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  1. 1. Chapter 6 Multinational Cost of Capital & Capital Structure
  2. 2. 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. A17 - 2
  3. 3. 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. A17 - 3
  4. 4. Cost of Capital• A firm’s weighted average 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 E is the equity of the firm kd is the before-tax cost of its debt t is the corporate tax rate ke is the cost of financing with equity A17 - 4
  5. 5. Cost of Capital Problem• A firm’s weighted average cost of capital kc = ( D ) k (1 _ t ) + ( E ) k d e D+E D+E If debt D = 30 and Equity E = 70, return on debt = 10%, return on equity = 15% and tax rate = 30% Calculate company cost of capital. A17 - 5
  6. 6. Cost of Capital - Solution• (30/100) * 10( 1- 0.30) + ( 70/100) * 15• = (0.30 * 7.00) + (0.7 * 15) = 2.10 + 10.5 = 12.6% A17 - 6
  7. 7. 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. A17 - 7
  8. 8. 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. A17 - 8
  9. 9. 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. M NCs may have more stable cash inflows due to international diversification, such that their probability of bankruptcy may be lower. A17 - 9
  10. 10. 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. M NCs that have a higher percentage of assets invested in foreign countries are more exposed to country risk. A17 - 10
  11. 11. 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 + β (Rm – Rf ) where ke = the required return on a stock Rf = risk-free rate of return Rm = market return β = the beta of the stock A17 - 11
  12. 12. 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. A17 - 12
  13. 13. 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. A17 - 13
  14. 14. 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. A17 - 14
  15. 15. 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. A17 - 15
  16. 16. 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. A17 - 16
  17. 17. 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. A17 - 17
  18. 18. 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. A17 - 18
  19. 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. A17 - 19
  20. 20. 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. A17 - 20
  21. 21. Risk and Return – Portfolio Theory• Harry Markowitz’s portfolio theory can be used to estimate returns required by investors in different stock market investments. Investor can reduce standard deviation of portfolio returns by choosing stocks that do not move exactly together. A17 - 21
  22. 22. Portfolio theory• Suppose investment in shares of Coca-cola or Reebok has to be made. Reebok offers an expected return of 20% and Coca-cola 10%. Std. deviation of returns is 31.5% for Coca-cola and 58.5% for Reebok. The correlation between the returns of coca-coal and Reebok has been 0.20.• What will be the expected return on the portfolio and what will be the portfolio standard deviation, if it is decided to invest 65% in Coca-cola and 35% in Reebok. A17 - 22
  23. 23. Two security case• Portfolio risk can be formally defined as σp =• √X σ + X σ 2 x 2 x 2 y 2 y + 2XxX (rx σx σ ) y y y• Where σp = Portfolio standard deviationXx X =% of total portfolio value in stock X,Y yσx ,σy = Standard deviation of stock X and Y and rxy = correlation coefficient of X and Y• Note :rxy σx σ = Cov y xy A17 - 23
  24. 24. Expected return - Solution• Reebok expected return = 20%• Coca cola = 10%• Investment in Reebok = 35%• Investment in Coca Cola = 65%• Expected return on portfolio =• (0.35 x 0.20) + (0.65 x 0.10) = 0.07 + 0.065 = 0.135 = 13.5% A17 - 24
  25. 25. Solution• Variance = [(0.652) x (31.52)] +• [(0.352) x (58.52)] +• 2(0.65 x 0.35 x 0.2 x 31.5 x 58.5)• = 1006.1• Std.deviation = 31.7 A17 - 25
  26. 26. 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. A17 - 26
  27. 27. 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. A17 - 27
  28. 28. The MNC’s Capital Structure DecisionCorporate 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. A17 - 28
  29. 29. The MNC’s Capital Structure DecisionCorporate 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. A17 - 29
  30. 30. The MNC’s Capital Structure DecisionCountry 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. A17 - 30
  31. 31. The MNC’s Capital Structure DecisionCountry 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. A17 - 31
  32. 32. The MNC’s Capital Structure DecisionCountry Characteristics• Tax laws. MNCs may use more local debt financing if the local tax rates (corporate tax rate, withholding tax rate, etc.) are higher. A17 - 32
  33. 33. 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      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 A17 - 33
  34. 34. 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 A17 - 34
  35. 35. Chapter Review• Cost of Capital for MNCs … continued ¤ Cost of Capital Comparison Using the CAPM ¤ Implications of the CAPM for an MNC’s Risk A17 - 35