Chapter 13

The Global Cost

of Capital
 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.
 Using the WACC

• 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.
 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 The Effect of Portfolio
Diversification
 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

• 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 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 principles 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.
 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 MNE’s 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?