17
Chapter
Multinational Cost of Capital
& Capital Structure
South-Western/Thomson Learning © 2003
Chapter Objectives
• To explain how corporate and
country characteristics influence an
MNC’s 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 firm’s 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
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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Cost of Capital
• A firm’s weighted average cost of capital
kc = ( D ) kd (1 _ t ) + ( E ) ke
D+E
where D
E
kd
t
ke
D+E
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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Cost of Capital
• The interest payments on debt are tax
deductible. However, as interest expenses
increase, the probability of bankruptcy will
increase too.
• It is favorable to increase the use of debt
financing until the point at which the
bankruptcy probability becomes large
enough to offset the tax advantage of
using debt.
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Cost of Capital
Cost of Capital
Debt’s Tradeoff
Debt Ratio
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Cost of Capital for MNCs
• The cost of capital for MNCs may differ
from that for domestic firms because of
the following differences.
 Size of Firm. Because of their size, MNCs
are often given preferential treatment by
creditors. They can usually achieve
smaller per unit flotation costs too.
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Cost of Capital for MNCs
 Acess to International Capital Markets.
MNCs are normally able to obtain funds
through international capital markets,
where the cost of funds may be lower.
 International Diversification. MNCs may
have more stable cash inflows due to
international diversification, such that
their probability of bankruptcy may be
lower.
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Cost of Capital for MNCs
 Exposure to Exchange Rate Risk. MNCs
may be more exposed to exchange rate
fluctuations, such that their cash flows
may be more uncertain and their
probability of bankruptcy higher.
 Exposure to Country Risk. MNCs that
have a higher percentage of assets
invested in foreign countries are more
exposed to country risk.
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Cost of Capital for MNCs
Larger size
Greater access
to international
capital markets
Preferential
treatment from
creditors
International
diversification
Possible
access to lowcost foreign
financing
Exposure to
exchange rate
risk
Probability of
bankruptcy
Cost of
capital
Exposure to
country risk
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Cost of Capital for MNCs
• 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.
• According to 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 Capital for MNCs
• A stock’s beta represents the sensitivity of
the stock’s returns to market returns, just
as a project’s beta represents the
sensitivity of the project’s cash flows to
market conditions.
• The lower a project’s 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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Cost of Capital for MNCs
• An MNC that increases its foreign sales
may be able to reduce its stock’s beta, and
hence the return required by investors.
This translates into a lower overall cost of
capital.
• However, MNCs may consider
unsystematic risk as an important factor
when determining a foreign project’s
required rate of return.
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Cost of Capital for MNCs
• Hence, we cannot be certain if an MNC will
have a lower cost of capital than a purely
domestic firm in the same industry.
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Costs of Capital Across Countries
• The cost of capital may vary across
countries, such that:
 MNCs based in some countries may 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 may have
a more debt-intensive capital structure.
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Costs of Capital Across Countries
• The cost of debt to a firm is primarily
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 and demand for
funds. It may vary due to different tax
laws, demographics, monetary policies,
and economic conditions.
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Costs of Capital Across Countries
• The risk premium compensates creditors
for the risk that the borrower may be
unable to meet its payment obligations.
• The risk premium may vary due to
different economic conditions,
relationships between corporations and
creditors, government intervention, and
degrees of financial leverage.
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Costs of Capital Across Countries
• Although the cost of debt may vary across
countries, there is some positive
correlation among country cost-of-debt
levels over time.
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Costs of Capital Across Countries
Costs of Debt (%)
14
12
Canada
10
U.S.
8
6
4
Japan
2
0
1990
Germany
1992
1994
1996
1998
2000
2002
B17 - 19
Costs of Capital Across Countries
• A country’s cost of equity represents an
opportunity cost – what the shareholders
could have earned on investments with
similar risk if the equity funds had been
distributed to them.
• The return on equity can be measured by
the risk-free interest rate plus a premium
that reflects the risk of the firm.
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Costs of Capital Across Countries
• A country’s cost of equity can also be
estimated by applying the price/earnings
multiple to a given stream of earnings.
• A high price/earnings multiple implies that
the firm receives a high price when selling
new stock for a given level of earnings.
So, the cost of equity financing is low.
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Costs of Capital Across Countries
• The costs of debt and equity can be
combined, using the relative proportions
of debt and equity as weights, to derive an
overall cost of capital.
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Using the Cost of Capital
for Assessing Foreign Projects
• Foreign projects may have risk levels
different from that of the MNC, such that
the MNC’s weighted average cost of
capital (WACC) may not be the appropriate
required rate of return.
• 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.
¤
The probability distribution of NPVs can be
computed to determine the probability that
the foreign project will generate a return
that is at least equal to the firm’s WACC.
 Adjust the WACC for the risk differential.
¤
The MNC may estimate the cost of equity
and the after-tax cost of debt of the funds
needed to finance the project.
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The MNC’s
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 MNC’s
Capital Structure Decision
Corporate Characteristics
• Stability of cash flows. MNCs with more
stable cash flows can handle more debt.
• Credit risk. MNCs that have lower credit
risk have more access to credit.
• Access to retained earnings. Profitable
MNCs and MNCs with less growth may be
able to finance most of their investment
with retained earnings.
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The MNC’s
Capital Structure Decision
Corporate Characteristics
• Guarantees on debt. If the parent backs
the subsidiary’s debt, the subsidiary may
be able to borrow more.
• Agency problems. Host country
shareholders may monitor a subsidiary,
though not from the parent’s perspective.
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The MNC’s
Capital Structure Decision
Country Characteristics
• Stock restrictions. MNCs in countries
where investors have less investment
opportunities may be able to raise equity
at a lower cost.
• Interest rates. MNCs may be able to obtain
loanable funds (debt) at a lower cost in
some countries.
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The MNC’s
Capital Structure Decision
Country Characteristics
• Strength of currencies. MNCs tend to
borrow the host country currency if they
expect it to weaken, so as to reduce their
exposure to exchange rate risk.
• Country risk. If the host government is
likely to block funds or confiscate assets,
the subsidiary may prefer debt financing.
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The MNC’s
Capital Structure Decision
Country Characteristics
• Tax laws. MNCs may use more local debt
financing if the local tax rates (corporate
tax rate, withholding tax rate, etc.) are
higher.
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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.
 The
need for debt financing by the parent
may be reduced.
• The revised composition of debt financing
may affect the interest charged on debt as
well as the MNC’s overall exposure to
exchange rate risk.
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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.
 The
need for debt financing by the parent
may be increased.
• The revised composition of debt financing
may affect the interest charged on debt as
well as the MNC’s overall exposure to
exchange rate risk.
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Interaction Between Subsidiary
and Parent Financing Decisions
Host Country
Conditions
Amount of
Internal
Local Debt
Funds
Financed by Available
Subsidiary to Parent
Amount of
Debt
Financed
by Parent
Higher Country Risk
Lower Interest Rates
Higher
Higher
Higher
Higher
Lower
Lower
Expected Weakness
of Local Currency
Blockage of Funds
Higher Taxes
Higher
Higher
Lower
Higher
Higher
Higher
Higher
Lower
Lower
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Using a Target Capital Structure
on a Local versus Global Basis
• An MNC may deviate from its “local”
target capital structure as necessitated by
local conditions.
• However, the proportions of debt and
equity financing in one subsidiary may be
adjusted to offset an abnormal degree of
financial leverage in another subsidiary.
• Hence, the MNC may still achieve its
“global” target capital structure.
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Using a Target Capital Structure
on a Local versus Global Basis
• Note that a capital structure revision may
result in a higher cost of capital.
• Hence, an unusually high or low degree of
financial leverage should only be adopted
if the benefits outweigh the overall costs.
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Using a Target Capital Structure
on a Local versus Global Basis
• The volumes of debt and equity issued in
financial markets vary across countries,
indicating that firms in some countries
(such as Japan) have a higher degree of
financial leverage on average.
• However, conditions may change over
time. In Germany for example, firms are
shifting from local bank loans to the use
of debt security and equity markets.
B17 - 36
Impact of Multinational Capital Structure
Decisions on an MNC’s Value
Parent’s Capital Structure
Decisions
m

E CFj , t  E ER j , t 
n 
 j 1

Value =  

t
1  k 
t =1 



E (CFj,t ) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k
= weighted average cost of capital of the parent
B17 - 37
Chapter Review
• Introduction to the Cost of Capital
¤
Comparing the Costs of Equity and Debt
• Cost of Capital for MNCs
- Size of Firm
- Access to International Capital Markets
- International Diversification
- Exposure to Exchange Rate Risk
- Exposure to Country Risk
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Chapter Review
• Cost of Capital for MNCs … continued
¤
¤
Cost of Capital Comparison Using the
CAPM
Implications of the CAPM for an MNC’s
Risk
B17 - 39
Chapter Review
• Costs of Capital Across Countries
¤
¤
¤
Country Differences in the Cost of Debt
Country Differences in the Cost of Equity
Combining the Costs of Debt and Equity
• Using the Cost of Capital for Assessing
Foreign Projects
¤ Derive NPVs Based on the WACC
¤ Adjust the WACC for the Risk Differential
B17 - 40
Chapter Review
• The MNC’s Capital Structure Decision
¤
¤
Influence of Corporate Characteristics
Influence of Country Characteristics
• Interaction Between Subsidiary and Parent
Financing Decisions
¤ Impact of Increased Debt Financing by the
Subsidiary
¤ Impact of Reduced Debt Financing by the
Subsidiary
B17 - 41
Chapter Review
• Using a Target Capital Structure on a
Local versus Global Basis
¤ Offsetting a Subsidiary’s Abnormal Degree
of Financial Leverage
¤ Limitations of Offsets
¤ Differences in Financing Tendencies
Among Countries
• Impact of Capital Structure Decisions on
an MNC’s Value
B17 - 42