Optimal Capital Structure in Multinational Corporations

by Prof. Dr. Dr. Joachim Hcker

Content

1.

Financial issues of multinational companies

2.

Theoretical analysis on optimal capital structure

2.1. The leverage effect

2.2. The Modigliani Miller proposition

2.3. The traditional approach

3.

Practical analysis on optimal capital structure

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1. Financial issues of multinational companies

Financial Management Definition Three core elements:

Capital structure: Determination of debt and equity properties necessary to maximize firms financial health and long-term competitiveness. Capital budgeting: Analysis of investment opportunities considered by the firm. Cash management: Management of the levels and composition of the current assets of the firm (cash, receivables, inventories) and their proper funding. International: Goods produced in the domestic market and then exported to foreign buyers. Multinational: Parent company in home country and numerous subsidiaries or joint ventures in foreign countries.

Multinational Corporation (MNC)

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2. Theoretical analysis on optimal capital structure

2.1 The leverage effect

Definition: Leverage effect

The financial leverage effect describes the impact of the level of debt on return on equity.

NI = ROE * E ROE * E = ROC * (E + D) i * D ROE * E = ROC * E + ROC * D i * D ROE * E = ROC * E + (ROC i) * D ROE = ROC + (ROC - i) * D / E

Note: NI .. E ..... D ..... ROE ..... ROC ..... i ..... D/E ..... Net income Equity Debt Return on equity Return on total capital Interest rate Debt to equity ratio

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ROC versus interest rate

(ROC > i): If return on total capital is larger than the interest rate on debt, return on equity increases in proportion to the debt-equity ratio. The rate of

ROE

(ROC > i)

increase is determined by the spread between the return on total capital and the interest rate on debt.

(ROC = i): If return on total capital equals the interest rate on debt, return on equity remains constant with an increasing debt-equity ratio.

(ROC = i) (ROC < i)

(ROC < i): If return on total capital is lower than the interest rate on debt, return on equity decreases with a higher debt-equity ratio (magnitude depends on spread).

D/E

ROE = ROC + (ROC - i) * D / E

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Example (1): Constant debt-equity ratio (D = E):

Deployed capital can, affected by an unfavourable (ROC = 2%), average (ROC = 6%), or favourable (ROC = 14%) market development with equal probability, earn three different returns.

With a debt-equity ratio of 1 (D = E) and an interest rate on debt of i = 6%, the leverage equation gives the following returns on equity:

3 Cases

ROE

ROC 2% 6% 14%

+ (ROC + + + (2% (6% (14%

i) 6%) 6%) 6%)

* * * *

D/E 1 1 1

= = = =

ROE -2% 6% 22%

ROC < i ROE (unfavourable) ROC = i ROE (average) ROC > i ROE (favourable)

Besides business risk and investment risk, the company incurs a financial or capital structure risk with the use of debt.

The spread of percentage returns on equity is amplified. With a higher debt-equity ratio, both the opportunity for a high return on equity and the risk of a low (negative) return on equity increases simultaneously.

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Example (2): Different debt levels:

Return on equity depends on the debt level

Shareholders:

Risk but also potential reward increase with growing level of debt.

3 Cases

D/E

0/100 2% 6% 14%

25/75 0.67% 6% 16.67%

50/50 -2% 6% 22%

75/25 -10% 6% 38%

Lenders:

ROC < i Unfavourable ROC = i Average ROC > i Favourable

Although interest payments are relatively safe at a low level of debt, negative returns on equity may occur with an increasing level of debt, potentially leading to a total consumption of equity.

With increasing debt levels, interest and principal payments are increasingly at risk.

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Question:

What is the effect of the capital structure on return on equity?

Answer

With increasing leverage, the potential reward (risk) of increasing (decreasing) return on equity is amplified. The outcome is a financial or capital structure risk: If: ROC > i If: ROC = i If: ROC < i ROE (ROC-i; D/E) ROE (ROC-i; D/E) ROE (ROC-i; D/E)

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2.2 The Modigliani Miller proposition

Market value

The Modigliani / Miller proposition states that the market value of any firm is independent of its capital structure. I.e., changes in capital structure do not affect the stockholders welfare. 2 companies that generate the same stream of operating income and differ only in capital structure will have the same valuation. Assuming perfect markets, the arbitrage argument ensures this equilibrium. If levered firms were priced too high, rational investors would simply borrow on personal account to buy shares in unlevered firms, thus duplicating the effects of corporate leverage. The arbitrage process would decrease the value of the levered firm and increase the value of the unlevered firm, until both valuations are again in equilibrium. Once again, investors are indifferent between investment choices. Since the equilibrium price is derived on markets, market values and not book values are relevant.

Arbitrage

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2.2 The Modigliani Miller proposition (contd)

Assumptions

The Modigliani Miller proposition is based on the following assumptions (perfect capital markets): (1) Every investor maximizes his financial utility (2) Corporations and individuals can borrow at the same interest rate (3) The borrowing interest rate equals the lending interest rate (4) No transaction costs (5) No bankruptcy costs (6) Debt instruments can be divided at the discretion of market participants (7) Taxation of all investment and debt instruments for all market participants is equal

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2.3 The traditional approach

ROE WACC i

Shows the dependence of the required return on equity on the level of debt.

ROE

WACC i

Minimizing WACC equals maximizing overall firm value.

Optimal level of debt

Debt ratio

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Conclusion:

The value of the company is derived by discounting future cash flows with the weighted average cost of capital (WACC).

With increasing levels of debt, expensive equity is replaced by cheap debt. If a company gradually increases its debt level, risk increases. This fact will either be neglected by equity holders, or it seems to them to be negligible.

Future cash flows will be discounted with the same WACC. Thus, company value increases. Only with a significant increase of the debt level the exact threshold is unknown equity holders act on the increase of risk. Consequently, they require a higher return on equity, and future cash flows are discounted with a higher WACC.

Debt holders act similarly but temporally delayed. Maximum company value is derived at the minimum WACC.

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Comparison of theories

The question regarding the existence of an optimal capital structure is not unequivocally answered in theory. Leverage Effect

Modigliani Miller

Traditional Approach

With increasing debt levels the return on equity changes, depending on ROC and i If ROC > i, the optimal capital structure implies a fully levered firm If ROC < i, a fully unlevered firm is optimal

The capital structure is irrelevant for the market value of a company I.e., there is no optimal capital structure

There is an optimal capital structure This is the case at the minimum WACC (or the maximum overall firm value)

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3. Practical analysis on optimal capital structure

Marktwerte (Mio. Euro) vom 17.9.99 Name Sector DEUTSCHE TELEKOM DAIMLERCHRYSLER AG MANNESMANN AG SIEMENS AG BAYER AG VEBA AG BASF AG HOECHST AG RWE AG BAYER MOTOREN WERK SAP AG VOLKSWAGEN AG METRO AG VIAG AG THYSSEN KRUPP AG PREUSSAG AG SCHERING AG DEUTSCHE LUFTHANSA WCM BETEIL&GRUNDBE DEGUSSA-HULS AG BEIERSDORF AG HEIDELBERGER DRUCK FRESENIUS MEDICAL LINDE AG HENKEL KGAA HEIDELBERGER ZEMEN Other Telecommunications Motor Vehicles Diversified Manufacture Diversified Electronic Products Major Chemicals Multi-Sector Companies Major Chemicals Major Pharmaceuticals Multi-Sector Companies Motor Vehicles Computer Software Motor Vehicles Other Specialty Stores Multi-Sector Companies Multi-Sector Companies Multi-Sector Companies Major Pharmaceuticals Airlines Real Estate Major Chemicals Package Goods/Cosmetics Industrial Machinery/Components Medical Specialties Multi-Sector Companies Package Goods/Cosmetics Building Materials Jahr 12/1998 12/1998 12/1998 09/1998 12/1998 12/1998 12/1998 12/1998 06/1997 12/1998 12/1998 12/1998 12/1998 12/1998 09/1998 09/1998 12/1998 12/1998 12/1998 09/1998 12/1998 03/1997 12/1998 12/1998 12/1998 12/1998 Marktwert Equity ratio 120.229 68.619 54.462 47.672 28.739 28.106 28.479 24.400 19.701 18.045 17.753 16.999 15.979 13.909 10.856 8.731 6.881 6.697 6.253 5.886 5.704 5.163 4.970 4.795 3.949 4.019 32% 23% 37% 27% 44% 31% 50% 34% 18% 21% 60% 16% 22% 16% 26% 18% 45% 27% 54% 26% 46% 59% 59% 52% 31% 40% Gearing I (Buchwert) excl./ incl. Pens.rkst. 57% 41% 2% 23% 18% 18% -1% 39% n.m. 58% -40% 43% 39% 25% 33% 25% -66% 18% 3% 29% -61% -12% 27% -16% 35% 27% Gearing II (Marktwert) excl./ incl. Pens.rkst. 59% 22% Since theory does not 23% offer a 55% 24% 36% 28% 0% let us analyse 4% clear answer, 49% 9% 23% 37% 9% 21% the question of an optimal 36% 9% 21% capital structure empirically. 23% -1% 12% 48% 19% 26% -21% -47% -6% As an example, the DAX 100 63% 33% 38% -38% -3% companies -3% are analysed 62% 29% 47% 45% 14% 17% 48% 10% 24% 58% 21% 43% 49% 5% 14% 13% -13% 4% 51% 10% 34% 4% 0% 0% 48% 9% 17% -4% -7% -1% 6% -4% 2% 28% 17% 18% 10% -7% 5% 54% 27% 44% 35% 15% 21%

60%

Source: Extel, FactSet, year 2000 values

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Marktwerte (Mio. Euro) vom 17.9.99 Name Sector ADIDAS-SALOMON AG KARSTADT AG MAN AG HOCHTIEF AG METALLGESELLSCHAFT GEHE AG CONTINENTAL AG ALTANA AG BEWAG AG PORSCHE AG FRESENIUS AG IVG HOLDING AG MERCK KGAA DOUGLAS HLDG AG SGL CARBON AG SKW TROSTBERG AG AVA ALLG HANDELS V BUDERUS AG HOLZMANN(PHILIPP) SCHWARZ PHARMA AG BILFINGER & BERGER PROSIEBEN MEDIA AG AGIV AG JENOPTIK AG K & S AG KLOECKNER WERKE Shoe Manufacturing Department Stores Diversified Manufacture Engineering & Construction Multi-Sector Companies Medical/Dental Distributors Auto Parts: O.E.M. Other Pharmaceuticals Non-U.S. Utilities Motor Vehicles Medical Specialties Multi-Sector Companies Other Pharmaceuticals Other Specialty Stores Industrial Specialties Specialty Chemicals Department Stores Building Products Engineering & Construction Other Pharmaceuticals Engineering & Construction Broadcasting Industrial Machinery/Components Diversified Manufacture Environmental Services Specialty Chemicals

Jahr 12/1998 12/1998 06/1997 12/1998 09/1998 12/1998 12/1998 12/1998 06/1997 07/1998 12/1998 12/1998 12/1998 12/1998 12/1998 12/1998 12/1998 09/1998 12/1998 12/1998 12/1998 12/1998 12/1998 12/1998 12/1998 09/1998

Marktwert Equity ratio 3.753 3.654 3.551 2.975 2.771 2.770 2.745 2.576 2.215 2.249 1.670 1.595 1.571 1.500 1.494 1.342 1.145 1.102 913 827 857 756 718 710 723 688 16% 16% 25% 29% 32% 14% 28% 23% 55% 35% 28% 38% 38% 31% 45% 27% 21% 33% 32% 12% 49% 22% 49% 28% 35% 34% 15%

Gearing I (Buchwert) excl./ incl. Pens.rkst. 77% 42% -75% n.m. n.m. 48% 54% n.m. 13% n.m. 42% 53% 48% 16% 39% 61% 33% -82% 66% 29% n.m. 28% n.m. 28% n.m. 65% 77%

Gearing II (Marktwert) excl./ incl. Pens.rkst. 31% 31%

14%

63% 21% 39% Definition: 13% -32% 8% Equity ratio-66% = -138% -34% 18% -17% 4% Equity incl. minority stakes / 49% 28% 29% 64% 38% 48% total assets. -21% -40% -10% 21% 11% 17% -31% -18% -5% Analysis of 77 DAX 100 44% 38% 40% companies. 54% 20% 21% 59% 50% 61% 19% 5% 6% Excluded were financial service 53% 11% 18% 66% 36% insurance 42% providers (incl. 34% 14% 15% 18% -17% asset 7% companies and 71% 52% 58% management companies) 32% 14% 16% as well n.m. n.m. n.m. as28% real estate companies. 20% 20% -51% -61% -25% 36% 17% 23% -62% -89% -31% 72% 37% 44%

12%

15%

Source: Extel, FactSet

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Marktwerte (Mio. Euro) vom 17.9.99 Name Sector WELLA AG SIXT AG GEA AG FAG KUGELFISCHER DYCKERHOFF AG SCHMALBACH LUBECA DEUTZ AG BOSS (HUGO) AG IWKA AG SUDZUCKER AG GROHE(FRIEDRICH)AG GERRESHEIMER GLAS RHON-KLINIKUM AG KIEKERT AG DUERR AG PUMA AG FIELMANN AG VOSSLOH AG TARKETT SOMMER AG BRAU UND BRUNNEN RHEINMETALL AG BABCOCK BORSIG AG JUNGHEINRICH PHOENIX AG KRONES AG SPAR HANDELS AG ESCADA AG KSB KL SCHANZ BECK Source: Extel, FactSet

Jahr

Marktwert Equity ratio 658 652 637 588 463 450 418 413 396 364 361 361 343 340 319 311 304 300 282 269 269 261 221 211 122 124 98 99 28% 28% 21% 32% 26% 39% 22% 16% n.a. 28% n.a. 51% n.a. 21% 44% n.a. 44% 61% 42% 18% 15% 23% 5% 34% 35% 56% 18% 29% 32%

Gearing I (Buchwert) excl./ incl. Pens.rkst. 44% 70% -1% 49% 27% 52% 6% n.a. -5% n.a. -46% n.a. 54% 32% n.a. -5% 14% 29% 72% 61% 27% 81% 11% 39% -48% 21% 57% -19% 56% 70% 17% 65% 39% 62% 67% n.a. 23% n.a. 2% n.a. 55% 35% n.a. 7% 14% 33% 73% 78% 54% 87% 29% 44% -29% 29% 57% 28%

Gearing II (Marktwert) excl./ incl. Pens.rkst. 35% 47% -1% 42% 34% 52% 3% 0% -4% 0% -34% 0% 34% 16% 0% -2% 9% 21% 64% 40% 30% 52% 13% 34% n.m. 41% 65% -29% 47% 47% 13% 58% 47% 62% 44% 0% 17% 0% 2% 0% 34% 18% 0% 2% 9% 25% 66% 60% 58% 64% 34% 39% -149% 51% 65% 36%

Package Goods/Cosmetics 12/1998 Rental/Leasing Companies 12/1998 Industrial Machinery/Components 12/1998 Metal Fabrications 12/1998 Building Materials 12/1998 Containers/Packaging 12/1998 Industrial Machinery/Components 12/1998 Apparel 12/1998 Industrial Machinery/Components 12/1998 Specialty Foods/Candy 02/1999 Building Products 12/1998 Containers/Packaging 12/1998 Medical/Nursing Services 12/1998 Auto Parts: O.E.M. 12/1998 Industrial Machinery/Components 12/1998 Shoe Manufacturing 12/1998 Other Specialty Stores 12/1998 Diversified Electronic Products 12/1998 Building Products 12/1998 Alcoholic Beverages 12/1998 Diversified Manufacture 12/1998 Industrial Machinery/Components 09/1998 Construction/Ag Equipment/Trucks 12/1998 Auto Parts: O.E.M. 12/1998 Industrial Machinery/Components 12/1998 Food Chains 12/1998 Apparel 10/1998 Fluid Controls 12/1998

61%

5%

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Equity ratio of DAX 100 companies

Cummulative number of companies (right axis)

The German equity ratio (for DAX 100 companies) averages 31%. The European equity ratio (based on EuroStoxx) averages 38%. The unlisted German Mittelstand equity ratio averages around 10% Business practice supports the traditional approach. Empirically, a large spread of optimal equity ratios can be shown depending on numerous factors such as sectors, profitability and liquidity.

90 80

14 12 10 8

13 11

13

Number of companies (left axis)

70 9 60 50 6 6 4 2 2 0 Up to Up to Up to Up to Up to Up to Up to Up to Up to Up to Up to Up to Up to 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70%
Source: Extel, FactSet, based on year 2000 numbers

6 5 5

40 30

3 1

20 10 0

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International outlook
Country Automotive Food Paper Debt Ratio Country Mean

Singapore Argentina Australia Brazil UK US Benelux Canada Switzerland Germany Denmark Spain France Italy Industry Mean
Source: Sekely/Collins (1988)

0.22 0.42 0.50 0.66 0.73 0.58 0.62 n.a. n.a. 0.57 n.a. 0.59 0.67 0.49 0.58

0.28 0.35 0.45 0.57 0.55 0.56 0.64 n.a. 0.54 0.49 0.69 0.66 0.78 0.85 0.62

n.a. n.a. 0.48 0.37 0.56 0.58 0.65 0.68 n.a. 0.70 0.74 0.85 5.163 03/1997 12/1998 0.74 4.970 12/1998 4.795 12/1998 0.77 3.949
12/1998 4.019

0.34 34% 0.38 0.46 0.54 0.55 0.55 0.56 0.58 0.60 62% 0.62 0.63 0.64 0.71 0.76 76%

Empirical study compares debt ratios for 677 listed firms in 9 industries in 23 countries. Capital structure standards vary considerably from country to country,but are similar for firms within a country. Neither industry nor size is -1% of an important determinant 6% -4% 2% debt ratios.17% 28% 18%
10% 54% 35% -7% 27% 15% 5% 44% 21%

-12% 27% -16% 35% 27%

0.63

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Capital structure decision for MNC

How does international availability of capital affect the optimal debt ratio of a MNC?

Maintenance of desired debt ratio is facilitated by access to international capital markets, even when significant amounts of new funds must be raised.

International availability of capital to a MNC may allow for lower cost of capital than what is available to a domestic firm.

Therefore, the value of MNCs can exceed the value of its national peers

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Capital structure decision for MNC

Pro centralisation

MNCs should choose a capital structure that minimizes consolidated cost of capital. The individual subsidiary does not have an independent cost of capital. Thus, the subsidiarys cost of capital is relevant only to the degree that it has an effect on the overall goal.

Contra centralisation

Localized capital structure for foreign subsidiary helps management to evaluate ROE relative to local competitors. Better public relations with host country monetary authorities might result.

Capital structure should be an issue of centralised management style. MNCs should borrow at lowest cost, after adjusting for foreign exchange risk, anywhere in the world without considering the impact on a particular subsidiarys capital structure.
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