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Chapter 13

The Global Cost


and Availability
of Capital

Learning Objectives
Explore the evolution of how corporate
strategy and financial globalization may
align
Examine how the cost of capital in the
capital asset pricing model changes for the
multinational
Evaluate the effect of market liquidity and
segmentation on the cost of capital
Compare the weighted average cost of
capital for an MNE with its domestic
counterpart
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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.
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.
Exhibit 13.1 illustrates these points.
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Exhibit 13.1 Dimensions of the Cost and


Availability of Capital Strategy

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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 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.

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Global Cost and Availability


of Capital
Firms resident in countries with 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 in that
market differs from the required rate of
return on securities of comparable expected
return and risk traded on other securities
markets.
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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:

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Cost of Equity
The capital asset pricing model (CAPM)
approach is to define the cost of equity for a
firm by the following formula:

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Cost of Equity
The key component of CAPM is beta, the measure
of systematic risk.
If beta < 1.0 returns are less volatile than the
market
If beta = 1 returns are the same as the market
If beta > 1.0 returns are more volatile than the
market

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Cost of Debt
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(1 - t), the
weighted average after-tax cost of debt.

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International Portfolio Theory


and Diversification
The total risk of any portfolio is therefore composed
of systematic risk (the market as measured by
beta) and unsystematic risk (the individual
securities).
Increasing the number of securities in the portfolio
reduces the unsystematic risk component but
leaves the systematic risk component unchanged.
A fully diversified domestic portfolio would have a
beta of 1.0.
Exhibit 13.2 illustrates the incremental gains of
diversifying both domestically and internationally.

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Exhibit 13.2 Market Liquidity, Segmentation,


and the Marginal Cost of Capital

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International Portfolio Theory


and Diversification
Internationally diversified portfolios are similar to
domestic portfolios because the investor is
attempting to combine assets that are less than
perfectly correlated.
International diversification is different in that when
the investor acquires assets or securities from
outside the investors host-country market, the
investor may also be acquiring a foreign currencydenominated asset. Thus, the investor has actually
acquired two additional assetsthe currency of
denomination and the asset subsequently
purchased with the currency.
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International CAPM (ICAPM)


ICAPM assumes the financial markets are
global, not just domestic.
Our WACC equation adjusts for new
opportunities:

The risk-free rate is unlikely to change


much, but beta easily could change.
Exhibit 13.3 presents an example for Nestl

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Exhibit 13.3 The Cost of Equity for


Nestl of Switzerland

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Equity Risk Premiums


The weighted average cost of capital is
normally used as the risk-adjusted 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.
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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).

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Equity Risk Premiums


While the field of finance does agree that a
cost of equity calculation should be forwardlooking, practitioners typically use historical
evidence as a basis for their forward-looking
projections.
The current debate begins with a debate
over what actually happened in the past.
Arithmetic and geometric average returns
provide different historic risk premiums and
they differ across countries.
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Equity Risk Premiums


Different analysts and academics tend to
use different measures for the market risk
premium.
Exhibit 13.4 shows how this can lead to
significantly different results.

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Exhibit 13.4 Alternative Estimates of Cost of


Equity for a Hypothetical U.S. Firm Assuming =
1 and krf = 4%

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The Demand for Foreign Securities: The Role


of International Portfolio Investors
Gradual deregulation 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:
portfolio risk reduction;
portfolio rate of return; and
foreign currency risk.

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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 portfolios rate of return for a given level of risk,
or to minimize risk for a given rate of return.
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.

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The Demand for Foreign Securities: The Role


of International Portfolio Investors
Market liquidity (observed by noting the degree to
which a firm can issue a new security without
depressing the existing market price) can affect a
firms cost of capital.
In the domestic case, a firms marginal cost of
capital will eventually increase as suppliers of
capital become saturated with the firms securities.
In the multinational case, a firm is able to tap many
capital markets above and beyond what would have
been available in a domestic capital market only.

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The Demand for Foreign Securities: The Role


of International Portfolio Investors

Capital market segmentation is caused


mainly by:
government constraints;
institutional practices; and
investor perceptions.

While there are many imperfections that can


affect the efficiency of a national market,
these markets can still be relatively efficient
in a national context but segmented in an
international context (recall the finance
definition of efficiency).
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The Demand for Foreign Securities: The Role


of International Portfolio Investors

Some capital market imperfections include:

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Asymmetric information
Lack of transparency
High transaction costs
Foreign exchange risks
Political risks
Corporate governance issues
Regulatory barriers

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The Effect of Market Liquidity


and Segmentation
The degree to which capital markets are illiquid or segmented
has an important influence on a firms marginal cost of capital
(and thus on its weighted average cost of capital).
The marginal return on capital at different budget levels is
denoted as MRR in Exhibit 13.5.
If the firm is limited to raising funds in its domestic market,
the line MCCD shows the marginal domestic cost of capital.
If the firm has additional sources of capital outside the
domestic (illiquid) capital market, the marginal cost of capital
shifts right to MCCF.
If the MNE is located in a capital market that is both illiquid
and segmented, the line MCCU represents the decreased
marginal cost of capital if it gains access to other equity
markets.
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Exhibit 13.5 Market Liquidity, Segmentation,


and the Marginal Cost of Capital

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The Cost of Capital for MNEs


Compared to Domestic Firms
Determining whether a MNEs cost of capital is
higher or lower than a domestic counterpart is a
function of the:

marginal cost of capital;


relative after-tax cost of debt;
optimal debt ratio; and
relative cost of equity.

While the MNE is supposed to have a lower


marginal cost of capital (MCC) than a domestic
firm, empirical studies show the opposite (as a
result of the additional risks and complexities
associated with foreign operations).
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The Cost of Capital for MNEs


Compared to Domestic Firms
This relationship lies in the link between the cost of capital, its
availability, and the opportunity set of projects.
As the opportunity set of projects increases, the firm will
eventually need 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.
This would be at a higher weighted average cost of capital
than would have occurred for a lower level of the optimal
capital budget.

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Exhibit 13.6 The Cost of Capital


for MNE and Domestic Counterpart Compared

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The Cost of Capital for MNEs


Compared to Domestic Firms
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 an increasing marginal cost
of capital, then the MNE would have a lower
WACC.
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Exhibit 13.7 Do MNEs Have a Higher or Lower


Cost of Capital Than Their Domestic
Counterparts?

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