Chapter 13

Global Cost and

Availability
of Capital

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 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 market, it can achieve this lower global
cost and greater availability of capital by a properly
designed and implemented capital budgeting strategy

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 Exhibit 13.1 Dimensions of the Cost and Availability of Capital
Strategy
This exhibit demonstrates the various dimensions of cost and availability of
capital strategy

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 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

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 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

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 Global Cost and Availability 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:

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 WACC - The Cost of Equity

 The capital asset pricing model (CAPM) approach is to define the cost of
equity for a firm by the following formula:

 ke = expected (required) rate of return on equity

 krf = rate of interest on risk-free bonds (Treasury bonds, for example)

 βj = 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

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 WACC – The 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

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 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.

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 Exhibit 13.2 Market Liquidity, Segmentation, and the Marginal
Cost of Capital

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 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.

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 International CAPM (ICAPM)

 ICAPM assumes the financial markets are global, not just

domestic

 Thus, the WACC equation adjusts for new opportunities:

keglobal = krfg + βjg (kmg – krfg)

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

could change

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 Ganado's Cost of Capital – Application (Class Problem)
Market conditions have changed. Maria Gonzalez now estimates the risk-free rate to be 3.60%, the company's
credit risk premium is 4.40%, the domestic beta is estimated at 1.05, the international beta at .85, and the
company's capital structure is now 30% debt. All other values remain the same. For both the domestic CAPM and
ICAPM, calculate:

a. Ganado's cost of equity

b. Ganado's cost of debt
c. Ganado's weighted average cost of capital
Domestic International
Assumptions CAPM ICAPM
Ganado's beta, β 1.05 0.85
Risk-free rate of interest, krf 3.60% 3.60%
Company credit risk premium 4.40% 4.40%
Cost of debt, before tax, kd 8.00% 8.00%
Corporate income tax rate, t 35% 35%
General return on market portfolio, km 9.00% 8.00%
Optimal capital structure:
Proportion of debt, D/V 30% 30%
Proportion of equity, E/V 70% 70%

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 Ganado's Cost of Capital – Application (Class Problem)
Domestic International
Assumptions CAPM ICAPM
Ganado's beta, β 1.05 0.85
Risk-free rate of interest, krf 3.60% 3.60%
Company credit risk premium 4.40% 4.40%
Cost of debt, before tax, kd 8.00% 8.00%
Corporate income tax rate, t 35% 35%
General return on market portfolio, km 9.00% 8.00%
Optimal capital structure:
Proportion of debt, D/V 30% 30%
Proportion of equity, E/V 70% 70%

a) Ganado's cost of equity 9.270% 7.340%

ke = krf + ( km - krf ) β

b) Ganado's cost of debt, after tax 5.200% 5.200%

kd x ( 1 - t )

c) Ganado's weighted average cost of capital 8.049% 6.6980%

WACC = [ ke x E/V ] + [ ( kd x ( 1 - t ) ) x D/V ]

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 Exhibit 13.3 The Cost of Equity for Nestlé of Switzerland

Presents an example for Nestlé

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 Nestle of Switzerland – Application (Class Problem)
Nestle of Switzerland is revisiting its cost of equity analysis in 2014. As a result of extraordinary actions by
the Swiss Central Bank, the Swiss bond index yield (10-year maturity) has dropped to a record low of
0.520%. The Swiss equity markets have been averaging 8.400% returns, while the Financial Times global
equity market returns, indexed back to Swiss francs, is at 8.820%. Nestle's corporate treasury staff has
estimated the company's domestic beta at 0.825, but its global beta (against the larger global equity
market portfolio) at .515.

a. What is Nestle's cost of equity based on the domestic portfolio of a Swiss investor?
b. What is Nestle's cost of equity based on a global portfolio for a Swiss investor?

Assumptions Domestic Portfolio Global Portfolio

Swiss bond index yield, the risk-free rate 0.520% 0.520%
Swiss equity market return, in Swiss francs 8.400%
Global equity yield, in Swiss francs 8.820%
Nestle's beta versus Swiss equity market 0.825
Nestle's beta versus Global equity market 0.515

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 Nestle of Switzerland – Application (Class Problem)

ke = krf + ( km - krf ) β

Assumptions Domestic Portfolio Global Portfolio

Swiss bond index yield, the risk-free rate 0.520% 0.520%
Swiss equity market return, in Swiss francs 8.400%
Global equity yield, in Swiss francs 8.820%
Nestle's beta versus Swiss equity market 0.825
Nestle's beta versus Global equity market 0.515

Nestle's cost of equity using CAPM 7.0210% 4.7945%

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 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

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 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)

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 Equity Risk Premiums

 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 13.4)

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 Exhibit 13.4 Alternative Estimates of Cost of Equity for a
Hypothetical U.S. Firm Assuming β = 1 and krf = 4%

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 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

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 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

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 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

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 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)

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 The Demand for Foreign Securities: The Role of International
Portfolio Investors

 Some capital market imperfections include:

 Asymmetric information

 Lack of transparency

 High transaction costs

 Political risks

 Corporate governance issues

 Regulatory barriers

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 The Demand for Foreign Securities: The Role of International
Portfolio Investors
 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)

 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

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 Exhibit 13.5 Market Liquidity, Segmentation, and the Marginal
Cost of Capital

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 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, 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)

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 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

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 Exhibit 13.6 The Cost of Capital for MNE and Domestic
Counterpart Compared

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 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

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 Exhibit 13.7 Do MNEs Have a Higher or Lower Cost of Capital Than
Their Domestic Counterparts?

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