Chapter 12



International Capital Markets and Global Cost of Capital

International Financing

← There are a number of reasons why borrowing in a foreign market may be beneficial:

✓ Lenders may face fewer regulatory requirements than in the U.S.

✓ Lenders might assess the borrower’s credit risk more favorably

✓ Foreign lenders may face lower taxes on interest income

✓ Foreign governments may want to subsidize investment by foreign companies

✓ Example: U.S. and British banks add default-risk premia, known as a “spread,” to the respective LIBOR rates. Suppose the U.S. bank quotes Eurodollar LIBOR (5%) plus a 200 basis point (2%) spread, but the British bank quotes the GBP LIBOR (7.5%) rate plus a 150 basis point (1.5%) spread. Current spot rate is $2.000/ £ and forward rate is $1.950/ £.

Then if the U.S. company borrows GBP, for each dollar, the company will have to borrow the amount of GBP as: $1.00/2.000 $/ £ = £ 0.500, but the loan payoff in one year would be £ 0.500*(1.09)= £ 0.545. Under the forward agreement, the $US required to meet the loan payoff is: £ 0.545* 1.950$/ £ = $ 1.0628. This compares favorably to the 7.00% cost of the dollar loan from the U.S. bank.

Sourcing Equity Globally

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 and/or segmented capital markets, it can achieve this lower global cost and greater availability of capital by a properly strategy

Designing a strategy to source equity globally

Most firms raise their initial capital in their own domestic market

However, most firms that have only raised capital in their domestic market are not well known enough to attract foreign investors

Bridge this gap by conducting an international bond offering and/or cross-listing equity shares on more highly liquid foreign stock exchanges

To gain access to global capital markets a firm must attract international investors

Require some restructuring of the firm, improving the quality and level of its disclosure, and making its accounting and reporting standards more transparent to potential foreign investors

5 Foreign equity listing and issuance

A firm must choose one or more stock markets on which to cross-list its shares and sell new equity

Just where to go depends mainly on the firm’s specific motives and the willingness of the host stock market to accept the firm

Cross-listing attempts to accomplish one or more of many objectives:

Improve the liquidity of its existing shares and support a liquid secondary market for new equity issues in foreign markets

Increase its share price by overcoming mis-pricing in a segmented and illiquid home capital market

Increase the firms visibility

Establish a secondary market for shares used to acquire other firms

Create a secondary market for shares that can be used to compensate local management and employees in foreign subsidiaries

6 Effect of cross-listing and equity issuance on share price

← Cross-listing may have a favorable impact on share price if the new market values the firm or its industry more than the home market does

← It is well known that the combined impact of a new equity issue undertaken simultaneously with a cross-listing has a more favorable impact on stock price than cross-listing alone

← Even US firms can benefit by issuing equity abroad as increased investor recognition and participation in the primary and secondary markets results

7 Barriers to cross-listing and selling equity abroad

The most serious of these includes the future commitment to providing full and transparent disclosure of operating results and balance sheets as well as a continuous program of investor relations.

The US school of thought is that the worldwide trend toward requiring fuller, more transparent, and more standardized financial disclosure of operating results and balance sheet positions may have the desirable effect of lowering the cost of equity capital

8 Gain access to US capital markets

The largest equity market in the world

To directly issue equity, require more disclosure, and accounting and reporting standards more transparent

American depository receipts (ADRs) and private placements under SEC Rule 144A

• ADRs are certificates traded in the United States and denominated in US dollars

• ADRs are sold, registered, and transferred in the US in the same manner as any share of stock with each ADR representing some multiple of the underlying foreign share

• ADRs can be exchanged for the underlying foreign shares, or vice versa, so arbitrage keeps foreign and US prices of any given share the same after adjusting for transfer costs

• While ADRs are quoted only in US dollars and traded only in the US, Global Registered Shares (GRSs) can be traded on equity exchanges around the globe in a variety of currencies

Global Cost of Capital

11 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:

kWACC = keE/V + kd(1-t)D/V

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)

A few important points:

11 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

12 The interest costs of different debt components are then averaged (according to their proportion).

13 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.

14 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.

15 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.

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

ke = krf + βj(km – krf)

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

← 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)

← 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

12 Example (p293):

13 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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