Ch. 13 - Global Cost and Availability of Capital

If a firm is located in a country with illiquid, small or segmented capital markets, it can

achieve lower global cost and greater availability of capital by a properly designed and implemented strategy

Portfolio Risk Reduction

• Total risk of any portfolio is composed of systematic and unsystematic risk

• Increasing the number of securities reduces the unsystematic risk component, but leaves systematic risk unchanged

A fully diversified domestic portfolio has a beta of

1.0

The international portfolio’s market risk is ______ than a domestic portfolio

lower

Foreign Exchange Risk

• Internationally diversified portfolios are the same in principle because the investor is attempting to combine assets that are less than perfectly correlated, reducing the total risk of the portfolio

• Investor is however exposed to foreign exchange risk, since parts of portfolio are in foreign currency

If beta is < 1.0

returns are less volatile than the market

If beta = 1

returns are same as the market

if beta > 1.0

returns are more volatile than the market

The normal prodecure to measure the cost of debt requires a forecast of …

interest rates for the next few years, proportions of various classes of debt the firm expects to use, and the corporate income tax rate

• Interest costs of different debt components are then averaged

In the CAPM

• Risk-free rate is unlikely to change

• Market return will change

• Firm’s beta will likely chang

ICAPM Considerations

Primary distinction in the estimation of the cost of equity for an individual firm using an internationalized version of the CAPM is the definition of the “market” and a recalculation of the firm’s beta for that market

• 3 basic components of the CAPM must be reconsidered

  • Risk-free rate

  • Market return

  • Beta

Global Betas

• International portfolio theory typically concludes that adding international securities to a domestic portfolio will reduce portfolio risk

• Amount of the reduction will depend on the individual firms in individual markets

Equity Risk Premiums

Practicitioners use historical evidence for a basis for forward looking projections

Internationally diversified portfolios often have a _____ expected rate of return, and they nearly always have a _____ level of portfolio risk

higher, lower

Improving Market Liquidity

• Market liquidity can affect a firm’s cost of capital

• Domestic: firm’s marginal cost of capital will eventually increase as suppliers of capital become saturated with firm’s securities

• Multinational: firm is able to tap many capital markets above and beyond what would have been available in a domestic capital market only

Market Segmentation is caused by:

1. Government constraints

2. Institutional practices

3. Investor perceptions

Market imperfections _______ imply that national securities markets are inefficient

do not

The Effect of Market Liquidity and Segmentation

Degree to which capital markets are illiquid or segemnted has an important influence on a firm’s marginal cost of capital and thus on its WACC

Availability of capital

• International Portfolio Investors may lower their cost of equity and debt compared with most domestic firms

• This permits an MNE to maintain its desired debt ratio

Empirical studies to Financial Structure, Systematic Risk, Cost of Capital for MNE’s

• MNE’s faced higher (than domestic firms) agency costs, political risk, foreign exchange risk, and assymetric information

• Bankruptcy risk is also the same for MNEs as domestic firms