International Financing &
Cost of Capital
Reading: Chapters 11 (pg 373-392), 12 & 13 (443-454)
Lecture Outline
Cost of Capital – WACC (revision?)
Cost of Capital for MNEs
Illiquid/Segmented Markets
Sourcing Equity Globally
Sourcing Debt Globally
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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 = ke E + kd(1-t) D
V V
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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 Capital for MNEs
Should MNEs have a lower cost of capital than other
companies?
Global integration of capital markets has given many
firms access to new and cheaper sources of funds
beyond those available in their home markets.
Therefore the cost of capital for MNEs that can raise
money in international markets should be lower than that
of other companies which only have access to funds in
their domestic market.
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Cost of Capital for MNEs
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 which will, in turn, damage the
overall competitiveness of the firm.
Firms resident in industrial countries with small capital
markets can also benefit from access to bigger, highly
liquid global markets.
Firms resident in countries with 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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Market Illiquidity
Market liquidity (observed by noting the degree to which
a firm can issue a new security without depressing the
existing market price) can affect a firm’s cost of capital.
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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Segmented Markets
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
expected return and risk traded on other securities
markets.
Capital market segmentation is caused mainly by:
– government constraints
– institutional practices
– investor perceptions
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Segmented Markets
Some capital market imperfections that can cause
segmented markets include:
– Asymmetric information
– Lack of transparency
– High transaction costs
– Political risks
– Corporate governance issues
– Regulatory barriers
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Overcoming Illiquidity/Segmentation
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).
In the following diagram, the marginal return on capital at
different budget levels is denoted as MRR.
If the firm is limited to raising funds in its illiquid or segmented
domestic market, the line MCCD shows the marginal domestic
cost of capital.
If the firm has some additional sources of capital outside the
domestic capital market the marginal cost of capital shifts right
to MCCF.
If the MNE can gain full access to international markets, the
line MCCU represents the decreased marginal cost of capital
due to the international pricing of the firm’s securities.
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Overcoming Illiquidity/Segmentation
Segmented Integrated
Market Market
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Lower Cost of Capital
The lower cost of capital to firms that access
international markets is easiest explained by the fact that
they can now access more funding at a lower cost. In
other words, there is a higher upper limit on the amount
they can borrow.
However, they can also obtain an additional saving in
their cost of capital in international markets because
there may be high demand from international investors
for their securities. If the firm’s securities offer
international investors an added diversification benefit,
then the investors would be willing to accept a lower
return, which equates to a lower cost of funds to the
company.
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Lower Cost of Capital
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Sourcing Equity Globally
To implement the goal of gaining access to global capital
markets a firm must begin by designing a strategy that
will ultimately attract international investors.
This means identifying and choosing alternative paths to
access global markets.
This usually requires 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.
The process is often aided by the appointment of an
investment bank as an official advisor to the firm.
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Sourcing 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.
Incremental steps to bridge this gap include conducting
an international bond offering and/or cross-listing equity
shares on more highly liquid foreign stock exchanges.
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Sourcing Equity Globally
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Sourcing Equity Globally
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.
Choices for Australian companies include:
– New York Stock Exchange (NYSE)
– Nasdaq
– London Stock Exchange
– Luxembourg Stock Exchange
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Sourcing Equity Globally
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.
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Sourcing Equity Globally
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.
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Sourcing Equity Globally
There are certainly barriers to cross-listing and/or 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.
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ADRs
Depositary receipts (depositary shares) are negotiable
certificates issued by a bank to represent the underlying
shares of stock, which are held in trust at a foreign
custodian bank.
American depository receipts (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 (allowing for ADR pricing to resemble conventional
US share pricing between $20 and $50 per share).
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ADRs
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ADRs
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.
ADRs also convey certain technical advantages to
US shareholders.
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.
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Types of ADRs
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GRSs
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Other Alternatives
Alternative instruments to source equity in global
markets include the following:
– Sale of a directed public share issue to investors in a
target market
– Sale of a Euroequity public issue to investors in more than
one market (foreign and domestic markets)
– Private placements under SEC Rule 144A
– Sale of shares to private equity funds
– Sale of shares to a foreign firm as part of a strategic
alliance
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Directed Issue
A directed public share issue is defined as one
that is targeted at investors in a single country
and underwritten in whole or in part by
investment institutions from that country.
The issue might or might not be denominated in
the currency of the target market.
The shares might or might not be cross-listed on
a stock exchange in the target market.
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Euro-equity
The gradual integration of the world’s capital markets
and increased international portfolio investment has
spawned the emergence of a very viable Euroequity
market.
A firm can now issue equity underwritten and distributed
in multiple foreign equity markets, sometimes
simultaneously with distribution in the domestic market.
The “Euro” market (a generic term for international
securities issues originating and being sold anywhere in
the world), was created by the same financial institutions
that had previously created an infrastructure for the
Euronote and Eurobond markets.
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Private Placement
One type of directed issue with a long history as a
source of both equity and debt is the private
placement market.
A private placement is the sale of a security to a
small set of qualified institutional buyers under SEC
Rule 144A.
Since the securities are not registered for sale to the
public, investors have typically followed a “buy and
hold” policy.
Private placement markets now exist in most
countries.
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Private Equity Funds
Private equity funds are usually limited partnerships of
institutional and wealthy individual investors that raise
their capital in the most liquid capital markets.
These investors then invest the private equity fund in
mature, family-owned firms located in emerging
markets.
The investment objective is to help these firms to
restructure and modernize in order to face increasing
competition and the growth of new technologies.
Private equity funds differ from traditional venture
capital funds as private equity funds operate in many
countries, fund companies in many industry sectors
and have often have a longer time horizon for exiting.
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Strategic Alliances
Strategic alliances are normally formed by firms that
expect to gain synergies from one or more of the
following joint efforts:
– Sharing the cost of developing technology
– Gaining economies of scale or scope
– Financial assistance (lowering of cost of capital
through attractively priced debt or equity
financing)
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Sourcing Debt Globally
The international debt market offers the borrower
a wide variety of different maturities, repayment
structures and currencies of denomination.
The markets and their many different instruments
vary by source of funding, pricing structure,
maturity and subordination or linkage to other
debt and equity instruments.
The three major sources of debt funding on the
international markets are depicted in the following
exhibit.
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Sourcing Debt Globally
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Bank Loans & Syndications
International bank loans have traditionally been
sourced in the Eurocurrency markets, there is a
narrow interest rate spread between deposit and loan
rates of less than 1%.
Eurocredits are bank loans to MNEs, sovereign
governments, international institutions and banks
denominated in Eurocurrencies and extended by
banks in countries other than the country in whose
currency the loan is denominated.
The syndication of loans has enabled banks to
spread the risk of very large loans among a number
of banks (this is significant for MNEs as they usually
need credit in an amount larger than a single bank’s
loan limit).
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Euronote Market
Euronotes and Euronote facilities are short to medium in
term and are either underwritten and non-underwritten.
Euro-commercial paper is a short-term debt obligation of
a corporation or bank (usually denominated in US
dollars).
Euro medium-term notes is a new entrant to the world’s
debt markets, which bridges the gap between Euro-
commercial paper and a longer-term and less flexible
international bond.
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International Bond Markets
A Eurobond is underwritten by an international syndicate
of banks and other securities firms and is sold
exclusively in countries other than the country in whose
currency the issue is denominated.
A foreign bond is underwritten by a syndicate composed
of members from a single country, sold principally within
that country, and denominated in the currency of that
country (e.g. Yankee or Samurai bonds).
The Eurobond markets differ from the Eurodollar
markets in that there is an absence of regulatory
interference, less stringent disclosure rules and
favorable tax treatments for these bonds.
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Pricing Foreign Bonds & Eurobonds
We use the same pricing formula for foreign and
Eurobonds as domestic bonds:
Pfc = c(1-(1+y)-n)/y + FV/(1+y)n
Then once we have found the price in the foreign
currency (fc), we convert this into local currency
(lc) at the spot rate:
Plc = Pfc / St or Plc = Pfc x St
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Pricing Foreign Bonds & Eurobonds
Calculate the AUD price of a USD bond with the
following characteristics:
3-year bond with 6% semi-annual coupons
Face value of $100
US market yield is 4.8%
Spot Rate: AUD1.23/USD
Pfc = c(1-(1+y)-n)/y + FV/(1+y)n = USD$103.32
Plc = Pfc x St = 103.32x1.23 = AUD$127.08
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Project Finance
Project finance is the arrangement of financing for long-
term capital projects, large in scale, long in life, and
generally high in risk.
Project finance is used widely today by MNEs in the
development of large-scale infrastructure projects in
China, India and many other emerging markets.
Most of these transactions are highly leveraged, with
debt making up more than 60% of the total financing.
Equity is a small component of project financing for two
reasons; first, the scale of investment projects is often
too large for an investor or group of investors to fund and
second, many projects involve subjects traditionally
funded by governments.
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Project Finance
Since project financing usually utilizes a substantial
amount of debt financing, additional levels of risk
reduction are needed in order to create an environment
whereby lenders feel comfortable lending:
– Separability of the project from its investors
– Long-lived and capital-intensive singular projects
– Cash flow predictability from third-party commitments
– Finite projects with finite lives
See examples - infrastructure projects
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