Chapter 14
Global Cost and
Availability
of Capital
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Global Cost and Availability
of Capital
• Global integration of capital
markets access to new and
cheaper sources of funds
• firm is located in a country with
illiquid, small, and/or segmented
capital markets. This will be lower
global cost and greater
availability of capital
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Exhibit 14.1 Dimensions of the Cost and
Availability of Capital Strategy
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Global Cost and Availability
of Capital
• A firm in a highly illiquid domestic
securities market will have high cost
of capital and will face limited
availability of such capital
• Firms in industrial countries may
enjoy an improved availability of
funds at a lower cost
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Global Cost and Availability
of Capital
• Firms in countries with
segmented capital markets must
devise a strategy for their longterm debt and equity needs.
• A national capital market is
segmented
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14.1 Weighted Average Cost of
Capital
• WACC
kWACC = keE + kd(1-t)D
V
V
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Weighted Average Cost of Capital
kWACC = weighted average after-tax cost of capital
ke = risk-adjusted cost of equity
kd = before-tax cost of debt
t = marginal tax rate
E = market value of the firm’s equity
D = market value of the firm’s debt
V = total market value of the firm’s securities (D+E)
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Cost of Equity (P.368)
• The capital asset pricing model (CAPM)
ke = krf + βj(km – krf)
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Weighted Average Cost of Capital
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
km = expected (required) rate of return on the
market portfolio of stocks
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Cost of Debt (P.369)
• 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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Adjusted Cost of Capital
• 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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Calculating Equity Risk Premium In
practice (P.371)
• 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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Weighted Average Cost of Capital
• 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.
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14.2 The Demand for Foreign Securities:
The Role of International Portfolio Investors
• deregulation of equity markets elicited increased
competition from domestic players but also
opened up markets to foreign competitors.
• requires an understanding of the principals of:
– portfolio risk reduction;
– portfolio rate of return, and
– foreign currency risk.
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The Link between Cost and
Availability of Capital (P.374)
• 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.
• internationally diversified portfolios often have a
higher expected rate of return, and a lower level
of portfolio risk. Because securities markets are
imperfectly correlated with one another.
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Improving Market Liquidity (P.374)
• Market liquidity can affect a firm’s cost of capital
• observed by noting the degree to which a firm can issue a
new security without depressing the existing market price
• 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.
• markets can still be relatively efficient in a
national context but segmented in an
international context
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Market Segmentation(P.374)
• 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 Effect of Market Liquidity
Segmentation(P.375)
• 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 as MRR.
• MCCD marginal domestic cost of capital.
• outside the domestic (illiquid) capital market, the marginal
cost of capital MCCF.
• If the MNE is located in a capital market that is both liquid
and unsegmented, the line MCCU represents the decreased
marginal cost of capital if it gains access to other equity
markets.
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Exhibit 14.7 Market Liquidity, Segmentation,
and the Marginal Cost of Capital
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14.3 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
• 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 14.8 The Cost of Capital
for MNE and Domestic Counterpart Compared
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14.4 Solving a Riddle : is WACC for
MNEs higher?
• 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 and increasing marginal
cost of capital, then the MNE would have a
lower WACC.
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Exhibit 14.9 Do MNEs Have a Higher or Lower
WACC Than Their Domestic Counterparts?
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Exhibit 14.2 Calculation of Trident’s
Weighted Average Cost of Capital
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Exhibit 14.3 Estimating the Global
Cost of Equity for Nestlé
(Switzerland)
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Exhibit 14.4 Equity Risk Premiums
around the World, 1900–2002
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Exhibit 14.5 Arithmetic versus
Geometric Returns: A Sample
Calculation
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Exhibit 14.6 Alternative Estimates of Cost of
Equity for a Hypothetical U.S. Firm
Assuming β = 1 and krf = 4%
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