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Chapter 12. The Global Cost and Availability of Capital. Global Cost & Availability of Capital: Learning Objectives. Examine how a firm headquartered in a country with an illiquid and segmented capital market achieves a lower global cost of and greater availability of capital

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Chapter 12 l.jpg

Chapter 12

The Global Cost and Availability of Capital


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Global Cost & Availability of Capital: Learning Objectives

Examine how a firm headquartered in a country with an illiquid and segmented capital market achieves a lower global cost of and greater availability of capital

Analyze the linkage between cost and availability of capital

Evaluate the effect of market liquidity and segmentation on the cost of capital

Explain how the weighted average cost of capital for an MNE compares with its domestic counterpart


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Financial Globalization and Strategy

Global integration of capital markets has given many firms access to new and cheaper sources of funds beyond those available in their home market

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

This in turn will limit the firm’s ability to compete both internationally and vis-à-vis foreign firms entering its market


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Financial Globalization and Strategy

Firms resident in small capital markets often source their long-term debt and equity at home in these partially-liquid domestic markets

The costs of funds is slightly better than that of illiquid markets, however, if these firms can tap the highly liquid international capital markets, their competitiveness can be strengthened

Firms resident in segmented capital markets must devise a strategy to escape dependence on that market for their long-term debt and equity needs


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Financial Globalization and Strategy

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 such factors as excessive regulatory control, perceived political risk, anticipated FOREX risk, lack of transparency, asymmetric information, cronyism, insider trading and other market imperfections


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Financial Globalization and Strategy

Firms constrained by any of these above conditions must develop a strategy to escape their own limited capital markets and source some of their long-term capital needs abroad



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Cost of Capital Capital Strategy

Where

kWACC = weighted average cost of capital

ke = risk adjusted cost of equity

kd = before tax cost of debt

t = tax rate

E = market value of equity

D = market value of debt

V = market value of firm (D+E)


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Cost of Equity and Debt Capital Strategy

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

Where

ke = expected rate of return on equity

krf = risk free rate on bonds

km = expected rate of return on the market

β = coefficient of firm’s systematic risk

  • The normal calculation for cost of debt is analyzing the various proportions of debt and their associated interest rates for the firm and calculating a before and after tax weighted average cost of debt


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The Cost of Capital Capital Strategy

The key component of CAPM is beta, the measure of systematic risk. Systematic risk is a measure of how the firm’s returns vary with those of the market in which it trades

Beta will have a value of less than 1.0 if the firm’s returns are less volatile than the market, 1.0 if the same as the market, or greater than 1.0 if more volatile—or risky—than the market

CAPM’s biggest challenge is that the beta used needs to be for the future and not the past

International CAPM (ICAPM) assumes that there is a global market in which the firm’s equity trades, and estimates of the firm’s beta

keglobal = krfg + βjg (kmg – krfg)


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Trident’s WACC Capital Strategy

ke = krf + β(km - krf) = 4.00% + 1.2 (9.00% - 5.00%) = 10.00%

kd (1 - t) = 8.00 (1 - 0.35) = 8.00 (0.65) = 5.20%

kWACC = ke E /V + kd (1 – t) D/V

= 10.00% (.60) + 5.20% (.40) = 8.08%


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Trident’s WACC Capital Strategy

keglobal = krfg + βjg (kmg – krfg)

= 4.00% + 0.90 (8.00% - 4.00%) = 7.60%

kWACCICAPM = keglobalE/V + kd (1 – t)D/V

= 7.60% (.60) + 5.20% (.40) = 6.64%


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Nestlé: An Application of the International CAPM Capital Strategy

The process of calculating an international WACC differs from a domestic WACC in the selection of the appropriate market portfolio and beta

Stulz (1995) suggests using a global portfolio of securities available to investors rather than the world portfolio of all securities (some of which may not be available to investors) when calculating a firm’s international cost of equity

The next slide shows the domestic and international risk-free rates, market portfolios, and betas for Nestlé used to calculate required rates of return for equity

In this example the domestic required return for Nestlé of 9.4065% differs slightly from Nestlé’s global required return of 9.3840%



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Calculating Equity Risk Premia in Practice Capital Strategy

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 riskless debt

Typically, the market’s 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


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Calculating Equity Risk Premia in Practice Capital Strategy

The field of finance does agree that a cost of equity calculation should be forward-looking, meaning that the inputs to the equation should represent what is expected to happen over the relevant future time horizon

As is typically the case, however, practitioners use historical evidence as the basis for their forward-looking projections



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Exhibit 12.4 Alternative Estimates of Cost of Equity for a Hypothetical U.S Firm Assuming β = 1 and krf = 4%



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The Demand for Foreign Securities Estimation

International portfolio investment and cross-listing of equity shares on foreign markets have become commonplace

As both domestic and international portfolio managers are asset allocators, their 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

International portfolio managers can choose from a larger bundle of assets than portfolio managers limited to domestic-only asset allocations

Some important diversification dimensions include diversification by country, geographic region and/or stage of development


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Link between Cost & Availability of Capital Estimation

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 the 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


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Market Segmentation Estimation

Capital market segmentation is a financial market imperfection caused mainly by government constraints, institutional practices, and investor perceptions

Other imperfections are

Asymmetric information

Lack of transparency

High securities transaction costs

Foreign exchange risks

Political risks

Corporate governance differences

Regulatory barriers


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Effects of Market Liquidity & Segmentation Estimation

The degree to which capital markets are illiquid or segmented has an important influence on a firm’s marginal cost of capital

An MNE has a given marginal return on capital at differing budget levels determined by which capital projects it can and chooses to take on

If the firm is limited to raising funds in its domestic market, it has domestic marginal cost of capital at various budget levels


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Effects of Market Liquidity & Segmentation Estimation

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



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Globalization of Securities Markets Marginal Cost of Capital

During the 1990s, national restrictions on cross-border portfolio investment were gradually eased under pressure from the Organization for Economic Cooperation and Development (OECD)

Presently, market segmentation has been significantly reduced, although the liquidity of individual national markets remains limited

Significantly higher value accrues to firms that have “imported” an Anglo-American corporate governance system


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Cost of Capital for MNEs versus Domestic Firms Marginal Cost of Capital

Is the WACC or an MNE higher or lower than for its domestic counterpart?

The answer is a function of

The marginal cost of capital

The after-tax cost of debt

The optimal debt ratio

The 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




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Summary of Learning Objectives Than Their Domestic Counterparts?

Gaining access to global capital markets should allow a firm to lower its cost of capital. A firm can improve access to global capital markets by increasing the market liquidity of its shares and by escaping its home capital market

The costs and availability of capital is directly linked to the degree of market liquidity and segmentation. Firms having access to markets with high liquidity and low segmentation should have a lower cost of capital


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Summary of Learning Objectives Than Their Domestic Counterparts?

A firm is able to increase its market liquidity by raising debt in the Euromarket, by selling issues in individual national markets and by tapping capital markets through foreign subsidiaries. Increased market liquidity causes the marginal cost of capital line to “flatten out to the right.”This results in the firm being able to raise more capital at the same low marginal cost of capital, and thereby justify investing in more capital projects. The key is to attract international portfolio investors.


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Summary of Learning Objectives Than Their Domestic Counterparts?

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 that are traded on other national securities markets. Capital market segmentation is a financial market imperfection caused by government constraints and investor perceptions. The most important imperfections are:

1) asymmetric information

2) transaction costs

3) foreign exchange risk

4) corporate governance differences

5) political risk

6) regulatory barriers


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Summary of Learning Objectives Than Their Domestic Counterparts?

The most important imperfections are

asymmetric information

transaction costs

foreign exchange risk

political risk

corporate governance differences

regulatory barriers

Segmentation results in a higher cost of capital and less availability of capital


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Summary of Learning Objectives Than Their Domestic Counterparts?

Segmentation results in a higher cost of capital and less availability of capital

If a firm is resident in a segmented capital market, it can escape from this market by sourcing its debt and equity abroad The result should be a lower marginal cost of capital, improved liquidity for its shares, and a larger capital budget

Whether MNEs have a lower cost of capital than their domestic counterparts depends on their optimal financial structures, systematic risk, availability of capital, and the level of the optimal capital budget


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Summary of Learning Objectives Than Their Domestic Counterparts?

If a firm is resident in a segmented capital market, it can still escape from this market by sourcing its debts and equity abroad. The result should be a lower marginal cost of capital, improved liquidity for its securities, and a larger capital budget

Whether or not MNEs have a lower cost of capital than their domestic counterparts depends on their optimal financial structures, systematic risk, availability of capital, and the level of optimal capital budget


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