2. 12 Multinational Capital Structure & Long Term Financing
Chapter Objectives
This chapter will:
Explain why the cost of capital of MNCs differs from that of domestic firms
Explain why there are differences in the costs of capital among countries
Explain how to account for the cost of capital when assessing new international projects
Explain how corporate and country characteristics are considered by an MNC when it establishes its capital structure
Explain the interaction between subsidiary and parent financing decisions 2

3. Background on Cost of Capital
Equity:
Cost of retained earnings: opportunity cost of what the existing shareholders could have earned if they had received dividends.
Cost of new common equity: opportunity cost of what the existing shareholders could have earned if they had invested their funds elsewhere
Debt:
Advantage: interest payments are tax deductible
Disadvantage: higher interest expense could lead to higher probability that the firm will be unable to meet expenses.

4. Comparing the Costs of Equity and Debt
where
kc weighted average cost of capital
D amount of the firm’s debt
kd before-tax cost of its debt
t corporate tax rate
E firm’s equity
ke cost of financing with equity 4

5. Domestic versus MNC Cost of Capital
Cost of capital for MNC may differ because of:
Size of firm
Access to international capital markets
International diversification
Exposure to exchange rate risk
Exposure to country risk

6. Exhibit 17.1 Searching for the Appropriate Capital Structure6

7. Exhibit 17.2 Summary of Factors That Cause the Cost of Capital of MNCs to Differ From That of Domestic Firms 7

8. Cost of Equity Comparison Using the CAPM
ke = Rf + B(Rm – Rf)
Where
ke = required return on stock
Rf = risk-free rate of return
Rm = market return
B = beta of stock

9. The CAPM
The CAPM suggests that required return is a positive function of:
The risk-free rate of interest
The market rate of return
The stock’s beta
Implications of the CAPM for an MNC’s risk:
MNC may have lower cost of capital than domestic firms
If financial markets are segmented, then MNC offer diversification benefits

10. Costs of Capital Across Countries
Country differences in the cost of debt
Differences in the risk-free rate
Differences in the risk premium
Comparative costs of debt across countries
Country differences in the cost of equity
Impact of the Euro
Combining the costs of debt and equity
Estimating the cost of debt and equity

11. Cost of Capital of Foreign Projects
Derive NPV based on the WACC
Adjust the WACC for the risk differential
Derive the Net Present Value of the Equity Investment

12. Net Present Value Considerations
Relationship between NPV and capital structure
Tradeoff when financing in developing countries
Accounting for multiple periods
Comparing alternative debt compositions
Assessing alternative exchange rate scenarios
Considering foreign stock ownership

13. The MNC’s Capital Structure Decision: Influence of Corporate Characteristics
Stability of MNC’s cash flows
MNC’s credit risk
MNC’s access to retained earnings
MNC’s guarantees on debt
MNC’s agency problems

14. The MNC’s Capital Structure Decision: Influence of Country Characteristics
Stock restrictions in host countries
Stock valuation in host countries
Interest rates in host countries
Strength of host countries
Strength of host country currencies
Country risk in host countries
Tax laws in host countries

15. Revising the Capital Structure
MNC may revise capital structure based on:
Discontinued business operations
Tax reductions in home country
Interest rates in foreign country increase
Interest rates in foreign country decrease
Political risk increases

16. Subsidiary versus Parent Capital Financing
Impact of subsidiary debt financing
Impact of reduced subsidiary debt financing
Limitations in offsetting a subsidiary’s leverage
Factors that affect subsidiary financing decisions

17. Exhibit 17.7 Effect of Global Conditions on Financing

18. Long-Term Financing Chapter Objectives This chapter will:
Explain how exchange rate movements affect the cost of long-term financing in foreign currencies
Explain how to reduce the exchange rate risk associated with debt financing in foreign currencies
C. Explain the exposure and hedging of interest rate risk due to debt financing

19. Long-Term Financing Decision
Sources of Equity
Domestic equity offering
Global equity offering
Private placement of equity in home country
Private placement of equity in foreign country
Sources of Debt
Public placement of debt in own country
Global debt offering
Private placement of debt in home country
Private placement of debt in foreign country
Stockholder versus Creditor Conflict 3

20. Cost of Debt Financing
To make long-term financing decision, the MNC must:
Determine the amount of funds needed
Forecast the price at which it can issue the bond
Forecast periodic exchange rate values for the currency denominating the bond 4

21. Measuring the Cost of Financing
Impact of a strong currency on financing costs: if the currency that was borrowed appreciates over time, an MNC will need more funds to cover the coupon or principal payments.
Impact of a weak currency on financing costs: a depreciating currency will reduce the issuer’s outflow payments and reduce financing costs. 5

22. Uncertainty of Financing Costs
Accounting for Uncertainty of Financing Costs by:
Sensitivity Analysis: develop alternative forecasts for exchange rates each period and reestimate cost of financing.
Simulation: develop a probability distribution for the exchange rate in each period and use a computer simulation program to iterate possible future scenarios.
Actual Financing Costs
Determine how exchange rate movements affected the costs of bonds denominated in a foreign currency. 6

23. Reducing Exchange Rate Risk
Offsetting cash inflows
Offsetting cash flows with high-yield debt
Forward contracts
Currency swaps
Parallel loans
Using parallel loans to hedge risk
Diversifying among currencies 7

24. Exhibit 18.7 Illustration of a Currency Swap

25. Interest Rate Risk from Debt Financing
The debt maturity decision: interest rates and the vary across maturities and across countries. Yield curve can be upward sloping, flat, or inverted in different countries.
The fixed versus floating decision: floating rate coupons can be tied to the London Interbank Offer Rate (LIBOR) 11

26. Hedging with Interest Rate Swaps
The plain vanilla swap: contract to exchange floating rate payments for fixed rate payments.
Determining swap payments: based on a notional principal but the principal itself is not exchanged.
Limitations of interest rate swaps:
Time and resources associated with searching for suitable swap candidate and negotiating terms
Risk that the counterparty could default on payments. 12

27. Exhibit 18.10 Illustration of an Interest Rate Swap

28. Other Types of Interest Rate Swaps
Accretion swap
Amortizing swap
Basis (floating-for-floating) swap
Callable swap
Forward swap
Putable swap
Zero-coupon swap
Swaption 14

29. Standardization of Swap Market
International Swaps and Derivatives Association (ISDA): a global trade association representing leading participants in the privately negotiated derivatives industry.
ISDA Master Agreement: provides a general legal document to standardize the derivatives market. 15