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CHAPTER17INTERNATIONALCAPITALSTRUCTUREANDTHECOSTOFCAPITAL

ANSWERS&SOLUTIONSTOEND-OF-CHAPTERQUESTIONSANDPROBLEMS

QUESTIONS

1.Supposethatyourfirmisoperatinginasegmentedcapitalmarket.Whatactionswouldyourecommendtomitigatethenegativeeffects?

Answer:Thebestsolutionforthisproblemistocross-listyourfirm’sstockinoverseasmarketslikeLondonandNewYorkthatarenotsegmented.Butyoushouldbeawareoftheassociatedcostssuchasthecostofadjustingfinancialstatements,feeschargedbythelistingexchanges,etc.

2.Explainwhyandhowafirm’scostofcapitalmaydecreasewhenthefirm’sstockiscross-listedonforeignstockexchanges.

Answer:Ifastockbecomesinternationallytradableuponoverseaslisting,therequiredreturnonthestockislikelytogodownbecausetheshareholderbasetendstobeexpandedacrosscountriesandthestockwillbepricedaccordingtotheinternationalsystematicriskratherthanthelocalsystematicrisk.Itiswellknownthatforatypicalstock,theinternationalsystematicriskislowerthanthelocalsystematicrisk.

3.Explainthepricingspill-overeffect.

Answer:Supposeafirmoperatinginarelativelysegmentedcapitalmarket(likeChina,forexample)decidestocross-listitsstockinNewYorkorLondon.Uponcross-borderlisting,thefirm’sstockwillbepricedinternationally.Inaddition,thepricingofremainingpurelydomesticstocks(otherChinesestocks)willbeaffectedinsuchawaythatthesestockswillbepricedpartiallyinternationallyandpartiallydomestically.Thedegreeofinternationalpricingdependsonthecorrelationsbetweenthesepurelydomesticstocksandinternationallytradedstocks.

4.Inwhatsensedofirmswithnontradableassetsgetafree-ridefromfirmswhosesecuritiesareinternationallytradable?

Answer:Duetothespillovereffect,firmswithnontradablesecuritiescanbenefitintermsofhighersecuritypricesandlowercostofcapital,withoutincurringanycostsassociatedwithmakingthesecuritiesinternationallytradable.Thisisanexampleoffree-ride.

5.Defineanddiscussindirectworldsystematicrisk.

Answer:Theindirectworldsystematicriskcanbedefinedasthecovariancebetweenanontradableassetandtheworldmarketportfoliothatisinducedbytradableassets.Inthepresenceofinternationallytradableassets,nontradableassetswillbepricedpartlybytheindirectworldsystematicriskandpartlybythepuredomesticsystematicrisk.

6.Discusshowthecostofcapitalisdeterminedinsegmentedvs.integratedcapitalmarkets.

Answer:Insegmentedcapitalmarkets,thecostofcapitalwillbedeterminedessentiallybythesecurities’domesticsystematicrisks.Inintegratedcapitalmarkets,ontheotherhand,thecostofcapitalwillbedeterminedbythesecurities’worldsystematicrisk,regardlessofnationality.

7.SupposethereexistsanontradableassetwithaperfectpositivecorrelationwithaportfolioToftradableassets.Howwillthenontradableassetbepriced?

Answer:ThenontradableassetwithaperfectpositivecorrelationwithportfolioT(fortradable)willbepricedasifitweretradablebyitself.Inaword,itwillbepricedsolelyaccordingtoitsworldsystematicrisk.

8.DiscusswhatfactorsmotivatedNovoIndustriestoseekU.S.listingofitsstock.WhatlessonscanbederivedfromNovo’sexperiences?

Answer:Novo,arapidlygrowingcompany,wasdomiciledinasmallandsegmentedDanishmarket.Thisrestrictedthefirm’sabilitytoraisecapitalatacompetitiverate.Asdiscussedinthetext,NovosolvedthisproblembylistingitsstockinLondonandNewYorkstockexchanges.ThismoveenabledNovotogainaccesstolargecapitalsourcesandloweritscostofcapital.

9.Discussforeignequityownershiprestrictions.Whydoyouthinkcountriesimposetheserestrictions?

Answer:Manycountriesrestrictthemaximumfractionalownershipoflocalfirmsbyforeigners.Mostly,theserestrictionsareimposedtoensuredomesticcontroloflocalfirms.

10.Explainthepricing-to-marketphenomenon.

Answer:Thepricing-to-market(PTM)referstothephenomenonthatthesamesecuritiesarepriceddifferentlyfordifferentinvestors.Awell-knownexampleofPTMisprovidedbyNestle.Upuntil1988November,foreignerswereonlyallowedtoholdNestlebearershares;onlySwissresidentswereallowedtoholdregisteredshares.AsindicatedinExhibit17.11inthetext,bearersharesweretradingforabouttwicethepriceofregisteredshares.

11.Explainhowthepremiumanddiscountaredeterminedwhenassetsarepriced-to-market.Whenwouldthelawofonepriceprevailininternationalcapitalmarketsevenifforeignequityownershiprestrictionsareimposed?

Answer:Thepremiumanddiscountaredeterminedby(i)theseverityofrestrictionsimposedonforeignersand(ii)foreigners’abilitytomitigatetheeffectoftheserestrictionsusingtheirowndomesticsecurities.Inaspecialcasewhereforeignerscanexactlyreplicatethesecuritiesunderrestriction,thenPTMwillceasetoapply.

12.Underwhatconditionswilltheforeignsubsidiary’sfinancialstructurebecomerelevant?

Answer:Thesubsidiary’sownfinancialstructurewillbecomerelevantwhentheparentfirmisnotresponsibleforthefinancialobligationsofthesubsidiary.

13.Underwhatconditionswouldyourecommendthattheforeignsubsidiaryconformtothelocalnormoffinancialstructure?

Answer:Itmaymakesenseforthesubsidiarytoconfirmtothelocalnormiftheparentisnotresponsibleforthesubsidiary’sdebtandthesubsidiaryhastodependonlocalfinancialmarketsforraisingcapital.

Problems

Answerproblems1-3basedonthestockmarketdatagivenbythefollowingtable.

CorrelationCoefficients

Telmex

Mexico

World

SD(%)

(%)

Telmex

1.00

.90

0.60

18

?

Mexico

1.00

0.75

15

14

World

1.00

10

12

TheabovetableprovidesthecorrelationsamongTelmex,atelephone/communicationcompanylocatedinMexico,theMexicostockmarketindex,andtheworldmarketindex,togetherwiththestandarddeviations(SD)ofreturnsandtheexpectedreturns().Therisk-freerateis5%.

1.ComputethedomesticcountrybetaofTelmexaswellasitsworldbeta.Whatdothesebetasmeasure?

2.SupposetheMexicanstockmarketissegmentedfromtherestoftheworld.UsingtheCAPMparadigm,estimatetheequitycostofcapitalofTelmex.

3.Suppos