Systematic (Market) Risk
The risk of share price changes that cannot be avoided by diversification.
Risk that the stock market as a whole will rise or fall, and the price of shares of an individual company will rise and fall with the market.
Measures the amount of fluctuation expected in a firm’s share price, relative to the stock market as a whole.
(A beta of 0.8 would indicate an expectation that the share price of a given company would rise or fall at 80% of the rise or fall of the stock market in general.)
The degree to which a firm can issue a new security without depressing the existing market price
The degree to which a change in price of its securities elicits a substantial order flow.
Disadvantages of Illiquid Markets
Difficult to buy or sell shares, and especially an abnormally large number of shares, without a major change in price.
Difficult to raise new capital because there are insufficient buyers for a reasonably sized offering (company perspective)
Difficulty selling any shares owned without a major drop in price (investor perspective).
If a firm is limited to raising funds in its domestic capital market, what happens to its marginal cost of capital as it expands?
Marginal cost of capital increases as more funds are raised.
If a firm can raise funds abroad, what happens to its marginal cost of capital as it expands?
Marginal cost of capital stays flat for the longer period of raising new capital.
A financial market imperfection caused mainly by government constraints, institutional practices, and investor perceptions.
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.
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.
Market Segmentation Causes
Asymmetric information between domestic and foreign-based investors
Lack of transparency
High securities transaction costs
Foreign exchange risks
Corporate governance differences
Disadvantages of Segmented Market
Usually have a higher cost of capital (increasing marginal cost of capital) and less availability of capital.
They can overcome these limitations by following a proactive strategy to internationalize their cost and availability of capital.
Optimal Capital Structure Objective
When taxes and bankruptcy costs are considered, a firm has an optimal financial structure, determined by that particular mix of debt and equity that minimizes the firm’s cost of capital for a given level of business risk.
If the business risk of new projects differs from the risk of existing projects, the optimal mix of debt and equity would change to recognize tradeoffs between business and financial risks.
Cost of Debt
The nominal rate of interest
Frequently evaluated on an after-tax basis, because debt interest expense is frequently deductible in the calculation of corporate income tax liabilities.
Cost of Equity
Calculated by corporate management using a model or framework that estimates the returns investors expect when purchasing equity shares in the company in question.
The most widely used calculation methodology is the Capital Asset Pricing Model (CAPM). The international version of that methodology, ICAPM, attempts to estimate the cost of equity in an international setting.
ke = krf + Bj(km - krf)
Underwritten by an international syndicate of banks and other securities firms
Sold exclusively in countries other than the country in whose currency the issue is denominated (a bond issued by a firm resident in the United States, denominated in U.S. dollars, but sold to investors in Europe and Japan, would be a eurobond)
Underwritten by a syndicate composed of members from a single country, sold principally within that country, and denominated in the currency of that country.
The issuer, however, is from another country.
(A bond issued by a firm resident in Sweden, denominated in dollars, and sold in the U.S. to U.S. investors by U.S. investment bankers, would be a foreign bond.)
Eurobond or Foreign Bond?
The distinction is based on whether the borrower is a domestic or a foreign resident, and whether the issue is denominated in the local currency or a foreign currency.
The MNE is supposed to have a lower marginal cost of capital (MCC) than a domestic firm because of the MNE’s access to a global cost and availability of capital.
On the other hand, the empirical studies we mentioned show that the MNE’s weighted average cost of capital (WACC) is actually higher than for a comparable domestic firm because of agency costs, foreign exchange risk, political risk, asymmetric information, and other complexities of foreign operations.
The answer to this riddle lies in the link between the cost of capital, its availability, and the opportunity set of projects.
As the opportunity set of projects increases, eventually the firm needs 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.
However, this would be at a higher weighted average cost of capital than would have occurred for a lower level of the optimal capital budget.
Alternative Paths to Globalise Cost/Availability of Capital
1 - International Bond Issue (Less prestigious markets)
2 - International Bond Issue (Target markets or Eurobond markets)
3 - Equity Listings (Less prestigious markets)
4 - Equity Issue (Less prestigious markets)
5 - Equity Listing (Target markets)
6 - Euroeguity Issue (Global markets)
Optimal Finance Structure (MNEs)
- Domestic theory of optimal financial structures needs to be modified by four more
- variables in order to accommodate the case of the MNE.
1) availability of capital
2) diversification of cash flows
3) foreign exchange risk
4) expectations of international portfolio investors.
Raise Equity Capital
Initial Public Offering
Euroequity Issue (issued on 2 or more exchanges, in two or more countries, simultaneously)
Directed Public/Private Issue
Foreign Equity Listing and Issuance
- Improve liquidity - of existing shares and support a liquid secondary market for
- new equity issues in foreign markets.
- Increase share price - overcoming mis-pricing in a segmented and illiquid home
- capital market
- Increase the firm’s visibility and political acceptance to its customers, suppliers,
- creditors, and host governments
- Establish a secondary market for shares used to acquire other firms in the host
- Create a secondary market for shares that can be used to compensate local
- management and employees in foreign subsidiaries
Debt Funding on the International Market
International bank loans and syndicated credits
International bond market
Eurocurrency markets - Purpose
Eurocurrency deposits are an efficient and convenient money market device for holding excess corporate liquidity.
- The Eurocurrency market is a major source of
- short-term bank loans to finance corporate working capital needs, including the financing of imports and exports.