Cost of CapitalizationCost of Capitalization

Taking advantage of the capital market Taking advantage of the capital market imperfection M>N>C can lower the cost of imperfection M>N>C can lower the cost of capitalization.capitalization.

WACC = KeE/E+D + KdD/E+DWACC = KeE/E+D + KdD/E+D Cost of Equity = Ke = d/p+gCost of Equity = Ke = d/p+g Capital Asset Pricing Model = Ke = Rf + B*(Rm-Rf)Capital Asset Pricing Model = Ke = Rf + B*(Rm-Rf) Cost of Debt: Cy, Y-T-M, H.P.Y. W.A.Y.T.M. , ...Cost of Debt: Cy, Y-T-M, H.P.Y. W.A.Y.T.M. , ...

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MNC Influences Cost of MNC Influences Cost of Capitalization by:Capitalization by:

1. Availability of capital from domestic as well 1. Availability of capital from domestic as well as from international as from international – MNC have higher capacity to raise funds as extensions of

the MC curve making it easier to borrow more at a lower rate.

2. Market segmentation2. Market segmentation– if the required rate on a security in a market is different

from the required rate on a comparable security in an efficient capital market, the cost of capitalization will be lower if MNC has access to fully-integrated markets as it shifts the MC curve further down.

– Cost of capital varies as the amount of employed TD/TA increases; an after tax cost of capital decrease reduces the overall cost of capital after a certain level of perceived risk by the investor increases the cost of capital.

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3. Investor’s Premium for International 3. Investor’s Premium for International DiversificationDiversification– reduces the perceived risk by the investor and reduces the

cost of capitalization.

4. Managing Foreign Exchange Rate Risk and 4. Managing Foreign Exchange Rate Risk and Political RiskPolitical Risk

5. Taking Advantage of Tax Treaties5. Taking Advantage of Tax Treaties– MNC could be subject to taxation both home and abroad.– Retained earnings in foreign affiliate are not subject to

U.S. tax until they are reported, so it could reduce the cost of equity. Transfer pricing also affects the tax liability of MNC.

MNC Influences Cost of Capitalization by (con...):

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6. Disclosure of International Financial 6. Disclosure of International Financial StatementsStatements– improved financial disclosure will tend to increase the

relative weighting which investors place in favorable firm’s statistics relative to others, especially in capital formation from Eurocurrency Market.

– Rating of foreign bonds by Moody and S&P as asked by Japanese to help reduce risk for the investor.

7. Financial Structure of Different Countries7. Financial Structure of Different Countries– country debt ratio is different for different countries.

MNC Influences Cost of Capitalization by (con...):

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ExampleExampleWhen MNC issues foreign currency-dominated debt, its cost

of repaying the principal and interest in terms of patent’s own currency will be affected as follows:

If U.S. MNC borrows Deutschemarks for one year at 6% and the Mark increases interest of $ by 8%, the before tax cost of capital:

° Kc = interest on DM*additional interest to exchange rate change + additional principal due to exchange rate.

° If the interest rate in Germany = [(1.06*1.08)-1]*100 = 14.48% and if the tax rate is 54%, then the after tax cost of capital = 14.48%(1-.54) = 7.82%.

After tax expected dollar cost to foreign affiliate of one year foreign currency loan = r = (1-d)(1-t)-d, where r = interest rate, d = expected foreign currency devaluation to dollar and t = local tax.

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Advice on Avoidance of Excess Cost of Capitalization for MNCAdvice on Avoidance of Excess Cost of Capitalization for MNC

Under no condition should a firm borrow long-term in a foreign currency which has been eliminated.

Borrow long-term in foreign currency if you anticipate cash outflow on principal and interest is matched by anticipated operating receivable in the same currency.

Borrow for the purpose of diversifying long-term currency commitments.

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