Segmented Capital Markets and the Cost of External Finance

Segmented capital markets may allow firms to reduce their cost of capital by increasing their reliance on the relatively cheaper market. However, this potential benefit is attenuated by the firm's costs of accessing the markets. This paper models a firm with access to two segmented capital markets, and illustrates howhigher costs of accessing either market lead to lower firm values. While access costs clearly impact the firm's ability to arbitrage the two markets, we focus on a more subtle effect. Access to multiple markets may reduce the value loss arising from uncertainty in internally generated funds. The model also suggests a methodology for measuring access costs to segmented markets, allowing us to test our model on a sample of large banking firms. We label banks with relatively lower costs of accessing the two markets as more quot;financially flexible.quot; Our two key findings are 1) banks with greater financial flexibility have greater value, and 2) banks with greater financial flexibility devote a smaller percentage of assets to cash and marketable securities, consistent with the notion that financial flexibility reduces the sensitivity of firm profits to internal wealth shocks, thus reducing the firm's need to carry financial slack