The Global Cost and Avaitabitity of Capitat CHApTER t 4

383
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Novo is a Danish multinational firm that produces indus-
trial enzymes and pharmaceuticals (mostly insulin). In
1977, Novo's management decided to
,,internationalize',
its capital structure and sources offundsThis decision was
based on the observation that the Danish securities mar-
ket was both illiquid and segmented from other capital
markets" In particular, the lack of availability and high cost
of equity capital in Denmark resulted in Novo having a
higher cost of capital than its main multinational competi-
torq such as Eli L.illy (U.S.), Miles Laboratories (U.S.-a
subsidiary of Bayer, Germany), and Gist Brocades (the
Netherlands).
Apart from the cost of capital, Novo's projected
gowth opportunities signaled the eventual need to raise
new long,term capital beyond what could be raised in the
illiquid Danish market. As Novo is a technology leader in
its specialties, pianned capital investments in plant, equip-
menl, and research could not be postponed until internal
financing from cash flow became available. Novo,s com-
petitors would preempt any markets not served by Novo.
Even if an equity issue of the size required could have
been raised in Denmark, the required rate of re turn would
have been uuacceptably high. For example, Novo's
price/earnings ratio was typically around 5; that of its for-
eign competitors was well over 10.
yet
Novo's business
and financial risk appeared to be about equal to that of its
competitors. A price/earnings ratio of 5 appeared appro-
priate for Novo only within a domestic Danish context,
when Novn was compared with other domestic firms of
comparable business and financial risk.
If Denmark's securities markets were integrated with
world markets, one would expect foreign investors to rush
in and buy "undervalued" Danish securities. In that case,
firms like Novo would enjoy an intemational cost of cap-
ital comparable to that of their foreign competitors.
Strangely enough, no Danish governmental restrictions
existed that would have prevented foreign investors from
holding Danish securities. Thereforq one must look for
investor perception as the main cause of market segmen-
tation in Denmark at that time.
At least six characteristics of the Danish equity market
were responsible for market segmentation: 1) asymmetric
information base of Danish and foreign investorg 2) taxa-
tion,3) alternative sets of feasible portfolios,4) financial
risk,5) foreign exchange risk, and 6) political risk.
Asymmetric lnfurmation
Certain institutional characteristics of Denmark caused
Danish and foreign investors to be uninformed about each
other's equity securities. The most important inforrnation
barrier was a Danish regulation tttrat prohibited Danish
investors from holding foreign private sector securitles.
Therefore, Danish investors had no incentive to follow
developments in foreign securities markets or to factor
such information into their evaluation of Danish securi,
ties. As a result, Danish securities might have been priced
correctly in the efficient market sense relative to one
another, considering the Danish information base, but
priced incorrectly considering the combined foreign and
Danish information base. Another detrimental effect of
this regulation was that foreign securities firms did not
locate offices or personnel in Denmark, as they hacl no
product to sell. Lack of a physical presence in Denmark
reduced the ability of foreign security analysrs to follow
Danish securities.
A second information barrier was lack of enough
Danish security analysts following Danish securities. Only
one professional Danish securities analysis service was
published (Bprsinformation),
and that was in Danish. A
few Danish institutional investors employed in-house ana-
lysts, but their findings were not available to the public.
Almost no foreign security analysts followed Danish secu-
ritieq because they had no product to sell and the Danish
market was too small (small-country
bias).
Other information barriers included language and
accounting principles Naturally, financial information was
normally published in Danish, using Danish accounting
principles. A few firms, such as Novo, published English
versions, but almost none used U.S. or British accounting
principles or attempted to show any reconciliation with
such principles
Taxatlon
Danish taxation policy had all but eliminated investment
in common stock by individuals Until a tax law change in
July 1981, capital gains on shares held for over two vears
were taxed at a 50oh rate. Shares heid for less than two
years, or for "speculative" purposes. were taxed at per_
sonal income tax rales, with the top marginal rate being
75%.Ia contrast, capital gains on bonds were tax-free.
This situation resulted in bonds being issued at deep dis-
384
CHAPTER 1 4 The Global Cost and Availability of Capital
counts because the redemption at par at maturity was con-
sidered a capital gain.Thus, most individual investors held
bonds rathei than stocks'This factor reduced the liquidity
of the stock market and increased the required rate of
return on stocks if they were to compete with bonds'
Feasible Set ol Porthlios
Because of the prohibition on foreign security ownership,
Danish investors had a very limited set of securities from
which to choose a portfolio' In practice, Danish institu-
tional portfolios were composed of Danish stocks, gov-
aro*"rt bonds, and mortgage bonds' Because Danish
stock price movements are closely correlated with each
other, Danish portfolios possessed a rather high level of
systematic risk. In addition, government
policy had been
to provide a relatively high real rate of return on govern-
ment bonds after adjusting for inflation- The net result of
taxation policies on individuals, and attractive real yields
on government bonds was that required rates of return
on Jtocks were relatively high by international standards'
From a portfolio perspective, Danish stocks provided
an opportunity for foreign investors to diversify interna-
tionally. If Danish stock price movements
were not
closely correlated
with world stock price movements'
inclusion of Danish stocks in forergn portfolios should
reduce the systematic risk of these portfolios'
Furthermore, foreign investors were not subject to the
high Danish income tax rates, because they are normally
protected by tax treaties that typically limit their tax to
iSy" on dividends and capiral gains. As a result of the
international diversification
potential' foreign investors
might have required a lower rate of return on Danish
stiks than Danish investors, other things being equal'
However, other things were not equal, because foreign
investors perceived Danish stocks to carry more finan-
cial, foreign exchange, and political risk than their own
domestic securities.
Financial, Foreign Exchange, and Political nisks
Financial leverage utilized by Danish firms was relatively
high by U.S. ard U.K. standards, but not abnormal for
SJandinavia, Germany, Italy, or Japan' In addition, most of
the debt was short-term
with variable interest rates' Just
how foreign investors viewed financial risk in Danish
firms depended on what norms they follow in their home
countriei.We know from Novo's experience in tapping the
Eurobond market in 1978 that Morgan Grenfell, its
British investment banker, advised Novo to maintain a
debt ratio (debt/total capitalization) closer to -5(l%
rather
than the traditional Danish 65% lo 70%.
Foreign investors in Danish securities are subject to for-
eign exchange risk. Whether this is a plus or minus factor
depends on the investor's home curenc,vr perception about
the future strength of the Danish krone, aad its impact on
a firm's operating exposure. Through personal contacts
with foreign investors and bankerq Novo's manag*me*t
did not believe toreign exchange risk was a factor in
Novo's stock price, because its operations were perceived
as being well-diversified internationally' Over 90% af its
sales were to customers located outside of Denn.rark
With respect to political risk, Denmark was pereeived
as a stable Western democrary but onc with the poleiltial
to cause periodic problems for foreign investors' In partic-
ular, Denmark's national debt was regarded as too high
for comfort, although this
judgment had not yet sholvn up
in the form of risk premiums on Denmark's Eurocurrencv
syndicated loans.
Ihe Boad to Ghbalization
Although Novo's management in 1977 wished to escape
from the shackies of Denmark's segmented and illiquid
capital market, many barriers had to be overcome' It is
worthwhile to describe some of these obstacles, because
they typfy the barriers faced by other firms i:om seg-
mented markets that wish to internationalize their capital
sources,
Closing the lnformation Gap' Novo had Lreen a family-
owned firm from its founding in the 1920s by the two
Pedersen brothers until 1974, when it went public and
listed its "B" shares on the Copenhagen Stock Exchange'
The'4" shares were held by the Novo Foundation; the
"lf' shates were sufficient to maintain voting control'
However, Novo was essentially unknown in investment
circles outside of Denmark. To overcome this disparity irr
the information base, Novo increased the level o{ its finan-
cial and technical disclosure in both Danish and Engiish
versions.
The informatiotr
gap was further closed when h{organ
Grenfell successfully organized a syndicate to underwrite
and sell a $20 million convertible Eurobond issue for
Novo in 1978. In connection with this offering, Novo listed
its shares on the London Stock Exchange to facilitate con-
version and to gain visibility. These twin actions were the
key to dissolving the information barrier; of course' they
also raised a large amount of long-term capital on favor-
able terms, which would have been unavaiiable in
Denmark.
4
i
I
1
{
The Globat
Cost and Availabitity
of Capitat
CHAPTER
14
385
'ather
o for-
actor
rbout
ct on
rlacts
tllent
:r in
:iveel
>f its
ived
ntial
nic-
high
lup
)nc1
Despite
the favorable
impact
of the Eurobond
issue on
,T1l1lilTy.of
capitar,
Novo,s
cosr
"l
*U;actuarry
mcreased
when Danish i
porentiardilurion.rr;;;'Jr':l'J::'ff:ffi
tff
'rJJll;
1979, Novo's share price
in ouniri,
rron.i'ir[.j'i**"0
|;o#.*ouro
Dkr3ffi per share
,o urouJoiina
p",
The Biotechnology
Boom.
During
,1979,
a fortuitous
event occurred.
Biotechnology
began to att.act tie int*r_
est of the U.S. investment
community,
*iti, ,*u.ruir"nru_
tionally
oversubscribed
stock issues U, ,r.f.rOnw
n.*,
1s
Genenrech
and Cerus. Thanks
,o irr.lfo..*"Xion"A
domestic
information
gap, Danish inr".torr*.*
ir'u*u."
of these events and continued
to urfr" Nouo-"i',
"*
price/earnings
ratio of 5, compared
with over 10 for its
established
competito$
and 3-0 or *or" f.o, ttJr*'r"*
potential
competitors.
In order to profile
itself as a biotechnology
firm with a
proyQn
track record,
Novo organizea
"
,.,iin*ln"Nr*
York.City
on ApriI30,1980.
Soin after rn",.*ira.
**
sophisticated
individual
US. investors-i.r*'ilry*g
Novo's
shares
and convertible,
through;,
d;;;, i;*n
Exchange.
Danish
investors
were only too happy to supply
this foreign
demand.
Thelefore,
despite
,rrl#"fi
rrroog
demaad
from
U.S. and Britisfr
*"ira",'*""""i
,n*,
price
increased
onlv qradualty,
.u*Lrrg
'ol"i
i" ,n_
Pkri00
level by rnij_simm".. grr""r".."Aurtlig
the fol_
f:ty T"l,lr,
foreign
interesr.began
to rno*i"jr,"rno
Uy
lne
end of 1980, Novo,s
stock
i.i*
f,rd ,.r.i.O
,f,.
Dkr600
level.
Moreover,
foreigu
ir""u"*
f,uj i".i"r*O
their proportion
of share ownership
from virtually
noth_
ing to around
30olo. Noyo,s pri..;;."i;;.r"CiJO
r*"n
to around
16, which was oow in tine wittr'rtrai-oflir-ior"r_
nationat
comperirors
bur not *ith th;;;;;;
l#rl
at
this point,
one must conclude
that Novo fr"Jr_.r""0_O
f,
internationalizing
its cost of capital.
Otlr", Or*f,
,t*i-
ties remained
lockerl
in , ..*".r--^":,"1"_l:
Exhibit 1,h";;;;;;##;ff1::r#il:1,#il*
market
ia general
did not parallel
tn*,ire
i, No'Vot
slur"
price,
nor coutd it be explained
by,";;;;;;;i*
,.r.
or U,K. stock markets
as a whole.
Directed
Share lssue
in the United
States.
During the
first hatf of 1981, under the g"id;;;.;;;"rI#l-.*,
and with the assistance
of Morgan
Cr"nf"]f
,"0
ape
uid
tis
use
eg-
ital
Iv-
wo
nci
,e
)r
d
e
Share
pdcs
llaftot lndicos
1200
1800
1600
1400
he
JI.
nt
in
n-
;h
600
400
200
:!
o,t o
oo
Q6
,.",*;**
OC,
N6
l*ovo's
B-share
pri
x
j,r
o
i--i"-,-.
i- i. i
- _i ,:. i_:_
:sSIt:qa?s_rvo
'-
enbhhdsfiy=-i
--.,-H ,--,
:
,. .Y
"?
a
_ c.r
;d6566SS
[tr[FPe-FiFRE
?,[f;?;,#J*,W#,{trkl'tY!,t:'",,to*uno
the cost ot capitat: The Novo Expeience
%%***"-::.
I uilLv ilr+ilcauons'
Londoni John wey, 1982, p.7s.
Reprinted
with permission.
386
CHAPTER 1 4 The Gtobal Cost and Avaitabitity of Capitat
Copenhagen Handelsbank, Novo prepared a prospectus
for SEC registralion of a US. share offering and eventual
listing on the New York Stock Exchange. The main barri-
ers encountered in this effort, which would have general
applicability, were connected with preparing financial
statements that could be reconciled with U.S accounting
principles and the higher level of disclosure required by
the SEC. In particular, industry segment reporting was a
problem both from a disclosure perspective and an
accounting per$pective because the accounting data were
not available internally in that format. As it turned out,
the investment barriers in the U.S. were relatively
tractable, although expensive and time-consuming to
overcome,
The more serious barriers were caused by a variety of
institutional and governmental
regulations in Denmark.
The latter were never designed so that firms could issue
shares at market value, because Danish firms typically
issued stock at par value with preemptive rights. By this
timg however, Novo's share price, driven by continued
foreign buying, was so high that virtually nobody in
Denmark thought it was worth the price that foreigners
were willing to pay. In fact, prior to the time of the share
issue in July 1981, Novo's share price had risen to over
Dkr1500, before settling down to a level around Dkr1400.
Foreign ownership had increased to over 50yo of Novo,s
shares outstanding!
Stock Market Reactions. One final piece of evidence on
market segmentation can be gleaned from the way Danish
and foreign investors reacted to the announcement of the
proposed
$61 million U.S. share issue on May 29, 198i.
Novo's share price dropped 156 points the next trading
day in Copenhagdn, equal to about 10% of its market
value. As soon as trading started in New
york,
the stock
price immediately recovered all of its loss. The
Copenhagen reaction was typical for an illiquid market.
Investors worried about the dilution effect of the new
share issue because it would increase the number of
shares outstanding by about 8%.They did not believe that
Novo could invest the rew funds at a rate ofreturn that
would not dilute future earnings per share. They also
feared that the U.S. shares would eventually flow back to
Copenhagen if biotechnology lost its glitter.
The U.S. reaction to the announcement of the new
share issue was consistent with what one would expect in
a liquid and integrated market. U.S, investors viewed the
new issue as creating additional demand for the shareq as
Novo became more visible due to the selling efforts of a
large aggressive syndicate. Furthermore, the marketing
effort was directed at institutional investors who were pre-
viously underrepresented among Novo,s U.S. investors.
They had been underrepresented
because U.S. institu-
tional investors warrt to be assured of a liquid market in a
stock in order to be able to get out, if desired, without
depressing the share price. The wide distribution effected
by the new issue, plus SEC registration and a New
york
Stock Exchange listing, ali added up to more liquidity and
a giobal cost of capital.
Effect on Novo's Weighted Average Cost ot
Capital. During most of 1981 and the years thereafter,
Novo's share price was driven by international portfolio
iavestors transacting on the New
york,
London, and
Copenhagen stock exchanges. This situation reduced
Novols weighted average cost of capital and lowered its
marginal cost of capital. Novo,s systematic risk was
reduced from its previous level, which was determined by
nondiversified (internationally)
Danish institutional
investors and the Novo Foundation. However, its appro_
priate debt ratio level was also reduced to match the stan-
dards expected by international portfolio investors
trading in the United States, United Kingdom, and other
important markets, In essence, the U.S. dollar became
Novo's functional currency when being evaluated by
international investors. Theoretically, its revised weighted
average cost o{ capital should have become a new refet_
ence hurdle rate when evaluating new capital investments
in Denmark or abroad.
Other firms that follow Novo's strategy are also likely
to have their weighted average cost of capital become a
fuoction of the requirements of international portfolio
investors. Firins resident in some of the emerging market
countries have already experienced
,,dollarization,,
of
trade and finaacing for working capital.This phenomenon
might be extended to long-term financing and the
weighted average cost of capital.
The Novo experience has been described in hopes that
it can be a model for other firms wishing to escape from
segmented and illiquid home equity markt& In particu-
lar, MNEs based in emerging markets often face barriers
and lack of visibility similar to whar Novo faced. They
could benefit by following Novo,s proactive $trategy
employed to attract international portfolio investors.
However, a word of caution is advised. Novo had as excel-
lent operating track record and a very strong worldwide
market niche in two important industry sectorsl insulin
and industrial enzymes This record @ntinues to attract
investors in Denmark and abroad. Other companies
would also need to have such a favorable track record to
attract foreign investors