Chapter 12

The Global
Cost and
Availability
of Capital

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Global Cost & Availability of Capital:
Learning Objectives

• Examine how a firm headquartered in a country with an

illiquid and segmented capital market achieves a lower
global cost of and greater availability of capital
• Analyze the linkage between cost and availability of
capital
• Evaluate the effect of market liquidity and
segmentation on the cost of capital
• Compare the weighted average cost of capital for an
MNE with its domestic counterpart

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Global Cost & 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 market
• 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
• This in turn will limit the firm’s ability to compete both
internationally and vis-à-vis foreign firms entering its
market

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Global Cost & Availability of Capital

• Firms resident in small capital markets often source their long-

term debt and equity at home in these partially-liquid domestic
markets
• The costs of funds is slightly better than that of illiquid markets,
however, if these firms can tap the highly liquid international
capital markets, their competitiveness can be strengthened
• Firms resident in segmented capital markets must devise a
strategy to escape dependence on that market for their long-term
debt and equity needs

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Global Cost & Availability of Capital

• A national capital market is segmented if the required

rate of return on securities differs from the required rate
of return on securities of comparable expected return
and risk traded on other securities markets
• Capital markets become segmented because of such
factors as excessive regulatory control, perceived
political risk, anticipated FOREX risk, lack of
transparency, asymmetric information, cronyism,
insider trading and other market imperfections

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Global Cost & Availability of Capital

• Firms constrained by any of these above

conditions must develop a strategy to escape
their own limited capital markets and source
some of their long-term capital needs abroad

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Exhibit 12.1 Dimensions of the Cost
and Availability of Capital Strategy

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Weighted Average Cost of Capital

E D
k WACC = k e + k d (1 −t)
V V
Where
kWACC = weighted average cost of capital
ke = risk adjusted cost of equity
kd = before tax cost of debt
t = tax rate
E = market value of equity
D = market value of debt
V = market value of firm (D+E)

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Cost of Equity and Debt

• Cost of equity is calculated using the Capital Asset Pricing Model (CAPM)

k e = k rf + β (k m −k rf )
Where
ke = expected rate of return on equity
krf = risk free rate on bonds
km = expected rate of return on the market
β = coefficient of firm’s systematic risk

• The normal calculation for cost of debt is analyzing the various

proportions of debt and their associated interest rates for the firm
and calculating a before and after tax weighted average cost of debt
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Trident’s WACC

• Maria Gonzales, Trident’s CFO, believes that Carlton has access to global
capital markets and because it is headquartered in the US, that the US should
serve as its base for market risk and equity risk calculations

k WACC = 17.00%(0.60) +8.00%(1 −0.35)(0.40)

k WACC = 12.28%
Where
kWACC = weighted average cost of capital
ke = Carlton’s cost of equity is 17.0%
kd = Carlton’s before tax cost of debt is 8.0%
t = tax rate of 35.0%
E/V = equity to value ratio of Carlton is 60.0%
D/V = debt to value ratio of Carlton is 40.0%
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Exhibit 12.2 Calculation of Trident’s
Weighted Average Cost of Capital

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Nestlé: An Application of the
International CAPM
• The process of calculating an international WACC differs from a
domestic WACC in the selection of the appropriate market
portfolio and beta
• Stulz (1995) suggests using a global portfolio of securities
available to investors rather than the world portfolio of all
securities (some of which may not be available to investors) when
calculating a firm’s international cost of equity
• The next slide shows the domestic and international risk-free rates,
market portfolios, and betas for Nestlé used to calculate required
rates of return for equity
• In this example the domestic required return for Nestlé of 9.4065%
differs slightly from Nestlé’s global required return of 9.3840%

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Exhibit 12.3 Estimating the Global Cost
of Equity for Nestlé (Switzerland)

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Calculating Equity Risk
Premia in Practice

• Using CAPM, there is rising debate over what

numerical values should be used in its
application, especially the equity risk premium
– The equity risk premium is the expected average
annual return on the market above riskless debt
– Typically, the market’s return is calculated on a
historical basis yet others feel that the number
should be forward looking since it is being used to
calculate expected returns

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Calculating Equity Risk
Premia in Practice

• The field of finance does agree that a cost of

equity calculation should be forward-looking,
meaning that the inputs to the equation should
represent what is expected to happen over the
relevant future time horizon
• As is typically the case, however, practitioners
use historical evidence as the basis for their
forward-looking projections

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Exhibit 12.4 Equity Risk Premiums
Around the World, 1990-2002

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Exhibit 12.5
Arithmetic Versus Geometric Returns: A
Sample Calculation

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Exhibit 12.6 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

• International portfolio investment and cross-listing of equity

shares on foreign markets have become commonplace
• As both domestic and international portfolio managers are asset
allocators, their 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
• International portfolio managers can choose from a larger bundle
of assets than portfolio managers limited to domestic-only asset
allocations
• Some important diversification dimensions include diversification
by country, geographic region and/or stage of development

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Link between Cost &
Availability of Capital

• Although no consensus exists on the definition of market

liquidity, market liquidity can be observed by noting the degree
to which a firm can issue new securities without depressing
existing market prices
• In a domestic case, the underlying assumption is that total
availability of capital at anytime for a firm is determined by
supply and demand within its domestic the market
• In the multinational case, a firm is able to improve market
liquidity by raising funds in the Euromarkets, by selling
securities abroad, and by tapping local capital markets

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Market Segmentation

• Capital market segmentation is a financial market imperfection

caused mainly by government constraints, institutional practices,
and investor perceptions
• Other imperfections are
– Asymmetric information
– Lack of transparency
– High securities transaction costs
– Foreign exchange risks
– Political risks
– Corporate governance differences
– Regulatory barriers

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Effects of Market Liquidity &
Segmentation

• The degree to which capital markets are illiquid or

segmented has an important influence on a firm’s
marginal cost of capital
• An MNE has a given marginal return on capital at
differing budget levels determined by which capital
projects it can and chooses to take on
• If the firm is limited to raising funds in its domestic
market, it has domestic marginal cost of capital at
various budget levels

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Effects of Market Liquidity &
Segmentation

• If an MNE has access to additional sources of

capital outside its domestic market, its marginal
cost of capital can decrease
• If the MNE has unlimited access to capital both
domestic and abroad, then its marginal cost of
capital decreases even further

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Exhibit 12.7
Market Liquidity, Segmentation, and the
Marginal Cost of Capital

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Novo Industri A/S

• Illustrative case of a Danish multinational that sought to

internationalize its capital structure by accessing
foreign capital markets
• Novo Industri is a Danish industrial enzyme and
pharmaceutical firm
• In 1977 the management sought to tap in to other
capital markets because the Danish market was illiquid
and segmented causing Novo to incur a higher cost of
capital than that of its international competitors

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Novo Industri A/S

• The Danish equity markets had at least six factors of

market segmentation
– Asymmetric information for Danish and foreign investors
– Taxation
– Alternative sets of feasible portfolios
– Financial risk
– Foreign exchange risk
– Political risk

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Novo Industri A/S

• Asymmetric information
– Denmark had a regulation that prohibited Danish
investors from holding foreign private sector
securities
• This left little incentive for Danish investors to seek out
new information or follow developments in other markets
– Another barrier was the lack of equity analysts in
Denmark following Danish companies

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Novo Industri A/S

• Taxation
– Danish taxation policy charged a capital gains tax of 50% on shares
held for over two years
– Shares held for less than two years were taxed at a marginal income
tax rate as high as 75%
– This led to bonds being the security of choice among Danes
• Feasible set of portfolios
– Because of the prohibition on foreign security ownership, Danish
investors had a limited set of securities from which to choose
– Danish stocks offered international investors an opportunity to
diversify, but not the reciprocal for Danish investors

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Novo Industri A/S

• Financial, Foreign exchange and political

risks
– Danish firms were highly leveraged relative to US
and UK standards with most debt being short-term
– Foreign investors were subject to foreign exchange
risk but this was not a big obstacle for investment
– Denmark was very stable politically

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Novo Industri A/S

• The Road to Globalization

– When Novo’s management decided to access foreign equity
markets in 1977 they had several barriers to overcome
– Closing the information gap: Novo now needed to begin
disclosing their financials in accordance with international
standards
– In 1979 Novo had a successful Eurobond issues which lead to
more disclosure and international recognition among
investors

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Novo Industri A/S

• The Road to Globalization

– During 1979, Novo also listed its convertibles on the London
Stock Exchange (LSE)
– Also during that year there was a big boom in biotechnology
and Novo went to the US to sell investors on their company
– The road show worked and Novo’s shares on the Danish
exchange and the LSE rose in price from increased demand
– This prompted Novo to consider an equity issue in the US

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Novo Industri A/S

• The Road to Globalization

– During the first half of 1981 Novo prepared an SEC
registration
– Before the offering over 50% of Novo’s shareholders had
become foreign investors
– On May 30, 1981 Novo listed in the NYSE and although it
had lost 10% of its value in Copenhagen the previous day, the
$61 million offering was a success and the share price
quickly gained all its losses from the previous day

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Exhibit 12.8 Novo’s B-Share Prices
Compared with Stock Market Indices

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Cost of Capital for MNEs
versus Domestic Firms

• Is the WACC or an MNE higher or lower than for its domestic

counterpart?
– The answer is a function of
• The marginal cost of capital
• The after-tax cost of debt
• The optimal debt ratio
• The relative cost of equity
• An MNE should have a lower cost of capital because it has
access to a global cost and availability of capital
• This availability and cost allows the MNE more optimality in
capital projects and budgets compared to its domestic counterpart

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Exhibit 12.9
The Cost of Capital for MNE and
Domestic Counterpart Compared

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Exhibit 12.10
Do MNEs Have a Higher or Lower WACC
than Their Domestic Counterparts?

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Summary of Learning Objectives

• Gaining access to global capital markets should allow a

firm to lower its cost of capital. A firm can improve
access to global capital markets by increasing the
market liquidity of its shares and by escaping its home
capital market
• The costs and availability of capital is directly linked to
the degree of market liquidity and segmentation. Firms
having access to markets with high liquidity and low
segmentation should have a lower cost of capital

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Summary of Learning Objectives

• A firm is able to increase its market liquidity by raising

debt in the Euromarket, by selling issues in individual
national markets and by tapping capital markets through
foreign subsidiaries
• This causes the marginal cost of capital to lower for a firm
and it results in a firm’s ability to raise even more capital
• 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 return
and risk that are traded in other national capital markets

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Summary of Learning Objectives

• The most important imperfections are

– asymmetric information
– transaction costs
– foreign exchange risk
– political risk
– corporate governance differences
– regulatory barriers
• Segmentation results in a higher cost of capital and less
availability of capital

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Summary of Learning Objectives

• If a firm is resident in a segmented capital market, it can

escape from this market by sourcing its debt and equity
abroad
• The result should be a lower marginal cost of capital,
improved liquidity for its shares, and a larger capital
budget
• Whether MNEs have a lower cost of capital than their
domestic counterparts depends on their optimal financial
structures, systematic risk, availability of capital, and the
level of the optimal capital budget

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Summary of Learning Objectives

• If a firm is resident in a segmented capital market, it

can still escape from this market by sourcing its debts
and equity abroad. The result should be a lower
marginal cost of capital, improved liquidity for its
securities, and a larger capital budget
• Whether or not MNEs have a lower cost of capital than
their domestic counterparts depends on their optimal
financial structures, systematic risk, availability of
capital, and the level of optimal capital budget

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