Chapter 14

1. Chapter 14 The Global Cost and Availability of Capital

2. The Goals of Chapter 14 0 • 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

3. 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 domesticmarket 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

4. 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

5. 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

6. 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: 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)

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 = 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 βj = coefficient of systematic risk for the firm ( ) 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

8. 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

9. 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

10. Exhibit 11.2 Carlton Example of Calculating WACC

11. 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

12. 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

13. 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. 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

15. 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

16. 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

17. 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 the next currency unit raised

18. 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

19. 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

20. 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

21. 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 well-known 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

22. 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

23. Exhibit 14.7 Market Liquidity, Segmentation, and the Marginal Cost of Capital Marginal cost of capital and rate of return MCCF MCCU MCCD kD 20% kF kU 15% 13% MRR 10% • ※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 Capital Budget (millions of $) 10 20 30 40 50 60

24. 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

25. 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 segmentation in Denmark

26. 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

27. 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

28. 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 segmented

29. 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

30. 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

31. Exhibit 14.8 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 • ※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

32. 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

33. 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

34. 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

35. 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

36. 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% MRRMNE ※ 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 5% MRRDC Capital Budget (millions of $) 100 140 300 350 400

37. 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

38. 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

39. Exhibit 14.9 Do MNEs Have a Higher or Lower WACC Than Their Domestic Counterparts? ] [ ] [ Debt Equity kWACC = ke + kd ( 1 – t ) Value Value Is MNEwacc > or < Domesticwacc ? 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 equity