Multinational Cost of Capital & Capital Structure
Multinational Cost of Capital & Capital Structure
Multinational Cost of Capital & Capital Structure
17
Multinational Cost of Capital
& Capital Structure
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Cost of Capital
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Cost of Capital
kc = ( D )k (1_t) + ( E )k
d e
D+E D+E
where D is the amount of debt of the firm
Eis the equity of the firm
kdis the before-tax cost of its debt
tis the corporate tax rate
keis the cost of financing with equity
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Cost of Capital
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Cost of Capital
Debt’s Tradeoff
Cost of Capital
Debt Ratio
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Cost of Capital for MNCs
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Cost of Capital for MNCs
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Cost of Capital for MNCs
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Cost of Capital for MNCs
Larger size Preferential
treatment from
Greater access creditors
to international
capital markets Possible
access to low- Cost of
International cost foreign capital
diversification financing
Exposure to
exchange rate Probability of
risk bankruptcy
Exposure to
country risk
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Cost of Capital for MNCs
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Cost of Capital for MNCs
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Cost of Capital for MNCs
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Cost of Capital for MNCs
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Costs of Capital Across Countries
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Costs of Capital Across Countries
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Costs of Capital Across Countries
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Costs of Capital Across Countries
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Costs of Capital Across Countries
14
12 Canada
Costs of Debt (%)
10
U.S.
8
6
4
Germany
2 Japan
0
1990 1992 1994 1996 1998 2000 2002
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Costs of Capital Across Countries
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Costs of Capital Across Countries
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Costs of Capital Across Countries
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Online Application
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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.
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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
Amount of Internal Amount of
Local Debt Funds Debt
Host Country Financed by Available Financed
Conditions Subsidiary to Parent by Parent
Higher Country Risk Higher Higher Lower
Lower Interest Rates Higher Higher 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.
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Impact of Multinational Capital Structure
Decisions on an MNC’s Value
Parent’s Capital Structure
Decisions
m
n ∑
[
E ( CFj , t ) × E (ER j , t ) ]
j =1
Value = ∑
t =1 ( 1 + k ) t
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Chapter Review
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Chapter Review
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Chapter Review
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Chapter Review
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