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
 Operating Exposure

§ Operating exposure, also called economic exposure, competitive

exposure, and even strategic exposure, on occasion, measures any
change in the present value of a firm resulting from changes in
future operating cash flows caused by an unexpected change in
exchange rates.
§ Oprtg exposure analysis assesses impact of changing exchg rates on
firm’s own oprns over coming months/years & on its competitive
position vis-à-vis other firms.
§ Goal: identify strategic moves/oprtg techniques for adoption to
enhance value in face of unexpected exchg rate changes.
 Global Cost & 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.
 Dimensions of the Cost and
Availability of Capital Strategy
 Global Cost & Availability
of Capital (contd.)
§ 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.
 Global Cost & Availability
of Capital (contd.)
§ 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.
– Capital mkts become segmented b’coz of excessive regulatory
control, perceived political risk, lack of transparency, anticipated
FX risk, cronyism, insider trading, etc. mkt imperfections.
 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
firm’s optimal long-term financial structure:
 Cost of Equity
§ The capital asset pricing model (CAPM) approach defines the
cost of equity for a firm as the sum of a risk-free component & a
firm-specific intt spread over & above that risk-free component,
by the following formula:

Beta calculated as a fn of the total variability of expected returns of the firm’s stocks
relative to the mkt index (km) & the degree to which the variability of expected returns
of the firm is correlated to the expected returns on the mkt index.
 Cost of Equity (contd.)
§ 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
 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,
& 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.
 Weighted Average Cost of Capital
(contd.)

§ WACC is normally used as the risk-adjusted discount rate

whenever a firm’s 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.
 International Portfolio Theory &
Diversification
Portfolio Risk Reduction
§ 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.
§ Adding fgn securities in portfolio lowers portfolio beta, implying
that innl portfolio’s mkt risk is lower than that of domestic portfolio
(b’coz returns on fgn eq stocks not well correlated with returns on
domestic eq stocks)
 Market Liquidity, Segmentation &
the Marginal Cost of Capital
Illustrating the incremental gains of diversifying both domestically
and internationally.
 International Portfolio Theory &
Diversification (contd.)
Foreign Exchange Risk
§ Internationally diversified portfolios are similar to domestic
portfolios b’coz investor attempts to combine assets that are less
than perfectly correlated, to reduce total portfolio risk.
§ International diversification is different in that when the investor
acquires assets or securities from outside the investor’s host-
country market, the investor may also be acquiring a foreign
currency-denominated asset. Thus, the investor has actually
acquired 2 addl assets (in terms of expected returns & risks) –
– the currency of denomination, and
– the asset subsequently purchased with the currency.
 International CAPM (ICAPM)
§ ICAPM assumes the financial markets are global, not just domestic.
§ Our WACC equation adjusts for new opportunities:

§ Above estimates of beta & mkt risk premium supposed to reflect

global portfolio.
§ The risk-free rate is unlikely to change much, but beta could easily
change (+/-), as it would now reflect expected variations against a
greater global portfolio.
§ Main diffce in estimation of cost of eq (COE) for indvl firm using
ICAPM is
– Defn of “market”, &
– Re-calculation of firm’s beta for that mkt
The Cost of Equity for Nestlé of
Switzerland
 Equity Risk Premiums

• In practice, calculating a firm’s 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).
 Equity Risk Premiums (contd.)
• While the field of finance does agree that a cost of equity
calculation should be forward-looking, 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.
• Significant differences in eq risk premiums if difft mkts.
• Arithmetic and geometric average returns provide different
historic risk premiums and they differ across countries.
• Imp for co. to estimate its COE, & its general COC, to accurately
estimate the NPV of potential investts it has to accept or reject
b’coz of ltd capital resources.
 Alternative Estimates of Cost of Equity for
a Hypothetical U.S. Firm
Assuming β = 1 and krf = 4%
• Different analysts and academics tend to use different measures for the
market risk premium.
• This can lead to significantly different results.
 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
principles of:
– portfolio risk reduction;
– portfolio rate of return; and
– foreign currency risk.
 The Demand for Foreign Securities:
The Role of International Portfolio Investors
(contd.)

• 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.
 The Demand for Foreign Securities:
The Role of International Portfolio Investors
(contd.)

• 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 (in the short to medium term) 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; improved mkt liquidity.
 The Demand for Foreign Securities:
The Role of International Portfolio Investors
(contd.)
• 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 mkt, these mkts can still be relatively
efficient in a national context but segmented in an innl
context (as per the finance theory of efficiency, i.e. mkt
efficient if security prices there reflect all available info &
adjust quickly to any new info).
 The Demand for Foreign Securities:
The Role of International Portfolio Investors
(contd.)
• Mkt efficiency assumes low transaction costs, many participants
in the mkt & participants have sufficient fincl strength to move
security prices.
• In segmented mkts, fgn investors are not participants.
• Imp capital market imperfections are:
– Asymmetric information
– Lack of transparency
– High transaction costs
– Foreign exchange risks
– Political risks
– Corporate governance issues
– Regulatory barriers
 The Demand for Foreign Securities:
The Role of International Portfolio Investors
(contd.)

• Availability of capital depends on whether a co. can can gain

liquidity for its debt & eq securities, & a price for those securities
based on innl rather than national stds.
• Hence, co. must define strategy to attract innl portfolio investors
& escape the constraints of its illiquid or segmented national mkt.
The Effect of Market Liquidity & Segmentation

• 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).
• The marginal return on capital at different budget levels is denoted as
MRR in graph (next slide).
• 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.
Market Liquidity, Segmentation, and the
Marginal Cost of Capital
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).
The Cost of Capital for MNEs Compared to
Domestic Firms (contd.)

• 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.
The Cost of Capital for MNE and Domestic
Counterpart Compared
The Cost of Capital for MNEs Compared
to Domestic Firms (contd.)

• 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.
Do MNEs Have a Higher or Lower COC
Than Their Domestic Counterparts?