a firm's weighted average cost of capital.

Uploaded by

Angates1
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Global Cost and Availability of Capital

Eiteman et al., Chapter 11

Winter 2004

Global Cost and Availability of Capital


How can rms tap global capital markets? Why should they do so? To minimize their cost of capital? To maximize the availability of capital?

Global Cost and Availability of Capital


Global integration of capital markets has given rms access to new and cheaper sources of funds. This has encouraged the undertaking of more long-term projects and induced rms to invest more in capital improvement. Sourcing funds globally may enhance the possibilities of rms residing in countries with illiquid and/or segmented capital markets.

Global Cost and Availability of Capital


Whether and how a rm can raise funds globally depends on its specic characteristics and on the liquidity of the market for its shares. Raising funds from abroad may be a solution to some of the rms problems in terms of reducing its cost of borrowing or its cost of equity but it may also be well perceived due to the higher visibility provided by a presence in more than one market.

Illiquid Markets
Firms that source long-term debt and equity in highly illiquid markets face a relatively high cost of capital. Availability of capital may also be a problem, and thus these rms are disadvantaged vis--vis their international competitors. It may also be advantageous for rms residing in countries with small capital markets to source funds in the more liquid international markets.

Market Segmentation
Another problem affecting the cost of capital is market segmentation. A capital market is referred to as segmented when the return required by its investors differs from the return required by investors in other markets where similar securities are traded. It will also be advantageous for rms in this situation to seek funds in international capital markets.

The Weighted Average Cost of Capital


A rms weighted average cost of capital (WACC) is given by WACC = E D ke + (1 t )kd , E +D E +D

where E and D are the market values of rms equity and debt, respectively, ke and kd are the rms costs of equity and debt, respectively, and t is the corporate tax rate.

The Cost of Equity Capital


The CAPM is often used to estimate the cost of equity capital: ke = kr f + km kr f , where kr f is the risk-free rate of return, km is the return on the market portfolio and measures the systematic risk of the rms stock.

The Cost of Equity Capital


What is kr f ? Firms usually use the return on government securities with maturities that match the rms average investment horizon. For rm i, i is given by i = im i im i m cov(kei , km ) = = , var(km ) 2 m m

where im is the correlation of stock is return with the market portfolio return, i is the standard deviation of stock is return, and m is the standard deviation of the market portfolios return.
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The Cost of Equity Capital


What is the risk premium km kr f ? Must be forward-looking. Past data is often used to calculate it. Arithmetic or geometric average of past risk premia. Arithmetic mean captures volatility in markets, which is why most practitioners prefer it.

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The Cost of Debt


The rms cost of debt should reect the yield on the companys actual debt. Flotation costs could also be taken into account. Since interest payments are tax deductible, the after-tax cost of debt is used in WACC calculations.

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Nestls WACC
Suppose kr f = 3.3% average yield on Swiss gov. bonds; s k = 6.9% domestic (Switzerland) risk premium; km rf s = 0.885 Nestls beta w.r.t. a Swiss index. The return required on Nestls stock by an investor who only invests in Swiss equities can be approximated by
s s ke = kr f + s (km kr f )

= 3.3% + 0.885 6.9% = 9.407%.

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Nestls WACC
Suppose kr f = 3.3% average yield on Swiss gov. bonds; g km kr f = 8.4% global risk premium; g = 0.585 Nestls beta w.r.t. a global index. The return required on Nestls stock by an investor who invests globally can be approximated by
g g ke = kr f + g (km kr f )

= 3.3% + 0.585 8.4% = 8.214%.

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Nestls WACC
Let
E E +D

= .65, kd = 4% and tc = .2. Then

WACCs = .65 9.407% + .35 .8 4% = 7.235% WACCg = .65 8.214% + .35 .8 4% = 6.459%

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The Role of International Portfolio Investors


International portfolio investment and cross-listing of equity shares have become common over the past three decades. An investor willing to maximize the return of a portfolio for a given level of risk is better off with an international portfolio than with a domestic portfolio since the former offers smaller systematic risk.

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The Role of International Portfolio Investors


How to reduce risk with an international portfolio depends on the regulations in each country. It may be possible that only one asset be available to international investors in order to get exposed to the market risk of a specic country.

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Cost and Availability of Capital


WACC calculations assume that debt and equity capital are always available at the same required rate of return even for larger capital budgets. This assumption is correct for rms in highly liquid markets but is not correct for rm in illiquid or segmented markets.

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Improving Market Liquidity


There is no clear measure of liquidity but in a liquid market, round trips in a stock (simultaneous purchase and sale) are not too costly, rms can issue equity without depressing too much the existing stock price.

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Improving Market Liquidity


The marginal cost of capital of a rm in an illiquid market may rise very quickly, thus limiting the projects that can be undertaken. Assuming that rms preserve their optimal nancial structure, access to international nancial markets improves the situation of rms in illiquid markets by reducing the speed at which the marginal cost of capital increases.

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Market Segmentation
A rms domestic capital market may be segmented because it lacks efciency. This may be due to government interventions; asymmetric information; high transaction costs; political and foreign exchange risks; investors perceptions.

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Market Segmentation
Access to international ancial markets by a rm in a segmented market will correct the misperception about the rms risk and will reduce the rms cost of capital at any budget level. See exhibit 11.6

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Illustrative Case: Novo Industri A/S


Novo is a multinational rm that produces industrial enzymes and pharmaceuticals. In 1977, Novo decided to internationalize its capital structure, as it considered the Danish securities market as illiquid and segmented. Novos cost of capital was signicantly higher than its main multinational competitors. Novos P/E ratio was 5 whereas most of its international competitors had P/E ratios well over 10.
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Illustrative Case: Novo Industri A/S


Explanations for the Danish equity markets segmentation: Asymmetric information Taxation Feasible sets of portfolios Financial, foreign exchange and political risks

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Illustrative Case: Novo Industri A/S


Asymmetric Information Securities regulations were such that Danish investors could not buy private foreign securities, and thus would not follow foreign securities developments. Foreign securities rms did not locate ofces in Denmark since they had nothing to sell, so foreign investors had very little information about Danish rms.

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Illustrative Case: Novo Industri A/S


Taxation Until July 1981, capital gains were taxed at a 50% rate if holding period was over 2 years and at the holders personal income tax rate if holding period was below 2 years, the top marginal rate being 75%. Capital gains on bonds, on the other hand, were tax-free.

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Illustrative Case: Novo Industri A/S


Financial, Foreign Exchange and Political Risk Danish typical debt ratio was 65%. Foreign exchange risk was not seen as a big problem. Denmarks economy was considered stable, although national debt was relatively high.

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Novo: The Road to Internationalization


Increased level of disclosure both in Danish and English. 1978: $20 million convertible Eurobond issue (P ) and shares were listed on the London Stock Exchange. 1980: Seminar in New York (P ). 1981: Equity issue in the U.S..

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Novo: The Road to Internationalization


The full extent of the Danish markets segmentation can be seen by investors reaction to the U.S. issue. At the announcement, the stock price fell in Denmark due to the fear of dilution. When trading started in New York, the stock price increased.

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MNEs Cost of Capital Compared to Domestic Firms


International availability of capital to MNE or the possibility for large rms to attract international investors may lower the cost of equity and debt. Marginal cost of capital for such rms should be approximately constant. These rms should be able to maintain their optimal debt ratio. Agency costs, political and foreign exchange risks, however, are higher for MNEs.

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MNEs Cost of Capital Compared to Domestic Firms


Recent empirical studies have shown that U.S.-based MNEs WACC is generally higher than their domestic counterparts. U.S.-based MNEs debt ratios are lower than their domestic counterparts. U.S.-based MNEs have higher systematic risk than their domestic counterparts.

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