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Novo is a Danish multinational firm that produces indus-trial enzymes and pharmaceuticals (mostly insulin). In1977, Novo's management decided to ,,internationalize',its capital structure and sources offundsThis decision wasbased on the observation that the Danish securities mar-ket was both illiquid and segmented from other capitalmarkets" In particular, the lack of availability and high costof equity capital in Denmark resulted in Novo having ahigher cost of capital than its main multinational competi-torq such as Eli L.illy (U.S.), Miles Laboratories (U.S.-asubsidiary of Bayer, Germany), and Gist Brocades (theNetherlands).

Apart from the cost of capital, Novo's projectedgowth opportunities signaled the eventual need to raisenew long,term capital beyond what could be raised in theilliquid Danish market. As Novo is a technology leader inits specialties, pianned capital investments in plant, equip-menl, and research could not be postponed until internalfinancing 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 havebeen raised in Denmark, the required rate of re turn wouldhave been uuacceptably high. For example, Novo'sprice/earnings ratio was typically around 5; that of its for-eign competitors was well over 10. yet Novo's businessand financial risk appeared to be about equal to that of itscompetitors. 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 ofcomparable business and financial risk.

If Denmark's securities markets were integrated withworld markets, one would expect foreign investors to rushin 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 restrictionsexisted that would have prevented foreign investors fromholding Danish securities. Thereforq one must look forinvestor perception as the main cause of market segmen-tation in Denmark at that time.

At least six characteristics of the Danish equity marketwere responsible for market segmentation: 1) asymmetricinformation base of Danish and foreign investorg 2) taxa-tion,3) alternative sets of feasible portfolios,4) financialrisk,5) foreign exchange risk, and 6) political risk.

Asymmetric lnfurmationCertain institutional characteristics of Denmark causedDanish and foreign investors to be uninformed about eachother's equity securities. The most important inforrnationbarrier was a Danish regulation tttrat prohibited Danishinvestors from holding foreign private sector securitles.Therefore, Danish investors had no incentive to followdevelopments in foreign securities markets or to factorsuch information into their evaluation of Danish securi,ties. As a result, Danish securities might have been pricedcorrectly in the efficient market sense relative to oneanother, considering the Danish information base, butpriced incorrectly considering the combined foreign andDanish information base. Another detrimental effect ofthis regulation was that foreign securities firms did notlocate offices or personnel in Denmark, as they hacl noproduct to sell. Lack of a physical presence in Denmarkreduced the ability of foreign security analysrs to followDanish securities.

A second information barrier was lack of enoughDanish security analysts following Danish securities. Onlyone professional Danish securities analysis service waspublished (Bprsinformation), and that was in Danish. Afew 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 Danishmarket was too small (small-country bias).

Other information barriers included language andaccounting principles Naturally, financial information wasnormally published in Danish, using Danish accountingprinciples. A few firms, such as Novo, published Englishversions, but almost none used U.S. or British accountingprinciples or attempted to show any reconciliation withsuch principles

TaxatlonDanish taxation policy had all but eliminated investmentin common stock by individuals Until a tax law change inJuly 1981, capital gains on shares held for over two vearswere taxed at a 50oh rate. Shares heid for less than twoyears, or for "speculative" purposes. were taxed at per_sonal income tax rales, with the top marginal rate being75%.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 heldbonds rathei than stocks'This factor reduced the liquidityof the stock market and increased the required rate ofreturn on stocks if they were to compete with bonds'

Feasible Set ol PorthliosBecause of the prohibition on foreign security ownership,Danish investors had a very limited set of securities fromwhich to choose a portfolio' In practice, Danish institu-tional portfolios were composed of Danish stocks, gov-aro*"rt bonds, and mortgage bonds' Because Danishstock price movements are closely correlated with eachother, Danish portfolios possessed a rather high level ofsystematic risk. In addition, government policy had beento provide a relatively high real rate of return on govern-ment bonds after adjusting for inflation- The net result oftaxation policies on individuals, and attractive real yields

on government bonds was that required rates of returnon Jtocks were relatively high by international standards'

From a portfolio perspective, Danish stocks providedan opportunity for foreign investors to diversify interna-tionally. If Danish stock price movements were notclosely correlated with world stock price movements'inclusion of Danish stocks in forergn portfolios shouldreduce the systematic risk of these portfolios'Furthermore, foreign investors were not subject to thehigh Danish income tax rates, because they are normallyprotected by tax treaties that typically limit their tax toiSy" on dividends and capiral gains. As a result of theinternational diversification potential' foreign investorsmight have required a lower rate of return on Danishstiks than Danish investors, other things being equal'However, other things were not equal, because foreigninvestors perceived Danish stocks to carry more finan-cial, foreign exchange, and political risk than their owndomestic securities.

Financial, Foreign Exchange, and Political nisks

Financial leverage utilized by Danish firms was relativelyhigh by U.S. ard U.K. standards, but not abnormal forSJandinavia, Germany, Italy, or Japan' In addition, most ofthe debt was short-term with variable interest rates' Justhow foreign investors viewed financial risk in Danishfirms depended on what norms they follow in their homecountriei.We know from Novo's experience in tapping the

Eurobond market in 1978 that Morgan Grenfell, itsBritish investment banker, advised Novo to maintain a

debt ratio (debt/total capitalization) closer to -5(l% ratherthan 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 factordepends on the investor's home curenc,vr perception aboutthe future strength of the Danish krone, aad its impact ona firm's operating exposure. Through personal contactswith foreign investors and bankerq Novo's manag*me*tdid not believe toreign exchange risk was a factor inNovo's stock price, because its operations were perceivedas being well-diversified internationally' Over 90% af itssales were to customers located outside of Denn.rark

With respect to political risk, Denmark was pereeivedas a stable Western democrary but onc with the poleiltialto cause periodic problems for foreign investors' In partic-ular, Denmark's national debt was regarded as too highfor comfort, although this judgment had not yet sholvn upin the form of risk premiums on Denmark's Eurocurrencvsyndicated loans.

Ihe Boad to GhbalizationAlthough Novo's management in 1977 wished to escapefrom the shackies of Denmark's segmented and illiquidcapital market, many barriers had to be overcome' It isworthwhile to describe some of these obstacles, becausethey typfy the barriers faced by other firms i:om seg-mented markets that wish to internationalize their capitalsources,

Closing the lnformation Gap' Novo had Lreen a family-owned firm from its founding in the 1920s by the twoPedersen brothers until 1974, when it went public andlisted 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 investmentcircles outside of Denmark. To overcome this disparity irrthe information base, Novo increased the level o{ its finan-cial and technical disclosure in both Danish and Engiishversions.

The informatiotr gap was further closed when h{organGrenfell successfully organized a syndicate to underwriteand sell a $20 million convertible Eurobond issue forNovo in 1978. In connection with this offering, Novo listedits shares on the London Stock Exchange to facilitate con-

version and to gain visibility. These twin actions were thekey to dissolving the information barrier; of course' theyalso raised a large amount of long-term capital on favor-able terms, which would have been unavaiiable inDenmark.

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The Globat Cost and Availabitity of Capitat CHAPTER 14 385

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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 fortuitousevent 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"Adomestic 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 itsestablished competito$ and 3-0 or *or" f.o, ttJr*'r"*potential competitors.

In order to profile itself as a biotechnology firm with aproyQn track record, Novo organizea "

,.,iin*ln"Nr*York.City on ApriI30,1980. Soin after rn",.*ira. **sophisticated individual US. investors-i.r*'ilry*gNovo's shares and convertible, through;, d;;;, i;*n

Exchange. Danish investors were only too happy to supplythis foreign demand. Thelefore, despite ,rrl#"fi rrroogdemaad 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 Uylne 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*Otheir proportion of share ownership from virtually noth_ing to around 30olo. Noyo,s pri..;;."i;;.r"CiJO r*"nto around 16, which was oow in tine wittr'rtrai-oflir-ior"r_

nationat comperirors bur not *ith th;;;;;; l#rl atthis 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 thefirst hatf of 1981, under the g"id;;;.;;;"rI#l-.*,and with the assistance of Morgan Cr"nf"]f ,"0

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386 CHAPTER 1 4 The Gtobal Cost and Avaitabitity of Capitat

Copenhagen Handelsbank, Novo prepared a prospectusfor SEC registralion of a US. share offering and eventuallisting on the New York Stock Exchange. The main barri-ers encountered in this effort, which would have generalapplicability, were connected with preparing financialstatements that could be reconciled with U.S accountingprinciples and the higher level of disclosure required bythe SEC. In particular, industry segment reporting was aproblem both from a disclosure perspective and anaccounting per$pective because the accounting data werenot available internally in that format. As it turned out,the investment barriers in the U.S. were relativelytractable, although expensive and time-consuming toovercome,

The more serious barriers were caused by a variety ofinstitutional and governmental regulations in Denmark.The latter were never designed so that firms could issueshares at market value, because Danish firms typicallyissued stock at par value with preemptive rights. By thistimg however, Novo's share price, driven by continuedforeign buying, was so high that virtually nobody inDenmark thought it was worth the price that foreignerswere willing to pay. In fact, prior to the time of the shareissue in July 1981, Novo's share price had risen to overDkr1500, before settling down to a level around Dkr1400.Foreign ownership had increased to over 50yo of Novo,sshares outstanding!

Stock Market Reactions. One final piece of evidence onmarket segmentation can be gleaned from the way Danishand foreign investors reacted to the announcement of theproposed $61 million U.S. share issue on May 29, 198i.Novo's share price dropped 156 points the next tradingday in Copenhagdn, equal to about 10% of its marketvalue. As soon as trading started in New york, the stockprice immediately recovered all of its loss. TheCopenhagen reaction was typical for an illiquid market.Investors worried about the dilution effect of the newshare issue because it would increase the number ofshares outstanding by about 8%.They did not believe thatNovo could invest the rew funds at a rate ofreturn thatwould not dilute future earnings per share. They alsofeared that the U.S. shares would eventually flow back toCopenhagen if biotechnology lost its glitter.

The U.S. reaction to the announcement of the newshare issue was consistent with what one would expect ina liquid and integrated market. U.S, investors viewed thenew issue as creating additional demand for the shareq asNovo became more visible due to the selling efforts of alarge aggressive syndicate. Furthermore, the marketingeffort 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 astock in order to be able to get out, if desired, withoutdepressing the share price. The wide distribution effectedby the new issue, plus SEC registration and a New yorkStock Exchange listing, ali added up to more liquidity anda giobal cost of capital.

Effect on Novo's Weighted Average Cost otCapital. During most of 1981 and the years thereafter,Novo's share price was driven by international portfolioiavestors transacting on the New york, London, andCopenhagen stock exchanges. This situation reducedNovols weighted average cost of capital and lowered itsmarginal cost of capital. Novo,s systematic risk wasreduced from its previous level, which was determined bynondiversified (internationally) Danish institutionalinvestors and the Novo Foundation. However, its appro_priate debt ratio level was also reduced to match the stan-dards expected by international portfolio investorstrading in the United States, United Kingdom, and otherimportant markets, In essence, the U.S. dollar becameNovo's functional currency when being evaluated byinternational investors. Theoretically, its revised weightedaverage cost o{ capital should have become a new refet_ence hurdle rate when evaluating new capital investmentsin Denmark or abroad.

Other firms that follow Novo's strategy are also likelyto have their weighted average cost of capital become afuoction of the requirements of international portfolioinvestors. Firins resident in some of the emerging marketcountries have already experienced ,,dollarization,, oftrade and finaacing for working capital.This phenomenonmight be extended to long-term financing and theweighted average cost of capital.

The Novo experience has been described in hopes thatit can be a model for other firms wishing to escape fromsegmented and illiquid home equity markt& In particu-lar, MNEs based in emerging markets often face barriersand lack of visibility similar to whar Novo faced. Theycould benefit by following Novo,s proactive $trategyemployed to attract international portfolio investors.However, a word of caution is advised. Novo had as excel-lent operating track record and a very strong worldwidemarket niche in two important industry sectorsl insulinand industrial enzymes This record @ntinues to attractinvestors in Denmark and abroad. Other companieswould also need to have such a favorable track record toattract foreign investors