8.

The Global Cost and Availability of Capital

8-1. Dimensions of the Cost and Availability of Capital. Global integration has given many firms access to new and cheaper sources of funds beyond those available in their home markets. The dimensions of a strategy to capture this lower cost and greater availability of capital is of great importance for MNCs. Global integration of capital markets has given many firms access to new and cheaper sources of funds beyond those available in their home markets. These firms can then accept more long-term projects and invest more in capital improvements and expansion. If a firm resides in a country with illiquid and/or segmented capital markets, it can achieve a lower global cost and greater availability of capital by a properly designed and implemented strategy. The main benefits of achieving a lower cost and greater availability of capital are: A firm can accept more long-term projects and invest more in capital improvements and expansion because of the lower hurdle rate in capital budgeting and the lower marginal cost of capital as more funds are raised. If a firm is located in a country with illiquid, small, and/or segmented capital markets, it can achieve this lower global cost and greater availability of capital by a properly designed and implemented strategy 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.

Fig 8-1 Dimensions of the Cost and Availability of Capital Strategy

In order to understand the cost of capital in global context it is important to review some key concepts: Systematic risk. Systematic risk is the risk of share price changes that cannot be avoided by diversification. In other words, it is the risk that the stock market as a whole will raise or fall, and the price of shares of an individual company will rise and fall with the market. Systematic risk is sometimes called market risk.

Unsystematic risk. Unsystematic risk is risk that can be avoided by diversification. It arises because some of the characteristics of a given company are peculiar to that company, causing it to perform in a way that differs from the performance of the market as a whole. Unsystematic risk is also called unique risk, residual risk, specific risk, or diversifiable risk. 8-2 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 firms optimal long-term financial structure: kWACC = ke E + kd(1-t) D E+D E+D With : 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 firms equity D = market value of the firms debt V = total market value of the firms securities (D+E) The weighted average cost of capital is normally used as the riskadjusted discount rate whenever a firms 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.

The capital asset pricing model (CAPM) approach is to define the cost of equity for a firm by the following formula: ke = krf + j(km krf) with: ke = expected (required) rate of return on equity krf = rate of interest on risk-free bonds (Treasury bonds, for example) j = coefficient of systematic risk for the firm km = expected (required) rate of return on the market portfolio of stocks 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(1t), the weighted average after-tax cost of debt. The weighted average cost of capital is normally used as the riskadjusted discount rate whenever a firms new projects are in the same general risk class as its existing projects. On the other hand, a projectspecific required rate of return should be used as the discount rate if a new project differs from existing projects in business or financial risk.

Beta (in the Capital Asset Pricing Model). Beta is a measure of the systematic risk of a firm, where systematic risk means that risk that cannot be diversified away. Beta measures the amount of fluctuation expected in a firms share price, relative to the stock market as a whole. Thus a beta of 0.8 would indicate an expectation that the share price of a given company would rise or fall at 80% of the rise or fall in
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the stock market in general. The stock is expected to be less volatile than the market as a whole. A beta of 1.6 would indicate an expectation that the share price of a given company would rise or fall at 60% more that the rise or fall in the market. If the market rose, say, 20% during a year, a stock with a beta of 1.6 would be expected to rise (0.20)(1.6) = 0.32, or 32%. Equity Risk Premiums. In practice, calculating a firms 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). It is a difference between calculating an equity risk premium using arithmetic returns, and using geometric returns. The mean arithmetic return is simply the average of the annual percentage changes in capital appreciation plus dividend distributions. This is a rate of return calculation with which every business graduate is familiar. The mean geometric return, however, is a more specialized calculation that takes into account only the beginning and ending values over an extended period of history. It then calculates the annual average rate of compounded growth to get from the beginning to the end, without paying attention to the specific path taken in between. It is to be mentioned that usually there are arithmetic mean risk premiums always higher than geometric mean risk premiums. The geometric change is calculated using only the beginning and ending values, 10 and 14, and the geometric root of [(14/10)1/4 1] is found (the superscript 1/4

is in reference to 4 periods of change). The geometric change assumes reinvested compounding, whereas the arithmetic mean only assumes point to point investment. Example: 1: Calculation of the Tridents company Average Cost of Capital Weighted

Example 2: Estimating the Global Cost of Equity for Nestl (Switzerland)

Example 3:Arithmetic Calculation

versus

Geometric

Returns:

Sample

Example 4: Alternative Estimates of Cost of Equity for a Hypothetical U.S. Firm Assuming = 1 and krf = 4%

Fig 8-2 Equity Risk Premiums around the World, 19002002

8-3. Portfolio Investors. Both domestic and international portfolio managers are asset allocators. Their objective is to maximize a portfolios 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. The main advantage that international portfolio managers have compared to portfolio managers limited to domestic-only asset allocation are: a. Internationally diversified portfolios often have a higher expected rate of return, and they nearly always have a lower level of portfolio risk, since national securities markets are imperfectly correlated with one another. b. Portfolio asset allocation can be accomplished along many dimensions depending on the investment objective of the portfolio manager. The various dimensions to be considered are: For example, portfolios can be diversified according to the type of securities. They can be composed of stocks only or bonds only or a combination of both. They also can be diversified by industry or by size of capitalization (small-cap, mid-cap, and large-cap stock portfolios). For our purposes, the most relevant dimensions are diversification by country, geographic region, stage of development, or a combination of these (global). An example of diversification by country is the Korea Fund. It was at one time the only vehicle for foreign investors to hold South Korean securities, but foreign ownership restrictions have more recently been liberalized. A typical regional diversification would be one of the many Asian funds. These performed exceptionally well until the bubble burst in Japan and Southeast Asia during the second half of the 1990s.
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Portfolios composed of emerging market securities are examples of diversification by stage of development. They are composed of securities from different countries, geographic regions, and stage(s) of development. 8-4. Market Liquidity. Although no consensus exists about the definition of market liquidity, we can observe market liquidity by noting the degree to which a firm can issue a new security without depressing the existing market price, as well as the degree to which a change in price of its securities elicits a substantial order flow. An illiquid market is one in which it is difficult to buy or sell shares, and especially an abnormally large number of shares, without a major change in price. From a company perspective, an illiquid market is one in which it is difficult to raise new capital because there are insufficient buyers for a reasonably sized offering. From an investors perspective, an illiquid market means that the investor will have difficulty selling any shares owned without a major drop in price. If a firm is limited to raising funds in its domestic capital market, its marginal cost of capital will have a new dynamic as it expands. The marginal cost of capital increases as more funds are raised. If a firm can raise funds abroad, as it expands, its marginal cost of capital stays flat for a longer range of raising new capital. 8-5. Market Segmentation. Firms resident in countries with segmented capital markets must devise a strategy to escape dependence on that market for their longterm 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. Capital markets become segmented because of such factors as excessive regulatory control, perceived political risk, anticipated foreign exchange
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risk, lack of transparency, asymmetric availability of information, cronyism, insider trading, and many other market imperfections. The six main causes of market segmentation. Capital market segmentation is a financial market imperfection caused mainly by government constraints, institutional practices, and investor perceptions. The most important imperfections are: Asymmetric information between domestic and foreign-based investors Lack of transparency High securities transaction costs Foreign exchange risks Political risks Corporate governance differences Regulatory barriers Firms located in a segmented market usually have a higher cost of capital (increasing marginal cost of capital) and less availability of capital. They can overcome these limitations by following a proactive strategy to internationalize their cost and availability of capital. It can be identified the effect of market liquidity and segmentation on a firms cost of capital. Firms located in an illiquid and segmented capital market will usually have a higher marginal cost of capital. 8-6. Cost of Capital for MNEs Compared to Domestic Firms. Theoretically MNEs should be in a better position than their domestic counterparts to support higher debt ratios because their cash flows are diversified internationally. However, recent empirical studies have come to the opposite conclusion. These studies also concluded that MNEs have higher betas than their domestic counterparts.
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According to the empirical studies the MNEs have lower debt ratios than their domestic counterparts. Despite the theoretical elegance of this hypothesis, empirical studies have come to the opposite conclusion. Despite the favorable effect of international diversification of cash flows, bankruptcy risk was only about the same for MNEs as for domestic firms. However, MNEs faced higher agency costs, political risk, foreign exchange risk, and asymmetric information. These have been identified as the factors leading to lower debt ratios and even a higher cost of long-term debt for MNEs. Domestic firms rely much more heavily on short and intermediate debt, which lie at the low cost end of the yield curve. In the same time According to the empirical studies MNEs have higher betas than their domestic counterparts. One study found that MNEs have a higher level of systematic risk than their domestic counterparts. The same factors caused this phenomenon as caused the lower debt ratios for MNEs. The study concluded that the increased standard deviation of cash flows from internationalization more than offset the lower correlation from diversification. The riddle is an attempt to explain under what conditions an MNE would have a higher or lower debt ratio and beta than its domestic counterpart. The answer to this riddle lies in the link between the cost of capital, its availability, and the opportunity set of projects. As the opportunity set of projects increases, eventually the firm needs 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. However, this would be at a higher weighted average cost of capital than would have occurred for a lower level of the optimal capital budget. To illustrate this linkage Exhibit 8.3 shows the marginal cost of capital given different optimal capital budgets. Assume that there are

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two different demand schedules based on the opportunity set of projects for both the multinational enterprise (MNE) and domestic counterpart (DC). Fig. 8-3 The Cost of Capital for MNE and Domestic Counterpart Compared

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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Fig. 8-4 Do MNEs Have a Higher or Lower WACC Than Their Domestic Counterparts?

Apart from improving liquidity and escaping from a segmented home market, might emerging market MNEs further lower their cost of capital by listing and selling equity abroad. A recent study found that internationalization actually allowed emerging market MNEs to carry a higher level of debt and lowered their systematic risk. This occurred because the emerging market MNEs are investing in more stable economies abroad, a strategy that lowers their operating, financial, foreign exchange, and political risks. The reduction in risk more than offsets their increased agency costs and allows the emerging market MNEs to enjoy higher leverage and lower systematic risk than their U.S.-based MNE counterparts.

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