COST OF CAPITAL OF MNC

Name: Sheshank Phadte

Seat No. : 285-2016

Admission No. : 1606

Class: M.Com Part-II

Subject: International financial

Management

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 INDEX
Sr. Title Page no.
No.
Introduction
1. Cost of capital and international financial
environment
2. MNC’S cost of capital
3. Costs of capital across countries

4. Cost of debt
5. Cost of equity
6. Combining cost debt and equity
7. Combining the costs of debt and equity
8. Cost of borrowing
9. Tax implication on cost of capital to
subsidiary and parent company
10. Conclusion
Bibliography

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1. INTRODUCTION
A central question for multinational corporations is whether the required rate of return on foreign
projects should be higher, lower, or the same as that for domestic projects. To answer this
question, we must examine the issue of cost of capital for multinational firms, one of the most
complex issues in international financial management. Yet it is an issue that must be addressed,
because the foreign investment decision cannot be made properly without knowledge of the
appropriate cost of capital.

The cost of capital for a given investment is the minimum risk-adjusted return required by
shareholders of the firm for undertaking that investment. As such, it is the basic measure of
financial performance. Unless the investment generates sufficient funds to repay suppliers of
capital, the firm's value will suffer. This return requirement is met only if the net present value of
future project cash flows, using the project's cost of capital as the discount rate, is positive.
Because cost-of-capital measures for multinational firms are to be used as discount rates to aid in
the global resource-allocation process, the rates must reflect the value to firms of engaging in
specific activities. Thus, the emphasis here is on the cost of capital or required rate of return for a
specific foreign project rather than for the firm as a whole. Unless the financial structures and
commercial risks are similar for a1l projects engaged in, the use of a single overall cost of capital
for project evaluation is incorrect. Different discount rates should be used to value projects that
are expected to change the risk complexion of the firm.

2. COST OF CAPITAL AND INTERNATIONAL FINANCIAL ENVIRONMENT

A multinational corporation operates in multi-economic environment comprising of
international, host country, and domestic financial environment. Therefore, the cost of capital for
a multinational firm can be affected by any of the factors present in these environments. In
general, following factors affect the cost of capital:

1. The availability of capital: In multinational environment, the firm has access to domestic and
international financial markets, thereby its access to liquidity increases and firm can
choose capital with lower cost of capital.

2. Segmented markets: Segmented national capital markets can distort the cost of capital for the
firms domiciled in these markets. The segmentation of markets is created by the barriers

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 to free flow of capital. In developing countries capital account out flows are restricted
therefore inflows also get restricted and the cost of capital rises.

3. Political risk adjustment: Cost of capital of every foreign project is to be adjusted for
political risk. This risk is additional to other project specific risks. This makes the asking
rate of return to rise.

4. Taxation policies: Taxation policies of both the home and host government affect the cost of
capital. The firm has to consider how a firm should include tax considerations when
sourcing funds and making financial structure decisions.
5. Financial disclosures and cost of capital: The firm’s financial disclosures for obtaining
funds from international market affect the cost of capital. Various capital markets have different
disclosure norms. The market where disclosure norms are well defined and are strictly
implemented, the asking rate or return falls because of less degree of risk therefore in these
markets the cost of capital declines. American disclosure norms are stringent consequently most
of Indian companies follow GDR route to obtain capital from American capital market.

6. Optimal financial structure: Multinational operations may change a firm’s optimal financial
structure. The added international availability of capital and ability to diversify cash
flows internationally affects the firms optimal debt ratio.

7. International and host country lending norms: The financial structure of affiliates have to
take into account the lending norms of international agencies or host country and a
compromise has to be reached to reflect affiliate’s need of liquidity, minimization of
foreign exchange and political risk, fulfilling of legal requirements and the tax
minimization. All these necessities increase the cost of capital.

3. MNC’S COST OF CAPITAL

There are two issues to be examined by an MNC’S, unlike the domestic corporates; first question
is whether the required rate of return is higher than the cost of capital and second question
whether the required rate of return on foreign projects is higher than on domestic projects, after
adjustment for inflation and currency depreciation. Foreign investment proposal cannot be made

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without the knowledge of the cost of capital. By definition the cost of capital is the minimum risk
adjusted return required by the company’s stakeholders.

There is no single overall cost of capital for the MNC’S, in view of investment in varied types of
countries abroad, with different degree of risk. Thus there are different rates of return (cost of
capital) for foreign projects in different countries, which are to be used as measure to decide
whether to make the specific investment in a foreign country.

The cost of equity capital of a firm is the minimum rate of return needed to satisfy the equity
stakeholders of the company. In the conceptual sense, it is the yield covering the time value of
the money plus the premium for risk. In accounting sense, the cost of capital is the rates used to
capitalize the cash flows, generated from the investments. It is the weighted average rate from
the different projects undertaken by the company and different countries. Thus the cost of equity
capital for the firm as a whole is taken to discount the future equity cash flows to arrive at the
value of the equity of the firm. The overall cost of capital is not however reflective of the
required rate of returns on individual foreign investments. If the return and the capital structure
of an investment is expected to be similar to those of the firms typical investment, the overall
cost of equity capital may serve as the proxy for the required return on equity of the projects.

Cost of Capital for MNC’s

The cost of capital for MNCs may differ from that for domestic firms because of the following
characteristics that differentiate MNCs from domestic firms.
1. Size of firm: An MNC that often borrows substantial amounts may receive preferential
treatment from creditors, thereby reducing its cost of capital. Furthermore, its relatively
large issues of stocks or bonds allow for reduced floatation costs (as percentage of the
amount of financing).

2. Access to international capital markets: MNCs are normally able to obtain funds
through the international capital markets. Since the cost of funds can vary among
markets, the MNCs access to the international capital markets may allow it to obtain
funds at a lower cost than paid by domestic firms. In addition, subsidiaries may be able to
obtain funds locally at a lower cost than that available to the parent if the prevailing
interest rates in the host country are relatively low.

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 3. International diversification: A firm’s cost of capital is affected by the probability that
it will go bankrupt. If the firm’s cash inflows come from sources all over the world, those
cash inflows may be more stable because the firm’s total sales will not be highly
influenced by a single currency. To the extent that individual economies are independent
of each other, net cash flows from a portfolio of subsidiaries should exhibit less
variability, which may reduce the probability of bankruptcy and therefore reduce the cost
of capital.

4. Exposure to exchange rate risk: An MNCs cash flows could be more volatile than those
of domestic firms in the same industry if it is highly exposed to exchange rate risk. If
foreign earnings are remitted to the US parent of an MNC, they will not be worth as
much when US dollar is strong against major currencies. Thus, the capability of making
interest payments on outstanding debt is reduced and the probability of bankruptcy is
higher. This could force creditors and shareholders to require a higher return which
increases the MNCs cost of capital.

5. Exposure to country risk: An MNC that establishes foreign subsidiaries is subject to the
possibility that a host country government may seize a subsidiary’s assets. The
probability of such an occurrence is influenced by many factors, including the attitude of
the host country government and the industry of concern. If assets are seized and fair
compensation is not provided, the probability of the MNCs going bankrupt increases. The
higher the percentage of an MNCs assets invested in foreign countries and the higher the
overall country risk of operating in these countries, the higher will be the MNCs
probability of bankruptcy (and therefore its cost of capital), other things being equal.
Other forms of country risk such as changes in the hoist government’s tax laws, could
also affect subsidiary’s cash flows.

Factors that cause the Cost of Capital of MNCs to differ from that of Domestic Firms

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Table 1.1
4. COSTS OF CAPITAL ACROSS COUNTRIES
An understanding of why the cost of capital can vary among countries is relevant for three
reasons. First, it can explain why MNCs based in some countries may have a competitive
advantage over others. Just as technology and resources differ across countries, so does the cost
of capital. MNCs based in some countries will have a larger set of feasible (positive net present
value) projects because their cost of capital is lower; thus, these MNCs can more easily increase
their world market share. MNCs operating in countries with a high cost of capital will be forced
to decline projects that might be feasible for MNCs operating in countries with a low cost of
capital.
Second, MNCs may be able to adjust their international operations and sources of funds to
capitalize on differences in the cost of capital among countries. Third, differences in the costs of
each capital component (debt and equity) can help explain why MNCs based in some countries
tend to use a more debt-intensive capital structure than MNCs based elsewhere. Country
differences in the cost of debt are discussed next, followed by country differences in the cost of
equity.

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4.1 COST OF DEBT

The debts may be either short-term debts or long-term debts. The cost of capital in the form of
debts is the interest which the company has to pay. But this is not the real cost attached with the
debt capital. The real cost is something less than the rate of interest which the company has to
pay. This is due to the fact that the interest on debts is a tax-deductible expenditure. If the
amount of interest is considered as a part of expenses, the tax liability of the company reduces
proportionately. As such, while computing the cost of debts, adjustments are required to be made
for its tax impact. Suppose a company issues the debentures having the face value of Rs.100
each, bearing the rate of interest of % p.a. If the tax rate applicable to the company is 50%, the
cost of debentures is not 10%, which is the rate of interest but it is to be duly deducted by the tax
benefit available for this interest. The tax benefit is 50% of 10%. Hence, the cost of debentures is
only 5%.

However, the debt capital also has a hidden cost. If the debt component in the capital structure of
a company exceeds the optimal level, the investors start considering company as too risky and
their expectation from equity shares increase. This is the hidden cost of debt.
The cost of debt to affirm is primarily determined by the prevailing risk-free interest rate in the
currency borrowed and the risk premium required by creditors. The cost of debt for firms is
higher in some countries than others because the because of corresponding risk-free rate is higher
at a specific point in time because the risk premium is higher.

Difference in the risk-free rates:

i. The risk-free rate is determined by the interaction of the supply and demand for
funds. Any factors that influence the supply and/or demand will affect the risk-free
rate. These factors include tax laws, demographic, monetary policies, and economic
conditions, all of which differ among countries.

ii. Tax laws m some countries such as law related to depreciation and investment tax
credits, can offer more incentives to save than others, which can influence the supply
of savings and therefore interest rates.

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 iii. A country’s demographics influence the supply of savings available and the amount
of loanable funds demanded. Since demographics differ among countries, so will
supply and demand conditions and, therefore, nominal interest rates. Countries with
younger population are likely to experience higher interest rates, because younger
households tend to save less and borrow more.

iv. The monetary policy implemented by a country’s central bank influences the supply
of loanable funds and therefore influence interest rates. Each central bank implement
sits own monetary policy, and this cm came interest rates to differ among countries.
Since economic conditions influence interest rates, they can cause rates to vary across
countries. The cost of debt is much higher in many less developed countries than in
industrialized countries primarily, because of economic conditions. Countries such as Brazil and
Russia commonly have high risk-free interest rates, which is partially attributed to high inflation.
Investors in these countries will invest in a firm’s debt securities only if they are compensated
the degree to which prices of products are expected to increase.

Differences in the Risk Premium.

The risk premium on debt must be large enough to compensate creditors for the risk that the
borrower may be unable to meet its payment obligations. This risk can vary among countries
because of differences in economic conditions, relationships between corporations and creditors,
government intervention, and degree of financial leverage. When a country’s economic
conditions tend to be stable, the risk of a recession in that country is relatively low. Thus, the
probability that a firm might not meet its obligations is lower, allowing for a lower risk premium.
Corporations and creditors have closer relationships in some countries than in others. In Japan,
creditors stand ready to extend credit in the event of a corporation’s financial distress, which
reduces the risk of illiquidity. The cost of a Japanese firm’s financial problems may be shared in
various ways by the firm’s management, business customers, and consumers. Since the financial
problems are not borne entirely by creditors, all parties involved have more incentive to see that
the problems are resolved.
Thus, there is less likelihood (for a given level of debt) that Japanese firms will go bankrupt,
allowing for a lower risk premium on the debt of Japanese fi rms. Governments in some

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countries are more willing to intervene and rescue failing fi rms. For example, in the United
Kingdom many firms are partially owned by the government. It may be in the government’s best
interest to rescue firms that it partially owns. Even if the government is not a partial owner, it
may provide direct subsidies or extend loans to failing fi rms. In the United States, government
rescues are less likely because taxpayers prefer not to bear the cost of corporate mismanagement.
Although the government has intervened occasionally in the United States to protect particular
industries, the probability that a failing firm will be rescued by the government is lower there
than in other countries. Therefore, the risk premium on a given level of debt may be higher for
U.S. firms than for firms of other countries.
Firms in some countries have greater borrowing capacity because their creditors are willing to
tolerate a higher degree of financial leverage. For example, firms in Japan and Germany have a
higher degree of financial leverage than firms in the United States. If all other factors were equal,
these high-leverage firms would have to pay a higher risk premium. However, all other factors
are not equal. In fact, these firms are allowed to use a higher degree of financial leverage because
of their unique relationships with the creditors and governments.

Comparative Costs of Debt across Countries.

The before-tax cost of debt (as measured by high-rated corporate bond yields) for various
countries is displayed in Exhibit 17.3. There is some positive correlation between country cost-of
debt levels over time. Notice how interest rates in various countries tend to move in the same
direction. However, some rates change to a greater degree than others. The disparity in the cost
of debt among the countries is due primarily to the disparity in their risk-free interest rates.

Weighted Average Cost of Capital: It is also known as the Composite Cost of Capital. This
gives us the overall cost of capital. Weightage is given to the cost of each source of funds by
assessing the relative proportion of each source of funds to the total, and is ascertained by using
the book value or market value of each type of capital. The cost of capital of the market value is
usually higher than it would be if the book value is used. The market value weights are
sometimes preferred to the book value weights, for the market value represents the true
expectations of the investors. However, the market value suffers from the following limitations:
(i) market values undergo frequent fluctuations and have to be normalized, and (ii) the use of

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market value tends to cause a shift towards larger amounts of equity funds, particularly when
additional financing is undertaken.

In the light of the limitations of the market value method, it is desirable to use the book value
weights. This method has the following advantages: (i) the capital structure targets are usually
fixed in terms of book value; (ii) it is easy to know the book value; (iii) investors are interested in
knowing the debt-equity ratio on the basis of book values, and (iv) it is easier to evaluate the
performance of a management in procuring funds by comparing on the basis of book value.

The process of computing the weighted average cost of capital is carried on by the steps stated
below:
1. Assign weights to various sources of funds. It may be stated here that the weights may be
in the form of book value of funds or market value of funds.

2. Multiplying the cost of each source of fund by the weight assigned.

3. Calculate the composite cost by dividing total weighted cost by the total weights.

There are three major approaches to the computation on weighted average cost of capital:
1. Book Value Approach
In this approach, for the computation of weighted average cost of capital, the book values
sources of each type of capital are taken at their values, and weights are assigned
according to the relative proportions of different kinds of sources in the existing capital
structure.

2. Market Value Approach

In this approach, weights are assigned on the basis of the relative proportion of each type
of sources in the capital structure, but the values of sources are the market values. Most
of the financial analysis prefers to use market values because unlike book values, market
values will reflect the true current values of the sources, the market values of the specific

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 sources are closely approximate to their current values. However, there are practical
difficulties to determine the market value of each source, particularly retained earnings.

3. Marginal Cost Approach

This approach disregards the existing capital structure and takes into account the
proportion of each type of sources in the total additional funds raised from all the sources
for financing of the new project, and assigns weights on this basis. The values of sources
are taken to be their market values. This approach is more realistic for capital expenditure
decision.

E D P
KO = KE [ ] + KD [ ] + KP [ ]
E+D+P+R E+D+P+R E+D+P+R
R
+ KR [ ]
E+D+P+R
Here, E = Equity share capital;
D = Debt;
P = Preference Share Capital;
R = Retained earnings.

4.2 THE COST OF EQUITY CAPITAL

The cost of equity capital for a firm is the minimum rate of return necessary to induce investors
to buy or hold the firm's stock. This required return equals a basic yield covering the time value
of money plus a premium for risk. Because owners of common stock have only a residual claim
on corporate income, their risk is the greatest, and so also are the returns they demand.

Alternatively, the cost of equity capital is the rate used to capitalize total corporate cash flows.
As such, it is just the weighted average of the required rates of return on the firm's individual
activities. From this perspective, the company is a mutual fund of specified projects, selling a
compound security to capital markets. According to the principle of value additively, the value of
this compound security equals the sum of the individual values of the projects.

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Although the two definitions are equivalent, the latter view is preferred from a conceptual
standpoint because it focuses on the most important feature of the cost of equity capital since this
cost is not an attribute of the firm but is a function of the riskiness of the activities in which it
engages. Thus, the cost of equity capital for the firm as a whole can be used to value the stream
of future equity cash flows-that is, to set a price on equity shares in the firm. It cannot be used as
a measure of the required return on equity investments in future projects unless these projects are
of a similar nature to the average of those already being undertaken by the firm.

One approach to determining the project-specific required return on equity is based on modern
capital market theory. According to this theory, an equilibrium relationship exists between an
asset's required return and its associated risk, which can be represented by the capital asset
pricing model or CAPM:

ri = rf + βi(rm - rf) (1)

Where

ri = equilibrium expected return for asset i

rf = rate of return on a risk-free asset, usually measured as the yield on a 30-day government

Treasury bill

2
rm = expected return on the market portfolio consisting of all risky assets βi = cov(ri, rm)/σ (rm),

where cov(ri, rm) refers to the covariance between returns on security i and the market portfolio
2
and σ (rm) is the variance of returns on the market portfolio. The CAPM is based on the notion

that intelligent, risk-averse shareholders will seek to diversify their risks, and as a consequence,
the only risk that will be rewarded with a risk premium will be systematic risk. As can be seen
from Equation 1, the risk premium associated with a particular asset i is assumed to equal βi (rm –

rf), where βi is the systematic, or non-diversifiable risk of the asset. In effect, β (beta) measures

the correlation between returns on a particular asset and returns on the market portfolio, The term
rm - rf is known as the market risk premium.

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Where the returns and financial structure of an investment are expected to be similar to those of
the firm's typical investment, the corporate-wide cost of equity capital may serve as a reasonable
proxy for the required return on equity of the project. In this case estimates of the value of the
project's beta can be found either by direct computation using the CAPM or through professional
investment companies that keep track of company betas.
It should be emphasized again that using a company beta to estimate the required return on a
project's equity capital is valid only for investments with financial characteristics typical of the
"pool" of projects represented by the company. This cost-of-equity capital estimate is useless in
calculating project-specific required returns on equity when the characteristics of the project
diverge from the corporate norm.

Impact of the Euro

The adoption of the euro has facilitated the integration of European stock markets because
investors from each country are more willing to invest in other countries where the euro is used
as the currency. As demand for shares by investors has increased, trading volume has increased,
making the European stock markets more liquid. Investors in one euro zone country no longer
need to be concerned about exchange rate risk when they buy stock of a firm based in another
euro zone country. In addition, the euro allows the valuations of firms to be more transparent
because firms throughout the euro zone can be more easily compared since their values are all
denominated in the same currency. Given the increased willingness of European investors to
invest in stocks, MNCs based in Europe may obtain equity financing at a lower cost.

4.3 Combining the Costs of Debt and Equity

The costs of debt and equity can be combined to derive an overall cost of capital. The relative
proportions of debt and equity used by firms in each country must be applied as weights to
reasonably estimate this cost of capital. Given the differences in the costs of debt and equity
across countries, it is understandable that the cost of capital may be lower for firms based in
specific countries. Japan, for example, commonly has a relatively low cost of capital. It usually
has a relatively low risk-free interest rate, which not only affects the cost of debt but also
indirectly affects the cost of equity. In addition, the price-earnings multiples of Japanese firms
are usually high, allowing these firms to obtain equity funding at a relatively low cost. MNCs

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can attempt to access capital from countries where capital costs are low, but when the capital is
used to support operations in other countries, the cost of using that capital is exposed to
exchange rate risk. Thus, the cost of capital may ultimately turn out to be higher than expected.
Estimating the Cost of Debt and Equity
When financing new projects, MNCs estimate their cost of debt and equity from various sources.
They consider these estimates when they decide on the capital structure to use for financing the
projects. The after-tax cost of debt can be estimated with reasonable accuracy using public
information on the present costs of debt (bond yields) incurred by other firms whose risk level is
similar to that of the project. The cost of equity is an opportunity cost: what investors could earn
on alternative equity investments with similar risk. The MNC can attempt to measure the
expected return on a set of stocks that exhibit the same risk as its project. This expected return
can serve as the cost of equity. The required rate of return on the project will be the project’s
weighted cost of capital, based on the estimates as explained here.
THE WEIGHTED AVERAGE COST OF CAPITAL FOR FOREIGN PROJECTS

The required return on equity for a particular investment assumes that the financial structure and
risk of the project is similar to that for the firm as a whole. This cost of equity capital, ke is then
combined with the after-tax cost of debt, id (1 – t), yield a weighted average cost of capital

(WACC) for the parent and the project, k0 computed as

K0 = (1 – L) ke + Lid(1 – t) (2)

where L is the parent's debt ratio (debt to total assets). This cost of capital is then used as the
discount rate in evaluating the specific foreign investment. It should be stressed that ko is the

required return on the firm's stock given the particular debt ratio selected.

Two caveats in employing the weighted average cost of capital are appropriate here. First, the
weights must be based on the proportion of the firm's capital structure accounted for by each
source of capital using market, not book values. Second, in calculating the WACC, the firm's
historical debt-equity mix is not relevant. Rather, the weights must be marginal weights that
reflect the firm’s target capital structure, that is, the proportions of debt and equity the firm plans
to use in the future.

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Book value of weights: The book value weights are derived from the stated values of individual
components of the capital structure on the firm’s current balance sheet. There are two major
advantages to book value weights, (i) the proportions of the capital structure are stable over time
because book value weights do not depend on market prices, and (ii) book value weights are easy
to determine because they are derived from stated values on the firm’s balance sheet.

One important problem with these weights is that the value of bonds and equity change over time
because of the change in market conditions therefore these may not reflect the desired value of
capital structure.

Market value weights: Market value weights are based on the current market prices of bonds and
stock. Because the primary goal of a firm is to maximize its market value, therefore this set of
weights are consistent with the company’s objective. The market value of the company’s
securities depends on the expected earnings of the company and the risk of the securities as
perceived by the investors. Thus the market values reflect assessments of current buyer and
sellers of future earnings and the risk. This weighted average cost of capital with market value
weights should be the right average rate of return required by the investors from the firm’s
securities.

Example 1. Estimating the weighted average cost of capital

Suppose a company is financed with 60 per cent common stock, 30 per cent debt, and 10 per cent
preferred stock, with respective after-tax costs of 20 per cent, 6 per cent, and 14 per cent. Based
on the financing proportion and the after-tax costs of the various capital component and Equation
2, the WACC for this firm is calculated as 15.2 per cent (0.6 × 0.20 + 0.3 × 0.06 + 0.1 × 0.14). If
the net present value of those cash flows-discounted at the weighted average cost of capital is
positive, the investment should be undertaken; if it is negative, the investment should be rejected.

However, both project risk and project financial structure can vary from the corporate norm. It is
necessary, therefore, to adjust the costs and weights of the different cost
components to reflect their actual values. Computing the weighted average cost of
capital

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With no change in risk characteristics, the parent's after-tax cost of debt and equity remain at id (1

– t) and ks respectively. As introduced above, the subsidiary's cost of retained earnings equals k,

and its expected after-tax cost of foreign debt equals if. Under these circumstances the weighted

cost of capital for the project equals

KI = k0 – a(ke – ks) – b[id(1 – t) – if] (3)

Where a = Ef/I and b = Df/I. If this investment changes the parent’s risk characteristics in such a

way that its cost of equity capital is k´e, and its cost of debt id rather than i´d, Equation 3 becomes

instead
KI = k0 + (1 – L) (k´e – ke) + L (i´d – id) (1 – t) – a(k´e – ks) – b[i´d (1 – t) – if]

4.4 COST OF BORROWING

The term Cost of borrowing might seem to apply to several other terms in this article. In
business, and especially in the financial industries, however, the term refers the total cost a
debtor pays for borrowing. Cost of borrowing usually appears as an amount in currency units
such as dollars, euro, od pounds.
When a debtor repays a loan over time, the following equation holds:

Total payments = Repayment of loan principal + cost of borrowing

Calculating Cost of Borrowing

Cost of borrowing may include, for instance, interest payments, and (in some cases) loan
origination fees, loan account maintenance fees, borrower insurance fees, and still other fees. As
an example, consider a loan with the following properties:

Loan properties

Amount to borrow (loan $100,000.00

principle):

Annual interest rate: 6.0%

Amortization time: 10 Years

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 Payment frequency: Monthly

Annual borrower $25.00

insurance

Such a loan calls for 120 monthly payments of $1,110.21. Therefore, the borrower who makes
all payments on schedule ends up repaying a total of 120 x $1,110.21, or $133,225. The
borrower will also pay $200 for loan origination, $600 in account maintenance fees (120 x $5),
and $250 in borrower insurance. The cost of borrowing therefore calculates as:

Cost of borrowing calculation

Total repayments: $133,225.20.00

Less principal ($100,000.00)

repaid:

Total interest 33,225.20

payments::

Loan origination fee: 200.00

Account $600.00
maintenance:

Borrower insurance 250.00

fees:

Total cost of $34,255.20

borrowing:

Over the last few decades, lending institutions everywhere have started facing increasingly
stringent laws requiring disclosure of Cost of borrowing figures. These laws call for potential
buyers to be informed in clear, accurate terms, before they sign loan agreements.

4.5 TAX IMPLICATION ON COST OF CAPITAL TO SUBSIDIARY AND PARENT

COMPANY

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Tax Rules Related to International Investment

Income from international investment is subject to several layers of taxation. Host governments
typically impose corporate taxes on income earned within their jurisdictions regardless of the
ownership of capital. Many countries subject foreign-source income to home-country personal
income taxation. In certain cases, corporate surtaxes are imposed by the home government.
Countries also impose withholding taxes on income repatriated from abroad. Such overlapping
tax jurisdictions subject certain foreign-source income to both home-country and host-country
taxation. Such double taxation of international income should be a deterrent to international
investment because of the implied high effective tax rates. In order to avoid double taxation of
international investment income and encourage free flows of capital, countries typically provide
some kind of tax relief on foreign-source income. The exact nature and extent of double-taxation
relief differs across countries and types of income. The most extreme, simplistic, and generous
way to provide double-taxation relief is to exempt foreign-source income from home-country
taxation. In this case, the only taxes charged for foreign-source income are the income and
withholding taxes imposed by the host government. Only a few countries (e.g., the Netherlands)
adopt this “territorial” system under which there is no residence-based taxation of foreign-source
income. As a result of bilateral tax treaties, however, this exemption method is, in practice, more
prevalent than implied by the tax statutes of each country. A pair of countries can agree to
exempt from domestic taxation their residents’ income earned in the other country. Most
countries assert the right to tax the income of their residents regardless of where the income is
earned. Under this more conventional “residence” system, foreign-source income is subject to
home-country taxation, but a credit or deduction is allowed for taxes paid to the host
government. In practice, no country allows unlimited foreign tax credits. Foreign tax credits are
typically limited to home-country tax liability on foreign-source income. Investors whose
potentially creditable foreign taxes exceed the actual credit limit are said to be in an “excess
credit” position.6 Thus, foreign tax credit limitations are likely to be binding when the firm
invests in a high-tax country. If the foreign taxes paid are less than the limitation on credits, the
firm is said to be in a “deficit credit” or “full credit” position. When a multinational invests in
several foreign countries, it is normally allowed to pool the income repatriated from all of these
countries and credit against the domestic taxes due on this income any corporate and withholding
taxes paid abroad on this income. In doing so, it can use excess credits from operations in one

19
country to reduce any domestic taxes due on operations in another country. If, in total, its credits
are sufficient to wipe out its domestic tax liabilities on its worldwide foreign operations, then no
domestic corporate taxes are due. In this case, its final net income is the same as in the tectorial
case. In addition to providing foreign tax credits, residence-system countries typically allow their
firms to defer home-country tax on certain types of foreign source income until the income is
repatriated. In general, active business income belongs to this category. Income from passive
investment (dividends and interest, e.g.) is typically taxed on an accrual basis; however. And
most countries do not allow tax deferral for foreign-branch income. Tax deferral can be an
important source of tax benefits since under certain circumstances it may lower the effective tax
rate on foreign investment. The asymmetric treatment of a given economic activity across
different jurisdictions may significantly influence the way multinationals allocate capital
between domestic and foreign operations.’ Local investment incentives and financing sources in
the host country will further complicate the investment and financing decisions of this firm. The
common notion of tax-induced location choice is based on the comparison of after-tax rates of
return in different places.

Effects of the Basic Corporate Tax Systems

This section focuses on the effects on the cost of capital of the basic corporate statutes in the
sample countries. Results based on possible behavioral responses by multinationals are reported
in the following sections.

1. Domestic Investment versus Foreign Investment

Compare first the costs of capital for domestic investment and foreign investment. Table 4.4
presents the cost of capital for U.S., Japanese, U.K., and German firms as well as local firms
operating in the 11 sample countries. In this base case, parent retained earnings are assumed to
be the marginal source of funds for both domestic and foreign investment. Column (1) reports
the cost of capital for domestic investment. This result can be comparable to traditional
international comparisons of the cost of capital except that this study isolates the impact of
corporate taxes from other influences. The effects of corporate tax rules on the cost of capital
differentials for domestic investment between countries do not appear to be large, which is in
line with the findings of most previous studies. Across countries, the required pretax rates of

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return on domestic investment are higher in Japan, Germany, Italy, and Australia than in other
countries, reflecting their relatively high corporate tax rates. U.S. domestic firms face a lower
cost of capital (7.6 percent) than Japanese domestic firms (9.0 percent) because of relatively high
corporate tax rates in Japan. Note that several studies have found that U.S. firms are at a
competitive disadvantage relative to firms in Japan. In McCauley and Zimmer (1989) and
Bernheim and Shoven (1987), for example, the cost of-capital gap in 1988 was 4.0 and 7.0
percent, respectively. The cost-of-capital advantage of U.S. firms in this study (1.4 percent),
therefore, reiterates the significance of the difference in the cost of funds between the two
countries in the 1980s. Now consider the cost of capital for firms from major investing countries.
As shown in column (2), U.S. firms face a significantly higher cost of equity capital for foreign
investment than for domestic investment. In the sample host countries, U.S. firm’s face about a
20 percent higher cost of capital on average than in the case of U.S. domestic investment (9.3 vs.
7.6 percent).

2. Competition with Local Firms

The results in table 4.4 also indicate that because of the tax costs associated with foreign
investment, firms investing abroad may very likely face a higher cost of capital than local
competitors. For example, a 20 percent higher cost of capital for foreign investment would put
U.S. multinationals in a disadvantageous position in most foreign markets. Comparing columns
(1) and (2) indicates, in fact, that U.S. firms face a higher cost of capital than their local
counterparts in every sample country. Similar results are obtained for firms from other countries.
Because of the tax costs associated with international investment, U.S. firms face a higher cost of
equity capital than do local firms in Japan (10.6 vs. 9.0 percent), according to the calculations
that underlie the figures reported in table 4.4. As noted above, Japanese firms have enjoyed a
cost-of-capital advantage over U.S. firms due mainly to the difference in the cost of funds
between the two countries. Since the results reported here are based on the assumption that there
are no cost-of-funds differentials between countries, the negative impact of international tax
rules on the cost of capital can be interpreted as an additional source of disadvantage for U.S.
firms operating in Japan when these firms draw transfers from their domestic parents.

3. Competition among Foreign Firms

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In a foreign market, U.S. firms compete not only with local firms but also with firms from other
investing countries. Table 4.5 shows the cost-of-capital measures for firms from different
countries operating in Japan, the United Kingdom, and Germany. In Japan, the variation of the
cost of capital across investing countries is not large. This is mainly because the high Japanese
corporate tax rate dominates the tax rates in investor countries in determining the overall
effective tax rate on foreign investment in Japan. The cost of capital for U.S. firms (10.6 percent)
is not greater than for firms from other countries, though the difference is not large. One
interesting observation is that those firms whose cost of capital is higher than that for U.S. firms
are from countries with a dividend credit scheme (Canada, France, Germany, the Netherlands,
the United Kingdom, Italy, and Australia). In other countries, the cost of capital for U.S. firms is
close to the sample average. Note that the cost of capital for foreign firms in the United Kingdom
shows relatively greater variation across investor countries. This is because low U.K. corporate
taxes are often dominated by home-country taxation of U.K.- source income in determining the
cost of capital.

Personal Taxes and the Dividend Imputation Scheme

The costs of two sources of parent equity funds-new equity and retained earnings-are different
mainly for two tax reasons, as discussed in section 4.2. First, a personal tax advantage for capital
gains relative to dividends will lower the cost of retained earnings for the parent. On the other
hand, a dividend imputation scheme will make the cost of parent new equity lower than that for
parent retained earnings for financing domestic investment.

1. Effects of the Dividend Imputation Scheme in the Home Country

Some countries try to restrict investors’ ability to use the dividend imputation scheme on
dividends from domestic corporations financed by earnings from abroad. Typically, countries
require that dividends eligible for the dividend imputation scheme be less than the firm’s after-
tax profits from domestic operations. Unless a firm desires an abnormally high dividend payout
rate, however, this restriction is unlikely to be binding. If shareholders in the countries with the
dividend imputation scheme are allowed to take such dividend imputation credits for foreign-
source dividends, firms from some of these countries can possibly lower the cost of capital for
foreign investment by using parent new equity instead of parent retained earnings as the source

22
of transfers. Table 4.6 presents the cost-of-capital measures that reflect personal taxes and
dividend credits for firms investing in Japan. Columns (1) and (2) show the impact of the home-
country imputation scheme on the relative costs of capital for the two sources of equity transfers.
Personal taxes are ignored to highlight the influence of the dividend imputation scheme. For
firms from countries with the classical system, therefore, the cost of capital is the same for the
two cases. Firms from countries with a dividend imputation scheme have a clear advantage over
U.S. firms. Without dividend credit benefits, the cost of capital for U.S. firms is at the low end of
the spectrum (col. [l]). With credits available, however, the average cost of capital over firms
from imputation countries is 5.4 percent, about half of the cost of capital for US. Firms (col. [2]).
This result suggests the potential importance of integrating personal and corporate taxation in
enhancing US. Competitiveness. Columns (3) and (4) report the results that combine the effects
of personal taxes and dividend credits. Overall, the cost of capital is lower here than in the base
case since the nominal required rate of return is defined to be (1 - m)i in the calculations. The
effects of relatively lower effective tax rates on capital gains are dominant in most of the sample
countries, though the impact of the imputation scheme has a significantly offsetting impact in
those countries with such a scheme. In Australia and the United Kingdom, parent new equity is
still the cheaper of the two sources. In the presence of widespread foreign financing sources (see
the next section) and international portfolio investment with the possibility of tax evasion,I9 the
role of personal taxes in determining the required rate of return on foreign investment in not as
clear as in the model presented earlier. In principle, there must be no dividend credits when there
is no dividend taxation. However, the corporate veil between domestic shareholders and foreign
investment may be thick and complex enough for multinationals to somehow manage to get
some dividend credits even when personal taxation on the level of domestic shareholders does
not affect their cost of capital. If this is the case, the first two columns of table 4.6 will represent
a more realistic picture of the cost-of capital gap across financing sources and investor countries.

2. Effects of the Dividend Imputation Scheme in the Host Country

The presence of the dividend imputation scheme provides incentives to reduce the cost of
capital, not only for the subsidiaries of the domestic parent, but also for the local subsidiaries of
firms in other countries. As discussed in section 4.2, most countries deny dividend credits to
foreign shareholders. However, some firms may have enough flexibility to avoid such statutory

23
restrictions. Table 4.7 presents results based on the assumption that U.S. firms can get the full
credits available in foreign countries. Column (1) produces column (2) of table 4.4, the base case
result based on the notion that restrictions in the tax statutes are strictly binding.*O In most
sample countries with the imputation scheme, U.S. firms can lower the cost of capital.*' In the
United Kingdom, there is no change in the cost of capital, which is not surprising. The United
Kingdom taxes corporate income rather lightly, and benefits from the full credit (c = 0.250) are
not a large addition because U.S. firms are already allowed to take a half-credit (0.125). U.S.
firms, therefore, must still face U.S. surtax, and the total effective tax rate is determined mostly
by the U.S. taxes. On average, U.S. firms can lower their cost of capital about 12 percent (from
9.3 to 8.2 percent) in the sample countries.

3. Implications for Local Financing Sources

In the face of a high cost of capital for foreign investment financed through equity transfers by
the parent, the subsidiary may seek alternative sources of funds. First, parent transfers can be
made in debt instead of equity. These two types of transfer differ in terms of the rate of
withholding tax in the host country and the tax treatment of repatriated income in the home
country. While many countries in the sample adopt the exemption method for foreign-source
dividends, 2z all sample countries adopt the credit method for foreign-source interest. In the host
countries, on the other hand, interest payments face lower withholding taxes than dividend
payments in many cases. The cost-of-capital difference between these two types of transfers in
the actual calculation is small and not separately

4. Local Debt Financing

It is likely that more important alternative sources of funds lie in the host country Local
borrowing, which is ignored by most previous studies of foreign investment, has been an
important source of funds for foreign investment. At the end of 1989, the share of local and other
foreign borrowing in total external finance for U.S. firms operating abroad was 60.3 percent. The
corresponding figure for foreign firms operating in the United States was 71.2 percent. In
general, because interest payments are tax deductible, debt financing should be preferred to
equity financing as far as taxes are concerned. Column (3) of table 4.8 shows that the cost of
capital for foreign investment financed by local borrowing is much lower than that for equity

24
financing regimes. The deduction benefits are proportional to the marginal corporate tax rate in a
country, and debt financing is particularly attractive in Japan and Germany because of their
relatively high corporate tax rates. Local debt may be an especially attractive way of financing
foreign investment for the following reasons. First, the tax cost of not using debt is much higher
for foreign investment than for domestic investment, as shown in column (5) of table 4.8. For
domestic investment in the United States, the tax cost of using equity financing is 5.0 percent.
For U.S. firms operating in Japan, for example, the cost can be as large as 9.0 percent. This result
reflects the tax costs associated with international investment. Firms usually do not raise the
leverage ratio as much as tax benefits would suggest because of various nontax costs associated
with leverage, such as perceived bankruptcy or agency costs. In the case of multinational
investment, however, the nontax cost of using debt may not be as significant as for domestic
investment. A multinational may face less risk of default, since it can pool relatively independent
risks from its operations in several different countries and so be able to borrow more. In addition,
if it can use its combined assets as collateral for loans, regardless of which affiliate does the
borrowing, and then it can concentrate its borrowing in the country where the deductions are
most valuable. Thus, the tax benefits of an interest deduction may be a much more important
determinant of corporate leverage for a foreign subsidiary than for a purely domestic firm. In
addition, foreign borrowing is an important way to hedge against exchange risks associated with
foreign-source income. When borrowing abroad, a U.S. multinational may have an incentive to
concentrate its borrowing where tax benefits are large. Japan, Germany, Italy, and Australia are
more attractive places for foreign borrowing than Canada, France, the Netherlands, the United
Kingdom, Sweden, and Switzerland as far as taxes are concerned. This observation might
become more relevant as integrated world capital markets narrow differences in interest rates
between countries.

5. Tax Deferral and Subsidiary Retained Earnings

If, for some nontax reasons, a U.S. firm has to finance foreign investment using an equity source,
subsidiary retained earnings are typically cheaper than parent equity transfers, except in
Germany where split corporate tax rates discriminate against retained earnings (table 4.8, col.
[4]). Note, however, that the cost of capital for subsidiary retained earnings as reported in this
study implicitly assumes that home-country taxes on repatriated earnings can be deferred. If such

25
deferrals are not allowed in the United States, then the cost of capital for foreign investment
financed through subsidiary retained earnings will be higher for firms that are in a deficit credit
position than those reported in column (QZ4 Unlike the foreign tax credit, the main objective of
which is to avoid double taxation of foreign-source income, tax deferrals have been a source of
controversy in the United States because this provision gives home-based multinationals a tax
incentive to keep placing their earnings in foreign countries. Further, the deferral of the home tax
on foreign-source income is often regarded as a violation of the principle of tax neutrality
between domestic and outward foreign investment (capital export neutrality) since taxation of
domestic-source income generally cannot be deferred. Tax Deferral and Subsidiary Retained
Earnings

The decision by a subsidiary to use internal equity financing (retaining and reinvesting its
earnings) or obtain debt financing can affect its degree of reliance on parent financing and the
amount of funds that it can remit to the parent. Thus, its financing decisions should be made in
consultation with the parent. The potential impact of two common subsidiary financing situations
on the parent’s capital structure are explained next.

 Impact of Increased Debt Financing by the Subsidiary

When global conditions increase a subsidiary’s debt financing, the amount of internal
equity financing needed by the subsidiary is reduced. As these extra internal funds are remitted to
the parent, the parent will have a larger amount of internal funds to use for financing before
resorting to external financing. Assuming that the parent’s operations absorb all internal funds
and require some debt financing, there are offsetting effects on the capital structures of the
subsidiary and the parent. The increased use of debt financing by the subsidiary is offset by the
reduced debt financing of the parent. Nevertheless, the cost of capital for the MNC overall could
have changed for two reasons.

First, the revised composition of debt financing (more by the subsidiary, less by the
parent) could affect the interest charged on the debt. Second, it could affect the MNC’s overall
exposure to exchange rate risk and therefore influence the risk premium on capital. In some
situations, the subsidiary’s increased use of debt financing will not be offset by the parent’s
reduced debt financing. For example, if there are any restrictions or excessive taxes on remitted

26
funds, the parent may not be able to rely on the subsidiary and may need some debt financing as
well.

In this case, international conditions that encourage increased use of debt financing by
the subsidiary will result in a more debt-intensive capital structure for the MNC. Again, for
reasons already mentioned, the cost of capital to the MNC could be affected by the subsidiary’s
increased debt financing. In addition, the use of a higher proportion of debt financing for the
MNC overall would also affect the cost of capital.

 Impact of Reduced Debt Financing by the Subsidiary

When global conditions encourage the subsidiary to use less debt financing, the
subsidiary will need to use more internal financing. Consequently, it will remit fewer funds to the
parent, reducing the amount of internal funds available to the parent. If the parent’s operations
absorb all internal funds and require some debt financing, there are offsetting effects on the
capital structures of the subsidiary and parent.

The subsidiary’s reduced use of debt financing is offset by the parent’s increased use. For
reasons expressed earlier, the cost of capital may change even if the MNC’s overall capital
structure does not. If the parent’s operations can be fully financed with internal funds, the parent
will not use debt financing. Thus, the subsidiary’s reduced debt financing is not offset by the
parent’s increased debt financing, and the MNC’s overall capital structure becomes more equity
intensive.

Tax treatment for both the parent and subsidiary company during a spinoff

A common separation strategy used by corporations includes divestiture activities that segment a
portion of a company's operations, resulting in a new corporate entity. Also known as a spinoff, a
business has the ability to create a new company that conducts separate operations from the
parent company, which may prove to be more beneficial to its shareholders in terms of long-term
profitability. Spinoffs may also take place in an effort to reduce potential regulatory issues with
the parent company, to enhance the company's competitive advantage or to diversify the
corporation's investment portfolio. The new entity established during a spinoff is known as the
subsidiary company and in most cases it is still owned by the shareholders of the parent business.

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Corporations implement a spinoff of the business in lieu of selling a portion of operations in an
effort to avoid debilitating corporate taxation on the transaction.

1) Taxation of the Parent Company

Under the Internal Revenue Code Section 355, most parent companies can avoid taxation on
spinoff activity because no funds are provided in exchange for ownership. Instead, a spinoff
involves the distribution of company stock of the subsidiary entity from the parent company on a
pro rata basis to shareholders, making the same shareholders of the parent company owners of
the subsidiary. No cash is exchanged when the subsidiary is formed in a spinoff, and as such, no
ordinary income or capital gains taxes are assessed.

2) Taxation of the Subsidiary

Similar to the parent company tax benefits experienced in a spinoff, the subsidiary company can
also avoid taxation during the transaction. Because the shareholders of the subsidiary company
receive stock on a pro rata basis from the parent company in lieu of cash for sale of the company,
ordinary income and capital gains taxes are not applicable. Instead, the owners of the parent
company become the owners of the subsidiary through the transfer of shares as a more cost-
effective alternative than receiving compensation for the new company through a stock dividend.

IRC Section 355 requires that the parent company and the subsidiary must meet stringent
requirements to maintain the tax-free benefits of a spinoff, however. A spinoff remains a non-
taxable event when the parent company retains control over at least 80% of the newly formed
entity's voting shares and nonvoting stock classes. Additionally, both the parent and subsidiary
companies are required to maintain engagement in the trade or business of the companies that
had been conducted during the five years prior to the spinoff taking place. A spinoff may not be
used solely as a mechanism for distributing profits or earnings of the parent or subsidiary
companies, and the parent company may not have taken control of the subsidiary in a similar
manner in the past five years of operations. If the parent or subsidiary does not meet the
requirements set out in IRC Section 355, a spinoff is considered taxable to both parties at the
applicable corporate tax rates.

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3) Tax Laws for a Subsidiary Corporation

Parent companies create subsidiary corporations and maintain them as separate legal entities,
although they still retain an element of control through partial or total shareholding and the
ability to appoint the subsidiary’s board of directors. Nevertheless, the law generally requires
subsidiary corporations to maintain their own separate set of financial books, file their own tax
returns and pay income tax for the revenues they generate. The law allows subsidiaries to deviate
from these requirements under some circumstances.

4) Tax Liability –

The tax system requires all American companies to pay federal income tax. Subsidiary
corporations are legal entities that exist separately from the parent company. At registration, the
incorporators of a subsidiary submit the name, articles of incorporation and bylaws of the
subsidiary and obtain a federal tax identification number that is distinct from that of the parent
company. Because they are companies in their own right, they are subject to the federal tax laws
that require them to pay income tax on all their activities.

5) Tax Relief –

Since subsidiaries are a creation of parent companies, the Internal Revenue Code allows the
latter to file consolidated group financial reports under limited circumstances. Parent companies
may submit consolidated tax returns when the company presents itself and its subsidiaries as a
single taxpayer. This is done when the parent company wishes to offset the losses of one
company against the profits of another. However, the parent company can only combine the
financial statements and tax returns of subsidiaries in which it owns at least 80 percent of the
shareholding and voting rights. Furthermore, the subsidiary corporation must also file an election
with the IRS to confirm that it is filing a consolidated tax return for that year.

29
6) State Taxes –

States also impose a variety of corporate taxes, including sales and use tax and taxes on the use
of intangible assets such as trademarks and patents. Subsidiary corporations may be useful in
minimizing or avoiding these taxes because parent companies may set them up in states where
tax rates are lower or nonexistent. For example, if a subsidiary corporation wishes to exploit a
new trademark, it may open up a subsidiary in Delaware, which doesn't have a trademark tax.

7) Foreign Subsidiaries –

The profits of a foreign subsidiary corporation are ordinarily not subject to tax in the United
States because the general Internal Revenue Service rule is that foreign subsidiaries are not
considered U.S. corporations even if they are wholly owned. However, when the subsidiary pays
dividends to the U.S. parent company as a shareholder, the IRS deems the amount as taxable
income for which the parent company has to pay tax. The income is not taxed if it stays within
the foreign subsidiary, but when it is paid to the U.S. parent company, a 35 percent corporate tax
rate applies. This rule allows companies such as Apple to establish foreign subsidiaries where
they can invest heavily and park their profits.
Conclusion

MNCS constitute as a major part of the countries income. Government earns with taxation and
also with increase in the standard of living of people and employment opportunities. So to study
about the MNCS, its cost of capital can help increase the profitable opportunities available. In
domestic market entry of MNCS can lead to increase in competition, standardisation and quality
of product so MNCS cost of capital is considered as a strength of its abilities through which they
earn and work

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Bibliography

Text book referred:

International financial management by dr. pradip kumar sinha,

International financial management by. V. Sharan

International financial management by jeff Madura, 9th edition

International financial management by pradeeo gupta

Sites referred

www.ddegjust.ac.in/studymaterial/mba/ib-416.pdf

http://www.cengage.com/resource_uploads/downloads/0324593473_140177.pdf

Joosung Jun.- The Impact of International Tax Rules on the Cost of Capital
http://www.nber.org/chapters/c7741

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