25295740 Chapter 17 Multinational Cost of Capital and Capital Structure

7/29/2019 25295740 Chapter 17 Multinational Cost of Capital and Capital Structure

1/26

Multinational Cost of Capitaland Capital Structure

17

Chapter

South-Western/Thomson Learning 2006 Slides by Yee-Tien (Ted) Fu


2/26

17 - 2

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.


3/26

17 - 3

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 opportunitycost, while the cost of debt is reflected in

the interest expenses.

Firms want a capital structure that willminimize their cost of capital, and hence

the required rate of return on projects.


4/26

17 - 4

A firms weighted average cost of capital

kc = (D )kd(

1_t) + ( E )ke

D

+

E D

+

Ewhere D is the amount of debt of the firm

E is the equity of the firm

kdis the before-tax cost of its debt

t is the corporate tax rate

ke is the cost of financing with equity

Comparing the Costs of Equity and Debt


5/26

17 - 5

CostofCapital

Debt Ratio

Searching for the Appropriate

Capital Structure

Interest payments on debt are tax deductible

However, the tradeoff is that the probability of

bankruptcy will rise as interest expenses increases.


6/26

17 - 6

Factors that Cause the Cost of Capital forMNCs to Differ from That of Domestic Firms

Exposure toexchange rate

risk

Exposure to

country risk

Greater accessto international

capital markets Possibleaccess to low-

cost foreignfinancing

Larger sizePreferential

treatment fromcreditors &

smaller per unitflotation costs

Cost ofcapitalInternational

diversification

Probability ofbankruptcy


7/2617 - 7

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+ (RmRf)

where ke = the required return on a stockRf = risk-free rate of return

Rm= market return

b = the beta of the stock

Cost-of-Equity Comparison

Using the CAPM


8/2617 - 8

A stocks beta represents the sensitivity ofthe 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 requiredrate of return, if its unsystematic risk can

be diversified away.

Cost-of-Equity Comparison

Using the CAPM


9/2617 - 9

An MNC that increases its foreign salesmay be able to reduce its stocks beta, and

hence reduce the required return.

However, some MNCs considerunsystematic project risk to be important

in determining a projects required return.

Hence, we cannot say whether an MNCwill have a lower cost of capital than a

purely domestic firm in the same industry.

Implications of the CAPM

for an MNCs Risk


10/2617 - 10

Cost of Capital Across Countries

The cost of capital can vary acrosscountries, 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; andMNCs based in some countries tend to

use a debt-intensive capital structure.


11/2617 - 11

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 theinteraction of the supply of and demand

for funds. It is thus influenced by tax laws,demographics, monetary policies,

economic conditions, etc.


12/2617 - 12

Cost of Debt Across Countries


13/2617 - 13

Country Differences in the Cost of Equity

A firms return on equity can be measuredby the risk-free interest rate plus a

premium that reflects the risk of the firm.

The cost of equity represents anopportunity cost, and is thus also based

on the available investment opportunities.

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

High PE multiple low cost of equity


14/2617 - 14

LexonsEstimated Weighted Average Cost of Capital (WACC)

for Financing a Project

To derive the overall cost of capital, the costs ofdebt and equity are combined, using the relative

proportions of debt and equity as weights.


15/2617 - 15

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 thisrisk differential in the capital budgeting

process.


16/2617 - 16


for Assessing Foreign ProjectsDerive 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.

Adjust the WACC for the risk differential.

If the project is riskier, add a risk premiumto the WACC to derive the required rate of

return on the project.


17/2617 - 17


for Assessing Foreign ProjectsDerive 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.


18/2617 - 18

Lexons Project: Two Financing Alternatives


19/2617 - 19

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 itssubsidiaries.

The capital structure decision involves thechoice of debt versus equity financing,

and is influenced by both corporate and

country characteristics.


20/2617 - 20

The MNCsCapital Structure Decision

Corporate Characteristics

Stability of MNCscash flows

More stable cash flowsthe MNC can handle more debt

MNCs access toretained earnings

Profitable / less growth opportunitiesmore able to finance with earnings

MNCs agencyproblems

Not easy to monitor subsidiaryissue stock in host country (Note:

there is a potential conflict of interest)

MNCs credit risk Lower risk more access to credit

MNCs guaranteeon debt Subsidiary debt is backed by parentthe subsidiary can borrow more


21/2617 - 21

The MNCsCapital Structure Decision

Country Characteristics

Stock restrictions Less investment opportunitieslower cost of raising equity

Strength of hostcountry currency

Expect to weaken borrow hostcountry currency to reduce exposure

Tax laws Higher tax rateprefer local debt financing

Interest rates Lower rate lower cost of debt

Country risk Likely to block funds / confiscateassets prefer local debt financing


22/26

17 - 22

Interaction Between Subsidiary

and Parent Financing DecisionsIncreased debt financing by the subsidiary

A larger amount of internal funds may be

available to the parent.The need for debt financing by the parent

may be reduced.

The revised composition of debt financingmay affect the interest charged on debt aswell as the MNCs overall exposure to

exchange rate risk.


23/26

17 - 23

Interaction Between Subsidiary

and Parent Financing DecisionsReduced debt financing by the subsidiary

A smaller amount of internal funds may be

available to the parent.The need for debt financing by the parent

may be increased.

The revised composition of debt financingmay affect the interest charged on debt aswell as the MNCs overall exposure to

exchange rate risk.


24/26

17 - 24

Local Debt Internal DebtFinancing Funds Financing

Host Country by Available ProvidedConditions Subsidiary to Parent by Parent

Higher country risk Higher Higher Lower

Effect of Global Conditions on Financing

Higher interest rates Lower Lower Higher

Lower Interest Rates Higher Higher Lower

Local currency Higher Higher Lowerexpected to weaken

Local currency Lower Lower Higherexpected to strengthenBlocked funds Higher Higher Lower

Higher withholding tax Higher Higher Lower

Higher corporate tax Higher Higher Lower


25/26

17 - 25

Local versus Global

Target Capital Structure An MNC may deviate from its local

target capital structure when local

conditions and project characteristics aretaken into consideration.

If the proportions of debt and equityfinancing in the parent or some other

subsidiaries can be adjusted accordingly,the MNC may still achieve its global

target capital structure.


26/26

For example, a high degree of financialleverage 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 unusuallyhigh or low degree of financial leverage

should be adopted only if the benefits

outweigh the overall costs.

Local versus Global

Target Capital Structure

Documents

25295740 Chapter 17 Multinational Cost of Capital and Capital Structure