Transcript Chapter 14

Chap 14 Global Cost and Availability of Capital
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Global integration of capital markets has
given many firms access to new and cheaper
sources of funds beyond those available in
their home markets.
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If a firm is located in a country with illiquid,
small, and/or segmented capital markets, it
can achieve a lower global cost and greater
availability of capital by a properly designed
and implemented strategy.
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Firms that must finance their long-term debt and
equity in a highly illiquid domestic securities market
will probably have a relatively high cost of capital
and a limited availability of such capital which will,
in turn, damage the overall competitiveness of the
firm.
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Firms reside in industrial countries with small capital
markets may enjoy an improved availability of funds
at a lower cost comparing to the illiquid market, but
would also benefit from access to highly liquid
global markets.
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Firms reside in countries with segmented
capital markets must devise a strategy to
escape dependence on that market for their
long-term debt and equity needs.
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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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Firm´s weighted average cost of capital
(WACC) is a weighted average of its cost of
equity and cost of debt. The weights are the
proportion of the firm´s market value of
equity and debt to the market value of the
firm:
RWACC = ReE + Rd(1-τ)D
V
V
where V is Market value of the firms Equity plus debt, and E is firms market
value of equity and D is its market value of debt. Τ is the tax rate.
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RWACC = weighted average cost of capital
Re = cost of equity
Rd = before-tax cost of debt
τ = marginal income tax rate*
E = market value of the firm’s equity
D = market value of the firm’s debt
V = total market value of the firm, (D+E)
* Due to the tax deductibility of interest payment on debt
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The cost of equity for a firm is derived from the
capital asset pricing model (CAPM)
by the following formula:
Re = Rrf + βj(Rm – Rrf)
Where Re is expected (required) rate of return
on equity
Rrf is rate of interest on risk-free bonds
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βj = coefficient of systematic risk of the firm
Rm = expected (or required) rate of return on
the market portfolio.
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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, τ.
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The interest costs of different debt components are then
averaged (according to their proportion).
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The before-tax average, kd, is then multiplied by the
expression (1-tax rate), to obtain kd(1- τ), the weighted
average after-tax cost of debt.
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The weighted average cost of capital is
normally used as the discount rate whenever
a firm’s new projects are in the same general
risk class as its existing projects.
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if a new project differs from existing projects
in business or financial risk, then, a projectspecific required rate of return should be used
as the discount rate.
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Market Risk Premium is the average annual
return of the market expected by investors
over and above riskless debt, that is, (Rm –
Rrf). For example 6,5%-1%=5,5%.
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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, i.e. the
equity risk premium.
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In practice, calculating a firm’s equity risk premium is quite
controversial.
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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.
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The motivation of portfolio investors to purchase and hold
foreign securities :
 portfolio risk reduction;
 portfolio rate of return, and
 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.
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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 can affect a firm’s cost of capital.
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In the domestic case, a firm’s marginal cost of
capital will eventually increase as the borrowing
amount increases. The upward slopping marginal
COST curve.
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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 given that the firm is capable of
investment in international setting.
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Capital market segmentation is caused mainly
by:
 government constraints;
 institutional practices, and
 investor perceptions.
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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.
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Some capital market imperfections include:
 Asymmetric information
 Lack of transparency
 High transaction costs
 Political risks
 Corporate governance issues
 Regulatory barriers
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Recall, from Microeconomics theory, that the marginal price
of a product equals to its marginal revenue. MR=MC. In a
competitive market equilibrium, MR=MC=p
The effective interest rate for a firm is the marginal cost of
capital.
Marginal cost of capital: the interest rate for the borrower to
borrow an additional dollar. As opposed to average interest
rate of the firm´s all borrowings.
The next two slides show lower and lower cost of capital as
the firm goes international. KD >KF >KU
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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).
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the marginal rate of return on capital at different budget levels is denoted as
MRR.
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If the firm is limited to raising funds in its domestic market, the line MCCD shows
the marginal domestic cost of capital.
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If the firm has additional sources of capital outside the domestic (illiquid) capital
market the marginal cost of capital shifts right to MCCF.
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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 subcequently
gains access to other equity markets.
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Determining whether a MNEs cost of capital is higher or
lower than a domestic counterpart is a function of the
marginal cost of capital, the relative after-tax cost of debt,
the optimal debt ratio and the relative cost of equity.
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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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This relationship lies in the link between the cost of capital, its
availability, and available projects.
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As available projects increases, the firm will eventually need to increase
its capital budget to the point where its marginal cost of capital is
increasing. (see the next slide)
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This would point to a higher weighted average cost of capital than would
have been for a lower level of the optimal capital budget. (see next slide)
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KD2
KMNE
KD
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Novo is a Danish multinational firm.
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The company’s management decided to “internationalize” the firm’s
capital structure and sources of funds.
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This was based on the observation that the Danish securities market was
both illiquid and segmented from other capital markets (at the time).
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Management realized that the company’s projected growth
opportunities required raising capital beyond what could be raised in the
domestic market alone.
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Six characteristics of the Danish equity market
were responsible for market segmentation:
 asymmetric information base of Danish and foreign
investors;
 taxation;
 alternative sets of feasible portfolios;
 financial risk;
 foreign exchange risk, and
 political risk.
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Although Novo’s management wished to escape from the
shackles of Denmark’s segmented and illiquid capital
market, many barriers had to be overcome.
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These barriers included closing the information gap between
the capital markets and the company itself and executing a
share offering in the US (which required resolving additional
barriers imposed by the government of Denmark on
securities issuances).
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