Chapter

17
Multinational Cost of Capital
& Capital Structure

South-Western/Thomson Learning © 2003

 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
characteristics are considered by an MNC
when it establishes its capital structure.

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 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
minimize their cost of capital, and hence the
required rate of return on projects.

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 Cost of Capital

• A firm’s weighted average cost of capital

kc = ( D )k (1_t) + ( E )k
d 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

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 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.

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 Cost of Capital

Debt’s Tradeoff
Cost of Capital

Debt Ratio

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 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
smaller per unit flotation costs too.

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 Cost of Capital for MNCs

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.

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 Cost of Capital for MNCs

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.

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 Cost of Capital for MNCs
Larger size Preferential
treatment from
Greater access creditors
to international
capital markets Possible
access to low- Cost of
International cost foreign capital
diversification financing

Exposure to
exchange rate Probability of
risk bankruptcy

Exposure to
country risk
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 Cost of Capital for MNCs

• 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 + β (Rm – Rf )
where ke = the required return on a stock
Rf = risk-free rate of return
Rm = market return
β = the beta of the stock

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 Cost of Capital for MNCs

• 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.

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 Cost of Capital for MNCs

• 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.

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 Cost of Capital for MNCs

• Hence, we cannot be certain if an MNC will

have a lower cost of capital than a purely
domestic firm in the same industry.

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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
more debt-intensive capital structure.

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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
economic conditions.

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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,
relationships between corporations and
creditors, government intervention, and
degrees of financial leverage.

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Costs of Capital Across Countries

• Although the cost of debt may vary across

countries, there is some positive
correlation among country cost-of-debt
levels over time.

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Costs of Capital Across Countries
14
12 Canada
Costs of Debt (%)

10
U.S.
8
6
4
Germany
2 Japan
0
1990 1992 1994 1996 1998 2000 2002

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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.
• The return on equity can be measured by
the risk-free interest rate plus a premium
that reflects the risk of the firm.

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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.
So, the cost of equity financing is low.

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Costs of Capital Across Countries

• The costs of debt and equity can be

combined, using the relative proportions
of debt and equity as weights, to derive an
overall cost of capital.

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 Online Application

• For country-specific information, visit:

¤ http://www.bloomberg.com/
¤ http://www.pwcglobal.com
¤ http://www.morganstanley.com/gef/
¤ http://www.worldbank.org/data/
¤ http://biz.yahoo.com/ifc/

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 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
process.

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 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
the after-tax cost of debt of the funds needed
to finance the project.

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 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,
and is influenced by both corporate and
country characteristics.

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 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
finance most of their investment with retained
earnings.

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 The MNC’s
Capital Structure Decision
Corporate Characteristics
• Guarantees on debt. If the parent backs the
subsidiary’s debt, the subsidiary may be able
to borrow more.
• Agency problems. Host country
shareholders may monitor a subsidiary,
though not from the parent’s perspective.

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 The MNC’s
Capital Structure Decision
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.

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 The MNC’s
Capital Structure Decision
Country Characteristics
• 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.

• Country risk. If the host government is

likely to block funds or confiscate assets,
the subsidiary may prefer debt financing.

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 The MNC’s
Capital Structure Decision
Country Characteristics
• Tax laws. MNCs may use more local debt
financing if the local tax rates (corporate
tax rate, withholding tax rate, etc.) are
higher.

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 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.
• The revised composition of debt financing may
affect the interest charged on debt as well as
the MNC’s overall exposure to exchange rate
risk.

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 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.
• The revised composition of debt financing may
affect the interest charged on debt as well as
the MNC’s overall exposure to exchange rate
risk.

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 Interaction Between Subsidiary
and Parent Financing Decisions
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

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 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.
• Hence, the MNC may still achieve its “global”
target capital structure.

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 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.
• Hence, an unusually high or low degree of
financial leverage should only be adopted
if the benefits outweigh the overall costs.

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 Using a Target Capital Structure
on a Local versus Global Basis
• 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.

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Impact of Multinational Capital Structure
Decisions on an MNC’s Value
Parent’s Capital Structure
Decisions

m 
n ∑
[
E ( CFj , t ) × E (ER j , t ) ] 
 j =1 
Value = ∑  
t =1  ( 1 + k ) t

 

E (CFj,t ) = expected cash flows in

currency j to be received by the U.S. parent at
the end of period t
E (ERj,t ) = expected exchange rate at
which currency j can be converted to dollars at
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 Chapter Review

• 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

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 Chapter Review

• Cost of Capital for MNCs … continued

¤ Cost of Capital Comparison Using the
CAPM
¤ Implications of the CAPM for an MNC’s
Risk

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 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
¤ Adjust the WACC for the Risk Differential

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 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
Subsidiary

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 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
MNC’s Value

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