Corporate Finance MLI28C060 Lecture 5 Friday 16 October 2015

Capital structure II: Equity and debt valuation Structure: - Implications for firm from International versus domestic capital raising - The concept of portfolio diversification - Capital raising from two points of view: that of capital issuer (firm) and investor - Introduction of capital asset pricing model (CAPM) and its international counterpart (ICAPM) in equity valuation Reading: Brealey & Myers: Chapter 8

- Implications for firm from International versus domestic capital raising - The concept of portfolio diversification

International Diversification and Risk Portfolio Risk reduction – The case for international diversification of portfolios can be decomposed into two components, the potential risk reduction benefits of holding international securities. The potential added foreign exchange risk. – Portfolio beta A measure of portfolio risk The ratio of the variance of a portfolio’s return relative to the variance of the market return A fully diversified domestic portfolio have a beta of 1.0

International Diversification and Risk Portfolio Risk reduction

International Diversification and Risk The total risk of a portfolio is composed of – systematic risk (the market) and – unsystematic risk (the individual securities). Increasing the number of securities in the portfolio reduces the unsystematic risk component

International Diversification and Risk

Foreign exchange risk. – Purchasing assets in foreign markets in foreign currencies may alter the correlations associated with securities in different countries (and currencies). – This provides portfolio composition and diversification possibilities that domestic investment and portfolio construction may not provide. – International diversification helps to reduce the foreign exchange risks of a portfolio.

Internationalizing the Domestic Portfolio The optimal domestic portfolio – Risk-averse typical investor is in search of a portfolio that maximises expected portfolio return per unit of expected portfolio risk. – The domestic investor may choose among a set of individual securities in the domestic market. – The near-infinite set of portfolio combinations of domestic securities form the domestic portfolio opportunity set – The set of portfolios along the extreme left edge of the set is termed the efficient frontier which represents the optimal portfolios of securities that possess the minimum expected risk for each level of expected portfolio return.

Internationalizing the Domestic Portfolio The optimal domestic portfolio

Internationalizing the Domestic Portfolio The optimal domestic portfolio [Figure 16.3 – above slide] – The minimum risk domestic portfolio (MR DP ) is the portfolio with the minimum risk – The individual investor will search out the optimal domestic portfolio (DP), which combines the risk-free asset and a portfolio of domestic securities found on the efficient frontier. – He or she begins with the risk-free asset (R f ) and moves out along the security market line until reaching portfolio DP. – This portfolio (DP) is defined as the optimal domestic portfolio

International Diversification and Risk International diversification – The internationally diversified portfolio opportunity set shifts leftward of the purely domestic opportunity set.

International Diversification and Risk International diversification

International Diversification and Risk International diversification – The internationally diversified portfolio opportunity set is of lower expected risk than comparable domestic portfolios. – The gains arise from the introduction of additional securities and/or portfolios that are of less than perfect correlation with the securities and portfolios within the domestic opportunity set.

International Diversification and Risk International diversification

International Diversification and Risk The optimal international portfolio (IP) [Figure 16.5 – above slide] – The investor can choose an optimal portfolio that combines the same risk-free asset with a portfolio from the efficient frontier of the internationally diversified portfolio opportunity set. – The IP is found by locating that point on the capital market line which extends from the risk-free asset return of R f to a point of tangency along the internationally diversified efficient frontier. – IP offers higher expected portfolio return with a lower portfolio risk compared to the domestic portfolio alone.

International Diversification and Risk Calculation of portfolio risk and return – An investor can reduce investment risk by holding risky assets in a portfolio. as long as the asset returns are not perfectly positively correlated, the investor can reduce risk, because some of the fluctuations of the asset returns will offset each other. Calculation of portfolio risk and return – An example Ausdrill’s Chief Financial Officer, Caitlin, is considering investing Ausdrill’s marketable securities in two different risky assets: an index of the Australian equity markets and an index of the German equity markets. The two equities are characterised by the following expected returns and expected risks.

International Diversification and Risk Calculation of portfolio risk and return – An example The expected return of the portfolio

International Diversification and Risk Calculation of portfolio risk and return – An example The standard deviation of the portfolio’s expected return

International Diversification and Risk Calculation of portfolio risk and return – An example

International Diversification and Risk Calculation of portfolio risk and return Multiple-asset model

National Markets and Asset Performance The true benefits of global diversification arise from the fact that the returns of different stock markets around the world are not perfectly positively correlated. Fact is – Different industrial structures in different countries, and – Different economies do not exactly follow the same business cycle.

National Markets and Asset Performance

- Capital raising from two points of view: that of capital issuer (firm) and investor - Introduction of capital asset pricing model (CAPM) and its international counterpart (ICAPM) in equity valuation

The Firm’s Investment Decision and the Cost of Capital A firm that can reduce its cost of capital will increase the profitable capital expenditures that the firm can take on and increase the wealth of the shareholders. Internationalizing the firm’s cost of capital is one such policy. cost of capital (%) Investment ($) K global K local I local I global IRR

Cost of Capital in Segmented vs. Integrated Markets The cost of equity capital (K e ) of a firm is the expected return on the firm’s stock that investors require. This return is frequently estimated using the Capital Asset Pricing Model (CAPM): where i=i= Cov(R i, R M ) Var(R M ) R i = R f +  i (R M – R f )

Cost of Capital in Segmented vs. Integrated Markets If capital markets are segmented, then investors can only invest domestically. This means that the market portfolio (M) in the CAPM formula would be the domestic portfolio instead of the world portfolio. versus Clearly integration or segmentation of international financial markets has major implications for determining the cost of capital. R i = R f +  i (R U.S. – R f ) U.S. R i = R f +  i (R W – R f ) W

Does the Cost of Capital Differ among Countries? There do appear to be differences in the cost of capital in different countries. When markets are imperfect, international financing can lower the firm’s cost of capital. One way to achieve this is to internationalize the firm’s ownership structure.

Cross-Border Listings of Stocks Cross-border listings of stocks have become quite popular among major corporations. The largest contingent of foreign stocks are listed on the London Stock Exchange. U.S. exchanges attracted the next largest contingent of foreign stocks.

Cross-Border Listings of Stocks Cross-border listings of stocks benefit a company in the following ways. 1.The company can expand its potential investor base, which will lead to a higher stock price and lower cost of capital. 2.Cross-listing creates a secondary market for the company’s shares, which facilitates raising new capital in foreign markets. 3.Cross-listing can enhance the liquidity of the company’s stock. 4.Cross-listing enhances the visibility of the company’s name and its products in foreign marketplaces.

Cross-Border Listings of Stocks Cross-border listings of stocks do carry costs. 1.It can be costly to meet the disclosure and listing requirements imposed by the foreign exchange and regulatory authorities. 2.Once a company’s stock is traded in overseas markets, there can be volatility spillover from these markets. 3.Once a company’s stock is make available to foreigners, they might acquire a controlling interest and challenge the domestic control of the company.

Cross-Border Listings of Stocks On average, cross-border listings of stocks appears to be a profitable decision. The benefits outweigh the costs.

Preliminary Note: The difference between stock price and total return

Global Cost & Availability of Capital Global integration of capital markets has given many firms access to new and cheaper sources of funds beyond those available in their home market 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 This in turn will limit the firm’s ability to compete both internationally and vis-à-vis foreign firms entering its market

Global Cost & Availability of Capital Firms resident in small capital markets often source their long-term debt and equity at home in these partially-liquid domestic markets The costs of funds is slightly better than that of illiquid markets, however, if these firms can tap the highly liquid international capital markets, their competitiveness can be strengthened Firms resident in segmented capital markets must devise a strategy to escape dependence on that market for their long- term debt and equity needs

Global Cost & Availability of Capital A national capital market is segmented if the required rate of return on securities differs from the required rate of return on securities of comparable expected return and risk traded on other securities markets Capital markets become segmented because of such factors as excessive regulatory control, perceived political risk, anticipated FOREX risk, lack of transparency, asymmetric information, cronyism, insider trading and other market imperfections

Global Cost & Availability of Capital Firms constrained by any of these above conditions must develop a strategy to escape their own limited capital markets and source some of their long-term capital needs abroad

Figure 1: Dimensions of the Cost and Availability of Capital Strategy

Where k e = expected rate of return on equity k rf = risk free rate on bonds k m = expected rate of return on the market β = coefficient of firm’s systematic risk The normal calculation for cost of debt is analyzing the various proportions of debt and their associated interest rates for the firm and calculating a before and after tax weighted average cost of debt Cost of Equity and Debt Cost of equity is calculated using the Capital Asset Pricing Model (CAPM)

Where k WACC = weighted average cost of capital k e = Carlton’s cost of equity is 17.0% k d = Carlton’s before tax cost of debt is 8.0% t = tax rate of 35.0% E/V = equity to value ratio of Carlton is 60.0% D/V = debt to value ratio of Carlton is 40.0% Worked Example: Trident’s WACC Maria Gonzales, Trident’s CFO, believes that Carlton has access to global capital markets and because it is headquartered in the US, that the US should serve as its base for market risk and equity risk calculations

Nestlé: An Application of the International CAPM The process of calculating an international WACC differs from a domestic WACC in the selection of the appropriate market portfolio and beta Stulz (1995) suggests using a global portfolio of securities available to investors rather than the world portfolio of all securities (some of which may not be available to investors) when calculating a firm’s international cost of equity The next slide shows the domestic and international risk-free rates, market portfolios, and betas for Nestlé used to calculate required rates of return for equity In this example the domestic required return for Nestlé of % differs slightly from Nestlé’s global required return of %

Figure 3: Estimating the Global Cost of Equity for Nestlé (Switzerland)

Calculating Equity Risk Premia in Practice Using CAPM, there is rising debate over what numerical values should be used in its application, especially the equity risk premium – The equity risk premium is the expected average annual return on the market above riskless debt – Typically, the market’s return is calculated on a historical basis yet others feel that the number should be forward looking since it is being used to calculate expected returns

Calculating Equity Risk Premia in Practice The field of finance does agree that a cost of equity calculation should be forward-looking, meaning that the inputs to the equation should represent what is expected to happen over the relevant future time horizon As is typically the case, however, practitioners use historical evidence as the basis for their forward-looking projections

Figure 4: Equity Risk Premiums Around the World,

The Demand for Foreign Securities International portfolio investment and cross-listing of equity shares on foreign markets have become commonplace As both domestic and international portfolio managers are asset allocators, their objective is to maximize a portfolio’s rate of return for a given level of risk, or to minimize risk for a given rate of return International portfolio managers can choose from a larger bundle of assets than portfolio managers limited to domestic- only asset allocations Some important diversification dimensions include diversification by country, geographic region and/or stage of development

Link between Cost & Availability of Capital Although no consensus exists on the definition of market liquidity, market liquidity can be observed by noting the degree to which a firm can issue new securities without depressing existing market prices In a domestic case, the underlying assumption is that total availability of capital at anytime for a firm is determined by supply and demand within its domestic the market In the multinational case, a firm is able to improve market liquidity by raising funds in the Euromarkets, by selling securities abroad, and by tapping local capital markets

Market Segmentation Capital market segmentation is a financial market imperfection caused mainly by government constraints, institutional practices, and investor perceptions Other imperfections are – Asymmetric information – Lack of transparency – High securities transaction costs – Foreign exchange risks – Political risks – Corporate governance differences – Regulatory barriers