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kWACC = weighted average after-tax cost of capital ke = cost of equity (expected (required) rate of return on equity) kd = before-tax cost of debt t = corporate tax rate E = market value of the firms equity D = market value of the firms debt V = total market value of the firms securities (=D+E) 14-6
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The Demand for Foreign Securities: The Role of International Portfolio Investors
Gradual deregulation and integration 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 (1) portfolio risk reduction, (2) portfolio rate of return, and (3) foreign currency risk (these will be explained in detail in Ch 15) Later we only briefly discuss the benefit of international diversification 14-14
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 portfolios rate of return for a given level of risk, or to minimize risk for a given rate of return Portfolio asset allocation can be accomplished along many dimensions by, e.g. types of securities (stocks or bonds), industries (food or electronic), size of capitalization (small-cap or large-cap), countries (Korea or Taiwan), geographic region (Asian or Europe), stage of development (industrialized or emerging countries) In this text book, we focus on the latter three dimensions for international diversification 14-15
The Demand for Foreign Securities: The Role of International Portfolio Investors
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
In Carlton example, the costs of equity and debt are assumed to be the same even if Carltons capital budget were to expand This is a reasonable assumption if Carlton can access to international portfolio investors in global capital markets, but a bad assumption for firms in illiquid or segmented capital markets We will examine how market liquidity and market segmentation can affect a firms cost of capital Before that, we define the marginal cost of capital (MCC) first, which is the weighted average cost of 14-17 the next currency unit raised
The Demand for Foreign Securities: The Role of International Portfolio Investors
Market liquidity
Here we study the market liquidity by observing the degree to which a firm can issue a new security without depressing the existing market price (the depression of the market price implies the increase of the marginal cost of capital of issuing new security) Suppose firms always expand their capital budgets at their optimal capital structures, i.e. the financial risk of firms does not change with the expansion Even so, market liquidity still can affect a firms marginal cost of capital
In the domestic case, eventually the firm needs to increase its capital budget to the point where its marginal cost of capital is increasing because the domestic capital market become saturated
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The Demand for Foreign Securities: The Role of International Portfolio Investors
In the multinational case, a firm is able to tap many foreign capital markets and raises funds over what would have been available in a domestic capital market only
Escaping from an illiquid market, a firm could access more sources of capital, so it could raise more funds without increasing its marginal cost of capital
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The Demand for Foreign Securities: The Role of International Portfolio Investors
Market segmentation
Capital market segmentation is caused mainly by many market imperfections mentioned on Slide 11-5 In a segmented market, since there is no foreign participants, the securities would be priced on the basis of domestic rather than international standards In the example on Slide 11-14, the internationalized version of CAPM employed by international investors could generate a lower estimation for the firms cost of equity and thus a higher market value of the equity of the firm In a word, escaping from a segmented market, a firm could have a better price for its securities and thus a lower cost of capital based on international rather than domestic standards 14-20
The Demand for Foreign Securities: The Role of International Portfolio Investors
The effect of market liquidity and segmentation
We will illustrate that the degree to which capital markets are illiquid or segmented will influence a firms MCC and thus change its weighted average cost of capital In Exhibit 11.7, the line MCCD shows the domestic marginal cost of capital, and the marginal rate of return on capital at different capital budget levels is denoted as MRR, which is a negative-slope curve because it is wellknown that for larger capital budget levels, the marginal rate of return on capital should decrease If the firm is limited to raising funds in its domestic (illiquid) market, even the capital structure being the same and the thus financial risk remaining fixed, the MCC is 13% for small capital budget levels but finally increases with the increase of the capital budget level 14-21
The Demand for Foreign Securities: The Role of International Portfolio Investors
If the firm has additional sources of capital outside the domestic (illiquid or small) capital market, the marginal cost of capital shifts right to MCCF This is because foreign markets can provide long-term funds at times when the domestic market is saturated because of heavy use by other borrowers or equity issuers. As a consequence, given the same capital budge level for the firm, the MCCF is lower than or equal to MCCD If the domestic capital market is both illiquid and segmented, accessing the international capital market can bring both effects of greater availability of capital and international pricing of the firms securities Thus, MCCD becomes MCCU, which is lower and fixed at 10% for small capital budget levels, and begins to increase when the capital budget level is larger than about $50 million 14-22
Exhibit 14.7 Market Liquidity, Segmentation, and the Marginal Cost of Capital
Marginal cost of capital and rate of return
MCCD
20% 15% 13% 10%
MCCF MCC U
kU
kD
kF
MRR
Capital Budget (millions of $)
10
20
30
40
50
60
The intersection of MCCD and MRR indicates that the optimal capital budget is $40 million and the marginal cost of capital is 20% The intersection of MCCF and MRR indicates that the firm can reduce its marginal international cost of capital to 15% even while it raises an addition $10 million. The intersection of MCCU and MRR indicates that the marginal cost of capital declines to 13% and the optimal budget climbs to $60 million
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A true case of a firm to escape the domestically segmented and illiquid market to access the international capital market is shown Novo is a Danish firm that produces pharmaceuticals, and it had an excellent operating track record In 1977, the firms management decided to internationalize both the firms capital structure and sources of funds
This was based on the observation that the Danish securities market was both illiquid and segmented from other capital markets at that time As a consequence, the lack of availability of capital and high cost of equity capital in Denmark resulted in Novo having a higher cost of capital than its main multinational competitors 14-24
If Denmarks markets were integrated with would markets, there must be foreign investors rush to buy Danish securities Strangely enough, there is no Danish governmental restrictions existed that would prevented foreign investors from holding Danish securities So, there must be other reasons for market 14-25 segmentation in Denmark
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4. Financial risk
Financial leverage utilized by Danish firms was relatively high (debt ratio is about 65% to 70%) by U.S. and U.K. standards
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6. Political risk
With respect to political risk, Denmark was perceived as a stable Western democracy and with lower political risk
If Danish stock price movements were not closely correlated with world stock price movement, inclusion of Danish stocks in portfolios should reduce these portfolios systematic risk, which is a benefit for foreign investors Since the disadvantage is more serious than the gain from international diversification, the foreign investors avoided the Danish market and thus this market became segmented14-28
Exhibit 14.8 Novos B-Share Prices Compared with Stock Market Indices
Share Price
1800 1600 1000 1400 1200 1000
Market Indices
1200
Novo B-Shares
800 600 400 200 0
77.1 77.2 77.3 77.4 78.1 78.2 78.3 78.4 79.1 79.2 79.3 79.4 80.1 80.2 80.3 80.4 81.1 81.2 81.3 81.4 82.1 82.2
600 400
The Novo B-share price jumps upward substantially from the second quarter of 1980, from Dkr220 to about Dkr 1600 at the second quarter of 1982 The movement in the Danish stock market in general cannot be explained by movement in the U.S. or U.K. stock markets as a whole, so the Danish stock market was segmented 14-31
Danish investors reacted negatively to the listing on the NYSE due to the worry about the dilution effect of the new share, but why did not the U.S. investors adopt the same point of view as Danish investors?
This is because the enhancement of both the visibility and the liquidity from listing on the NYSE and the increase of the transparency from the SEC registration process will add up values for the Novos stock shares
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Exhibit 14.9 The Cost of Capital for MNE & Domestic Counterpart Compared
Marginal cost of capital and rate of return (percentage)
MCCDC
MCCMNE
MRRDC
MRRMNE
Capital Budget (millions of $) 100 140 300 350 400 MRRDC depicts a modest set of potential projects, and MRRMNE depicts a more ambitious set of projects, which are with higher capital budget levels and higher marginal rate of return Due to the better availability of capital, an MNEs MCC is constant for considerable ranges of its capital budget. On the contrary, the MCC for domestic firms increases with the increase of the capital budget level At low budget levels, MNEs have a higher MCC and probably WACC than its domestic counterpart At high budget levels, MNEs have a lower MCC and probably WACC than its domestic counterpart
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The comparisons between WACCs of MNEs and domestic firms regarding the debt ratio, the cost of debt, and the cost of equity are summarized in Exhibit 11.10 14-38
Exhibit 14.9 Do MNEs Have a Higher or Lower WACC Than Their Domestic Counterparts?
Is MNEwacc > or < Domesticwacc ? kWACC = ke
Equity Value
+ kd ( 1 t )
Debt Value
Empirical studies indicate MNEs have a lower debt/capital ratio than domestic counterparts due to higher agency costs, political risk, foreign exchange risk, and asymmetric information, so MNEs have a higher cost of capital Due to the greater availability of capital for MNEs, they usually have a lower average cost of debt than domestic counterparts, indicating MNEs have a lower cost of capital In empirical studies, the cost of equity required by investors is higher for multinational firms than for domestic firms. Although the international diversification for MNEs could lower jm, the increase of j from higher political risk, foreign exchange risk, and agency costs might offset the lower correlation from diversification and thus cause the increase of the cost of equity 14-39