Assessment of raising capital in emerging markets
The choice of listing in a particular geographic location considers the “ease and speed of the listing process” (Bell, Crreira da Silva & Preimanis, 2006 p. 7). The emerging markets appear as a favorable destination because of the reforms that have been undertaken to increase the speed of setting up a business. Hungary is recognized for implementing necessary reforms to ease regulation procedures that hinder foreign direct investment.
The bond market in emerging economies has little difference to those in mature economies. The most recognized difference between emerging economies and the bond market is that government bonds form a large share of the market in emerging economies. Some emerging economies such as Malaysia and South Korea report large proportions of corporate bonds. In Malaysia, corporate bonds account for 43%. It is 25% in South Korea (Luengnaruemitchai & Ong, 2005). Large proportions of corporate bonds indicate investor confidence in these emerging markets. Emerging markets demonstrate maturity in the financial market sector which favors raising of capital.
There is an increase in foreign direct investment cash flow to emerging economies. According to Suttle et al. (2012), FDI cash flows are “projected to rise by more than $20 billion in 2013 to reach $536 billion” (p. 9). Increase in FDI cash flow is likely to increase growth in emerging economies. It can also help to stabilize the balance of payments in emerging economies.
Capital flows to emerging markets is increasing gradually (IIF 2013). Mature economies such as the USA are seeing lower rates of return on investment. As a result of this, investors are choosing to relocate capital to emerging markets. Institute of International Finance (IIF 2013 p. 1) projects an increase of capital flows from mature markets to emerging markets. The expected increase is from $1,080 billion in 2012 to about $1,118 billion in 2013 and $1,150 billion in 2014. Higher economic growth in emerging economies is considered the drive behind the increase in capital flows to emerging economies. Economic growth is associated with higher rates of return to capital (IIF 2013). The mature economies such as the USA reported a risk free that approached zero in 2012. Mature economies averaged about 2.4% in GDP growth and a forecast of 2.5% in 2013.
The emerging markets in Asia and Latin America are projected to grow by about 5% in 2013 (IIF 2013, p. 4). Turkey GDP growth in 2011 was 8.5%, 2.8 in 2012, and estimates of 4.0% in 2013. Higher growth rates in emerging economies increase investors’ willingness to invest. Higher growth rates are associated with higher returns to investment. A better option for the company would be turkey because it has a higher growth rate than Hungary. A higher growth rate creates ease in raising capital because investors are optimistic about returns to investment.
A fraction of the cost of equity depends on the net earnings that investors require as a reward for taking risk. Pratt and Grabowski (2010) state that “the greater the financial and economic risks, “the greater the returns demanded by the market” (p. 408). Hungary has high financial risk. Return on assets declined in Hungary between 2007 and 2010. They were 1.2%, 0.8%, 0.7% and 0.1% in 2007, 2008, 2009, and 2010 respectively. Investors in Hungary who cannot seek foreign investment are likely to demand lower levels of interest rate. Raising capital through a high proportion of debts is unfavorable for business in Hungary because financial institutions charge higher rates of interest. Equity is a better option.
Hungary has experienced promising returns on equity between 2009 and 2008. In 2009, return on equity averaged 15.3% and in 2008 it was about 17.1% (Staff Country Reports 2009). There is an indication of good performance in equity investments. As a result of good performance, it may speed up raising capital in Hungary through equity.
Another factor that determines the cost of equity is the degree of openness and familiarity of cultures. A higher information asymmetry leads experts to choose a higher discounting factor (Bell, Correia da Silva & Preimanis 2006). Less information about the nature of a capital market is considered as uncertainty. Uncertainty is discounted as risk (Hanke 2013). Foreign investors may lack quality information from emerging economies which may make them demand higher interest rates. Mature economies have reliable information from regular reports and surveys.
One of the advantages of raising funds in the UK and transferring them to a foreign country is that the business entity is able to raise capital quickly because of familiarity with the UK capital markets (Oglivie 2006 p. 378). The cost of raising capital in the UK to fund foreign investment may increase if there are exchange controls. Exchange controls may impose higher taxes to discourage the transfer of large amounts of local currency abroad. On the other hand, a company that finances locally is more acceptable because part of the profit is shared locally.
Hungary indicates instability in the level of public debt. The debt was 78.4% in 2009, 80.4% in 2010, 76.6% in 2011, and 76.9% in 2012. It indicates the government is struggling to reduce dependency on deficit financing. According to IMF (2011 p. 40) report, Hungary government balance as a percentage of the GDP was -4.3% in 2009, -4.1 in 2010, 3.9 in 2011, and -4.3 in 2012. Annual deficit percentages of the country are low. The country may reduce its debt to GDP ratio in the long run if it shifts to operating under a surplus rather than deficit.
Confidence in financial markets is lost when countries indicate inability to repay debts. With lower debt to GDP ratio, investors are certain about long periods of financial market stability (Ciampi 2009 p. 75). Hungary has a high debt to GDP ratio and still operates on a deficit. It is riskier to start business in Hungary when an investor considers risk caused by high debt to GDP ratio.
The Hungarian authorities reduced the overnight lending rates in August 2012 to 6.25% to encourage investment (OECD 2012). The cost of equity is partially influenced by the policy rate and the premium rate (Agar 2005). Policy is the overnight lending rate by banks to each other. Premium rate is the return investors demand for offering capital. As a result of volatility in the financial markets and uncertainty of deficit financing, investors are likely to set a high premium rate in Hungary. Mature economies may face higher premium rates than emerging economies because investment may fail to generate the required rate of return as a result of slow economic growth.
Factors that favor raising capital in Hungary include political stability, a low policy rate, high returns on equity, and lower asset returns that may lower interest rates. Factors that may discourage a firm from raising capital in Hungary include the high debt to GDP ratio, and an increasing percentage of non-performing loans. Hungary is recovering from the low economic growth experienced in 2009. An emerging economy such as Turkey has the advantage of a high economic growth rate among other factors that Hungary lacks. Considering these factors the firm should choose another emerging market with a higher economic growth rather than Hungary such as Turkey.
Country risk analysis
Country risk refers to a set of political and economical factors that create uncertainty to the existence and operations of an enterprise. Some of the factors considered by Feinberg & Gupta (2006) include future government policies, reliability of the court system, unexpected expropriation, and the extent to which governance adheres to the rule of law. Most emerging economies have implemented reforms policies that have reduced some of these factors such as expropriation of assets and political influence on the rule of law. In most mature economies, factors that increase country risk were eliminated a long time ago. In most of the emerging economies, the reforms on policies are being tested. Hungary has gained stability in the political environment. The country is governed by the rule of law.
Experts use both quantitative and qualitative methods to evaluate country risk. Nath (2008) argues that qualitative analysis examines “a country’s economic, political, and social conditions and prospects” (p. 6). Quantitative analysis considers observable factors that indicate risk such as rescheduling debt, and rate of defaulting. Madura (2010, p. 482) explains that quantitative analysis may use models to convert economic and political factors into figures that can be calculated. The data on political and financial components are collected over a certain period. Regression analysis is used to analyze the sensitivity of variables to each other.
Weights which add up to 100% are used to convert descriptive information into mathematical figures (Madura 2010). The debt to GDP ratio is an indicator in the quantitative analysis of country risk. A high debt to GDP ratio may indicate high country risk. A country with a high debt to GDP ratio may be considered likely to default in the long run. A country’s beta is also used to analyze country risk.
The IMF projects a decrease in debt to GDP ratio in 60% of the countries in the emerging markets (IMF 2012). Lower debt to GDP ratios create stability and certainty. There are forecasts that debt to GDP ratio in low income countries will increase. There are projections that 85% of countries in the advanced economies will have a sustainable debt to GDP ratios by 2015. Using these comparisons, emerging economies provide better opportunities for growth and investment than advanced economies.
Country risk is considered to increase when a country with a high debt to GDP ratio borrows from multilateral credit institutions (Nogues & Grandes 2001, p. 129). Nogues & Grandes argues that “a fiscal deficit that investors consider to be increasingly high or unsustainable would portray the most pessimistic scenario” (p. 133). Investors may also consider factors such as tax structures, government spending, and fiscal responsibilities which have an influence on balance of payments.
Conklin (2002) discusses that political risk posed by restrictions to foreign direct investment and regulations have been reduced through the years in emerging markets. Restrictions increase inefficiencies. Political risk exists to the “extent that political decisions have an impact on business operations” (Conklin 2002, p. 174). Some of the factors that increase political risk include imposing new regulations, demands for nationalization, and special taxes. Uncertainty in the implementation of policies increases country risk. A country’s risk is higher if it has the habit of imposing new regulations within small intervals of time. A company may incur additional costs as a result of new policies.
Conklin (2002) claims that investors can reduce foreign exchange risk by transferring capital during times when the exchange rate is stable. They are moments when the exchange rate is more volatile as a result of social, economic or political factors that increases or reduces demand for foreign currency such as a holiday season. Conklin (2002) also mentions that spreading the purchase price over a long period of time reduces foreign exchange risk. In such a case, the impact of foreign exchange risk will rely on averages cast over a long period.
Increase in consumption by the private sector affects the level of country risk. According to Nogues & Grandes (2001 p. 127), there is a negative correlation between private consumption/investment in capital goods and country. Investment goods include equipment and machinery used in production of other goods and services. When the private sector invests in equipment, country risk declines. The decline in country risk is as a result of expected economic growth. On the other hand, country risk is positively correlated to the domestic prime rate. The domestic prime rate is the rate at which commercial banks charge borrowers. The higher the interest rate on loans, the higher the country risk.
Investors consider a country risk to be low if they expect high economic growth. A high economic growth is likely to offset the risk assumed by investors to invest in a country with high economic growth when other risk factors emerge from poor policy implementation.
Andrade (2009) argues that “the expected returns on emerging market stocks increase with the sovereign yield spread” (p. 681). The sovereign yield spread is the difference between the various Treasury bond rates that a government offers. For example, a large difference between the 3-year bond rate and a 10-year bond rate will result in increases in the expect rate of returns on emerging markets.
Nogues & Grande (2001) discuss two solvency variables that affect country risk. Increase in external debts to exports ratio increases a country’s risk (Nogues & Grandes 2001) High external debts are associated with a high cost of servicing debts. The current account surplus to GDP ratio should be positive or greater than -5%. A country with a ratio below -5% may be considered to be risky.
Nogues & Grande (2001 p. 137) argue that some external factors that make investments in international markets more attractive may increase country risk in developing countries. Advanced economies are less volatile because of political stability and stable structural policies. Institutional risks such as changes in policies that govern leverage experienced in the UK and US indicate that they are also found in stable economies (Carare 2011). It indicates that changes in policies is not only found in emerging economies but also mature economies.
In most emerging markets, policy reforms have stabilized the political environment. Political stability would rank as the most sensitive factors that affect country risk in emerging markets. However, most emerging markets have implemented policies that increase political stability such as privatization policies, reduced rate of expropriation, rule of law, and elimination of restrictions on foreign direct investment.
According to the IMF (2011), most emerging economies are likely to reduce their debt to GDP ratio in the near future. Debt to GDP ratio is a macroeconomic factor that may seem not to affect individual companies until the sustainability of debt level is questioned. Debt to GDP ratio may be considered second to political stability. Chances of defaulting by sovereign governments have made debt to GDP ratio an important factor in considering country risk. The chances of defaulting affected countries in mature economies such as the USA and Greece. A low debt to GDP ratio in most emerging markets encourages cash flow and investment.
The rate of interest used by banks to issue loans can be ranked third in determining a country risk. In Hungary, the percentage of non-performing loans is increasing (IMF 2012). Commercial banks charge a higher rate to individuals they consider safe and deny loans to risky individuals. It indicates that the country’s risk is high. A high country risk increases the cost of capital.
The volatility of the foreign exchange market will be the next factor to consider after rate of interest. A volatile foreign exchange rate increases the cost of doing business for multinationals. It involves the cost of hedging against the exchange rate risk.
Hungary country risk
Hungary recovered slowly from a recession that it experienced in 2009 (OECD 2012). The Hungarian government is implementing policies that are designed to reduce public debt such as the Szell Kalman plan (OECD 2012). The authorities discourage borrowing in foreign currencies. Hungary’s dependency on foreign cash flows is about 60% compared to Poland’s 20%. Hungary has a high credit risk because of the high proportion of foreign currency loans (Gautier 2013). Depreciation of the local currency has further increased the burden of external debt. Inflation in Hungary rose above the 3% target set by the central bank in 2011. A higher inflation and higher dependency on external debts cause Hungary country risk to be higher.
One of the factors affecting country risk is a stable banking sector. The Hungarian government is implementing policies that are likely to stabilize the banking sector. The Hungarian banking sector is volatile as a result of implementing borrowing reforms (OECD 2012). Among other reforms, the government is implementing policies to reduce reliance by financial institutions on external debts. Another reform being carried out by banks is deleveraging.
Banks are deleveraging in Hungary because they consider the rate of default high. Gautier (2013) claims that there was a high rate of loans that were not being serviced at the end of 2011 (about 14%). Hungary experiences a high level of deleveraging because of the high percentage of non-performing loans. Non-performing loans in Hungary increased between 2007 and 2010. The percentages of non-performing loans were 2.3%, 3.0%, 6.7%, and 9.1% in 2007, 2008, 2009, and 2010 (IMF 2011 p. 45). The deleveraging in Hungary is also associated with high interest rates for loans. Nogues & Grandes (2001) argue that higher interest rates on loans are an indication of increased country risk.
Hungary’s banking sector is affected by deleveraging, cross-border borrowing, and reliance on high loan-to-deposit ratios (OECD 2012). The banks are considered volatile in the medium term. This causes the country risk to increase. There is increased household deposit which may indicate potential of raising funds locally.
One of the factors that increase country risk is an unsustainable debt burden. The percentage of debt to GDP was 78.4% in 2009, 80.4% in 2010, 76.6% in 2011, and 76.9% in 2012 in Hungary (IMF 2011). The average annual deficit for the three years is about 3%. In 2011, the balance of government budget was -4% of the GDP. Hungary is likely to increase its percentage of debt to GDP ratio if government spending continues using deficit financing.
Hungarian financial markets are considered volatile with an increase in long-term interest rates on public debt. OECD (2012) report indicates that several debt auctions failed in 2011 which creates uncertainty about the ability to use deficit financing to fund government projects. When a country lacks the ability to raise capital through borrowing, it may limit the country’s ability to use an expansionary fiscal policy to correct imbalances.
Another factor affecting the country risk is the unexpected change in government policies. Hungary lacks “predictability in policy making” (Gautier 2013, para. 5). Unpredictability in policy making may result in loss of assets or increase in the cost of business operations among other concerns. Hungary country risk is high because of unpredictability of government policies.
Foreign exchange volatility is another factor that affects country risk. Foreign exchange is affected by the level of demand for foreign currency among other factors. Hungary financial institutions are more reliant on foreign currencies. Foreign exchange volatility is also affected by the level of inflation in a country. Hungary had an inflation rate of about 4% annually in the last four years (Gautier 2013). Its inflation rate is higher compared to its neighbors by about 2%. It may result in devaluation of the local currency from time to time.
Agar (2005) argues that there is no need to discount risk posed by volatility in foreign exchange because gains in liabilities are balanced by losses in assets and vice versa. Foreign exchange rate risk can be reduced by balancing asset and liabilities holdings between the home country and the foreign country. Foreign exchange volatility has less influence on country risk because of the various techniques that may be used to hedge against foreign exchange risk.
Hungary has a stable democratic system of governance. Country risk is reduced as a result of political stability (Slamanig 2012). Hungary is seeking to make amendments to its laws to adhere to Euro zone conventions. The government is carrying out structural reforms that are likely to increase political stability in the long run. Reforms in the banking sector may cause instability in the short run. This is because investors and commercial banks have to adjust to new regulations that limit reliance on external debts. In the long run all reforms are expected to increase stability in the political and economic environment.
A country’s risk may be influenced by factors that emerge from external financial markets. Carare (2011) discusses that fluctuations in Hungary’s economy are caused by a large extent by “the risk premium shocks emanating from the external environment” (p. 18). Carare (2011) discusses that “risk premium shocks in Hungary are more persistent than monetary policy shocks” (p. 15). The risk premium shocks are the changes to the expected returns on capital by investors. The Hungarian system appears to follow the external expected rates of return rather than its policy rate. It means the market is less sensitive to the monetary policies that are implemented to correct imbalances than it is to external rates of return. The lack of control over the level of borrowing by the Hungarian central bank may increase the country risk. Hungary may fail to control exchange rates and inflation using monetary policies. Ineffectiveness of monetary policy increases country risk.
Nogues & Grande (2001) argue that a country with a current account surplus below -5% is not creditworthy. Hungary’s current account balance in 2012 was 0.5% which shows creditworthiness. Creditworthiness reduces risk. However, there are projections of a possible increase in the negative side of this ratio in 2013 (-0.8%) and in 2014 (-1.3%) (Hungary 2013). The projections still indicate creditworthiness of the country to investors. This reduces the uncertainty that has been created by the government’s inability to auction securities.
CAPM and cost of equity
The cost of equity under the CAPM is expressed as RE = Rf + BE * (RM – Rf). According to Hamm (2006), it is interpreted as return on equity = risk free rate of return + beta * (average market rate of return – risk free rate).
The advantage of using CAPM is the ability to calculate the risk of companies that do not pay dividends (Hamm 2006). The main disadvantage is that one needs to find the values of beta and risk premium. These are estimated from past data rather than future expectations. A survey indicates that 96% of practitioners use historical beta figures compared to 4% who use beta forecasts (Nel 2011, p. 5339). According to Nel (2011) the “discounted cash flow method is the most accurate and equity valuation method” (p. 5336). Some components of the CAPM approach are used by academicians but are not used in practice (Nel 2011, p. 5337). The beta used in the CAPM approach varies from time to time. Statistics indicate that the beta is not related to returns. Cummins & Philips (2003) discuss that CAPM may “give inaccurate estimates because it omits important financial risk factors” (p. 4). Different methods of calculations are suitable for different companies and industries.
WACC measures the cost of capital according to the proportion funded by equity and debt in a firm’s capital structure (Hamm 2006).
WACC = (E/V) * RE + (D/V) * RD * (1 – TC)
- E/V represents the percentage financed by equity
- D/V represents the percentage financed by debt
- 1 – TC represents the rate after taxation
- RE is the cost of equity
The company under consideration is the Merchants Trust PLC with a beta of 1.03 (The Merchant Trust PLC 2013). The Hungarian government 10-year bond yield averaged 7.9% between 1999 and 2013 (Hungary Government Bond 10Y, 2013). In December 2012, Citibank issued Hungarian government 3-year treasury bonds at a 5.1% annual interest rate (Citibank Hungary, 2013). The risk free rate of return is considered the rate of interest on long term Treasury bonds. The Hungarian 10-year bond rate average of 7.9% serves as the risk free rate in this calculation.
Cost of equity for the Merchants Trust PLC
Using the formula RE = Rf + BE * (RM – Rf) and considering the risk free rate of return as 7.9%, an average market rate of return of 13%, and a beta value of 1.03, RE = 0.079 + 1.03 * (0.13 – 0.079) = 0.13153. The cost of equity for the company is 13.153%. It is about 1.18% higher than the average market rate of return on equity.
The WACC for the Merchants Trust PLC is calculated using the formula WACC = (E/V) * RE) + (D/V) * RD * (1 – TC)). A corporate tax rate of 21% is applied (Milmo 2012). From the Merchants Trust PLC balance sheet, total debt is 75,178,088 pounds as the amount owed to creditors. Total shareholders’ funds amount to 415,024,704 pounds (The Merchants Trust PLC Annual Financial Report for the Year Ended 31 January 2012, 2013). Using these figures to calculate percentage financed by equity, the value is 415,024,704/ (415,024,704 + 75,178,088) = 0.8466. The proportion financed by debts is 75,178,088/ (415,024,704 + 75,178,088) = 0.1534.
The calculation considers an average market return rate of 5.1% which is the bond rate for a 3-year bond as issued by Citibank in December 2012 (Citibank Hungary 2013).
WACC = (0.8466 * 0.13) + (0.1534 * 0.051 * (1.00 – 0.21)
WACC = 0.110058+ 0.00618 = 0.1162238
The calculation shows that the company may only invest in projects that promise an 11.62% rate of return on capital.
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