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Lecture 10: Global Cost of Capital and Financial Structure

Chapter 10: Global Cost of Capital and Financial Structure
Review of WACC & Portfolio Theory Demand for Foreign Securities • Case: Nestlé Cost and Availability of Capital: Liquidity and Segmentation The Effect of Going Global • Case: Novo MNEs vs. Domestic Firms on Cost of Capital Foreign Affiliates Exercises: 1 & 3

Revision Date: November 14, 2001

3-258-98: International Financial Management École des Hautes Études Commerciales, Montréal Copyright 2001 by Simon van Norden

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Lecture 10: Global Cost of Capital and Financial Structure

The Weighted Average Cost of Capital (WACC)
What discount rate should a firm use to evaluate new investment projects? 1. Let’s assume that marginal cost of capital equals average cost of capital. 2. Let’s assume that the firm’s financial structure (e.g. D/E) is optimal. E D - + r Debt ⋅ ( 1 – t ) ⋅ --WACC = r Equity ⋅ -V V

• V = D + E. • E, D are market values • t is the marginal tax rate (interest payments deductible.)

Revision Date: November 14, 2001

3-258-98: International Financial Management École des Hautes Études Commerciales, Montréal Copyright 2001 by Simon van Norden

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Montréal Copyright 2001 by Simon van Norden 3 de 14 Lecture 10: Global Cost of Capital and Financial Structure CAPM vs International Finance How does CAPM change as we move national => international context? The key is the set of stocks from which investors get to build portfolios. r m) ⁄ Var(r Market) This gives us the r Equity to use in WACC. 3. rriskfree . • international context contains all domestic stocks plus more. etc should be global rates. Result is CAPM r Equity = r riskfree + ( r m – r riskfree ) ⋅ β Equity β Equity = Cov(r Equity. for assets that make their portfolio riskier. get higher r. The risk that matters is the market or non-diversifiable risk. Investors will seek to diversify their holding across many assets. Revision Date: November 14. • rm. Montréal Copyright 2001 by Simon van Norden 4 de 14 . Assumption: The risk investors care about is that of their whole portfolio Implications: 1.Lecture 10: Global Cost of Capital and Financial Structure The Portfolio Approach to Asset Demand Investors maximize return for a given risk. 2. or more precisely. 2001 3-258-98: International Financial Management École des Hautes Études Commerciales. Revision Date: November 14. Investors will demand a higher return for riskier assets. 2001 3-258-98: International Financial Management École des Hautes Études Commerciales. not national. not national. so international investors can better diversify (face less risk). • β should be based on global index.

as investors get overexposed. this means revisiting the WACC assumption that average cost = marginal cost.585 = 9.384 ⋅ 0. Firms limited to their domestic & illiquid capital markets face same problem. in CHF). Montréal Copyright 2001 by Simon van Norden 6 de 14 .885. face poor liquidity. in CHF) and sees β Nestle =0. bonds. family-owned firms. etc.885 = 9.2196 % Revision Date: November 14. 2001 3-258-98: International Financial Management École des Hautes Études Commerciales. r Nestle = 3.65 + 4.35 = 7. • Rising marginal cost of capital.585 r Nestle = 3.2 – 3. • Particularly important for big firms.2% (Swiss equities. and they pay 4% (CHF) on their debt. • euromarkets.7 – 3. foreign affiliates. in CHF) and sees β Nestle =0.3% (Swiss govt.Lecture 10: Global Cost of Capital and Financial Structure Illustrative Case: Nestlé Domestic (Swiss) investor: faces r riskfree =3.0 ⋅ ( 1 – 0. (Honest!) Nestlé’s WACC: We’re told D/V=35%. Small domestic firms. firms face better liquidity.384 % Nearly the same! But it could have been very different. limited access to existing capital markets. so WACC = 9. r Equity =10. 2001 3-258-98: International Financial Management École des Hautes Études Commerciales.3 ) ⋅ 0. which helps to lower marginal cost of capital.2 ) ⋅ 0.3 + ( 10. In the context of raising capital. directed security issues. If they have access to global markets.7% (Global equities. • Not well known.4065 % Global (Swiss) investor: r Equity =13. emerging & small economies We assume that liquidity is better (or no worse) in global markets. Montréal Copyright 2001 by Simon van Norden 5 de 14 Lecture 10: Global Cost of Capital and Financial Structure Market Liquidity Definition: Liquidity is the degree to which you can transact large amounts without changing the prices you face.3 ) ⋅ 0. Revision Date: November 14. taxes=20%.3 + ( 13.

Is this necessarily true? (Think: must segmentation raise the rate of return for investors?) There’s lots of complex econometric modelling on measuring segmentation. but segmentation is a serious concern. Montréal Copyright 2001 by Simon van Norden 8 de 14 .e. Montréal Copyright 2001 by Simon van Norden 7 de 14 Lecture 10: Global Cost of Capital and Financial Structure Effects of Illiquidity & Segmentation Exhibit 10.4 Effect on MCC and Firm Size Downward sloping MRR curve reflects falling marginal product of capital. $50 M raised. debt could differ. rates of return) in different places. efficiency is about market prices incorporate all available information (i. 2001 3-258-98: International Financial Management École des Hautes Études Commerciales.Lecture 10: Global Cost of Capital and Financial Structure Market Segmentation Market Efficiency: In this context.they are a matter of degree Exhibit 10. $60 M raised (note typo in textbook: they mean line SSu) Textbook always assumes that segmentation raises the cost of capital for firms.e. Revision Date: November 14. we’ll look at the case of Novo Industri A/S. • more liquid finance gives 15% cost. To see its effects.) Market Segmentation: when the same asset would command different prices (i. 2001 3-258-98: International Financial Management École des Hautes Études Commerciales. • taxes? • residency restrictions on buying? selling? • regulations? (securities law? accounting practices?) • corruption? cronyism? • lack of information? language barriers? Revision Date: November 14. Most middle & heavy-weight stock markets look efficient.3 Milken Institute Capital Access Index: These are not binary variables . required rates of return on firm’s equity. • Therefore. • unsegmented access to intnl markets gives 13% cost. whether returns are predictable. Obviously implies there must be some barrier to arbitrage. • illiquid domestic finance gives 20% cost. $40 M raised.

• No big news about the business. Montréal Copyright 2001 by Simon van Norden 9 de 14 Lecture 10: Global Cost of Capital and Financial Structure Novo Industri A/S (cont. Asymmetric Information • Danes not permitted to buy foreign private equities.) 2. Meet SEC disclosure standards. so they didn’t follow news • international analysts didn’t follow the Danish market. • Greatly increased cost of equity finance in Denmark Solution: sell to foreign investors. 3. corporate interests. internationally diversified operations. Revision Date: November 14. yet valuation clearly changes. but normal by continental standards. Domestic Investment Portfolios • Lack of diversification made β ’s high. • FX risk not a big factor (hard currency. Taxation • Everyone bought bonds due to favourable capital gains tax treatment.5: The fact that Novo shares quadruple in value while various benchmarks look stable (Danish industry. FX and Political Risks • Debt ratios higher than in UK or US. 2001 3-258-98: International Financial Management École des Hautes Études Commerciales. Revision Date: November 14. who have more diversified portfolios. NY & London indices) is strong evidence of segmentation. 4. Solutions: Increase publication of materials in English. List in US and London. Montréal Copyright 2001 by Simon van Norden 10 de 14 . Financial.Lecture 10: Global Cost of Capital and Financial Structure Illustrative Case: Novo Industri A/S Exhibit 10. further raising cost of capital. 2001 3-258-98: International Financial Management École des Hautes Études Commerciales. who are taxed differently. friendly to intnl. 1. and didn’t read Danish • Different accounting principals. Understanding the barriers to arbitrage means understanding the barriers to accessing the global markets and the sources of segmentation. but not esp. Solution: sell to foreign investors.) • Stable Western Democracy.

but several possiblities exist. regulatory and translation burden.) 2.issue convertible bonds and list on LSE. • SEC prospectus to prepare for NYSE listing • foreigners now own > 50% of shares. Revision Date: November 14.Lecture 10: Global Cost of Capital and Financial Structure Novo Industri A/S (cont. 2001 3-258-98: International Financial Management École des Hautes Études Commerciales. 2001 3-258-98: International Financial Management École des Hautes Études Commerciales. ADR (5-for-1 split). Montréal Copyright 2001 by Simon van Norden 12 de 14 .worries about dilution . higher β and lower debt ratios than their domestic counterparts.raises cost of capital! 1980 . the higher debt ratios of domestic firms tends to lower WACC. Afterwards USD becomes functional currency for much reporting. Danes consider it wildly overpriced. Since debt is cheaper than equity. • US investors buy via London (bonds & stock). Why? The authors give no single answer. evaluation of the firm. stock price > doubles! 1981: NASDAQ listing. they finally admit that much research has found the opposite. Montréal Copyright 2001 by Simon van Norden 11 de 14 Lecture 10: Global Cost of Capital and Financial Structure Cost of Capital: MNEs vs Domestic Firms So far. Globalization brings many added costs (reporting. 1.) Revision Date: November 14. they have given only one (circa 1980) case study as evidence that it really does so. On p.) Outcomes Increase English publication of information. and foreign exchange risk.marketing in NY to cash in on 1st biotech wave. • slight drop in share price . etc. (This is not explain why MNEs don’t follow such a strategy. MNEs (defined as firms that are accessing global capital markets) have higher WACC. 323. In the process. 1978 . increased cost of issuing and marketing securities. political. the textbook has been a cheerleader for the benefits of globalization It has relentlessly sold the tapping of global capital markets as a way to lower the cost of capital.

U. MNEs may have higher.e. not lower. so as to respect the norms of international investors. for guarantees. Montréal Copyright 2001 by Simon van Norden 13 de 14 Lecture 10: Global Cost of Capital and Financial Structure Financial Structure of Foreign Affiliates Typical debt ratios vary from country to country. in high inflation environments. • Helps management compare ROE relative to local competitors (esp. 2001 3-258-98: International Financial Management École des Hautes Études Commerciales. Suggested compromise: Deviate from the overall optimal policy for the consolidated firm only to the extent that it is costless to do so.7). However. Kuwait). 2001 3-258-98: International Financial Management École des Hautes Études Commerciales.Lecture 10: Global Cost of Capital and Financial Structure Cost of Capital: MNEs vs Domestic Firms (cont. follow local norms) or maintain parent-corp. why reintroduce market segmentation?) • This may make it difficult to manage the ratios for the consolidated firm. Brazil. • In some cases. since lenders ultimately look to parent corp. regulatory barriers may prevent domestic savings from being invested abroad. Russia. 4. • This would imply that emerging-market MNEs should benefit doubly from Revision Date: November 14. r m) ⁄ Var(r Market) = ρ Equity. Germany) and starting operations in less stable economies (e. Domestic Finance could be cheaper finance. This does not imply that domestic firms could be the size of MNEs and still keep lower WACC (see Exhibit 10. Montréal Copyright 2001 by Simon van Norden 14 de 14 . debt ratios? Advanatges of going native • Better public relations with the locals.g.. global financing. this may mean higher Var(r Equity) .e.g.) 3. particularly for smaller firms. if this means leaving a stable domestic economy (e. Var(r Equity) β = Cov(r Equity. • Debt ratios for affiliates is largely costmetic.S. β s.) Disadvantages of going native • Why discard the supposed advantage of overcoming international barriers to the movement of capital (i. Revision Date: November 14. creating abnormally low cost of capital in domestic market. Market ⋅ ----------------------------Var(r Market) • International diversification of operations should lower ρ . Should MNEs foreign affiliates “go native” (i.