Chapter 11

Global Cost and Availability of

Capital

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
2

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 firms 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
3

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
4

Global Cost and Availability of Capital

Local Market Access

Global Market Access

Firm-Specific Characteristics
Firms securities appeal only
to domestic investors

Firms securities appeal to

international portfolio investors

Market Liquidity for Firms Securities

Illiquid domestic securities market
and limited international liquidity

Highly liquid domestic market and

broad international participation

Effect of Market Segmentation on Firms 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
5

Weighted Average Cost of

Capital
kWACC

E
D
ke k d ( 1 t)
V
V

Where
kWACC
ke
kd
t
E
D
V

= weighted average cost of capital

= risk adjusted cost of equity
= before tax cost of debt
= tax rate
= market value of equity
= market value of debt
= market value of firm (D+E)
6

Cost of Equity
Cost of equity is calculated using the Capital
Asset Pricing Model (CAPM)

ke k rf ( k m k rf )
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
= coefficient of firms systematic risk
7

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 firms 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:
Sfr1,500,000

Sfr1.500/$

= $1,000 ,000
8

Cost of Debt
At the end of the year, the US firm
repays the interest plus principal
Sfr1,500,000 x 1.05
= $1,093 ,750
Sfr1.440/$

The actual dollar cost of the loan is

not the nominal 5.00% paid in Swiss
francs, but 9.375%
$1,093,750
= 1.09375
1,000 ,000
9

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 currencys
value k $ = 1 + k FC x 1 + s - 1
d

[(

)]

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
10

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
FC/$
SFC/$
S
2
1

SFC/$
2

Sfr1.500/$ - Sfr1.440/$
x 100
x 100 4.1667%
Sfr1.440/$

The total cost is then

k d$ = [ ( 1 + .05) x ( 1 + 0.041667 ) ] - 1 = 0.09375

11

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%,
1.30,
and the tax
k e 0of
.04the
1.3(equity:
0.11 - 0.04
) 0.131
rate:
k 35%.
0.131( 0.60 ) 0.06( 1 - 0.35 )( 0.40 )
WACC

kWACC 0.0942
12

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 markets 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
13

Equity Market Risk Premiums In

Selected Countries, 1900-2000

Arithmetic Mean Average of

PT

P
0

Geometric Mean

1
T

Pt 1
1 over T years
Pt

1
14

Alternative Estimates of Cost of

Equity for a Hypothetical US Firm

15

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
16

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
17

Effects of Market Liquidity &

Segmentation
The degree to which capital markets are illiquid
or segmented has an important influence on a
firms 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
18

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
19

Effects of Market Liquidity &

Escaping
Segmentation

Illiquidity
and
Segmentati
on

Marginal cost of capital

and rate of return (percentage)

Escaping
Illiquidity
MCCF
MCCD
kD

20%
15%
13%
10%

kF

MCCU

kU

MRR

10

20

30

40

50

60

Budget
(millions of $)
20

Novo Industri A/S (Novo)

Novo is a Danish multinational firm.
The companys management decided to
internationalize the firms 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 companys projected
growth opportunities required raising capital
beyond what could be raised in the domestic
market alone.
21

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 Novos management wished to escape from the Denmarks

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).
22

Novo Industri A/S (Novo)

Source: Arthur I. Stonehill and Kre B. Dullum, Internationalizing the Cost of Capital: The
Novo Experience and National Policy Implications, London: John Wiley, 1982, p. 73.
23
Reprinted with permission.

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
The
The
The

marginal cost of capital

after-tax cost of debt
optimal debt ratio
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
24

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

25

Some Reality Check

Components of
jm j

m
where ,

jm the correlatio n between security j and the market, m

j the standard deviation of security j
m the standard deviation of the market, m
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
26

Cost of Capital for MNEs vs.

Domestic Firms
Marginal cost of capital
and rate of return (percentage)

MCCDC

20%

MCCMNE

15%
10%

MRRMNE

5%

MRRDC
100 140

300

350

400

Budget
(millions of $)
27

Cost of Capital for MNEs versus

Domestic Firms
Is MNEwacc > or < Domesticwacc ?
kWACC = ke

Equity
Value

kd ( 1 tx )

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
28
budget, the MNE would have a lower cost of capital.