IB0010-Unit-10-Management of a Multinational Firm Structure: 10.1 Introduction Objectives 10.

2 Cost of Capital for Multinational Corporations vs Domestic Firms Determinates of affiliates/subsidiarys capital structure Target capital structure Tax advantages to debt financing 10.3 The Optimal Capital Structure and Cost of Capital The cost of equity capital Computing the weighted cost of capital 10.4 Cost of Capital across Countries Country differences in cost of debt Country differences in cost of equity 10.5 Practical Framework of the Corporate Financing Decisions 10.6 Summary 10.7 Terminal Questions 10.8 Answers 10.1 Introduction In the last unit, we studied about the management of economic and operational exposure. Economic exposure refers to the extent to which the economic value of a company can decline due to changes in exchange rate. It is the overall impact of exchange rate changes on the value of the firm. Managing economic exposure is very important for the long-run health of an organisation than managing changes caused by transaction or translation exposure. In the present unit, you will study about the management of MNCs. Reflecting the trend towards more liberal world financial markets, major corporations throughout the world have begun to

internationalize their capital structure by raising funds both in the domestic as well as in the foreign market. An MNC's cost of capital may be lower than that of a domestic firm in the same industry due to its size advantage, access to international capital markets and an ability to stabilize cash flows through international diversification. Concurrently, MNCs whose operations are geographically well diversified will tend to have a lower systematic risk than those operating mainly in the domestic market. Objectives After studying this unit, you will be able to: Compare the cost of capital for MNCs and domestic firms Describe the optimal capital structure Identify the cost of capital across countries Describe the practical framework of corporate financing decisions 10.2 Cost of Capital for Multinational Corporations vs Domestic Firms The cost of capital for an MNC may differ from that of a fully established domestic firm on account of the characteristics of MNCs that differentiate them from domestic firms. These differences include the following: 1. Size of the firm: Firms that operate internationally are usually much bigger in size than firms which operate only in the domestic market. Firms that operate internationally generally borrow substantial amounts of funds and by virtue of their size, they are generally in a position to reduce the various transaction and brokerage costs and also get preferential treatment from creditors. This helps them to reduce their cost of capital compared to domestic firms. 2. Foreign exchange risk: An exceptionally volatile exchange rate, or one that always depreciates, is not conducive to attracting long-term foreign investors. Such a MNCs cash flow would have wide fluctuations and the capability of the corporation to make various fixed term commitments like interest would get reduced. This may force the shareholders and creditors to demand a higher return which, in turn, increases the MNCs cost of capital. A firm more exposed to exchange rate fluctuations would have a wider spread of possible cash flows in future periods. Thus, exposure to exchange rate fluctuations could lead to a higher cost of capital. 3. Access to international capital markets: The fact that MNCs can normally access the international capital market helps them to attract funds at a lower cost than the domestic firms. In a global context, since the funds are not completely mobile, the cost of funds varies among markets. Also, the subsidiary can obtain local funds at a lower rate than the parent if the prevailing interest rates in the host country are relatively low. This form of financing helps to lower the cost of capital and will generally not increase the MNCs exposure to exchange rate

risk. 4. International diversification effect: If a firms cash inflows come from sources all over the world, there might be more stability in them. MNCs like Nike, Coca-Cola, Microsoft, Intel, Procter and Gamble, British Airways, etc., have cash inflows coming from sources all over the world. Generally, MNCs by virtue of their diversified operations can reduce their cost of capital compared to domestic firms for two reasons. First, diversification contributes to the stability of the overall cash flows. As the variability in cash flows is less, this helps the firm in lowering its weighted average cost of capital. Second, international diversification helps to lower the systematic risk of the firm by lowering its beta coefficient and thus the cost of equity. (The International Capital Asset Pricing Model is used here.) 5. Political risk: Political risk can be accounted for in the cost of capital calculations by adding an arbitrary risk premium to the domestic cost of capital for a project of comparable risk. As political risk is likely to be higher in the later years of a project, cash flows in later years tend to get reduced. Thus political risk impacts the cost of capital of the MNC by moving it upwards as compared to a domestic firm. 6. Country risk: Country risk represents the potentially adverse impact of a countrys environment on the MNCs cash flows. If the country risk level of a particular country begins to increase, the MNC may consider divesting its subsidiaries located there. Several risk characteristics of a country may significantly affect the cash flows of the MNC and the MNC should be concerned about the degree of impact likely for each. 7. Tax concessions: MNCs generally choose countries where the tax laws are favourable for them as their net income is substantially influenced by the tax laws in the locations where they operate. In some cases, the MNC may be able to lower its cost of capital by availing of the various tax advantages not available to a purely domestic firm. 10.2.1 Determinates of affiliates/subsidiarys capital structure Although multinational affiliates are legally distinct entities, the capital structure decision of these affiliates cannot be considered separately from the capital structure decision of their parents. A number of surveys indicate that parent firms do not allow foreign subsidiaries to default on their obligations even in the absence of explicit parental guarantees. Consequently, the capital structure of the affiliates vary according to the relative prices of distinct financing instruments in different locations, i.e., the affiliates take advantage of opportunities to minimise the cost of capital. Thus, a subsidiary with a capital structure similar to its parent may miss out on profitable opportunities to lower its cost of funds. It may be very expensive for a subsidiary to borrow funds locally to meet parent norms if it is operating in a high-cost capital market. On the other hand, strict adherence to a fixed debt-equity ratio may not allow a subsidiary to take advantage of subsidised debt or low cost loans for international agencies. Hence, MNCs recognise the trade-off between using debt and equity financing and analyse the various characteristics to

arrive at the optimal capital structure decision. 10.2.2 Target capital structure An MNC may deviate from its target capital structure in each country where financing is obtained, yet still achieve its target capital structure on a consolidated basis. The following examples of particular foreign country conditions illustrate the motive behind deviating from a local target capital structure while stile satisfying a global target capital structure. Examples Consider an example in which country A allows the MNC to issue stock there and list its stock on its local exchange. Also assume that the project to be implemented in that country will not generate net cash flows for 7 years. In this case, equity financing may be more appropriate. The MNC could issue stock, and by paying low or zero dividends, it could avoid any major cash outflows for the next 7 years. It might offset this concentration in equity by using mostly debt financing in some other host country. As a second example, consider an MNC that desires financing in country B which is experiencing political unrest. The use of local bank loans would be most appropriate since local banks will ensure that MNC's operations are profitable and they are in a position to repay its loans. As a third example, consider a country C which does not allow MNCs with headquarters elsewhere to list their stock on its local stock exchange. Under these conditions, an MNC would most likely decide to borrow funds through bond issuance or bank loans rather than by issuing stock in this country. By being forced to use debt financing here, the MNC might deviate form its target capital structure, which could raise its overall cost of capital. It might offset this concentration in debt by using complete equality financing in some other host country that allowed the firm's stock to be listed on the local exchange. The above examples clearly illustrate that the MNC capital structure in each individual country may deviate from the global target capital structure established by the MNC. The right strategy for the parent here would be to adjust the mix of debt and equity financing in its own country (where it has the flexibility) to achieve the global target capital structure. 10.2.3 Tax advantages to debt financing The differential tax advantage to debt across markets for foreign affiliates is a function of the international tax system. For example, the US grants credit to multinationals for foreign taxes paid in order to mitigate double taxation. Borrowing through debt by a subsidiary also has the tax and flexibility advantage. This is due to the fact that a firm has a wider latitude in the repayment of loan and interest than as dividends or reductions in equity. Another advantage of using the parent company loans is the possibility of reducing taxes. If foreign tax rates are below home rates, dividends will generally lead to increased taxes whereas loan repayments will not. Firms

do not have complete flexibility in choosing their debt/equity ratios abroad. Self Assessment Questions 1. Financial managers are ultimately concerned with the MNC's ability to minimise the cost of capital. (True/False) 2. Firms that operate internationally are usually much bigger in size than the domestic firms. (True/False) 3. Exposure to exchange rate fluctuations could lead to a lower cost of capital. (True/False) 4. The political risk impacts the cost of capital of the MNC by moving it upwards as compared to a domestic firm. (True/False) 5. MNCs generally choose countries where the tax laws are favourable. (True/False) 6. The overall capital structure of a parent is essentially a combination of all of its subsidiarys capital structures. (True/False) 10.3 The Optimal Capital Structure and Cost of Capital The objective of capital structure management is to mix the permanent sources of funds in a manner that will maximise the companys common stock price. This will also minimise the firms composite cost of capital. This proper mix of fund sources is referred to as the optimal capital structure. Thus, for each firm, there is a combination of debt, equity and other forms (preferred stock) which maximises the value of the firm while simultaneously minimising the cost of capital. The financial manager is continuously trying to achieve an optimal proportion of debt and equity that will achieve this objective. 10.3.1 The cost of equity capital The cost of equity capital is the required rate of return needed to motivate the investors to buy the firms stock. Calculation of the cost of equity is a difficult process and needs more approximations than calculating the cost of debt. For established firms, the dividend growth model may be used for computing the cost of equity. This model is also called the Gordon model.

Where, Ke is the cost of equity capital D1 are Dividends expected in year one

P0 is the current market price of the firms stock g is the compounded annual rate of growth in dividends or earnings Alternatively, the cost of equity capital may be calculated by using the modern capital market theory. According to this theory, an equilibrium relationship exists between an assets required rate of return and its associated risk which can be calculated by the Capital Asset Pricing Model (CAPM). The cost of equity may be calculated by the CAPM by using the following formula

Where E(Rj) is the expected rate of return on asset j. Rf is the rate of return on a risk free asset measured by the current rate of return or yield on treasury bonds. E(Rm) is the expected rate of return on a broad market index such as the standard and poor index of industrial stocks. is the beta of stock j, measured by the relative variability or volatility of the rate of return on the stock compared to the variability of the return on a broad market index. A beta of 1 (unity) denotes a risk equivalent to the one entailed in an investment in a diversified portfolio of stocks. Figure 10.1 shows the Capital Asset Pricing Model.

Figure 10.1: The Capital Asset Pricing Model Both, the Gordon Model and the CAPM, yield a risk adjusted rate of return on equity. The major difference is that the latter utilises beta which is a measure of the market related or systematic risk rather than total risk which is traditionally measured by the standard deviation. Both methods yield acceptable and conceptually defensible estimates of the rate required by the investors given the degree of risk inherent in the investment. For firms with no established track record and for which beta coefficients are not available, the cost of equity may be derived by adding an arbitrary risk premium (ranging between four to six percentage points) to the firms

recent borrowing rate. 10.3.2 Computing the weighted cost of capital A firms weighted cost of capital is a composite of the individual costs of financing weighted by the percentage of financing provided by each source. Therefore, a firms weighted cost of capital is a function of (i) the individual cost of capital, and (ii) the make up of the capital structure, i.e., the percentage of funds provided by debt, preferred stock and common stock. Thus, when a firm has both debt and equity in its capital structure, its financing cost can be represented by the weighted average cost of capital. This can be computed by weighting the after-tax borrowing cost of the firm and the cost of equity capital using debt ratio as the weight. Specifically K = (1 Wd) Ke + Wd (1 T) i Where K is weighted average cost of capital Ke is cost of equity capital for a levered firm i is before-tax borrowing cost T is applicable marginal corporate tax rate and Wd is debt to total market value ratio. In general, both Ke and i increase as the proportion of debt in the firms capital structure increases. At the optimal combination of debt and equity financing, however, the weighted average cost of capital (K) will be the lowest. Firms generally use debt financing to take advantage of the tax deductibility of interest payments. However, this should be balanced against the possible bankruptcy costs associated with higher debt. A trade-off between the tax advantage of debt and potential bankruptcy costs is thus, a major factor in determining the optimal capital structure. The firms cost of capital can also be measured as the weighted average cost of the individual sources of long-term financing. Specifically Ko = Wd Kd (i t) + Wp Rp + We Re Where, We refers to the relative share of equity capital to the total long-term funds of the organisation. Wp refers to the weighted preference share capital. Wd refers to the weighted cost of debt and Ke, Kp and Kd refer to the cost of equity, preference

and debt respectively. The weights used to calculate the relative proportions of Wd, Wp and We could be based on book value or market value. Generally, market value weights are considered to be theoretically superior to book value weights as they represent the current market scenario. In practice, however, there are practical problems involved in the calculation of market value weights. The firm would like to calculate the optimal capital structure that represents the combination of debt and equity financing that minimises the cost of capital. However, this minimum cost of capital would generally vary with each firms operating and financial characteristics. Firms with more stable cash inflows would not mind a capital structure with a relatively large proportion of debt as the interest payments can be met with certainty.

Self Assessment Questions 7. MNCs with erratic cash flow may prefer _________ . 8. MNCs that have a higher level of retained earning may rely more on _________ capital structure. 9. MNCs that have subsidiaries diversified across several countries also tend to have a more _________ capital structure. 10. The objective of capital structure management is to mix the permanent sources of funds in a manner that will _________ the companys common stock price. 11. The proper mix of fund sources is referred to as the _________ capital structure. 10.4 Cost of Capital across Countries Just like technological or resource differences, there exist differences in the cost of capital across countries. Such differences can be advantageous to MNCs in the following ways: 1. Increased competitive advantage results to the MNC as a result of using low cost capital obtained from international financial markets compared to domestic firms in the foreign country. This, in turn, results in lower costs that can then be translated into higher market shares. 2. MNCs have the ability to adjust international operations to capitalise on cost of capital differences among countries, something not possible for domestic firms. 3. Country differences in the use of debt or equity can be understood and capitalised on by MNCs.

We now examine how the costs of each individual source of finance can differ across countries. 10.4.1 Country differences in cost of debt Before tax cost of debt (Kd) = Rf + Risk Premium This is the prevailing risk free interest rate in the currency borrowed and the risk premium required by creditors. Thus, the cost of debt in two countries may differ due to difference in the risk free rate or the risk premium: (a) Differences in risk free rate: Since the risk free rate is a function of supply and demand, any factors affecting the supply and demand will affect the risk free rate. These factors include: -Tax laws: Incentives to save may influence the supply of savings and thus the interest rates. The corporate tax laws may also affect interest rates through effects on corporate demand for funds. -Demographics: They affect the supply of savings available and the amount of loanable funds demanded depending on the culture and values of a given country. This may affect the interest rates in a country. -Monetary policy: It affects interest rates through the supply of loanable funds. Thus a loose monetary policy results in lower interest rates if a low rate of inflation is maintained in the country. -Economic conditions: A high expected rate of inflation results in the creditors expecting a high rate of interest which increases the risk free rate. (b) Differences in risk premium: The risk premium on the debt must be large enough to compensate the creditors for the risk of default by the borrowers. The risk varies with the following: -Economic conditions: Stable economic conditions result in a low risk of recession. Thus there is a lower probability of default. -Relationships between creditors and corporations: If the relationships are close and the creditors would support the firm in case of financial distress, the risk of illiquidity of the firm is very low. Thus a lower risk premium. -Government intervention: If the government is willing to intervene and rescue a firm, the risk of bankruptcy and thus, default is very low, resulting in a low risk premium. -Degree of financial leverage: All other factors being the same, highly leveraged firms would have to pay a higher risk premium. 10.4.2 Country differences in cost of equity

Cost of equity (Ke) = Rf + (Rm Rf) The return on equity can be measured as an interest free rate that could have been earned by the shareholders, plus a premium to reflect the risk of the firm. Since risk free interest rates vary if we describe how finance managers generally pay little attention to what the theory says they should do about their capital structure and across countries, the costs of equity can also vary. In a country with many investment opportunities, potential returns may be relatively high, resulting in a high cost of funds and thus a high cost of capital. Issue and floatation costs, the dividends given to the shareholders, withholding taxes and capital gains taxes are some of the variants that affect the cost of equity of the MNCs cost of equity. Self Assessment Questions 12. The cost of debt in two countries may differ due to difference in the _________ or the risk premium. 13. Monetary policy affects the ____ through the supply of loanable funds. 10.5 Practical Framework of the Corporate Financing Decisions Pecking order of financing: The phenomenon was first discovered by Donaldson and is considered to be the cornerstone of modern capital structure theory and practice. Pecking order can be explained if we describe how finance managers generally pay little attention to what the theory says they should do about their capital structure and follow their own strategy based on return vs risk framework, investment and financing decision in order to optimise their capital structure. Each company has its own preferred optimal capital structure, which depends upon macroeconomic, industry-specific, firm-specific and manager-specific factors. Retained earnings are the most efficient way to finance a firm as they incur the minimum cost compared to debt or equity. It is very difficult to say in absolute terms which are the preferred source of financing: debt or equity, short-term debt or long-term debt. Each one has its own merits and has a unique role to play. However, in terms of issuance costs retention are the cheapest, then come trade credits, short-term credits, then bank loans, then private issues of bonds, convertible bonds and equity in that order. This generally corresponds to the "pecking order" hypothesis. Matching financing decisions with specific markets: In terms of specific markets, firms may prefer to use a customised financing approach for different markets for example, capital abroad can be serviced at lower rates than domestically to gain a comparative advantage. Also, domestic markets can be segmented into various groups based on regulatory and other issues. Each of these strategies will, in the long run, hopefully minimise the firm's cost of capital. Matching financing strategy with competitive strategy: Each firm has an efficient, unique and powerful competitive strategy. Firms pay a lot of attention to the strategy that they hope to follow in the long run whether to integrate with a few other firms or to operate independently in

high-tech areas or in traditional markets. Generally the competitive strategy that the firm adopts will be an important factor in the financing decision. Illustration 1: A firm with a corporate wide debt/equity ratio of 1:2, an after-tax cost of debt of 7% and a cost of equity capital of 15% is interested in pursuing a foreign project. The debt capacity of the project is the same as for the company as a whole but its systematic risk is such that the required return on equity is estimated to be about 12%. The after-tax cost of debt is expected to remain at 7%. (a) What is the projects weighted average cost of capital? How does it compare with the parents WACC? (b) If the projects equity beta is 1.21, what is its unlevered beta? Solution (a) The weighted average cost of capital for the project is K1 = (1 w) ke1 + w x id (1 t) Where w is the ratio of debt to total assets, ke is the required risk adjusted return on project equity and id (1 t) is the after-tax cost of debt for the project. Substituting the numbers provided yields K1 = 1/3 12% + 2/3 7% = 8.67% (b) The following approximation is usually used to unlever beta Unlevered beta = Levered beta/[1 + (1 t) D/E] where t is the firms marginal tax rate and D/E is its debt/equity ratio. Without knowing the firms marginal tax rate, we cannot unlever beta. Assuming that the marginal tax rate is about 40%, the unlevered beta is Unlevered beta = 1.21/[1 + (1 .4) ] = .93 Illustration 2: Suppose that a foreign project has a beta of 0.85, the riskfree return is 12% and the required return on the market is estimated at 19%. What is the cost of capital for the project? Solution

The cost of capital for the project is K* = Rf + ?* [E(Rm) Rf] where Rf is the risk free required return, ?* is the project beta and E(Rm) is the expected return on the market. Substituting the numbers provided in the problem yields K* = .12 + .85 (.19 .12) = 17.95% Illustration 3: ABC Inc. has a $200 million principal value euro-bond with two more 10% coupon interest payments due at the end of the next two years. ABC Inc. would like to switch currencies on the bond. The issue is currently denominated in yen but ABC Inc. feels the Deutschemark would be more advantageous. Given the following current and expected currency rates, what should ABC Inc. do, assuming it wishes to minimise its expected financing cost? The interest rate will remain at 10%.

Solution Assuming the 10% interest rate applies to all currencies, then the dollar obligation translates into the yen and DM obligations as shown below:

In both cases, the expected dollar equivalent coupon and principal payments exceed the corresponding dollar payments that would be made under the Euro-dollar bond financing ($20 million in year 1 and $220 million in year 2). As can be seen from the figures above, dollar financing is least expensive followed by yen financing. The DM financing is most expensive.

Illustration 4: Suppose the current rate of exchange between the US dollar and the pound sterling is 1 = $2. The English affiliate of Global Industries, GI Ltd, is contemplating raising $12 million by issuing bonds denominated either in dollars or pounds sterling. The dollar bonds would carry a coupon rate of 10% and the pound sterling bonds would carry a coupon rate of 13%. In either case, the bonds would have annual interest payments and mature in five years. (a) Suppose GI Ltd is interested only in minimising its expected financing costs. In the absence of taxes, what annual rate of pound devaluation or revaluation would leave GI Ltd indifferent between borrowing either pounds or dollars? What should be the expected exchange rate at the end of year 5, given these currency changes? Solution The break-even amount of annual pound devaluation that would leave GI Ltd indifferent between borrowing pounds or dollars is found as the solution to .13 (1 d) d = .10 or d = 2.65% This translates into the following sequence of exchange rates

Self Assessment Questions 14. The competitive strategy that the firm adopts will be an important factor in the financing decision. (True/False) 15. In terms of specific markets, firms may prefer to use a customised financing approach for different markets. (True/False) 10.6 Summary The ongoing liberalisation and deregulation of international financial markets has made a significant impact in measuring the firm's cost of capital and in determining the optimal capital structure. The cost of capital for an MNC will differ from that of a domestic firm because of characteristics peculiar to the MNC. The differences may be due to size of the firm, foreign exchange risk, access to international capital markets, political risk, international diversification and country risk. The cost of capital varies across countries due to country differences in the components of the cost of capital viz. cost of debt and cost of equity. There are country differencies in the risk free rate and the risk premium on debt. Capital structure decisions of the MNC are influenced by corporate characteristics such as stable cash flows, low credit risk etc in deciding whether to use a more debt intensive or equity

financing capital structure for its subsidiaries. Glossary CAPM: Capital Asset Pricing Model Cost of Equity: The cost of equity capital is the required rate of return needed to motivate the investors to buy the firms stock. Country Risk: Country risk represents the potentially adverse impact of a countrys environment on the MNCs cash flows. Foreign Exchange Risk: Risk arise due to changes in exchange rate. 10.7 Terminal Questions 1. Why should the cost of capital for an MNC differ from that for a domestic firm? Elucidate with examples. 2. Briefly explain how an MNC can calculate its cost of equity capital? 3. Explain the country differences in cost of debt. 4. Discuss the pecking order of financing as given by Donaldson. 10.8 Answers Answers to Self Assessment Questions 1. True 2. True 3. False 4. True 5. True 6. True 7. More debt 8. Equity intensive

9. Debt intensive 10. Maximise 11. Optimal 12. Risk free rate 13. Interest rates 14. True 15. True Answers to Terminal Questions 1. Refer to 10.2 The level of risk of an international firm is higher than a domestic firm due to the size of the firm, exchange risk and other risks etc. 2. Refer to 10.3 For calculating the cost of capital companies can used different models like CAPM, dividend model etc. 3. Refer to 10.4.1 The cost of debt in two countries may differ due to difference in the risk free rate or the risk premium. 4. Refer to 10.4 Pecking order focus on need based financing. Mini-case Capital Structure across Countries A Case Study of Pharmaceutical Firms In many developing countries, financing decisions of firms are greatly influenced by government controls, regulations and policies, such as relative tax treatment of debt vs. equity, bonds vs. loans, restriction on foreign ownership of equity and foreign placement of debt, special privileges to certain groups of investors etc. IFCs study (1994) on corporate capital structure practices in developing and developed countries identifies certain similarities and dissimilarities across firms. The study concludes that those emerging market firms, which are more leveraged, resort to outside financing and retain a greater share of earnings to grow faster than others. Also, developing country firms are much more lightly leveraged than their counterparts in developed countries which means the link between the corporate sector and the financial system are more important than in developed countries. The objective of the present case study is to examine whether developed countries have more debt in their capital structure vis-a-vis developing countries. Table 1 presents the debt-equity ratio of the parent company for four leading pharmaceutical companies namely Glaxo,

SmithKline Beecham, Novartis and Pfizer with the debt-equity ratio of their Indian subsidiaries over a duration of four years. Table 1: Debt-equity Trend

Glaxo Welcome is the leader in asthma products with approximately 31% share of the global market. SKB is known mainly for its hugely successful brand Iodex and also has a strong presence in vaccines. SKB, UK is one of the leading life-sciences companies in the world and its products like Iodex and Zevit are numero uno in their respective categories. Novartis was formed by merger of Sandoz with Hindustan Ciba (April 1996). Now it is a 51% subsidiary of Novartis AG, Switzerland, one of the leading life science companies in the world. Finally, Pfizer is one of the leading pharma companies in the world and has achieved great success with the anti-potency drug Viagra. Question Empirical evidence shows that firms strongly prefer retentions than debt and choose equity financing as a last resort. This is the cornerstone of modern capital structure theory and practice. Can you explain this phenomenon from the firms perspective? Hint: Companies prefer equity financing because it does not create any fixed burden on the company while in debt financing company have to pay the fixed expenses in any case.