CH-17 International Capital Structure and the Cost of Capital – International Financial Management : Book Guide

CHAPTER 17 INTERNATIONAL CAPITAL STRUCTURE AND THE COST OF CAPITAL ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS QUESTIONS 1. Suppose that your firm is operating in a segmented capital market. What actions would you recommend to mitigate the negative effects? Answer: The best solution for this problem is to cross-list your firm’s stock in overseas markets like London and New York that are not segmented. But you should be aware of the associated costs such as the cost of adjusting financial statements, fees charged by the listing exchanges, etc. 2. Explain why and how a firm’s cost of capital may decrease when the firm’s stock is crosslisted on foreign stock exchanges. Answer: If a stock becomes internationally tradable upon overseas listing, the required return on the stock is likely to go down because the shareholder base tends to be expanded across countries and the stock will be priced according to the international systematic risk rather than the local systematic risk. It is well known that for a typical stock, the international systematic risk is lower than the local systematic risk. 3. Explain the pricing spill-over effect. Answer: Suppose a firm operating in a relatively segmented capital market (like China, for example) decides to cross-list its stock in New York or London. Upon cross-border listing, the firm’s stock will be priced internationally. In addition, the pricing of remaining purely domestic stocks (other Chinese stocks) will be affected in such a way that these stocks will be priced partially internationally and partially domestically. The degree of international pricing depends on the correlations between these purely domestic stocks and internationally traded stocks. 4. In what sense do firms with nontradable assets get a free-ride from firms whose securities are internationally tradable? Answer: Due to the spillover effect, firms with nontradable securities can benefit in terms of higher security prices and lower cost of capital, without incurring any costs associated with making the securities internationally tradable. This is an example of free-ride. 5. Define and discuss indirect world systematic risk. Answer: The indirect world systematic risk can be defined as the covariance between a nontradable asset and the world market portfolio that is induced by tradable assets. In the presence of internationally tradable assets, nontradable assets will be priced partly by the indirect world systematic risk and partly by the pure domestic systematic risk. 6. Discuss how the cost of capital is determined in segmented vs. integrated capital markets. Answer: In segmented capital markets, the cost of capital will be determined essentially by the securities’ domestic systematic risks. In integrated capital markets, on the other hand, the cost of capital will be determined by the securities’ world systematic risk, regardless of nationality. 7. Suppose there exists a nontradable asset with a perfect positive correlation with a portfolio T of tradable assets. How will the nontradable asset be priced? Answer: The nontradable asset with a perfect positive correlation with portfolio T (for tradable) will be priced as if it were tradable by itself. In a word, it will be priced solely according to its world systematic risk. 8. Discuss what factors motivated Novo Industries to seek U.S. listing of its stock. What lessons can be derived from Novo’s experiences? Answer: Novo, a rapidly growing company, was domiciled in a small and segmented Danish market. This restricted the firm’s ability to raise capital at a competitive rate. As discussed in the text, Novo solved this problem by listing its stock in London and New York stock exchanges. This move enabled Novo to gain access to large capital sources and lower its cost of capital. 9. Discuss foreign equity ownership restrictions. Why do you think countries impose these restrictions? Answer: Many countries restrict the maximum fractional ownership of local firms by foreigners. Mostly, these restrictions are imposed to ensure domestic control of local firms. 10. Explain the pricing-to-market phenomenon. Answer: The pricing-to-market (PTM) refers to the phenomenon that the same securities are priced differently for different investors. A well-known example of PTM is provided by Nestle. Up until 1988 November, foreigners were only allowed to hold Nestle bearer shares; only Swiss residents were allowed to hold registered shares. As indicated in Exhibit 17.11 in the text, bearer shares were trading for about twice the price of registered shares. 11. Explain how the premium and discount are determined when assets are priced-to-market. When would the law of one price prevail in international capital markets even if foreign equity ownership restrictions are imposed? Answer: The premium and discount are determined by (i) the severity of restrictions imposed on foreigners and (ii) foreigners’ ability to mitigate the effect of these restrictions using their own domestic securities. In a special case where foreigners can exactly replicate the securities under restriction, then PTM will cease to apply. 12. Under what conditions will the foreign subsidiary’s financial structure become relevant? Answer: The subsidiary’s own financial structure will become relevant when the parent firm is not responsible for the financial obligations of the subsidiary. 13. Under what conditions would you recommend that the foreign subsidiary conform to the local norm of financial structure? Answer: It may make sense for the subsidiary to confirm to the local norm if the parent is not responsible for the subsidiary’s debt and the subsidiary has to depend on local financial markets for raising capital. PROBLEMS Answer problems 1-3 based on the stock market data given by the following table. World Telmex .90 0.60 18 ? Mexico 1.00 0.75 15 14 World 1.00 10 12 The above table provides the correlations among Telmex, a telephone/communication company located in Mexico, the Mexico stock market index, and the world market index, together with the standard deviations (SD) of returns and the expected returns (R ). The risk-free rate is 5%. 1. Compute the domestic country beta of Telmex as well as its world beta. What do these betas measure? 2. Suppose the Mexican stock market is segmented from the rest of the world. Using the CAPM paradigm, estimate the equity cost of capital of Telmex. 3. Suppose now that Telmex has made its shares tradable internationally via cross-listing on NYSE. Again using the CAPM paradigm, estimate Telmex’s equity cost of capital. Discuss the possible effects of international pricing of Telmex shares on the share prices and the firm’s investment decisions. Solutions. 1. The domestic beta, TM , and the world beta, TW, of Telmex can be computed as follows: TM =TMM2 =TMM2TM = (18)(15)(0(15)2 .9) = 225243 =1.08 TW =TW2 =TW2TW = (18)(10)(0(10)2 .6) = 100108 =1.08 W W Both the domestic and world beta turn out to be the same. As the market moves by 1%, Telmex stock return will move by 1.08% . 2. RT =Rf + (RM −Rf )TM = 5 + (14 − 5)(1.08) =14.72% 3. RT =R f + (RW −R f )TW = 5 + (12 − 5)(1.08) =12.56% As the equity cost of capital decreases from 14.72% to 12.56%, Telmex will experience an increase in its share price. In addition, with a reduced cost of capital, Telmex will be able to undertake more investment projects profitably. International Capital Structure and the Cost of Capital Chapter Seventeen Chapter Outline • Cost of Capital • Cost of Capital in Segmented vs. Integrated Markets • Does the Cost of Capital Differ Among Countries? • Cross-Border Listings of Stocks • Capital Asset Pricing Under Cross-Listings • The Effect of Foreign Equity Ownership Restrictions • The Financial Structure of Subsidiaries Cost of Capital • The cost of capital is the minimum rate of return an investment project must generate in order to pay its financing costs. • For a levered firm, the financing costs can be represented by the weighted average cost of capital: K = (1 – )Kl + (1 – )i Where K = weighted average cost of capital  = debt to total market value ratio Kl = cost of equity capital for a levered firm t = marginal corporate income tax rate i = pretax cost of debt 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. Investment ($) Ilocal Iglobal Cost of Capital in Segmented vs. Integrated Markets • The cost of equity capital (Ke) 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): Ri = Rf + i(RM – Rf) Cov(R where i = i ,RM) Var(RM) 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. Ri = Rf + U.S.i (RU.S. – Rf) versus Ri = Rf + Wi (RW – Rf) ▪ Clearly integration or segmentation of international financial markets has major implications for determining the cost of capital. 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. Does the Cost of Capital Differ Among Countries? 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: – The company can expand its potential investor base, which will lead to a higher stock price and lower cost of capital. – Cross-listing creates a secondary market for the company’s shares, which facilitates raising new capital in foreign markets. – Cross-listing can enhance the liquidity of the company’s stock. – 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: – It can be costly to meet the disclosure and listing requirements imposed by the foreign exchange and regulatory authorities. – Controlling insiders may find it difficult to continue to derive private benefits once the company is cross-listed on foreign exchanges. – Once a company’s stock is traded in overseas markets, there can be volatility spillover from these markets. – Once a company’s stock is made 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. Australia BHP Billiton, Coles Meyer, Telstra, Westpac Banking Brazil Banco Itan, Embraer, Petrobras, Telebras, Unibanco, VALE Canada Alcan, Barrick Gold, Canadian Pacific, Domtar, Fairfax Financial, Mitel, Northern Telecom, Toronto Dominion Bank Chile Banco de Chile, Macedo, Vina Concha y Toro. China China Eastern Airlines, China Life Insurance, Huaneng Power, PetroChina, China Mobile Finland Nokia Corp., Stora Enso France Alcatel-Lucent, France Telecom, Sanofi-Aventis, Suez, Total, Vivendi Some Foreign Firms Listed on the NYSE Japan Canon, Honda Motor, Hitachi, Kubota, Kyocera, NTT Docomo, Sony, Panasonic Korea Korea Electric Power, Korea Telecom, Pohang Iron & Steel, SK Telecom Mexico Cemex, Empresas ICA, Grupo Televisa, Telefonos de Mexico Netherlands Aegon, Arcelor Mittal, Reed Elsevier, Unilever, CNH Global, ING, Royal Dutch Petroleum South Africa ASA, Anglo Gold Ashanti, Sasol Spain Banco Santander, Repsol, Switzerland ABB, Novartis, UBS United Barclays, BP, BT Group, Diageo, GlaxoSmithKlein, Some Foreign Firms Listed on the NYSE Capital Asset Pricing Under CrossListings Recall the definition of beta: Cov(Ri ,RM) bi= Var(RM) We can recalibrate the CAPM formula: Ri = Rf + bi(RM – Rf) As: Cov(Ri ,RM) Ri = Rf + (RM – Rf) × Var(RM) Capital Asset Pricing Under Cross- Listings We can develop a measure of aggregate risk aversion, AM Cov(Ri ,RM) Ri = Rf + (RM – Rf) × Var(RM) (RM – Rf) AMM = Var(RM) We can restate the CAPM using AM Ri = Rf + AMM Cov(Ri ,RM) Capital Asset Pricing Under CrossListings • This equation indicates that, given investors’ aggregate risk-aversion measure, the expected rate of return on an asset increases as the asset’s covariance with the market portfolio increases. • In fully integrated capital markets, each asset will be priced according to the world systematic risk. Ri = Rf + AMM Cov(Ri ,RM) Ri = Rf + AWW Cov(Ri ,RW) . Capital Asset Pricing Under CrossListings • The International Asset Pricing Model (IAPM) above has a number of implications. • International listing of assets in otherwise segmented markets directly integrates international capital markets by making these assets tradable. • Firms with nontradable assets essentially get a free ride from firms with tradable assets in the sense that the former indirectly benefit from international integration in terms of a lower cost of capital. Ri = Rf + AWW Cov(Ri ,RW) The Effect of Foreign Equity Ownership Restrictions • While companies have incentives to internationalize their ownership structure to lower the cost of capital and increase market share, they may be concerned with the possible loss of corporate control to foreigners. • In some countries, there are legal restrictions on the percentage of a firm that foreigners can own. • These restrictions are imposed as a means of ensuring domestic control of local firms. Historical Restrictions on Foreign Ownership Country Restrictions on foreigners Canada Limited to 20% in broadcasting; limited to 25% in banking/insurance France Limited to 20% China Foreigners restricted to B shares; locals eligible for A shares Japan Limited to 20-50% for several major firms; acquisition of over 10% of a single firm subject to approval Spain Limited to 0% of defense industries and mass media; limited to 50% of other firms Switzerland Limited to bearer shares United Kingdom Government retains veto power over foreign takeover of any British firm. Pricing-to-Market Phenomenon • Suppose foreigners, if allowed, would like to buy 30 percent of a Korean firm. • But because of ownership constraints imposed on foreigners, they can purchase at most 20 percent. • Because this constraint is effective in limiting desired foreign ownership, foreign and domestic investors many face different market share prices. • This dual pricing is the pricing-to-market phenomenon. Asset Pricing under Foreign Ownership Restrictions • An interesting outcome is that the firm’s cost of capital depends on which investors, domestic or foreign, supply capital. • The implication is that a firm can reduce its cost of capital by internationalizing its ownership structure. An Example of Foreign Ownership Restrictions: Nestlé • Nestlé used to issue two different classes of common stock: bearer shares and registered shares. – Foreigners were only allowed to buy bearer shares. – Swiss citizens could buy registered shares. – The bearer stock was more expensive. • On November 18, 1988, Nestlé lifted restrictions imposed on foreigners, allowing them to hold registered shares as well as bearer shares. Nestlé’s Foreign Ownership Restrictions Source: Financial Times, November 26, 1988 p.1. Adapted with permission. An Example of Foreign Ownership Restrictions: Nestlé • Following this, the price spread between the two types of shares narrowed dramatically. – This implies that there was a major transfer of wealth from foreign shareholders to Swiss shareholders. – The price of bearer shares declined about 25 percent. – The price of registered shares rose by about 35 percent. • Because registered shares represented about two-thirds of the market capitalization, the total value of Nestlé increased substantially when it internationalized its ownership structure. • Nestlé’s cost of capital therefore declined. An Example of Foreign Ownership Restrictions: Nestlé • Foreigners holding Nestlé bearer shares were exposed to political risk in a country that is widely viewed as a haven from such risk. • The Nestlé episode illustrates: – The importance of considering market imperfections. – The peril of political risk. – The benefits to the firm of internationalizing its ownership structure. The Financial Structure of Subsidiaries • There are three different approaches to determining a subsidiary’s financial structure: – Conform to the parent company's norm. – Conform to the local norm of the country where the subsidiary operates. – Vary judiciously to capitalize on opportunities to lower taxes, reduce financing costs and risk, and take advantage of various market imperfections. • In addition to taxes, political risk should be given due consideration in the choice of a subsidiary’s financial structure. Solution Manual for International Financial Management Cheol S. Eun, Bruce G. Resnick 9780077861605