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Chapter

17
Multinational Cost of Capital & Capital Structure

South-Western/Thomson Learning 2003

Cost of Capital
A firms 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 firms weighted average cost of capital
kc = ( D ) kd ( 1 _ t ) + ( E ) ke
D+E D+E where D E kd t ke is the amount of debt of the firm is the equity of the firm is the before-tax cost of its debt is the corporate tax rate is 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 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


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 + b (Rm Rf )


where ke = Rf = Rm = b = the required return on a stock risk-free rate of return market return the beta of the stock
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Cost of Capital for MNCs


A stocks beta represents the sensitivity
of the stocks returns to market returns, just as a projects beta represents the sensitivity of the projects cash flows to market conditions.

The lower a projects 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 stocks 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 projects 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


A countrys 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 countrys 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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Using the Cost of Capital for Assessing Foreign Projects


Foreign projects may have risk levels
different from that of the MNC, such that the MNCs 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 firms WACC. 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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Adjust the WACC for the risk differential.

The MNCs 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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