Multinational Cost of Capital & Capital Structure Rashedul Hasan

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.

Cost of Capital A firm’s weighted average cost of capital kc = ( D ) kd ( 1 _ t ) + ( E ) ke 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

Debt’s Tradeoff There is an advantage to using debt rather than equity as capital because the interest payment on debts are tax deductible. The greater the use of debts, the greater the interest expenses and the higher the probability that the firm will be unable to meet its expenses. However, as interest expenses increase, the probability of bankruptcy will increase too. The tradeoff between debt’s advantage (tax deductibility of interest expenses) and its disadvantage (increased probability of bankruptcy) is illustrated as follows,

Debt’s Tradeoff Debt’s Tradeoff Cost of Capital Debt Ratio

Debt’s Tradeoff The firm’s cost of capital initially decreases as the ratio of debt to total capital increases. However, after some point, the cost of capital rises as the ratio of debt to total capital increase. This suggest that, the firm should 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. To go beyond that point would increase the firm’s overall cost of capital.

The cost of Capital for MNCs  q       Size of Firm. Because of their size, MNCs are often given preferential treatment by creditors. Thereby can reduce the cost of capital. They can usually achieve smaller per unit flotation costs too. q       Access to International Capital Markets. MNCs are normally able to obtain funds through international capital markets, where the cost of funds may be lower. In addition, subsidiaries may be able to obtain funds locally at a lower cost than that available to the parent if the prevailing interest rates in the host country are relatively low.