Chapter 13Global Cost and Availability of Capital 2013 Pearson Education, Inc. All rights reserved. 13-2 Global Cost and Availability of CapitalGlobal 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. 2013 Pearson Education, Inc. All rights reserved. 13-3 Exhibit 13.1 Dimensions of the Cost and Availability of Capital Strategy 2013 Pearson Education, Inc. All rights reserved. 13-4 Global Cost and Availability of CapitalA 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. 2013 Pearson Education, Inc. All rights reserved. 13-5 Global Cost and Availability of CapitalFirms 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. 2013 Pearson Education, Inc. All rights reserved. 13-6 Weighted Average Cost of CapitalA 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 firms optimal long-term financial structure:kWACC = keE + kd(1-t)D VV 2013 Pearson Education, Inc. All rights reserved. 13-7 Weighted Average Cost of CapitalkWACC = weighted average after-tax cost of capitalke = risk-adjusted cost of equitykd = before-tax cost of debtt = marginal tax rateE = market value of the firms equityD = market value of the firms debtV = total market value of the firms securities (D+E) 2013 Pearson Education, Inc. All rights reserved. 13-8 WACC: The Cost of EquityThe capital asset pricing model (CAPM) approach is to define the cost of equity for a firm by the following formula:ke = krf + j(km krf) 2013 Pearson Education, Inc. All rights reserved. 13-9 WACC: The Cost of Equityke = expected (required) rate of return on equitykrf = rate of interest on risk-free bonds (Treasury bonds, for example)j = coefficient of systematic risk for the firm Beta is equal to the correlation between the security and the market portfolio multiplied by the standard deviation of return for the security and divided by the standard deviation of return for the market km = expected (required) rate of return on the market portfolio of stocks 2013 Pearson Education, Inc. All rights reserved. 13-10 WACC - DebtThe 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. 2013 Pearson Education, Inc. All rights reserved. 13-11 International CAPM (ICAPM)ICAPM assumes the financial markets are global, not just domestic.Our WACC equation adjusts for new opportunities:keglobal = krfg + jg(kmg krfg)The risk-free rate is unlikely to change much, but beta easily could change.Exhibit 13.2 presents an example for Nestl 2013 Pearson Education, Inc. All rights reserved. 13-12 Exhibit 13.2 The Cost of Equity for Nestl of Switzerland 2013 Pearson Education, Inc. All rights reserved. 13-13 Equity Risk PremiumsThe weighted average cost of capital is normally used as the risk-adjusted discount rate whenever a firms 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. 2013 Pearson Education, Inc. All rights reserved. 13-14 Equity Risk PremiumsIn practice, calculating a firms 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). 2013 Pearson Education, Inc. All rights reserved. 13-15 Equity Risk PremiumsWhile 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. See Exhibit 13.3 for an average return example. 2013 Pearson Education, Inc. All rights reserved. 13-16 Exhibit 13.3 Arithmetic Versus Geometric Returns: A Sample Calculation 2013 Pearson Education, Inc. All rights reserved. 13-17 Equity Risk PremiumsA 2010 study finds 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.A final note on the cost of equity and the selection of betas: For many years there has been a significant gulf between academia and industry on the importance of cost of equity and capital estimations (see Exhibit 13.5). 2013 Pearson Education, Inc. All rights reserved. 13-18 Exhibit 13.4 Alternative Estimates of Cost of Equity for a Hypothetical U.S. Firm Assuming = 1 and krf = 4% 2013 Pearson Education, Inc. All rights reserved. 13-19 Exhibit 13.5 Corporate Cost of Equity and Capital Estimation 2013 Pearson Education, Inc. All rights reserved. 13-20 The Demand for Foreign Securities: The Role of International Portfolio InvestorsGradual 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; andforeign currency risk. 2013 Pearson Education, Inc. All rights reserved. 13-21 The Demand for Foreign Securities: The Role of International Portfolio InvestorsBoth domestic and international portfolio managers are asset allocators whose objective is to maximize a portfolios 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. 2013 Pearson Education, Inc. All rights reserved. 13-22 The Demand for Foreign Securities: The Role of International Portfolio InvestorsMarket liquidity (observed by noting the degree to which a firm can issue a new security without depressing the existing market price) can affect a firms cost of capital.In the domestic case, a firms marginal cost of capital will eventually increase as suppliers of capital become saturated with the firms 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. 2013 Pearson Education, Inc. All rights reserved. 13-23 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 2013 Pearson Education, Inc. All rights reserved. 13-24 Some capital market imperfections include:Asymmetric informationLack of transparencyHigh transaction costsPolitical risksCorporate governance issuesRegulatory barriersThe Demand for Foreign Securities: The Role of International Portfolio Investors 2013 Pearson Education, Inc. All rights reserved. 13-25 The degree to which capital markets are illiquid or segmented has an important influence on a firms 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.The Demand for Foreign Securities: The Role of International Portfolio Investors 2013 Pearson Education, Inc. All rights reserved. 13-26 Exhibit 13.6 Market Liquidity, Segmentation, and the Marginal Cost of Capital 2013 Pearson Education, Inc. All rights reserved. 13-27 The Cost of Capital for MNEs Compared to Domestic FirmsDetermining 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.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). 2013 Pearson Education, Inc. All rights reserved. 13-28 The Cost of Capital for MNEs Compared to Domestic FirmsThis 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. 2013 Pearson Education, Inc. All rights reserved. 13-29 Exhibit 13.7 The Cost of Capital for MNE and Domestic Counterpart Compared 2013 Pearson Education, Inc. All rights reserved. 13-30 The Cost of Capital for MNEs Compared to Domestic FirmsIn 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. 2013 Pearson Education, Inc. All rights reserved. 13-31 Exhibit 13.8 Do MNEs Have a Higher or Lower Cost of Capital Than Their Domestic Counterparts?