International Cost of Capital

Dr.P.K. Gupta
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 and/or segmented

capital markets, it can achieve this lower global cost and
greater availability of capital by a properly designed and
implemented strategy.

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Exhibit 11.1 Dimensions of the Cost and Availability
of Capital Strategy
Local Market Access Global Market Access
Firm-Specific Characteristics

Firm’s securities appeal only Firm’s securities appeal to

to domestic investors international portfolio investors

Market Liquidity for Firm’s Securities

Illiquid domestic securities market Highly liquid domestic market and

and limited international liquidity broad international participation

Effect of Market Segmentation on Firm’s Securities and Cost of Capital

Segmented domestic securities Access to global securities market

market that prices shares that prices shares according to
according to domestic standards international standards
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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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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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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
Foreign currency risk
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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.
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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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 firm’s cost of capital.
In the domestic case, a firm’s marginal cost of capital will
eventually increase as suppliers of capital become saturated
with the firm’s 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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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).
Some capital market imperfections include:
Lack of transparency
Political risks
Corporate governance issues
Regulatory barriers

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The degree to which capital markets are illiquid or segmented has an
important influence on a firm’s marginal cost of capital (and thus on its
weighted average cost of capital).
In the following exhibit, the marginal return on capital at different budget
levels is denoted as MRR.
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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 Market Liquidity, Segmentation, and the Marginal
Cost of Capital
Marginal cost of capital and rate of return

MCCF
MCCD MCCU

kD
20% kF
15% kU
13%
MRR
10%
(percentage)

Budget
10 20 30 40 50 60 (millions of $)

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