Part IV: Financing Decisions from an International Perspective

1. Part IV: Financing Decisions from an International Perspective • A. Capital Structure and the Cost of Capital • Global Cost of Capital • Designing Financial Structure • B. International Financial Markets • Sourcing Equity Internationally • Sourcing Debt Internationally

2. Global Cost of Capital and Financial Structure • I. Cost of Capital: An Overview • II. Impacts of Internationalization on the Cost of Capital • Improving Market Liquidity • Overcoming Market Segmentation • Causes of Segmentation • Segmentation vs Efficiency • International Diversification and the cost of capital • International Cost of Capital Models • III. The Theory of Optimal Financial Structure • IV. Impact of Internationalization on Optimal Financial Structure • Effect of Availability of Capital • Effect of Cash Flow Diversification • V. Financial Structure of Foreign Affiliates

3. The Global Cost of Capital • I. Cost of Capital: An Overview • Cost of Capital: The minimum rate of return an investment project must generate in order to pay for its financing costs. When firms use both debt and equity in their capital structure, their financing cost can be represented by WACC. • Weighted Average Cost of Capital (WACC): • ke= risk-adjusted cost of equity; kd= before-tax cost of debt • E= market value of equity; D= market value of debt; V= value of firm (D +E) • kwacc : used as risk-adjusted discount rate for evaluating new projects with same risk class as the firm itself.

4. I. Cost of Capital: An Overview • Cost of Equity (ke): • Two methods: • i. Dividend Growth Model • D1= expected dividend in period 1; P0= market value of share at time 0; • g = expected growth rate of dividends • ii. Capital Asset Pricing Model (CAPM) • krf= risk free rate; km= expected return on market portfolio; • = systematic risk

5. I. Cost of Capital: An Overview cont’d • Cost of Debt (kd): • - forecast interest rates over years • - determine proportion of various classes of debt expected to be issued • - kd = the weighted average of forecasted interest rates • Note: Shareholder wealth maximization implies that new projects will be financed up to the point where the MRR of the last unit of new invested capital equals the marginal cost of capital of the last unit of new financing to be raised. • Hence, lower cost of capital • => increases profitable capital expenditures & shareholder wealth • II. Impacts of Internationalization on the Cost of Capital • * Access to global capital markets benefits MNCs by lowering their cost of capital. How? • A. Through improving their Market Liquidity • B. Through overcoming the negative impacts of Market Segmentation

6. II. Impacts of Internationalization on the Cost of Capital cont’d • A. Market Liquidity • - the degree to which a firm can issue a new security without depressing existing price • - depends on availability of capital • * Increased availability of capital in international markets improves MNCs’ market liquidity, leading to a lower cost of capital and larger value-maximizing capital budget [Exhibit 10.4]

7. II. Impacts of Internationalization on the Cost of Capital cont’d • B. Overcoming Market Segmentation • A market is segmented if the required rate of return on securities in the market differ from that of securities of comparable expected return and risk traded in other national markets. • If markets are fully integrated, securities of comparable risk and return should have the same required rate of return (i.e. cost of capital from the issuing company’s perspective). • Investors would require, on average, lower returns on securities under integration than under segmentation because they can diversify risk better under integration. (see slide 10) • ( Illustration: domestic CAPM vs International CAPM)) • => Thus, escaping from a segmented capital market can lower the firm’s cost of capital (i.e. command higher ‘international’ price for securities) • [see Exhibit 10.4]

8. II. Impacts of Internationalization on the Cost of Capital cont’d • Market Segmentation vs Market Efficiency • -A national securities market can be efficient and yet be segmented • -An efficient market “correctly” prices securities based on information available to participants in that market. • -Securities in segmented market would be priced based on domestic rather than international standards

9. II. Impacts of Internationalization on the Cost of Capital cont’d • What causes capital market segmentation? • - Informational barriers • - language, accounting standards, quality of disclosure • - Regulatory barriers • - Difference in tax rules, restrictions on foreign ownership, currency controls etc • -Transaction costs • - transaction taxes, brokerage commissions, lack of competition etc • - Foreign exchange risk • - volatile exchange rates, illiquid forward and derivative markets etc. • - Political Risk • - fear of government intervention, lack of protection to property rights etc. • - Small country bias • - small and illiquid markets less attractive to institutional investors

10. II. Impacts of Internationalization on the Cost of Capital cont’d • International diversification and the cost of capital: • Foreign securities have high demand because they provide diversification opportunities to portfolio investors. • - securities exhibit lower correlation across countries than within the same country • - holding securities across countries results in higher risk reduction • - such securities will be demanded by investors; the increased demand will bid up the price of the security; the issuing company raise capital at a lower cost

11. II. Impacts of Internationalization on the Cost of Capital cont’d • Aside: returns on investment on foreign security includes changes in the value of the currency in which the investment is denominated. The risk also includes currency risk. • E.g. U.S. investor purchased Japanese shares for $240,000 on Jan 1, 1998, and sold the shares at the prevailing price on Jan 1, 1999. • Jan. 1 1998 Jan. 1 1999 • Spot rate ¥ 120/$ ¥ 100/$ • Share Price ¥ 10,000 ¥ 12,000 • # of shares ={$240,000 X ¥ 120/$} / ¥ 10,000 = 2880 shares • Return = {$345,000 - $240,000}/$240,000 = 0.44 • => combination of return on investment on stock and currency gain • R$ = [(1+ r¥/$ ) (1+ rshares)] - 1 • R$ = [ 1+ 0.20) (1 +0.2)] - 1 = 0.44

12. II. Impacts of Internationalization on the Cost of Capital cont’d • Illustration of impact of internationalization on the cost of capital: The Case of Novo Industri A/S • - Danish market - Segmented and Illiquid • - Novo decided to internationalize its source of finance in 1977 • - Finally issued shares in U.S. in 1981 • preparations include: closing information gap by • - increasing visibility to foreign investors, and cross-listing in secondary markets • - Price reaction: dramatic price increase (lower cost of capital) [ Exhibit 11.6]

13. International Cost of Capital Models • Identical Cost of Capital (for all locations) • World CAPM or Multifactor Model (Sharpe-Ross) • Segmented/Integrated (Bekaert-Harvey) • Country Risk Rating (Erb-Harvey-Viskanta) • Goldman-integrated sovereign yield spread model • Goldman-segmented • Goldman-EHV hybrid • CSFB volatility ratio model

14. International Cost of Capital Models • Identical Cost of Capital • Ignores the fact that shareholders require different expected returns for different risks • Destroys value • Avoid

15. International Cost of Capital Models • World CAPM • Expected risk premium (in U.S. dollars) on investment that has average in a country= ß x world risk premium • Holds for developed markets if we allow risk to change through time (Harvey 1991) • Assumption of perfect market integration • Mean-Variance analysis implied by unity assumptions • Fails in emerging markets

16. International Cost of Capital Models • Segmented/Integrated CAPM • Bekaert and Harvey (1995) • If market integrated, world CPM holds • If market segmented, local CAPM holds • If going through the process of integration, a combination of two holds

17. International Cost of Capital Models • Segmented/Integrated CAPM • Expected return a function of covariance with world and covariance with local index • Weights determined by variables that proxy for degree of integration, like size of trade sector and equity market capitalization to GDP • Weights are dynamic, as are the risk loadings and the risk premiums • Downside:hard to implement; only appropriate for countries with equity markets

18. International Cost of Capital Models • Country Risk Rating Model • Erb, Harvey and Viskanta (1995) • Credit rating a good ex ante measure of risk • Impressive fit to data • Intuitive • Can be used in 136 countries, that is, in countries without equity markets • Fits developed and emerging markets

19. International Cost of Capital Models • Goldman-Integrated (EHV Hybrid) • Estimate market beta on the S&P 500 • Beta times historical US premium • Add sovereign yield spread • Goldman model only useful if you have sovereign yield spread • Use EHV model to fit ratings on yield spread

20. International Cost of Capital Models • Goldman-Segmented • Modified beta=standard deviation of local market return in US dollars divided by standard deviation of the US market return • Beta times historical US premium • Add sovereign yield spread

21. International Cost of Capital Models • CSFB • E[r]=SY+ß{E[r-RF] x A} x K • SY= Brady bond yield (or use fitted from EHV) • ß= beta of a stock against a local index • A= the coefficient of variation (CV) in the local market divided by the CV of the US market, where CV= standard deviation/mean • K is an adjustment factor to allow for correlation between risk free and risk premium (set=0.6)

22. III. Theory of Optimal Financial Structure • In perfect capital markets, financial structure irrelevant for firm value (MM Theorems) • The firm has an optimal mix of debt and equity that minimizes its cost of capital (maximizes value) given its business risk • The optimal financial structure determined by tradeoff between the tax benefits of debt and the bankruptcy and agency costs of debt.

23. IV. Impact of Internationalization on Optimal Financial Structure • Effect of availability of Capital • International availability permits firms to maintain desired (cost minimizing) debt ratio • - firm’s marginal cost of capital constant over wider range • Firms limited to domestic markets likely to deviate from their optimal • optimal debt= 30-60% • optimal cap. budget= 90M • MRR=MCC=14% • => accept if IRR >14% • Optimal debt =30-60% • Actual debt = 80% • Optimal budget=80M • MRR=MCC=18%

24. IV. Impact of Internationalization on Optimal Financial Structure (cont’d) • Effects of Cash flow Diversification • - International diversification of cash flow sources reduces financial risk of MNCs • - MNCs can support higher debt ratio • - Evidence: MNCs, in fact, have lower debt ratios than equivalent domestic firms • - Reason: higher agency costs due to political risk, market imperfections and complexity of international operations. • - Other implications: possible to a obtain the benefits of international diversification through holding a portfolio of MNCs

25. V. Financial Structure of Foreign Affiliates • Issue: How to set up the financial structure of a foreign subsidiary? Should it be determined independently (i.e. localized), or be determined from the perspective of the parent? • Generally, an individual affiliate’s capital structure should determined from the perspective of minimizing the overall (company-wide) cost of capital. • An affiliate does not source its capital (and does not have its own cost of capital) • In practice, country debt norms are also taken into account • Advantages of localized financial structure • - Improves image (political) of affiliate to host country • - Improves managerial decision (comparison with local competitors possible) • Disadvantages of localized financial structure • - sacrifices the comparative advantage of the MNC in lowering cost of capital • - increases perceived financial risk (weighted average of local debt ratios) • - debt of affiliate, in reality, is supported by parent’s cash flow

26. V. Financial Structure of Foreign Affiliates (cont’d) • Sources of Funds to Finance Foreign Affiliates • - Internal funds of the foreign affiliate • - Funds from within the corporate family • - Funds from sources external to the corporate family • Exhibit 14.4: Potential • Sources of Capital for • Financing a Foreign • Affiliate