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Chapter 13

The Global Cost and Availability

of Capital
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 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
 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.
Exhibit 13.1 Dimensions of the Cost and
Availability of Capital Strategy
 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.
 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.
 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 is to define

the cost of equity for a firm by the following formula:
 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
 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.
 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.
Exhibit 13.2 Market Liquidity, Segmentation,
and the Marginal Cost of Capital
 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 investor’s host-country market, the
investor may also be acquiring a foreign currency-
denominated asset. Thus, the investor has actually
acquired two additional assets—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:

● The risk-free rate is unlikely to change much, but beta easily

could change.
● Exhibit 13.3 presents an example for Nestlé
Exhibit 13.3 The Cost of Equity for Nestlé of
Switzerland
 Equity Risk Premiums

● The weighted average cost of capital 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.
 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

● 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.
● Arithmetic and geometric average returns provide different
historic risk premiums and they differ across countries.
 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.
Exhibit 13.4 Alternative Estimates of Cost of
Equity for a Hypothetical U.S. Firm Assuming
β = 1 and krf = 4%
 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.
 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
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
● 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.
 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).
 The Demand for Foreign Securities: The Role
of International Portfolio Investors

● Some capital market imperfections include:

● Asymmetric information
● Lack of transparency
● High transaction costs
● Foreign exchange risks
● Political risks
● Corporate governance issues
● Regulatory barriers
 The Effect of Market Liquidity and
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 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.
Exhibit 13.5 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

● 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.
Exhibit 13.6 The Cost of Capital for MNE
and Domestic Counterpart Compared
 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.
Exhibit 13.7 Do MNEs Have a Higher or Lower
Cost of Capital Than Their Domestic
Counterparts?