Multinational Finance

1
Multinational Finance

• Multinational Cost of Capital

2
Outline

• Objectives
• Cost of Capital
• Cost of Debt
• Cost of Equity

3
Objectives

• To explain how corporate and country
  characteristics influence an MNCs cost of
  capital.
• To explain why there are differences in the costs
  of capital across countries.
• To explain how corporate and country
  characteristics are considered by an MNC when it
  establishes its capital structure.

4
Cost of Capital

• A firms 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.

5
Cost of Capital Formula

• A firms weighted average cost of capital
• kc ( D ) kd ( 1 _ t ) ( E )
  ke
• D E
  D E
• 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

6
Background on Cost of Capital

• A firms capital consists of equity (retained
  earnings and funds obtained by issuing stock) and
  debt (borrowed funds).
• There is an advantage to using debt rather than
  equity as capital because the interest payments
  on debt are tax deductible.

7
Background on 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.

8
Cost of Capital for MNCs versus Domestic Firms

• The cost of capital for MNCs may differ from that
  for domestic firms because of the following
  differences.
• 1. Size of Firm.
• 2. Access to International Capital Markets.
• 3. International Diversification.
• 4. Exposure to Exchange Rate Risk.
• 5. Exposure to Country Risk.

9
Costs of Capital Across Countries

• The cost of capital may vary across countries
  because of these factors
• The cost of debt may vary across countries.
• The risk-free rate may vary across countries.
• The risk premium may vary across countries.
• The cost of equity may vary across countries.
• Opportunity costs

10
Cost of Equity

• To assess how required rates of return of MNCs
  differ from those of purely domestic firms, the
  CAPM can be applied.
• The CAPM suggests that the required return on a
  firms stock is a positive function of (1)the
  risk-free rate of interest,(2)the market rate of
  return and (3)the stocks beta
• The beta represents the sensitivity of the
  stocks returns to market returns

11
Cost of Equity

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

12
Cost of Equity

• Unsystematic risks vs. systematic risks.
• Capital asset pricing theory would suggest that
  the MNC cost of capital is generally lower than
  that of domestic firms.
• Since markets are becoming most integrated over
  time, one could argue that a world market is more
  appropriate than a U.S. market for US-based MNCs.
• MNCs may attempt to take full advantage of the
  favorable aspects that reduce its cost of
  capital.

13
The MNCs 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.

14
The MNCs Capital Structure Decision

• Influence of corporate concerns
• Stability of MNCs cash flows / profitability
• MNCs credit risk
• MNCs access to earnings
• Debt guarantees by parent
• Agency problems

15
The MNCs Capital Structure Decision

• Influence of country concerns
• Interest rates
• Investment opportunities
• F/X concerns
• Country risk
• Tax laws

16
The MNCs Capital Structure Decision

• When they exhibit such corporate characteristics
  as predictable cash flows, low credit risk, and
  limited access to retained earnings, an MNC may
  prefer to use a greater percentage of debt in its
  capital structure.

17
The MNCs Capital Structure Decision

• When they are subject to such international
  concerns as a high degree of country risk, weak
  local currencies, high taxes and low interest
  rates, an MNC may prefer to use a greater
  percentage of debt in its capital structure.

18
Conclusion

• 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

19
Conclusion

• Cost of Capital for MNCs continued
• Cost of Capital Comparison Using the CAPM
• Implications of the CAPM for an MNCs Risk
• Costs of Capital Across Countries
• Using the Cost of Capital for Assessing Foreign
  Projects
• The MNCs Capital Structure Decision

20
Problems

• Lets try a few problems!