17 Multinational Cost of Capital and Capital Structure

Chapter Objectives

Describe the key components of an MNC’s capital

Identify the factors that affect an MNC’s capital structure

Interaction between a subsidiary and parent in capital structure

decisions

Explain how the cost of capital is estimated

Explain why the cost of capital varies among countries

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 Components of Capital

• Inject Cash to Subsidiary → equity

investment
Parent • The subsidiary uses the cash
infusion to develop its business
operations in the host country

• Which the subsidiary can build

Subsidiary more equity is to offer its own
stock to the public

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 External Sources of Debt
Loans from Financial Institutions
• An MNC’s parent commonly borrows funds from financial
institutions

Private Placement of Bonds

• MNCs may offer a private placement of bonds to financial
institutions in their home country or in the foreign country

Bond Offering
• Domestic bond offering: the funds are denominated in
their local currency
• Global bond offering: simultaneously sell bonds
denominated in the currencies of multiple countries
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 External Sources of Debt

Private Placement of Equity

• Offer a private placement of equity to financial
institutions in their home country or in the
foreign country where they are expanding

Domestic Equity Offering

• Domestic equity offering in their home country
in which the funds are denominated in their
local currency

Global Equity Offering

• Global equity offering: simultaneously access
equity from multiple countries
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 Influence of Corporate Characteristics on
The MNC’s Capital Structure Decision

MNC’s
Access to
Retained
Earnings MNC’s
MNC’s
Guarantees
Credit Risk
on Debt

Stability of The MNC’s MNC’s

Capital
MNC’s Structure Agency
Cash Flows Decision Problems

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 Influence of Corporate Characteristics on
The MNC’s Capital Structure Decision
◼ Stability of MNC’s Cash Flows - MNCs with more stable cash flows
can handle more debt because there is a constant stream of cash
inflows to cover periodic interest payments on debt.
◼ MNC’s Credit Risk - MNCs that have lower credit risk have more
access to credit.
◼ MNC’s Access to Retained Earnings - Highly profitable MNCs may
be able to finance most of their investment with retained earnings and
therefore use an equity-intensive capital structure.
◼ MNC’s Guarantees on Debt - If the parent backs the debt of its
subsidiary, the subsidiary’s borrowing capacity might be increased.

◼ MNC’s Agency Problems - If a subsidiary in a foreign country cannot

easily be monitored by investors from the parent’s country, agency
costs are higher.

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 Influence of Host Country’s Characteristics on
The MNC’s Capital Structure Decision

Strength of
Country
Host
Risk in Host
Country
Countries
Currencies

Interest
Tax Laws in
Rates in
Host
Host The MNC’s Countries
Countries Capital
Structure
Decision

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 Influence of Host Country’s Characteristics on
The MNC’s Capital Structure Decision
◼ Interest Rates in Host Countries – The cost of loanable funds
may be lower in some countries.
◼ Strength of Host Country Currencies - If an MNC expects
weakness of the currencies in its subsidiaries’ host countries, it may
borrow in those currencies rather than rely on parent financing. If
the subsidiary’s local currency is expected to appreciate, then the
subsidiary may retain and reinvest its earnings.
◼ Country Risk in Host Countries - If an MNC’s subsidiary is
exposed to the risk that the host government might confiscate its
assets, the subsidiary may use much debt financing in that host
country..
◼ Tax Laws in Host Countries - Foreign subsidiaries may be subject
to a withholding tax when they remit earnings.

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 Response to Changing Country
Characteristics

The country Ideal capital

characteristics structure

vary among vary among

countries countries

change within
any particular
change over time
country over
time

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 Subsidiary Versus Parent Capital Structure
Decisions

Increased Subsidiary Debt Financing

• Relies heavily on debt financing
• Reduces its need for its internal equity financing
(retained earnings)

Reduced Subsidiary Debt Financing

• Need to use more internal financing
• Reduce the amount of internal funds available to remit to
the parent.

Limitations in Offsetting a Subsidiary’s

Leverage
• Foreign creditors may charge higher loan rates to a
subsidiary that uses a highly leveraged local capital
structure due to higher credit risk
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 Estimating an MNC’s Cost of Capital

 D   E 
kc =  k d (1 − t ) +  ke
D+E D+E
where
kc weighted average cost of capital
D amount of the firm’s debt
kd before-tax cost of its debt
t corporate tax rate
E firm’s equity
ke cost of financing with equity
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 Estimating an MNC’s Cost of Capital Examples

[Link] MNC has total assets of $100 million and debt

of $20 million. The firm’s before tax cost of debt is
12 percent, and its cost of financing
with equity is 15 percent. The MNC has a corporate
tax rate of 40 percent. What is this firm’s cost of
capital?
[Link] Corporation has a target capital structure
that consists of 40% debt and 60% equity. Werner
can borrow at an interest rate of 10%. Also, Werner
has determined its cost of equity to be 14%.
Werner's tax rate is 40%. What is Werner's weighted
average cost of capital?

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 Multinational Cost of Capital: Equity vs Debt
Financing

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 Exhibit 17.1 Searching for the Appropriate Capital
Structure

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 Cost of Capital for MNCs versus Domestic Firms

Size of firm

Access to global capital markets

International diversification

Exposure to exchange rate risk

Exposure to country risk

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 Cost of Capital for MNCs versus Domestic Firms

Cost of capital for MNCs may differ because of:

1. Size of firm - An MNC that often borrows substantial
amounts may receive preferential treatment from
creditors, thereby reducing its cost of capital.
2. Access to international capital markets - MNC’s access to
the international capital markets may allow it to obtain
funds at a lower cost than that paid by domestic firms.
3. International diversification - If a 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 economy.

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 Cost of Capital for MNCs versus Domestic Firms

Cost of capital for MNC may differ because of:

4. Exposure to exchange rate risk - An MNC’s cash flows
could be more volatile than those of a domestic firm in the
same industry if it is highly exposed to exchange rate risk.
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.

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 Exhibit 17.2 Summary of Factors that Cause the Cost of
Capital of MNCs to Differ from that of Domestic Firms

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 Cost of Equity Comparison Using
the CAPM

ke = Rf + B(Rm – Rf)
Where ke = required return on stock
Rf = risk-free rate of return
Rm = market return
B = beta of stock

The CAPM suggests that required return is a positive function of:

◼ The risk-free rate of interest
◼ The market rate of return
◼ The stock’s beta
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 Cost of Capital: Exercises

1. Wiley, Inc., an MNC, has a beta of 1.3. The U.S. stock market is
expected to generate an annual return of 11 percent. Currently,
Treasury bonds yield 2 percent. Based on this information, what is
Wiley’s estimated cost of equity?

2. Blues, Inc., is an MNC located in the United States. Blues would

like to estimate its cost of capital (WACC). On average, bonds
issued by Blues yield 9 percent. Currently, Treasury security rates
are 3 percent. Furthermore, Blues’ stock has a beta of 1.5, and the
return on the Wilshire 5000 stock index is expected to be 10 percent.
Blues’ target capital structure is 30 percent debt and 70 percent
equity. If Blues is in the 35 percent tax bracket, what is its cost of
capital?
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 Cost of Capital: Exercises (Cont.)
1. Ford is a U.S. firm that conducts major importing and exporting
business in Japan, and all transactions are invoiced in dollars. It obtained
debt in the United States at an interest rate of 10 percent per year. The
long-term risk-free rate in the United States is 8 percent. The stock
market return in the United States is expected to be 14 percent annually.
Ford’s beta is 1.2. Its target capital structure is 30 percent debt and 70
percent equity. Ford is subject to a 25 percent corporate tax rate. Estimate
the cost of capital to Ford

2. Messan Co. (a U.S. firm) borrows U.S. funds at an interest rate of 10

percent per year. Its beta is 1.0. The long-term annualized risk-free rate in
the United States is 6 percent. The stock market return in the United
States is expected to be 16 percent annually. Messan’s target capital
structure is 40 percent debt and 60 percent equity. Messan Co. is subject
to a 30 percent corporate tax rate. Estimate the cost of capital to Messan
Co.

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 Cost of Equity Comparison Using the CAPM

1. Implications of the CAPM for an MNC’s risk:

U.S. based MNC may be able to reduce its beta by
increasing its international business.
2. Implications of the CAPM for an MNC’s projects
Because many projects of U.S.-based MNCs are in
foreign countries, their cash flows are less sensitive to
general U.S. market conditions leading lower project
betas.
3. Applying CAPM with a World Market Index:
A world market may be more appropriate than a U.S.
market for determining the betas of U.S.–based MNCs.
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 Costs of Capital Across Countries

1. Country differences in the cost of debt

◼ Differences in the risk-free rate - The risk-free rate is
the interest rate charged on loans to a country’s
government that is perceived to have no risk of defaulting
on the loans.
◼ Differences in the Credit Risk Premium - The credit
risk premium paid by an MNC must be large enough to
compensate creditors for taking the risk that the MNC
may not meet its payment obligations.
◼ Comparative costs of debt across countries – There is
some positive correlation between country cost-of-debt
levels over time.
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 Exhibit 17.3 Costs of Debt across Countries

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 Costs of Capital Across Countries (Cont.)

2. Country differences in the cost of equity

◼ Differences in the risk-free rate - When the
country’s risk-free interest rate is high, local investors
would only invest in equity if the potential return is
sufficiently higher than that they can earn at the risk-
free rate.
◼ Differences in the Equity Risk Premium - Based on
investment opportunities in the country of concern. A
second factor that can influence the equity risk
premium is the country risk.

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 Home works
1. Slater Co. is a U.S.-based MNC that finances all operations with debt
and equity. It borrows U.S. funds at an interest rate of 11 percent per
year. The long-term risk-free rate in the United States is 7 percent. The
stock market return in the United States is expected to be 15 percent
annually. Slater’s beta is 1.4. Its target capital structure is 20 percent debt
and 80 percent equity. Slater Co. is subject to a 30 percent corporate tax
rate. Estimate the cost of capital to Slater Co

2. Slater Co. is a U.S.-based MNC that finances all operations with debt
and equity. It borrows U.S. funds at an interest rate of 11 percent
per year. The long-term risk-free rate in the United States is 7 percent.
The stock market return in the United States is expected to be 15 percent
annually. Slater’s beta is 1.4. Its target capital structure is 20 percent debt
and 80 percent equity. Slater Co. is subject to a 30 percent corporate tax
rate. Estimate the cost of capital to Slater Co

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 SUMMARY

◼ An MNC’s capital consists of debt and equity. MNCs

can access debt through domestic debt offerings, global
debt offerings, private placements of debt, and loans
from financial institutions. They can access equity by
retaining earnings and by issuing stock through
domestic offerings, global offerings, and private
placements of equity.
◼ If an MNC’s subsidiary’s financial leverage deviates
from the global target capital structure, the MNC can
still achieve the target if another subsidiary or the
parent take an offsetting position in financial leverage.
However, even with these offsetting effects, the cost of
capital might be affected.
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 SUMMARY (Cont.)

◼ An MNC’s capital structure decision is influenced by

corporate characteristics such as the stability of the MNC’s
cash flows, its credit risk, and its access to earnings. The
capital structure is also influenced by characteristics of the
countries where the MNC conducts business, such as
interest rates, strength of local currencies, country risk, and
tax laws. Some characteristics favor an equity-intensive
capital structure because they discourage the use of debt.
Other characteristics favor a debt-intensive structure
because of the desire to protect against risks by creating
foreign debt.

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 SUMMARY (Cont.)

◼ The cost of capital may be lower for an MNC than for a

domestic firm because of characteristics peculiar to the
MNC, including its size, its access to international capital
markets, and its degree of international diversification.
Yet some characteristics peculiar to an MNC can increase
the MNC’s cost of capital, such as exposure to exchange
rate risk and to country risk.
◼ Costs of capital vary across countries because of country
differences in the components that comprise the cost of
capital. Specifically, there are differences in the risk-free
rate, the risk premium on debt, and the cost of equity
among countries. Countries with a higher risk-free rate
tend to exhibit a higher cost of capital.
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