ch17-versc_2

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Multinational Cost of Capital& Capital Structure

17Chapter

South-Western/Thomson Learning 2003

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Chapter Objectives

To explain how corporate andcountry 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 countrycharacteristics are considered by an MNC

when it establishes its capital structure"

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Cost of Capital

# fir$s capitalconsists of equity%retainedearnins and funds obtained by issuin

stoc'( and debt%borrowed funds(" The cost of e)uity reflects an opportunity

cost* while the cost of debt is reflected in

interest expenses"

+ir$s want a capital structure that will$ini$i,e their cost of capital* and hence the

re)uired rate of return on projects"

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# fir$s weihted averae cost of capital

kc - % . (kd%1/t( 0 % (ke .0 .0

where D is the amount of debt of the firm

E is the equity of the firm

kd is the before-tax cost of its debtt is the corporate tax rate

ke is the cost of financing with equity

Cost of Capital

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The interest pay$ents on debt are taxdeductible" 2owever* as interest expenses

increase* the probability of ban'ruptcy willincrease too"

3t is favorable to increase the use of debtfinancin until the point at which the

ban'ruptcy probability beco$es lare

enouh to offset the tax advantae of usin

debt"

Cost of Capital

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Debts Tradeoff

Cost of Capital

Co

stofCapita

l

.ebt 4atio

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Cost of Capital for MNCs

The cost of capital for MNCs $ay differfro$ that for do$estic fir$s because of

the followin differences"Size of Firm.5ecause of their si,e* MNCs

are often iven preferential treat$ent by

creditors" They can usually achieves$aller per unit flotation costs too"

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Acess to International Capital Markets.

MNCs are nor$ally able to obtain funds

throuh international capital $ar'ets*where the cost of funds $ay be lower"

International Diersification.MNCs $ay

have $ore stable cash inflows due to

international diversification* such that their

probability of ban'ruptcy $ay be lower"


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!"posure to !"c#an$e %ate %isk.MNCs

$ay be $ore exposed to exchane rate

fluctuations* such that their cash flows $aybe $ore uncertain and their probability of

ban'ruptcy hiher"

!"posure to Country %isk.MNCs that have

a hiher percentae of assets invested in

forein countries are $ore exposed to

country ris'"


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6ossibleaccess to lowcost forein

financin

6referentialtreat$ent fro$

creditors8reater accessto internationalcapital $ar'ets

9arer si,e

3nternationaldiversification

xposure toexchane rateris'

xposure to

country ris'

Cost ofcapital

6robability ofban'ruptcy

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The capital asset pricin $odel %C#6M( can beused to assess how the re)uired rates of

return of MNCs differ fro$ those of purelydo$estic fir$s"

#ccordin to C#6M* ke- %f0 %%m: %f(

where ke = the required return on a stock

"# = risk-free rate of return

"m = market return

= the beta of the stock


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# stoc's beta represents the sensitivity ofthe stoc's returns to $ar'et returns* just as

a projects beta represents the sensitivity ofthe projects cash flows to $ar'et

conditions"

The lower a projects beta* the lower itssyste$atic ris'* and the lower its re)uired

rate of return* if its unsyste$atic ris' can be

diversified away"


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#n MNC that increases its forein sales $aybe able to reduce its stoc's beta* and

hence the return re)uired by investors" Thistranslates into a lower overall cost of

capital"

2owever* MNCs $ay consider unsyste$aticris' as an i$portant factor when

deter$inin a forein projects re)uired rate

of return"


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2ence* we cannot be certain if an MNC willhave a lower cost of capital than a purely

do$estic fir$ in the sa$e industry"


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Costs of Capital #cross Countries

The cost of capital $ay vary acrosscountries* such that;

MNCs based in some countries may hae acompetitie adantage oer others!

MNCs may be ab"e to ad#ust their

internationa" operations and sources of

funds to capita"i$e on the differences! and MNCs based in some countries may hae a

more debt-intensie capita" structure%

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The cost of debt to a fir$ is pri$arilydeter$ined by the prevailin ris'free

interest rate of the borrowed currency and

the ris' pre$iu$ re)uired by creditors"

The ris'free rate is deter$ined by theinteraction of the supply and de$and for

funds" 3t $ay vary due to different tax laws*

de$oraphics* $onetary policies* and

econo$ic conditions"

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The ris' pre$iu$ co$pensates creditorsfor the ris' that the borrower $ay be

unable to $eet its pay$ent obliations" The ris' pre$iu$ $ay vary due to

different econo$ic conditions*

relationships between corporations and

creditors* overn$ent intervention* and

derees of financial leverae"

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#lthouh the cost of debt $ay vary acrosscountries* there is so$e positive

correlation a$on country costofdebtlevels over ti$e"

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&

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+&

+'

+(

+,,& +,,' +,,( +,,) +,,* '&&& '&&'

Canada

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# countrys cost of e)uity represents anopportunity cost : what the shareholders

could have earned on invest$ents withsi$ilar ris' if the e)uity funds had been

distributed to the$"

The return on e)uity can be $easured by

the ris'free interest rate plus a pre$iu$

that reflects the ris' of the fir$"

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# countrys cost of e)uity can also beesti$ated by applyin the price>earnins

$ultiple to a iven strea$ of earnins" # hih price>earnins $ultiple i$plies that

the fir$ receives a hih price when sellin

new stoc' for a iven level of earnins"

So* the cost of e)uity financin is low"

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The costs of debt and e)uity can beco$bined* usin the relative proportions

of debt and e)uity as weihts* to derive anoverall cost of capital"

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+or countryspecific infor$ation* visit;

0 http122www%b"oomberg%com2

0 http122www%pwcg"oba"%com

0 http122www%morganstan"ey%com2gef2

0 http122www%wor"dbank%org2data2

0 http122bi$%yahoo%com2ifc2

Online #pplication
http://www.bloomberg.com/http://www.pwcglobal.com/http://www.morganstanley.com/gef/http://www.worldbank.org/data/http://biz.yahoo.com/ifc/http://biz.yahoo.com/ifc/http://biz.yahoo.com/ifc/http://biz.yahoo.com/ifc/http://www.worldbank.org/data/http://www.worldbank.org/data/http://www.worldbank.org/data/http://www.morganstanley.com/gef/http://www.morganstanley.com/gef/http://www.morganstanley.com/gef/http://www.morganstanley.com/gef/http://www.morganstanley.com/gef/http://www.pwcglobal.com/http://www.pwcglobal.com/http://www.pwcglobal.com/http://www.bloomberg.com/http://www.bloomberg.com/http://www.bloomberg.com/

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The MNCs

Capital Structure .ecision The overall capital structure of an MNC is

essentially a co$bination of the capital

structures of the parent body and itssubsidiaries"

The capital structure decision involves thechoice of debt versus e)uity financin*

and is influenced by both corporate and

country characteristics"

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The MNCs

Capital Structure .ecisionCorporate C#aracteristics

Stability of cas# flo&s.MNCs with $ore stable

cash flows can handle $ore debt" Credit risk.MNCs that have lower credit ris'

have $ore access to credit"

Access to retained earnin$s.6rofitable MNCsand MNCs with less rowth $ay be able to

finance $ost of their invest$ent with retained

earnins"

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The MNCs

Capital Structure .ecision

A$ency problems.2ost country

shareholders $ay $onitor a subsidiary*thouh not fro$ the parents perspective"

'uarantees on debt.3f the parent bac's

the subsidiarys debt* the subsidiary $aybe able to borrow $ore"

Corporate C#aracteristics

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Country C#aracteristics

Stock restrictions.MNCs in countries

where investors have less invest$entopportunities $ay be able to raise e)uity

at a lower cost"

Interest rates.MNCs $ay be able to obtainloanable funds %debt( at a lower cost inso$e countries"

The MNCs


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Country risk.3f the host overn$ent isli'ely to bloc' funds or confiscate assets*the subsidiary $ay prefer debt financin"

The MNCs


Stren$t# of currencies.MNCs tend to borrow

the host country currency if they expect it towea'en* so as to reduce their exposure to

exchane rate ris'"

Country C#aracteristics

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Ta" la&s.MNCs $ay use $ore local debt

financin if the local tax rates %corporatetax rate* withholdin tax rate* etc"( are

hiher"

The MNCs

Capital Structure .ecisionCountry C#aracteristics

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3nteraction 5etween Subsidiary

and 6arent +inancin .ecisionsIncreased debt financin$ by t#e subsidiary

# larer a$ount of internal funds $ay be

available to the parent"The need for debt financin by the parent $ay

be reduced"

The revised co$position of debt financin $ayaffect the interest chared on debt as well as

the MNCs overall exposure to exchane rate

ris'"

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and 6arent +inancin .ecisions%educed debt financin$ by t#e subsidiary

# s$aller a$ount of internal funds $ay be

available to the parent"The need for debt financin by the parent $ay

be increased"

The revised co$position of debt financin $ayaffect the interest chared on debt as well as

the MNCs overall exposure to exchane rate

ris'"

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#$ount of 3nternal #$ount of 9ocal .ebt +unds .ebt

2ost Country +inanced by #vailable +inanced

Conditions Subsidiary to 6arent by 6arent2iher Country 4is' 2iher 2iher 9ower

9ower 3nterest 4ates 2iher 2iher 9ower

xpected ?ea'ness 2iher 2iher 9ower of 9ocal Currency

5loc'ae of +unds 2iher 2iher 9ower

2iher Taxes 2iher 2iher 9ower


and 6arent +inancin .ecisions

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The volu$es of debt and e)uity issued infinancial $ar'ets vary across countries*

indicatin that fir$s in so$e countries%such as =apan( have a hiher deree of

financial leverae on averae"

2owever* conditions $ay chane over ti$e"

3n 8er$any for exa$ple* fir$s are shiftinfro$ local ban' loans to the use of debt

security and e)uity $ar'ets"

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3$pact of Multinational Capital Structure.ecisions on an MNCs @alue

( ) ( )[ ]( )

+

=

n

tt

m

$t$t$

k+=

+

99

+

E:EC;E=5a"ue

%C+()t ( - expected cash flows in

currency(to be received by the

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3ntroduction to the Cost of Capital0 Comparing the Costs of Equity and Debt


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Chapter 4eview

Cost of Capital for MNCs > continued0 Cost of Capita" Comparison ?sing the

C84M0 mp"ications of the C84M for an MNC6s

:isk

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Chapter 4eview

Costs of Capital #cross Countries0 Country Differences in the Cost of Debt

0 Country Differences in the Cost of Equity0 Combining the Costs of Debt and Equity

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Chapter 4eview

The MNCs Capital Structure .ecision0 nf"uence of Corporate Characteristics

0

nf"uence of Country Characteristics 3nteraction 5etween Subsidiary and 6arent

+inancin .ecisions

0 mpact of ncreased Debt ;inancing by the

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Chapter 4eview

ch17-versc_2

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