Globalization of Equity Markets and the Cost of Capital

Abstract

After World War II, most currencies were not convertible, so that investors could only invest in foreign markets if they could get access to often scarce foreign currencies.In addition to convertibility restrictions, most countries also had explicit restrictions on foreign investment.In some cases, foreign investors could not buy local shares.In other cases, domestic investors were not allowed to hold foreign shares.If foreign investors could buy local shares, they did not always have voting rights and often there was a limit on foreign ownership.Most countries had explicit foreign ownership limits of one type or another creating significant barriers to international investment.In addition to restrictions resulting from laws and regulations, there were other less formal obstacles to international investment.Foreign equity investment was also made difficult by political risk, inadequate institutions to deal with ownership of foreign shares, lack of accounting harmonization across countries, and obstacles to hedging foreign exchange rate risk.Over the last fifty years, barriers to international investment have crumbled among developed economies and have fallen dramatically among many emerging markets.As a result of this evolution, U.S. investors can buy the securities of a large number of foreign countries with almost no restrictions.Corporations can choose where to raise funds and have access to both offshore and onshore markets.Asian investors now worry about how the U.S. markets performed while they were asleep because they believe that the fate of their markets during the day depends on what happened in New York over the previous twelve hours.Similarly, morning news shows in the U.S. routinely discuss the overnight performance of Asian markets and try to forecast the performance of U.S. markets from the overnight returns of the Nikkei and Hang Seng indices.Though finance academics have generally welcomed this process of globalization and emphasized its benefits to investors and corporations, many policymakers have questioned whether this process has gone too far and whether 1 See Ando and Auerbach (1988) for an analysis of the issues that arise when comparing the cost of capital across countries when taxes are taken into account.We ignore taxation of the cash flows to equity in this paper because these taxation issues are of secondary importance in our analysis.2 "The hardest problem all through my business career was to obtain enough capital to do all the business I wanted to do and could do, given the necessary amount of money."Cited by Chernow (1997), p. 68. 2 controls on capital flows should be reintroduced.The recent upheavals in Asia and Russia have led to the reimposition of some barriers to international investment.In this paper, we evaluate how this process of globalization affects the cost of equity capital of companies.Though a firm's total cost of capital also depends on its cost of debt, the cost of debt depends in subtle ways on how a firm is taxed.By focusing on the cost of equity capital, we avoid dealing with complicated taxation issues.1 In Section I, we investigate how globalization affects the discount rate of a given stream of equity cash flows.We show that there are strong theoretical arguments for why this discount rate should fall when markets become more open to foreign investors.Such a fall in the discount rate means that both the value of equity and investment increase.Neo-classical financial economists and a number of consulting firms would argue that what we call the discount rate is simply the cost of capital for an all-equity firm.However, managers and financial economists who emphasize the importance of information asymmetries and agency costs do not think about the cost of capital in this way.Rockfeller used to explain that his main problem in business was to raise capital.He generally found this to be an extremely difficult and costly process that prevented him from investing as much as he felt was worthwhile. 2 There are two important reasons for this.First, managers are typically better informed about expected future cash flows than investors.This is the information asymmetry problem.Second, management has its own objectives