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.
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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
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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.
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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.
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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:
kWACC = keE + kd(1-t)D
V
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V
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Weighted Average Cost of Capital
kWACC = 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)
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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)
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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
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11-9
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.
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11-10
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.
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11-11
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).
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11-12
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.
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11-13
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
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11-14
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.
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11-15
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.
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11-16
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
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11-17
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.
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11-18
Exhibit 11.6 Market Liquidity, Segmentation,
and the Marginal Cost of Capital
Marginal cost of capital
and rate of return (percentage)
MCCF
MCCD
MCCU
kD
20%
15%
kF
kU
13%
MRR
10%
10
20
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30
40
50
60
Budget
(millions of $)
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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.
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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
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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).
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11-22
Exhibit 11.7 Novo’s B-Share Prices Compared
with Stock Market Indices
Share Price
Market Indices
1800
1200
1600
1400
1000
Dow Jones Industrial Average (NYSE)
1200
800
1000
Novo B-Shares
600
800
600
400
Financial Times (London)
Danish Industry
400
Index
200
200
0
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 81.2
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.
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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).
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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.
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11-25
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
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300
350
400
Budget
(millions of $)
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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.
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11-27
Exhibit 11.9 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 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.
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11-28