Multinational Cost of Capital & Capital Structure 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.

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.

kc = ( D ) kd ( 1 _ t ) + ( E ) ke 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

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.

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

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.

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.

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.

Cost of Capital for MNCs Possible access to low-cost foreign financing Preferential treatment from creditors Greater access to international capital markets Larger size International diversification Exposure to exchange rate risk Exposure to country risk Cost of capital Probability of bankruptcy

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 = the required return on a stock Rf = risk-free rate of return Rm = market return b = the beta of the stock

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.

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.

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.

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.

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.

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.

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.

Costs of Capital Across Countries Canada U.S. Germany Japan Costs of Debt (%)

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.

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.

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.

Online Application For country-specific information, visit: http://www.bloomberg.com/ http://www.pwcglobal.com http://www.morganstanley.com/gef/ http://www.worldbank.org/data/ http://biz.yahoo.com/ifc/

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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 Expected Weakness Higher Higher Lower of Local Currency Blockage of Funds Higher Higher Lower Higher Taxes Higher Higher Lower

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.

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.

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.

Impact of Multinational Capital Structure Decisions on an MNC’s Value 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 Parent’s Capital Structure Decisions

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

Chapter Review Cost of Capital for MNCs … continued Cost of Capital Comparison Using the CAPM Implications of the CAPM for an MNC’s Risk

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

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

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