Chapter 15 Multinational Capital Structure and Cost of Capital

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Chapter 15Multinational Capital Structure and
Cost of Capital
Learning objectives ? The MNCs optimal capital
structure ? Project valuation and the cost of
capital The impact of market
imperfections WACC versus APV Systematic
versus unsystematic risks ? Sources of funds
for multinational operations ? The international
evidence
Butler, Multinational Finance, 4e
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Capital structure

• Capital structure refers to the proportion of
  long-term debt and equity capital and the
  particular forms of capital chosen to finance the
  assets of the firm

The MNCs optimal capital structure
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Capital structure

• Managers must choose
• The proportions of debt and equity
• Features of the instruments
• Debt - fixed or floating rate interest payments,
  indenture provisions, conversion features,
  callability, seniority, and maturity
• The location(s) where securities are issued
• The currency of denomination

The MNCs optimal capital structure
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The MNCs financing opportunities
The MNCs optimal capital structure
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The weighted average cost of capital
The MNCs optimal capital structure
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The MNCs cost of capital
The MNCs optimal capital structure
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Optimal capital structure

• Far better an approximate answer to the
• right question, which is often vague,
• than an exact answer to a wrong question,
• which can always be made precise.
• John W. Tukey

The MNCs optimal capital structure
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The perfect market assumptions

• Frictionless markets
• No transaction costs, taxes, government
  intervention, agency costs, or costs of financial
  distress
• Equal access to market prices
• Everyone is a price taker
• Rational investors
• Return is good and risk is bad
• Equal access to costless information

Project valuation and the cost of capital
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MMs irrelevance proposition

• With equal access to perfect financial markets,
  individuals can replicate any financial action
  that the firm can take.
• This leads to Modigliani-Millers famous
  irrelevance proposition
• If financial markets are perfect, then corporate
  financial policy is irrelevant.

Project valuation and the cost of capital
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The converse of MMs irrelevance proposition

• V St ECFt / (1i)t
• If financial policy is to increase value, then it
  must either
• increase expected future cash flows
• decrease the discount rate
• in a way that cannot be replicated by individual
  investors.

Project valuation and the cost of capital
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Financial market integration

• In an integrated financial market, real after-tax
  rates of return on equivalent assets are equal

Project valuation and the cost of capital
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Factors leading tofinancial market segmentation

• Different legal and political systems
• Prohibitive transactions costs
• Regulatory interference
• Differential taxes
• Informational barriers
• Differential investor expectations
• Home asset bias
• (a preference for domestic assets)

Project valuation and the cost of capital
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Project valuation cost of capital

• Two approaches to project valuation
• WACC Weighted average cost of capital
• APV Adjusted present value
• Use an asset-specific discount rate
• Nominal cash flows should be discounted at a
  nominal discount rate
• Real cash flows should be discounted at a real
  discount rate
• Domestic currency cash flows should be a
  discounted at a domestic currency discount rate
• Foreign currency cash flows should be a
  discounted at a foreign currency discount rate

Project valuation and the cost of capital
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Weighted average cost of capital(WACC)

• NPV St ECFt / (1iWACC)t
• iWACC (B/(BS)) iB (1-TC) (S/(BS))iS
• B the market value of corporate bonds
• S the market value of corporate stock
• iB required return on corporate bonds
• iS required return on corporate stock
• TC marginal corporate tax rate

Project valuation and the cost of capital
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Adjusted present value(APV)

• APV VU PV(financing side effects)
• initial investment
• where
• VU the value of the unlevered or all-equity
  project
• PV(financing side effects)
• value of tax shields from the use of debt,
  net of the expected costs of financial distress

Project valuation and the cost of capital
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Systematic vs unsystematic risks

• Only systematic or nondiversifiable operating
  risks should be reflected in capital costs
• Capital costs are increased if these risks are
  positively related to the market portfolio
• Capital costs are decreased if these risks are
  negatively related to the market portfolio
• Operating risks that are unsystematic or
  diversifiable should not be priced by investors
  and should not be reflected in capital costs

Project valuation and the cost of capital
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Country risks and equity returns

• Equity returns are related to country risks
• Erb, Harvey and Viskanta find
• Prices go up (down) following a decrease
  (increase) in country risk
• Countries with high country risk tend to have
  more volatile returns
• Countries with high country risk tend to have
  lower betas (systematic risks)
• Erb, Harvey, Viskanta, Political Risk,
  Financial Risk Economic Risk, Financial
  Analysts Journal, 1996.

Project valuation and the cost of capital
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Liberalizations and the cost of capital

• Liberalizations tend to benefit firms and
  investors in the liberalized market
• Financial market liberalizations tend to
• Increase the correlation of emerging market and
  world market returns
• Have little impact on emerging market return
  volatility
• Decrease local firms capital costs by as much as
  1 percent
• Bekaert Harvey, Foreign Speculators and
  Emerging Equity Markets, Journal of Finance,
  2000.

Project valuation and the cost of capital
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http//www.ibbotson.com/

• International CAPM Eri rF bi (rworld - rF)
• Globally Nested CAPM Eri is a function of
  systematic country risk plus regional systematic
  risk not included in the world factor
• Country Risk Rating Model Eri based on country
  credit risk
• Country-Spread Model Adds a country-specific
  spread to a conventional cost of equity estimate
• Relative Standard Deviation Model Countries are
  assigned an equity premia in proportion to their
  standard deviation relative to the U.S.

Project valuation and the cost of capital
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Sources of funds for MNCs

• The financial pecking order
• Internal sources of funds are preferred by most
  managers
• External sources of funds are accessed only after
  internal sources are exhausted
• External debt is the preferred external funding
  source
• External equity is used only as a last resort

Sources of funds for multinational operations
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Sources of funds for foreign ops

• Adapted from Feldstein, The Effects of Outbound
  Foreign Direct Investment on the Domestic Capital
  Stock, in The Effects of Taxation on
  Multinational Corporations, edited by Feldstein,
  Hines, and Hubbard, 1995.

Sources of funds for multinational operations
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MNC sources of funds

• Internal sources External sources
• MNCs home Cash flow from New debt or equity
• country parent affiliates financing (perhaps
• in the parents issued or guaranteed
• home country by the parent firm)
• Foreign Cash flow from Local debt or equity
• projects existing operations from institutions
  or
• host country in the host country markets in
  the host
• country
• International Cash flow from Project finance
• financing other foreign Eurobonds
• sources affiliates Euroequity

Sources of funds for multinational operations
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Registered vs bearer securities

• Securities in the United States and Japan are
  issued in registered form
• The convention in Western European countries is
  to issue securities in bearer form

Sources of funds for multinational operations
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Targeted registered offerings

• Targeted registered offerings allow U.S.
  corporations to issue bearer securities to
  international investors
• Owner must be a financial institution
• Interest or dividends are paid to a registered
  institution
• Issuer certifies it has no knowledge of US
  taxpayers owning the security
• Issuer and the registered foreign institutions
  must follow SEC certification procedures

Sources of funds for multinational operations
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Global equity issues

• Domestic markets tend to react negatively to
  equity issues, including IPOs SEOs, in both the
  short and long run
• The usual explanation is that equity issues
  signal managers beliefs that equity is
  overvalued
• Global equity offerings do not appear to suffer
  the same degree of post-issuance underperformance
  as domestic issues

Sources of funds for multinational operations
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Project finance

• Project financing allows a project sponsor to
  raise external funds for a specific project
• Distinguishing characteristics
• The project is a separate legal entity and relies
  heavily on debt financing
• The debt is contractually linked to the cash flow
  generated by the project
• Governments participate through infrastructure
  support, operating or financial guarantees,
  rights-of-way, or assurances against political
  risk

Sources of funds for multinational operations
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The international evidenceon capital structure

• Leverage increases with
• Asset tangibility
• Firm size
• Leverage decreases with
• Growth opportunities
• Profitability, esp. in emerging markets
• Rajan and Zingales (What Do We Know about
  Capital Structure? Some Evidence from
  International Data, Journal of Finance, 1995.

The international evidence on capital structure