Chapter

17
Multinational Cost of Capital and Capital Structure

South-Western/Thomson Learning 2006

Slides by Yee-Tien (Ted) Fu

Chapter Objectives

To explain how corporate and country characteristics influence an MNCs cost of capital; To explain why there are differences in the costs of capital across countries; and To explain how corporate and country characteristics are considered by an MNC when it establishes its capital structure.

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Cost of Capital
A firms capital consists of equity
(retained earnings and funds obtained by issuing stock) and debt (borrowed funds).

The cost of equity reflects an opportunity

cost, while the cost of debt is reflected in the interest expenses.

Firms want a capital structure that will

minimize their cost of capital, and hence the required rate of return on projects.
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Comparing the Costs of Equity and Debt

A firms weighted average cost of capital
kc = ( D ) kd ( 1 _ t ) + ( E ) ke
D+E D+E where D E kd t ke is the amount of debt of the firm is the equity of the firm is the before-tax cost of its debt is the corporate tax rate is the cost of financing with equity

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Searching for the Appropriate Capital Structure

Cost of Capital

Debt Ratio Interest payments on debt are tax deductible However, the tradeoff is that the probability of bankruptcy will rise as interest expenses increases.
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Factors that Cause the Cost of Capital for MNCs to Differ from That of Domestic Firms
Larger size Greater access to international capital markets International diversification Exposure to exchange rate risk Exposure to country risk
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Preferential treatment from creditors & smaller per unit flotation costs Possible access to lowcost foreign financing

Cost of capital

Probability of bankruptcy

Cost-of-Equity Comparison Using the CAPM

The capital asset pricing model (CAPM)
can be used to assess how the required rates of return of MNCs differ from those of purely domestic firms.

CAPM: ke = Rf + b (Rm Rf )
where ke = Rf = Rm = b = the required return on a stock risk-free rate of return market return the beta of the stock
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Cost-of-Equity Comparison Using the CAPM

A stocks beta represents the sensitivity of
the stocks returns to market returns, just as a projects beta represents the sensitivity of the projects cash flows to market conditions.

The lower a projects beta, the lower its

systematic risk, and the lower its required rate of return, if its unsystematic risk can be diversified away.
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Implications of the CAPM for an MNCs Risk

An MNC that increases its foreign sales
may be able to reduce its stocks beta, and hence reduce the required return.

However, some MNCs consider

unsystematic project risk to be important in determining a projects required return.

Hence, we cannot say whether an MNC

will have a lower cost of capital than a purely domestic firm in the same industry.
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Cost of Capital Across Countries

The cost of capital can vary across
countries, such that: MNCs based in some countries have a competitive advantage over others; MNCs may be able to adjust their international operations and sources of funds to capitalize on the differences; and MNCs based in some countries tend to use a debt-intensive capital structure.
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Country Differences in the Cost of Debt

A firms cost of debt is determined by:

the prevailing risk-free interest rate of the borrowed currency, and the risk premium required by creditors.

The risk-free rate is determined by the

interaction of the supply of and demand for funds. It is thus influenced by tax laws, demographics, monetary policies, economic conditions, etc.
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Cost of Debt Across Countries

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Country Differences in the Cost of Equity

A firms return on equity can be measured
by the risk-free interest rate plus a premium that reflects the risk of the firm.

The cost of equity represents an

opportunity cost, and is thus also based on the available investment opportunities.

It can be estimated by applying a priceearnings multiple to a stream of earnings.

High PE multiple low cost of equity

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Lexons Estimated Weighted Average Cost of Capital (WACC) for Financing a Project

To derive the overall cost of capital, the costs of

debt and equity are combined, using the relative proportions of debt and equity as weights.
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Using the Cost of Capital for Assessing Foreign Projects

When the risk level of a foreign project is
different from that of the MNC, the MNCs weighted average cost of capital (WACC) may not be the appropriate required rate of return for the project.

There are various ways to account for this

risk differential in the capital budgeting process.

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Using the Cost of Capital for Assessing Foreign Projects

Derive NPVs based on the WACC.

Compute the probability distribution of NPVs to determine the probability that the foreign project will generate a return that is at least equal to the firms WACC.
If the project is riskier, add a risk premium to the WACC to derive the required rate of return on the project.
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Adjust the WACC for the risk differential.

Using the Cost of Capital for Assessing Foreign Projects

Derive the NPV of the equity investment.

Explicitly account for the MNCs debt payments (especially those in the foreign country), so as to fully account for the effects of expected exchange rate movements.

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Lexons Project: Two Financing Alternatives

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The MNCs Capital Structure Decision

The overall capital structure of an MNC is
essentially a combination of the capital structures of the parent body and its subsidiaries.

The capital structure decision involves the

choice of debt versus equity financing, and is influenced by both corporate and country characteristics.

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The MNCs Capital Structure Decision

Corporate Characteristics
Stability of MNCs cash flows MNCs credit risk MNCs access to retained earnings MNCs guarantee on debt MNCs agency problems More stable cash flows the MNC can handle more debt Lower risk more access to credit Profitable / less growth opportunities more able to finance with earnings Subsidiary debt is backed by parent the subsidiary can borrow more Not easy to monitor subsidiary issue stock in host country (Note: there is a potential conflict of interest)
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The MNCs Capital Structure Decision

Country Characteristics
Stock restrictions Interest rates Strength of host country currency Country risk Tax laws Less investment opportunities lower cost of raising equity Lower rate lower cost of debt Expect to weaken borrow host country currency to reduce exposure Likely to block funds / confiscate assets prefer local debt financing Higher tax rate prefer local debt financing
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Interaction Between Subsidiary and Parent Financing Decisions

Increased debt financing by the subsidiary
A

larger amount of internal funds may be available to the parent.

need for debt financing by the parent may be reduced. may affect the interest charged on debt as well as the MNCs overall exposure to exchange rate risk.
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The

The revised composition of debt financing

Interaction Between Subsidiary and Parent Financing Decisions

Reduced debt financing by the subsidiary
A

smaller amount of internal funds may be available to the parent.

need for debt financing by the parent may be increased. may affect the interest charged on debt as well as the MNCs overall exposure to exchange rate risk.
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The

The revised composition of debt financing

Effect of Global Conditions on Financing

Host Country Conditions Local Debt Internal Financing Funds by Available Subsidiary to Parent Debt Financing Provided by Parent

Higher country risk Higher interest rates Lower Interest Rates Local currency expected to weaken
Local currency expectedfunds Blocked to strengthen Higher withholding tax Higher corporate tax

Higher Lower Higher Higher

Lower Higher Higher Higher

Higher Lower Higher Higher

Lower Higher Higher Higher

Lower Higher Lower Lower

Higher Lower Lower Lower
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Local versus Global Target Capital Structure

An MNC may deviate from its local
target capital structure when local conditions and project characteristics are taken into consideration.

If the proportions of debt and equity

financing in the parent or some other subsidiaries can be adjusted accordingly, the MNC may still achieve its global target capital structure.
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Local versus Global Target Capital Structure

For example, a high degree of financial
leverage is appropriate when the host country is in political turmoil, while a low degree is preferred when the project will not generate net cash flows for some time.
A capital structure revision may result in a higher cost of capital. So, an unusually

high or low degree of financial leverage should be adopted only if the benefits outweigh the overall costs.
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