Chapter 14
The Global Cost and
Availability of Capital
The Goals of Chapter 14
• This chapter discusses the relationship between the
cost of capital of a company and the possibility of
acquiring the capital internationally
• Review the weighted average cost of capital
(WACC) and capital asset pricing model (CAPM)
• Analyze why a firm can attract international portfolio
investors to its securities
• Show how a Danish company escapes the
domestically segmented and illiquid market to access
the international capital market
• Compare the cost of capital and availability of capital
for MNEs and domestic firms
14-2
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
• The firm-specific characteristics (appealing to
domestic or international investors), the domestic
market liquidity for the firm’s securities, and the
definition and effect of market segmentation on
firm’s cost of capital are the main subjects to
influence the cost and availability of capital
• The effects of market liquidity and market
segmentation will be explained in detail later
14-3
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
face limited availability of capital and will probably
have a relatively high cost of capital, which will, in
turn, damage the overall competitiveness of the firm
• A capital market is segmented if the required rate of
return on securities in that market differs from
(usually higher than) the required rate of return on
securities of comparable risk traded on other
securities markets
• Firms resident in countries with segmented capital
markets could devise a strategy to escape that market
for acquiring cheaper long-term debt and equity
14-4
Global Cost and Availability
of Capital
• Capital markets become segmented because of
such factor as excessive regulatory control,
perceived political risk, lack of transparency,
asymmetric availability of information,
foreign exchange risks, corporate governance
differences, and many other market
imperfections
• If a firm is located in a country with illiquid (or
small) or segmented capital markets, it can
achieve greater availability of capital and
lower global cost of capital by a properly
designed strategy to escape that market
14-5
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 long-term
capital structure:
k WACC  k e
E
D
 k d (1  t)
V
V
kWACC = weighted average after-tax cost of capital
ke = cost of equity (expected (required) rate of return on equity)
kd = before-tax cost of debt
t = corporate 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)
14-6
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:
k e  k rf  β j (k m  k rf )
ke = expected (required) rate of return on equity
krf = rate of interest on risk-free bonds (Treasury bills, for
example)
km = expected (required) rate of return on the market portfolio
of stocks
ρ jm σ j
β

βj = coefficient of systematic risk for the firm ( j
)
σm
ρjm = correlation between returns of security j and the market
σj = standard deviation of the return on firm j
σm = standard deviation of the market return
14-7
Weighted Average Cost of Capital
• Beta will have a value of less than 1.0 if the
firms’ returns are less volatile than the market,
equal to 1.0 if the same as the market, or greater
than 1.0 if more volatile (risky) than the market
• CAPM assumes that the estimated expected
return, ke, is a hurdle rate to keep an investor’s
capital invested in the equity (so ke is also
called the required rate of return)
• If the equity’s expected return does not reach
the required return, CAPM assumes that
individual investors will liquidate their holdings
14-8
Weighted Average Cost of Capital
• The normal procedure for measuring the cost of
debt requires a forecast of (1) interest rates for
the next few years, (2) the proportions of
various classes of debt the firm expects to use,
and (3) 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 with
the expression (1- tax rate), to obtain kd(1-t),
the weighted average after-tax cost of debt
14-9
Exhibit 11.2 Carlton Example of
Calculating WACC
14-10
Weighted Average Cost of Capital
• The weighted average cost of capital (WACC) is
normally used as the risk-adjusted discount rate
for the future operating cash flows of a firm and
thus estimating the net present value of a firm
• When a firm’s new projects are in the same
general risk class as its existing business, WACC
is used as the discount rate for the new project
• On the other hand, a project-specific required rate
of return (rather than the WACC) should be used
as the discount rate if a new project differs from
existing business of the firm in various risk level
14-11
Weighted Average Cost of Capital
• 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 market risk premium (km – krf)
• This is because although it is well-known that a cost
of equity calculation should be forward-looking,
practitioners typically use historical evidence as a
basis for their forward-looking projections
• Moreover, different forecast service agent could
predict different forward-looking market risk
premiums and thus derive different cost-of-equity
estimation for the same firm with a known value of
beta
14-12
Weighted Average Cost of Capital
• An internationalized version of CAPM will have
a different definition of the market portfolio and a
recalculation of the firm’s beta for that market
portfolio
• So, the internationalized version of CAPM could
generate a different estimation from that of the
domestic version of CAPM
※ “FTA-Swiss index” means the Financial Times index in Swiss francs
14-13
The Demand for Foreign Securities:
The Role of International Portfolio Investors
• Gradual deregulation and integration 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 (1) portfolio risk
reduction, (2) portfolio rate of return, and (3)
foreign currency risk (these will be explained in
detail in Ch 15)
• Later we only briefly discuss the benefit of
international diversification
14-14
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
• Portfolio asset allocation can be accomplished along
many dimensions by, e.g. types of securities (stocks
or bonds), industries (food or electronic), size of
capitalization (small-cap or large-cap), countries
(Korea or Taiwan), geographic region (Asian or
Europe), stage of development (industrialized or
emerging countries)
• In this text book, we focus on the latter three
dimensions for international diversification
14-15
The Demand for Foreign Securities:
The Role of International Portfolio Investors
• 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
14-16
The Demand for Foreign Securities:
The Role of International Portfolio Investors
• In Carlton example, the costs of equity and debt are
assumed to be the same even if Carlton’s capital
budget were to expand
• This is a reasonable assumption if Carlton can
access to international portfolio investors in global
capital markets, but a bad assumption for firms in
illiquid or segmented capital markets
• We will examine how market liquidity and
market segmentation can affect a firm’s cost of
capital
• Before that, we define the marginal cost of capital
(MCC) first, which is the weighted average cost of
14-17
the next currency unit raised
The Demand for Foreign Securities:
The Role of International Portfolio Investors
• Market liquidity
– Here we study the market liquidity by observing the
degree to which a firm can issue a new security without
depressing the existing market price (the depression of
the market price implies the increase of the marginal cost
of capital of issuing new security)
– Suppose firms always expand their capital budgets at
their optimal capital structures, i.e. the financial risk of
firms does not change with the expansion
– Even so, market liquidity still can affect a firm’s
marginal cost of capital
• In the domestic case, eventually the firm needs to increase its
capital budget to the point where its marginal cost of capital is
increasing because the domestic capital market become saturated
14-18
The Demand for Foreign Securities:
The Role of International Portfolio Investors
• In the multinational case, a firm is able to tap many foreign
capital markets and raises funds over what would have been
available in a domestic capital market only
– Escaping from an illiquid market, a firm could access
more sources of capital, so it could raise more funds
without increasing its marginal cost of capital
14-19
The Demand for Foreign Securities:
The Role of International Portfolio Investors
• Market segmentation
– Capital market segmentation is caused mainly by many
market imperfections mentioned on Slide 11-5
– In a segmented market, since there is no foreign
participants, the securities would be priced on the basis
of domestic rather than international standards
– In the example on Slide 11-14, the internationalized
version of CAPM employed by international investors
could generate a lower estimation for the firm’s cost of
equity and thus a higher market value of the equity of the
firm
– In a word, escaping from a segmented market, a firm
could have a better price for its securities and thus a
lower cost of capital based on international rather than
domestic standards
14-20
The Demand for Foreign Securities:
The Role of International Portfolio Investors
• The effect of market liquidity and segmentation
– We will illustrate that the degree to which capital markets
are illiquid or segmented will influence a firm’s MCC
and thus change its weighted average cost of capital
– In Exhibit 11.7, the line MCCD shows the domestic
marginal cost of capital, and the marginal rate of return
on capital at different capital budget levels is denoted as
MRR, which is a negative-slope curve because it is wellknown that for larger capital budget levels, the marginal
rate of return on capital should decrease
– If the firm is limited to raising funds in its domestic
(illiquid) market, even the capital structure being the
same and the thus financial risk remaining fixed, the
MCC is 13% for small capital budget levels but finally
increases with the increase of the capital budget level
14-21
The Demand for Foreign Securities:
The Role of International Portfolio Investors
– If the firm has additional sources of capital outside the
domestic (illiquid or small) capital market, the marginal
cost of capital shifts right to MCCF
– This is because foreign markets can provide long-term
funds at times when the domestic market is saturated
because of heavy use by other borrowers or equity issuers.
As a consequence, given the same capital budge level for
the firm, the MCCF is lower than or equal to MCCD
– If the domestic capital market is both illiquid and
segmented, accessing the international capital market can
bring both effects of greater availability of capital and
international pricing of the firm’s securities
– Thus, MCCD becomes MCCU, which is lower and fixed at
10% for small capital budget levels, and begins to
increase when the capital budget level is larger than about
$50 million
14-22
Exhibit 14.7 Market Liquidity, Segmentation,
and the Marginal Cost of Capital
Marginal cost of capital
and rate of return
MCCD
kD
20%
15%
13%
10%
kF
MCCF MCC
U
kU
MRR
10
20
30
40
50
60
Capital Budget
(millions of $)
※The intersection of MCCD and MRR indicates that the optimal capital budget is $40
million and the marginal cost of capital is 20%
※The intersection of MCCF and MRR indicates that the firm can reduce its marginal
international cost of capital to 15% even while it raises an addition $10 million.
※The intersection of MCCU and MRR indicates that the marginal cost of capital
declines to 13% and the optimal budget climbs to $60 million
14-23
Illustrative Case:
Novo Industri A/S (Novo)
• A true case of a firm to escape the domestically
segmented and illiquid market to access the
international capital market is shown
• Novo is a Danish firm that produces pharmaceuticals,
and it had an excellent operating track record
• In 1977, the firm’s management decided to
“internationalize” both 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 that time
– As a consequence, the lack of availability of capital and
high cost of equity capital in Denmark resulted in Novo
having a higher cost of capital than its main multinational
competitors
14-24
Illustrative Case:
Novo Industri A/S (Novo)
– For example, given the same business and financial risk,
Novo’s price/earning ratio was typical around 5 (which was
common in the Danish market at that time), but
price/earning ratios of its foreign competitors were over 10
– Also Novo’s projected growth opportunities signaled the
eventual need to raise new long-term capital beyond what
could be raised in the illiquid Danish market
• If Denmark’s markets were integrated with would
markets, there must be foreign investors rush to buy
Danish securities
• Strangely enough, there is no Danish governmental
restrictions existed that would prevented foreign
investors from holding Danish securities
• So, there must be other reasons for market
14-25
segmentation in Denmark
Illustrative Case:
Novo Industri A/S (Novo)
• Six characteristics of the Danish equity market
were responsible for market segmentation:
1. Asymmetric information
• The first reason was a Danish regulation that prohibited
Danish investors from holding foreign private sector securities.
Therefore, Danish investors had no incentive to study foreign
securities and thus did not factor such information into their
evaluation of Danish securities
• The second reason is that only one professional Danish
securities analysis service was published, and that was in the
Danish language
• The third reason is that financial statements of firms was
published in Danish, using Danish accounting principles
• Finally, foreign securities firms did not locate offices or
personnel in Denmark, as they had no product to sell and they
do not know how to analyze and invest the Danish securities
14-26
Illustrative Case:
Novo Industri A/S (Novo)
2. Taxation
• At that time for domestic investors, capital gains on stocks held
for over two years were taxed at a 50% rate, and for stocks held
for less than two years (for speculative purposes), were taxed at
personal income tax rates, with the top marginal rate being 75%
• This factor reduced the trading motivation for domestic investors
and thus reduced the liquidity of the stock market
3. Feasible set of portfolios
• Danish government policy had provided a relative high real rate
of return on government bonds after adjusting for inflation
• The net results of taxation policies and attractive real yields on
government bonds cause that required rates of return on stock
were relatively high in the point of view of international
standards
4. Financial risk
• Financial leverage utilized by Danish firms was relatively high
(debt ratio is about 65% to 70%) by U.S. and U.K. standards
14-27
Illustrative Case:
Novo Industri A/S (Novo)
5. Foreign exchange risk
• Of course foreign investors in Danish securities are subject to
foreign exchange rate risk
• But Novo’s management did not believe foreign exchange risk was
a factor in Novo’s stock price, because its operations were perceived
as being well-diversified internationally (over 90% of its sales were
outside Denmarket)
6. Political risk
• With respect to political risk, Denmark was perceived as a stable
Western democracy and with lower political risk
※If Danish stock price movements were not closely
correlated with world stock price movement, inclusion of
Danish stocks in portfolios should reduce these portfolio’s
systematic risk, which is a benefit for foreign investors
※Since the disadvantage is more serious than the gain from
international diversification, the foreign investors avoided
the Danish market and thus this market became segmented14-28
Illustrative Case:
Novo Industri A/S (Novo)
• The road to globalization
– Novo went public in 1974 and it listed its “B” shares
on the Copenhagen Stock Exchange. The “A” shares
were held by the Novo Foundation, and the “A” shares
were sufficient to maintain voting control
– Morgan Grenfell successfully organized a syndicate to
underwrite and sell a $20 million convertible Eurobond
issue for Novo in 1978, and with this offering, Novo
listed its shares on the London Stock Exchange to
facilitate conversion and to gain visibility
– Danish investors reacted negatively to the potential
dilution effect of the conversion right, so during 1979,
Novo’s share price declined from around Dkr300 per
share to around Dkr220 per share
14-29
Illustrative Case:
Novo Industri A/S (Novo)
– During 1979, biotechnology began to attract the interest of
the U.S. investment community
– In order to profile itself as a biotechnology firm with a
proven track record, Novo organized a seminar in New
York City on April 30, 1980
– After the seminar, a few sophisticated individual U.S.
investors began buying Novo’s shares and convertibles
through the London Stock Exchange
– During the following months, foreign interest began to
snowball, and by the end of 1980, Novo’s stock price had
reached the Dkr 600 level, and its price/earnings ratio had
risen to around 16, which was now in line with that of its
international competitors
– During the first half of 1981, under the guidance of
Goldman Sachs and Morgan Grenfell, Novo is eventually
listed on the New York Stock Exchange
14-30
Exhibit 14.8 Novo’s B-Share Prices
Compared with Stock Market Indices
Share Price
Market Indices
1800
1200
1600
1000
1400
Dow Jones Industrial Average (NYSE)
1200
800
1000
Novo B-Shares
600
800
600
Financial Times (London)
400
Danish Industry
400
200
Index
0
200
0
77.1 77.2 77.3 77.4 78.1 78.2 78.3 78.4 79.1 79.2 79.3 79.4 80.1 80.2 80.3 80.4 81.1 81.2 81.3 81.4 82.1 82.2
※The Novo’ B-share price jumps upward substantially from the second quarter of 1980,
from Dkr220 to about Dkr 1600 at the second quarter of 1982
※The movement in the Danish stock market in general cannot be explained by movement in
the U.S. or U.K. stock markets as a whole, so the Danish stock market was segmented 14-31
Illustrative Case:
Novo Industri A/S (Novo)
– The difficulties for listing on the NYSE
• The main barrier encountered is to prepare financial statements
that could be reconciled with U.S. accounting principles and the
higher level of disclosure required by the SEC
• The second barrier is the regulations in Denmark, which were
not designed so that firms could issue shares at market value (in
the U.S., the new issue is sold at the market value to investing
public), because Danish firms typically issued stock at par value
with preemptive rights
– Danish investors reacted negatively to the listing on the
NYSE due to the worry about the dilution effect of the
new share, but why did not the U.S. investors adopt the
same point of view as Danish investors?
• This is because the enhancement of both the visibility and the
liquidity from listing on the NYSE and the increase of the
transparency from the SEC registration process will add up
values for the Novo’s stock shares
14-32
Illustrative Case:
Novo Industri A/S (Novo)
– The benefits from escaping the illiquid and segmented
Danish market
• Since the Novo’s share price was driven up, Novo’s cost of
equity was reduced
• Novo’s systematic risk was reduced. Its systematic risk used to
be associated with the Danish stock index, but was associated
with the global stock index after escaping the Danish market
• Since Novo’s equity value increases, its debt ratio level was
further reduced to match the standards expected by international
portfolio investors in U.S., U.K., or other important market
• In essence, the U.S. dollar became Novo’s functional currency
when being evaluated by international investors, so the foreign
exchange rate risk is reduced from the point of view of the
international portfolio investors
14-33
The Cost of Capital for MNEs
Compared to Domestic Firms
• Theoretically, the MNE is supposed to have a
lower marginal cost of capital (MCC) and thus a
lower weighted average cost of capital (WACC)
than a domestic firm, empirical studies show that
it is usually not the case, i.e. the MNE’s WACC
is actually higher than that for a comparable
domestic firm
• Determining whether a firm’s cost of capital is
higher or lower than a domestic counterpart is a
function of the marginal cost of capital, the
optimal debt ratio, the relative cost of debt, and
the relative cost of equity
14-34
The Cost of Capital for MNEs
Compared to Domestic Firms
• Regarding the marginal cost of capital (MCC)
and marginal rate of return (MRR) for different
capital budget levels, the results are illustrated in
Exhibit 11.9
– In conclusion, if both MNEs and domestic firms do
actually limit their capital budgets to what can be
financed without increasing their MCC, then it is
consistent with empirical findings that MNEs have
higher WACC stands
– If the domestic firm has such good growth
opportunities that it chooses to undertake growth
despite the increasing marginal cost of capital, then
the MNE would have a lower WACC
14-35
Exhibit 14.9 The Cost of Capital
for MNE & Domestic Counterpart Compared
Marginal cost of capital
and rate of return (percentage)
MCCDC
20%
MCCMNE
15%
10%
5%
MRRDC
MRRMNE
Capital Budget
(millions of $)
100 140
300
350
400
※ MRRDC depicts a modest set of potential projects, and MRRMNE depicts a more ambitious set of
projects, which are with higher capital budget levels and higher marginal rate of return
※ Due to the better availability of capital, an MNE’s MCC is constant for considerable ranges of its
capital budget. On the contrary, the MCC for domestic firms increases with the increase of the
capital budget level
※ At low budget levels, MNEs have a higher MCC and probably WACC than its domestic counterpart
※ At high budget levels, MNEs have a lower MCC and probably WACC than its domestic counterpart
14-36
The Cost of Capital for MNEs
Compared to Domestic Firms
• Regarding the optimal debt ratio
– Because a MNE’s cash flows are diversified internationally,
the variability of its cash flows is minimized and its ability
to serve the debt is enhanced
– Theoretically, MNEs could adopt higher debt ratios, but the
empirical studies have opposite conclusion: due to the
higher agency costs, political risk, foreign exchange risk,
and asymmetric information, MNEs have lower debt ratios
• Regarding the relative cost of debt
– Through financing globally, it is generally true that MNEs
can find debt funds with lower cost of debt
– However, for your information, despite the favorable effect
of international diversification of cash flows, bankruptcy
risk was about the same for MNEs as for domestic firms 14-37
The Cost of Capital for MNEs
Compared to Domestic Firms
• Regarding the relative cost of equity
– Surprisingly, Reeb, Kwok, and Baek (1998) found that
MNEs have a higher level of systematic risk
– The reason is that due to the higher agency costs,
political risk, foreign exchange risk, and asymmetric
information, the increased standard deviation of cash
flows σj offsets the lower correlation ρjm from the
diversification
– This conclusion is consistent with the observation that
many MNEs use a higher hurdle rate to discount
expected foreign project cash flows
• The comparisons between WACCs of MNEs and
domestic firms regarding the debt ratio, the cost of
debt, and the cost of equity are summarized in
Exhibit 11.10
14-38
Exhibit 14.9 Do MNEs Have a Higher or Lower
WACC Than Their Domestic Counterparts?
Is MNEwacc > or < Domesticwacc ?
kWACC = ke
[
Equity
Value
]
+ kd ( 1 – t )
[
Debt
Value
]
Empirical studies indicate MNEs have a lower debt/capital
ratio than domestic counterparts due to higher agency costs,
political risk, foreign exchange risk, and asymmetric
information, so MNEs have a higher cost of capital
Due to the greater availability of capital for MNEs, they
usually have a lower average cost of debt than domestic
counterparts, indicating MNEs have a lower cost of capital
In empirical studies, the cost of equity required by investors is higher for multinational firms
than for domestic firms. Although the international diversification for MNEs could lower ρjm,
the increase of σj from higher political risk, foreign exchange risk, and agency costs might
offset the lower correlation from diversification and thus cause the increase of the cost of equity14-39