Ch07-VersC.ppt

(1)

Multinational Cost of Capital

& Capital Structure

Multinational Cost of Capital

& Capital Structure

17

(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

(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

(4)

•

A firm’s weighted average cost of capital

k_c = ( D ) k_d (1 _ t ) + ( E ) k 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

(5)

•

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.

(6)

Debt’s Tradeoff

Cost of Capital

C

o

st

o

f

C

ap

it

al

(7)

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

(8)

 _{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.

(9)

 _{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.

(10)

Cost of Capital for MNCs

Possible access to

(11)

• 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, k_e = R_f + (R_m – R_f)

where k_e = the required return on a stock

R_f = risk-free rate of return

R_m = market return

 = the beta of the stock

(12)

•

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.

(13)

•

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.

(14)

•

Hence, we cannot be certain if an MNC will have a lower cost of capital than a purely domestic firm in the same industry.

(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}

(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

(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,

(18)

Costs of Capital Across Countries

•

Although the cost of debt may vary across countries, there is some positive

(19)

Costs of Capital Across Countries

0 2 4 6 8 10 12 14

1990 1992 1994 1996 1998 2000 2002

(20)

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.

(21)

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.

(22)

Costs of Capital Across Countries

•

The costs of debt and equity can be

(23)

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

(24)

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}

(25)

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,

(26)

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

(27)

The MNC’s

Capital Structure Decision

•

Agency problems. Host country

shareholders may monitor a subsidiary, though not from the parent’s perspective.

•

Guarantees on debt. If the parent backs the subsidiary’s debt, the subsidiary may be able to borrow more.

(28)

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

(29)

•

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

•

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.

(30)

•

Tax laws. MNCs may use more local debt financing if the local tax rates (corporate tax rate, withholding tax rate, etc.) are

higher.

The MNC’s

Capital Structure Decision

(31)

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.

(32)

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.

(33)

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

(34)

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.

(35)

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.

(36)

•

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.

(37)

C17 - 37

Impact of Multinational Capital Structure

Decisions on an MNC’s Value



 













               n t t m j t j t j k 1 = 1 , , 1 ER E CF E = Value

E (CF_j,t) = expected cash flows in currency j to

be received by the U.S. parent at the end of

period t

E (ER_j,t) = expected exchange rate at which

currency j can be converted to dollars at the end

(38)

•

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

(39)

Chapter Review

•

Cost of Capital for MNCs … continued

¤ Cost of Capital Comparison Using the

CAPM

¤ Implications of the CAPM for an MNC’s

(40)

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}

(41)

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}

(42)

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