MultinationalBusinessFinanceSixteenthEditionChapter13GlobalCostandAvailabilityofCapitalCopyright?2022,2019and2016PearsonEducation,Inc.AllRightsReservedLearningObjectives(1of2)13.1Exploretheevolutionofhowcorporatestrategyandfinancialglobalizationmayalign13.2Examinehowinternationalportfoliotheoryanddiversificationaltertheglobalcostofcapital13.3DescribehowinternationalportfolioinvestorsimpactthecostofcapitalLearningObjectives(2of2)13.4ComparetheweightedaveragecostofcapitalforanMNEwithitsdomesticcounterpart13.5AnalyzetheillustrativeandseminalcaseofNovoindustryA/S’sstrategytointernationalizeitscostandavailabilitytocapitalFinancialGlobalizationandStrategy(1of3)Globalintegrationofcapitalmarketshasgivenmanyfirmsaccesstonewandcheapersourcesoffundsbeyondthoseavailableintheirhomemarkets.Ifafirmislocatedinacountrywithilliquid,small,and/orsegmentedcapitalmarkets,itcanachievethislowerglobalcostandgreateravailabilityofcapitalbyaproperlydesignedandimplementedstrategy.Exhibit13.1illustratesthesepoints.Exhibit13.1DimensionsoftheCostandAvailabilityofCapitalStrategyForlongdescription,seeslide40:Appendix1FinancialGlobalizationandStrategy(2of3)Afirmthatmustsourceitslong-termdebtandequityinahighlyilliquiddomesticsecuritiesmarketwillprobablyhavearelativelyhighcostofcapitalandwillfacelimitedavailabilityofsuchcapitalwhichwill,inturn,damagetheoverallcompetitivenessofthefirm.Firmsresidentinindustrialcountrieswithsmallcapitalmarketsmayenjoyanimprovedavailabilityoffundsatalowercost,butwouldalsobenefitfromaccesstohighlyliquidglobalmarkets.FinancialGlobalizationandStrategy

(3of3)Firmsresidentincountrieswithsegmentedcapitalmarketsmustdeviseastrategytoescapedependenceonthatmarketfortheirlong-termdebtandequityneeds.Anationalcapitalmarketissegmentediftherequiredrateofreturnonsecuritiesinthatmarketdiffersfromtherequiredrateofreturnonsecuritiesofcomparableexpectedreturnandrisktradedonothersecuritiesmarkets.CostofCapitalAdomesticfirmnormallyfindsitscostofcapitalbyevaluatingwhereandfromwhomitwillraiseitscapital.Afirmnormallyfindsitsweightedaveragecostofcapital(WACC)bycombiningthecostofequitywiththecostofdebtinproportiontotherelativeweightofeachinthefirm’soptimallong-termfinancialstructure:whereweightedaverageafter-taxcostofcapitalrisk@adjustedcostofequitybefore@taxcostofdebtt=marginaltaxrateE=marketvalueofthefirm’sequityD=marketvalueofthefirm’sdebtV=marketvalueofthefirm’ssecurities(D+E)CostofEquity(1of2)Thecapitalassetpricingmodel(CAPM)approachisthemostwidelyacceptedandusedmethodofcalculatingthecostofequityforafirm:whereexpected(required)rateofreturnonequityrateofinterestonrisk-freebonds(Treasurybonds,forexample)coefficientofsystematicriskforthefirm(beta)expected(required)rateofreturnonthemarketportfolioofstocksCostofEquity(2of2)ThekeycomponentofCAPMisbeta,themeasureofsystematicrisk.Ifbeta<1.0returnsarelessvolatilethanthemarketIfbeta=1returnsarethesameasthemarketIfbeta>1.0returnsaremorevolatilethanthemarketwheremeasureofsystematicriskforsecurityj=correlationbetweensecurityjandthemarket=standarddeviationofthereturnonfirmj=standarddeviationofthemarketreturnCostofDebtThenormalprocedureformeasuringthecostofdebtrequiresaforecastofinterestratesforthenextfewyears,theproportionsofvariousclassesofdebtthefirmexpectstouse,andthecorporateincometaxrate.Theinterestcostsofdifferentdebtcomponentsarethenaveraged(accordingtotheirproportion).Thebefore-taxaverage,isthenadjustedforcorporateincometaxesbymultiplyingitbytheexpression(1?taxrate),toobtaintheweightedaverageafter-taxcostofdebt.InternationalPortfolioTheoryandDiversificationThetotalriskofanyportfoliois,therefore,composedofsystematicrisk(themarketasmeasuredbybeta)andunsystematicrisk(theindividualsecurities).Increasingthenumberofsecuritiesintheportfolioreducestheunsystematicriskcomponentbutleavesthesystematicriskcomponentunchanged.Afullydiversifieddomesticportfoliowouldhaveabetaof1.0.Exhibit13.2illustratestheincrementalgainsofdiversifyingbothdomesticallyandinternationally.Exhibit13.2MarketLiquidity,Segmentation,andtheMarginalCostofCapitalForlongdescription,seeslide41:Appendix2Whentheportfolioisdiversified,thevarianceoftheportfolio’sreturnrelativetothevarianceofthemarket’sreturn(beta)isreducedtothelevelofsystematicrisk—theriskofthemarketitself.Whentheportfolioisdiversifiedinternationally,theportfolio’sbetaislowered.ForeignExchangeRiskInternationallydiversifiedportfoliosaresimilartodomesticportfoliosbecausetheinvestorisattemptingtocombineassetsthatarelessthanperfectlycorrelated.Internationaldiversificationisdifferentinthatwhentheinvestoracquiresassetsorsecuritiesfromoutsidetheinvestor’shost-countrymarket,theinvestormayalsobeacquiringaforeigncurrency-denominatedasset.Thus,theinvestorhasactuallyacquiredtwoadditionalassets—thecurrencyofdenominationandtheassetsubsequentlypurchasedwiththecurrency.InternationalCAPM(ICAPM)ICAPMassumesthefinancialmarketsareglobal,notjustdomestic:Therisk-freerateisunlikelytochangemuch,butbetaeasilycouldchange.Exhibit13.3presentsanexampleforNestlé.Exhibit13.3TheCostofEquityforNestléofSwitzerlandNestlé’sestimateofitscostofequitywilldependuponwhetheraSwissinvestoristhoughttoholdadomesticportfolioofequitysecuritiesoraglobalportfolio.Forlongdescription,seeslide42:Appendix3Source:AllvaluesaretakenfromReneStulz,“TheCostofCapitalinInternationallyIntegratedMarkets:TheCaseofNestlé,”EuropeanFinancialManagement,Volume1,Number1,March1995,11–22.EquityRiskPremiums(1of2)ThereisrisingdebateoverwhatnumericalvaluesshouldbeusedintheapplicationofCAPM,especiallytheequityriskpremiumortheaverageannualreturnofthemarketexpectedbyinvestorsoverandaboverisklessdebt.Whilethefieldoffinancedoesagreethatacostofequitycalculationshouldbeforward-looking,practitionerstypicallyusehistoricalevidenceasabasisfortheirforward-lookingprojections.EquityRiskPremiums(2of2)Equityriskpremiumswillalsoobviouslydifferacrosscountrymarkets,asinterestrateandinterestrate-relatedreturns(likerisk-freeratesofreturn)differbycurrency.Exhibit13.4makesthisreadilyapparent,astheequitymarketriskpremiumisbothrelativelystableovertherecentfive-yearperiodbycountrybutdoesvarybycountry.Exhibit13.4TheEquityRiskPremiumAcrossGlobalMarkets(ImpliedPremium)Forlongdescription,seeslide43:Appendix4Source:EquityMarketRiskPremium—ResearchSummary,KPMG,January13,2017,p.7.KPMGderivestheimpliedequitymarketriskpremiumbydeductingtherisk-freeratefromtheimplieddiscountrateasyieldedbythevariousequitymarketindexes.TheRoleofInternationalPortfolioInvestorsGradualderegulationofequitymarketsduringthepastthreedecadesnotonlyelicitedincreasedcompetitionfromdomesticplayersbutalsoopenedupmarketstoforeigncompetitors.Internationalportfoliomanagerscanchoosefromalargerpoolofassetsthanportfoliomanagerslimitedtodomestic-onlyassetallocationsandthereforeusuallyexperienceahigherexpectedrateofreturnandlowerlevelofportfoliorisk.ImprovingMarketLiquidityMarketliquidity(observedbynotingthedegreetowhichafirmcanissueanewsecuritywithoutdepressingtheexistingmarketprice)canaffectafirm’scostofcapital.Inthedomesticcase,afirm’smarginalcostofcapitalwilleventuallyincreaseassuppliersofcapitalbecomesaturatedwiththefirm’ssecurities.Inthemultinationalcase,afirmisabletotapmanycapitalmarketsaboveandbeyondwhatwouldhavebeenavailableinadomesticcapitalmarketonly.MarketSegmentation(1of2)Capitalmarketsegmentationiscausedmainlyby:governmentconstraints;institutionalpractices;andinvestorperceptions.Whiletherearemanyimperfectionsthatcanaffecttheefficiencyofanationalmarket,thesemarketscanstillberelativelyefficientinanationalcontextbutsegmentedinaninternationalcontext(recallthefinancedefinitionofefficiency).MarketSegmentation(2of2)Somecapitalmarketimperfectionsinclude:AsymmetricinformationLackoftransparencyHightransactioncostsForeignexchangerisksPoliticalrisksCorporategovernanceissuesRegulatorybarriersTheEffectofMarketLiquidityandSegmentationThedegreetowhichcapitalmarketsareilliquidorsegmentedhasanimportantinfluenceonafirm’smarginalcostofcapital(andthusonitsweightedaveragecostofcapital).ThemarginalreturnoncapitalatdifferentbudgetlevelsisdenotedasMRRinExhibit13.5.Ifthefirmislimitedtoraisingfundsinitsdomesticmarket,thelineshowsthemarginaldomesticcostofcapital.Ifthefirmhasadditionalsourcesofcapitaloutsidethedomestic(illiquid)capitalmarket,themarginalcostofcapitalshiftsrighttoIftheMNEislocatedinacapitalmarketthatisbothilliquidandsegmented,thelinerepresentsthedecreasedmarginalcostofcapitalifitgainsaccesstootherequitymarkets.Exhibit13.5MarketLiquidity,Segmentation,andtheMarginalCostofCapitalForlongdescription,seeslide44:Appendix5TheCostofCapitalforMNEsComparedtoDomesticFirms(1of4)DeterminingwhetheraMNE’scostofcapitalishigherorlowerthanadomesticcounterpartisafunctionofthe:marginalcostofcapital;relativeafter-taxcostofdebt;optimaldebtratio;andrelativecostofequity.WhiletheMNEissupposedtohavealowermarginalcostofcapital(MCC)thanadomesticfirm,empiricalstudiesshowtheopposite(asaresultoftheadditionalrisksandcomplexitiesassociatedwithforeignoperations).TheCostofCapitalforMNEsComparedtoDomesticFirms(2of4)Toillustrateonepossibleexplanation,Exhibit13.6showsthemarginalcostofcapital(MCC)andasetofpossiblecapitalproject(MRR)schedulesforamultinationalenterprise(MNE)anditsdomesticcounterpart(Domestic).Notethatthemultinationalhasamuchlargersetofpossiblecapitalprojects,butalsosuffers—initially—fromahighermarginalcostofcapitalthanitsdomesticcounterpart.Exhibit13.6CostofCapitalforMNEandDomesticCounterpartComparedForlongdescription,seeslide45:Appendix6TheCostofCapitalforMNEsComparedtoDomesticFirms(3of4)Thisrelationshipliesinthelinkbetweenthecostofcapital,itsavailability,andtheopportunitysetofprojects.Astheopportunitysetofprojectsincreases,thefirmwilleventuallyneedtoincreaseitscapitalbudgettothepointwhereitsmarginalcostofcapitalisincreasing.Theoptimalcapitalbudgetwouldstillbeatthepointwheretherisingmarginalcostofcapitalequalsthedecliningrateofreturnontheopportunitysetofprojects.Thiswouldbeatahigherweightedaveragecostofcapitalthanwouldhaveoccurredforalowerleveloftheoptimalcapitalbudget.TheCostofCapitalforMNEsComparedtoDomesticFirms(4of4)Inconclusion,ifbothMNEsanddomesticfirmsdoactuallylimittheircapitalbudgetstowhatcanbefinancedwithoutincreasingtheirMCC,thentheempiricalfindingsthatMNEshavehigherWACCstands.Ifthedomesticfirmhassuchgoodgrowthopportunitiesthatitchoosestoundertakegrowthdespiteanincreasingmarginalcostofcapital,thiswoulddrivethecostofcapitalupforthedomesticfirmrelativetothecostofcapitaloftheMNE.SeeExhibit13.7Exhibit13.7DoMNEsHaveaHigherCostofCapitalThanTheirDomesticCounterparts?Forlongdescription,seeslide46:Appendix7IllustrativeCase:NovoIndustriA/S(1of2)NovoisaDanishmultinationalfirmthatproducesindustrialenzymesandpharmaceuticals(mostlyinsulin).In1977,Novo’smanagementdecidedto“internationalize”itscapitalstructureandsourcesoffundsbasedontheobservationthattheDanishsecuritiesmarketwasbothilliquidandsegmentedfromothercapitalmarkets.IllustrativeCase:NovoIndustriA/S

(2of2)AtleastsixcharacteristicsoftheDanishequitymarketwereresponsibleformarketsegmentation:AsymmetricinformationbaseofDanishandforeigninvestorsTaxationAlternativesetsoffeasibleportfoliosFinancialriskForeignexchangeriskPoliticalriskAsymmetricInformationThemostimportantinformationbarrierwasaDanishregulationthatprohibitedDanishinvestorsfromholdingforeignprivate-sectorsecurities.AlmostnoforeignsecurityanalystsfollowedDanishsecuritiesbecausetheyhadnoproducttosellandtheDanishmarketwastoosmall(small-countrybias).Otherinformationbarriersincludedlanguageandaccountingprinciples.TaxationDanishtaxationpolicyhadallbuteliminatedinvestmentincommonstockbyindividuals.UntilataxlawchangeinJuly1981,capitalgainsonsharesheldforovertwoyearsweretaxedata50%rate.Sharesheldforlessthantwoyears,orfor“speculative”purposes,weretaxedatpersonalincometaxrates,withthetopmarginalratebeing75%.Incontrast,capitalgainsonbondsweretax-free.FeasiblePortfoliosBecauseoftheprohibitiononforeignsecurityownership,DanishinvestorshadaverylimitedsetofsecuritiesfromwhichtochooseaportfoliobutDanishstocksprovidedanopportunityforforeigninvestorstodiversifyinternationally.However,foreigninvestorsperceivedDanishstockstocarrymorefinancial,foreignexchange,andpoliticalriskthantheirowndomesticsecurities.Financial,ForeignExchange,andPoliticalRisksFinancialrisk:thefinancialleverageutilizedbyDanishfirmswasrelativelyhighbyU.S.andU.K.standardsbutnotabnormalforScandinavia,Germany,Italy,orJapanForeignexchangerisk:basedonperceptionsaboutthefuturestrengthoftheDanishkrone,anditsimpactonafirm’soperatingexposurePoliticalrisk:Denmark’snationaldebtwasregardedastoohighTheRoadtoGlobalizationTheNovoexperiencecanbeamodelforotherfirmswishingtoescapefromsegmentedandilliquidhomeequitymarkets.Marketsegmentationhasbeensignificantlyreduced,althoughtheliquidityofindividualnationalmarketsremainslimited.ThegoodnewsisthatmanyfirmshavebeenassistedtobecomeMNEsbecausetheynowhaveaccesstoaglobalcostandavailabilityofcapital.Thebadnewsisthatthecorrelationamongsecuritiesmarketshasincreased,therebyreducing,butnoteliminating,thebenefitsofinternationalportfoliodiversification.CopyrightThisworkisprotectedbyUnitedStatescopyrightlawsandisprovidedsolelyfortheuseofinstructorsinteachingtheircoursesandassessingstudentlearning.Disseminationorsaleofanypartofthiswork(includingontheWorldWideWeb)willdestroytheintegrityoftheworkandisnotpermitted.Theworkandmaterialsfromitshouldneverbemadeavailabletostudentsexceptbyinstructorsusingtheaccompanyingtextintheirclasses.Allrecipientsofthisworkareexpectedtoabidebytheserestrictionsandtohonortheintendedpedagogicalpurposesandtheneedsofotherinstructorswhorelyonthesematerials.Appendix1LongDescriptionforExhibit13.1Adiagramillustratesthefactorsthatrelatetolocalmarketaccessandglobalmarketaccessasfollows:Dimension,Firmspecificcharacteristicsforlocalmarketaccess:Firm’ssecuritiesappealonlytodomesticinvestors;Globalmarketaccess:Firm’ssecuritiesappealtointernationalportfolioinvestors.Dimension,Marketliquidityforfirm’ssecuritiesforlocalmarketaccess,Illiquiddomesticsecuritiesmarketandlimitedinternationalliquidity;Globalmarketaccess,Highlyliquiddomesticmarketandbroadinternationalparticipation.Dimension,Effectofmarketsegmentationonfirm’ssecuritiesandcostofcapitalforlocalmarketaccess,Segmenteddomesticsecuritiesmarketthatpricessharesaccordingtodomesticstandards;Globalmarketaccess,Accesstoglobalsecuritiesmarketthatpricessharesaccordingtointernationalstandards.ReturntopresentationAppendix2LongDescriptionforExhibit13.2ThegraphhastwocurvesfortheportfolioofU.S.stocksandtheportfolioofinternationalstocks.ThecurvefortheportfolioofU.S.stocksfallswithdecreasingsteepnessfrom(1,100)throughestimatedpoint(10,35)towardyequals27percent.Thecurvefortheportfolioofinternationalstocksfallswithdecreasingsteepnessfrom(1,100)throughestimatedpoint(10,22)towardyequals12percent,whichrepresentsthesystematicrisk.Theheightofthecurvefortheportfolioofinternationalstocksrepresentsthetotalrisk.Thetotalriskisthesumofthediversifiableorunsystematicriskandthemarketorsystematicrisk.ReturntopresentationAppendix3LongDescriptionforExhibit13.3ThetableshowscalculationsforportfoliosforaSwissinvestor,domesticversusglobalportfolios.ksubR,Fequals3.3percentfordomestic,fromtheSwissbondindexyield,3.3percentforglobal,fromtheSwissbondindexyield.ksubMequals10.2percentfordomestic,fromtheSwissmarketportfolioinSF,13.7percentforglobal,fromtheFinancialTimesGlobalindexinSF.betasubNestléequals0.885fordomestic,fromNestléversusSwissmarketportfolio,0.585fromNestléversusF,T,AtoSwissindex.Forbothportfolios,ksubNestléequalsksubR,FplusbetasubNestléstartparenthesisksubMminusksubR,Fendparenthesis.Forthedomesticportfolio,requiredreturnonNestléisshownas,ksubesuperNestléequals9.4065percent.Fortheglobalportfolio,requiredreturnonNestléisshownas,ksubesuperNestléequals9.3840percent.ReturntopresentationAppendix4LongDescriptionforExhibit13.4Thegraphhascurvesfor6indicesasfollows:A,E,Xonly,AmsterdamstocksonEuronext;Dutchmarket,Amsterdamexchange;Stoxx50,BluechipindexforEurozone;SandP500,U.S.stockindexoftop500bymarketcapitalization;F,T,S,E,FinancialTimesStockExchange100,LondonStockExchange;STOXX600,BluechipindexforEurozonetop600bymarketcapitalization.OnSeptember30,2002,theequityriskpremiumsforthedifferentindicesrangedfrom2.00percentfortheSandP500to8.80percentfortheSTOXX600.Mostindicesreportedpremiumsbetween3.50and4.00percent.Overtime,theequityriskpremiumsconvergedtoward6.00percent.Bytheendof2016,thedifferentindicesreportedpremiumsfrom5.00percentfortheFTSEto6.80percentfortheSandP500.Allvaluesestimated.ReturntopresentationAppendix5LongDescriptionforExhibit13.5Costofcapitalincludesthemarginalcostofcapitalforusersandtherateofreturnforprovidersinpercent.CapitalbudgetiscapitalmadeavailablefornewinvestmentsinmillionsofU.S.dollars.Thegraphhasfourcurvesforthemarginalrateofreturn,orM,R,R,andthreeformsofthema