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AJA4604.12
Multinational Capital Budgeting, Cost of Capital
and Capital Structure
An Outline:
(a) Inputs into a Capital Budgeting Decision
(b) Additional Factors in Multinational Capital Budgeting.
(c) Adjusted Present Value Method
(d) Cost of Capital
(e) Capital Structure

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Definition: Capital budgeting is the decision-making
process with respect to investment in fixed assets.

Inputs into the Capital Budgeting Decision
Initial investment
Consumer demand
Price
Variable cost
Fixed cost
Project lifetime
Salvage value
Tax-laws
Required rate of return
A. Basics of Capital Budgeting
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Other Factors in Multinational Capital Budgeting
Exchange rate fluctuations
Relative inflation
Financing arrangements subsidies /penalties
Blocked funds
Remittance provisions
Uncertain salvage values
Impact of project on prevailing cash flows
Government incentives
Social costs / Externalities
Political risk /Country risk.
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Transfer prices
Treatment of fees, royalties, etc.
Aggregating the cash flows and assigning
applicable discount rate to each component.


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Basics of Capital Budgeting
Popular Techniques
1. Payback Period: Is the length of time needed to recoup the
initial investment. This equals the length of time it takes for
cumulative nominal cash inflows to equal the initial outlay.
Discounted Payback Period is a modified form of the Standard
Payback Period which incorporates time value.
2. Net Present Value: Is the expected value, in today's dollars, after
considering all costs, of cash flows from a project.





k = required rate of return on "project."
Cost of capital is the cost of long-term funds for the firm.
( )
NPV I
CF
k
t
t
t
n
= +
+
=

0
1
1
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Decision Rule: When NPV > 0, accept the project.
When NPV < 0, reject the project.

When each of two mutually exclusive projects has
positive NPV, the project with the higher NPV
should be selected.
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3. Profitability I ndex (PI ): Considers the ratio of present
value of a project's cash flows to its initial outlay.




CF
t
= cash flow at time t
I
0
= initial outlay
k = required rate of return (cost of capital)

Decision Rule: When PI > 1, accept the project.
When PI < 1, reject the project.
PI
CF
k
I
t
t
t
n
=
+
=

( ) 1
1
0
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4. I nternal Rate of Return (I RR): Is the rate of return
that the firm expects to earn on the project.
Mathematically, it is the "discount rate" that equates
the present value of cash flows to the initial outlay, so
that




Decision Rule:
When IRR > required rate of return, accept project.
When IRR < required rate of return, reject project.
CF
IRR
I
t
t
t
n
( ) 1
1
0
+
=
=

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5. Modified I nternal Rate of Return (MI RR):
This is given by:
PV Cost = PV of Terminal Value (TV)






I
0
I
1
I
2
I
j
CF
t
CF
t+1
CF
t+2
CF
n-t

|--------|--------|----------|----------------|-------|--------|-----------------|
0 1 2
j
t t+1 t+2 n
where: I
t
= cash outflows, COF; CF
t
= cash inflows
n
MIRR
TV
PVCost
) 1 ( +
=

= =

+
+
=
+
j
t
n
t
n
t n
t
t
t
MIRR
K CIF
k
COF
0 1
) 1 (
) 1 (
) 1 (

+
+
=
+
=
n
t
n
t n
t
n
MIRR
k CIF
MIRR
TV
PVCost
1
) 1 (
) 1 (
) 1 (
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Shareholders wealth maximization is the primary
objective.

Shareholders are interested in how many additional
dollars they will receive in the future for the dollars
invested today.

Hence, incremental, not total cash flow, is what
matters.

Incremental Cash Flows and Factors
Affecting Cash Flows
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Effects of sales from the (new) investment on
existing divisions:

Cannibalization: New product taking away sales
from the firm's existing products, e.g., substituting
foreign production for parent company exports.

Sales Creation: New investment creates
additional sales for existing products.
The benefits of additional sales (or lost sales) and
associated incremental (decreased) cash flows
should be attributed to the project.
Differences Between Incremental and
Total Cash Flows
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Transfer Pricing: Prices at which goods and
services are traded internally can significantly
distort the profitability of a proposed investment.

As far as possible prices of a project's inputs and
outputs should be market prices.

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Opportunity Costs: Project costs must include
the true economic cost of any resource required
for the project - already owned or just acquired.

Sunk Costs: Cash outlay already incurred, and
which cannot be recovered regardless of whether
project is accepted or rejected, e.g., site analysis,
feasibility studies, etc.
Exclude sunk costs from cost considerations.
Other Factors:
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Fees and Royalties: These are costs to the
project but are benefits to the parent, e.g., legal
counsel, power, lighting, heat, rent, R&D, H.Q.
cost, and management costs, etc.

A project should be charged only for additional
expenditures that are attributable to the project.

In general, incremental cash flows associated
with an investment can be found by subtracting
worldwide corporate cash flows without the
new investment from "with" the new investment
cash flows.

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Capital budgeting analysis for a foreign project is
considerably more complex than domestic case for
a number of reasons including:

Parent Cash Flows Vs. Project Cash Flows:
Parent cash flows often depend on the form of
financing - so that cash flows cannot be clearly
separated from financing decisions as is practicable
in a purely domestic capital budgeting exercise.


Foreign Complexities and Opportunities
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Remittance of funds to parent is compounded by
differences in tax systems and financial markets and
institutions as well as legal and political constraints
on funds movement.

Cash flows from affiliate to parent can be generated
by an array of operational, financial or non-financial
payments, e.g., fees, royalties, transfer pricing, etc.

Different rates of national inflation introduce changes
in competitive position.

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Unanticipated changes in foreign exchange rates
have direct and indirect effects on costs, prices, and
sales volume.

Transaction across segmented national markets may
create opportunities for financial gains or lead to
additional costs.
Benefits of enhanced global service network.

Diversification of production facilities.

Market diversification.
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Availability of host government subsidized loans
may complicate capital structure decisions and the
appropriate WACC.

Political risks must be evaluated, and costs may
be involved in the management of political risks.

Terminal value is more difficult to estimate, i.e.,
uncertain salvage value.

Foreign complexities must be quantified as
modifications to either expected cash flows or
the rate of discount.

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International Capital Budgeting Decision Model
Multinational capital budgeting problems can be
solved by appealing to the principle of value
additivity.
This states that the whole value of a project is equal
to the sum of its parts.

The Adjusted Present Value (APV) rule divides up
the present value terms and focuses on each
component to maximize the development and use
of information.
Each present value term employs an appropriate
discount rate for its level of systematic risk.
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Lessard (1981) extends this approach to deal
with foreign investment projects as follows:
APV= -PV of capital outlays
+PV of remittable after tax operating cash flows
+PV of tax savings from depreciation
+PV of financial subsidies
+PV of other tax savings
+PV of extra (indirect) remittances
+PV of projects contribution to corporate debt
capacity
+PV of residual plant and equipment (salvage)

Multinational Capital Budgeting Examples.
(See sample problem set III, part B)

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Multinational Cost of Capital & Capital Structure
A firms capital consists of:
Retained Earnings
Equity (existing or newly issued)
Preferred Stock
Debt (borrowed funds)

The firms cost of retained earnings reflects the
opportunity cost - what existing shareholders could
have earned if they invested the funds themselves.

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The firms cost of new equity also reflects an
opportunity cost - what the new shareholders could
have earned if they had invested their funds
elsewhere.

The cost of new equity exceeds the cost of retained
earnings by the floatation costs.

The firms cost of debt increases with the level of
debt.
Increases in the level of debt also increases the
probability of default.
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Tax deductibility of interest payments on debts
enhances the attractiveness of debt financing.

A firm must maintain a proper balance between
the tax advantage of debt and its disadvantage
(greater probability of bankruptcy).

The firms weighted average cost of capital
(WACC) can be computed as:
(Total Capital = Debt + Equity + Pref. Stock)

WACC = W
d
K
d
(1-t) + W
p
K
p
+ W
e
K
e


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Assuming that the firms capital is made up of
debt and equity, then:



where:
D = Proportion of capital (D+E) made up of debt,
E = The proportion of equity,
K
d
= Cost of debt,
K
e
= Cost of Equity and
t = tax rate.

( )
e d
K
E D
E
t K
E D
D
WACC
|
.
|

\
|
+
+
|
.
|

\
|
+
= 1
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Factors in Multinational Cost of Capital
Size of the Firm: The larger the size of the firm, the
larger the amount that is borrowed. In addition, larger
issues of stocks or bonds allow for reduced
percentage flotation costs.

Access to International Capital Markets: Access to
international capital markets allows MNCs to attract
funds at lower costs than purely domestic firms.

International Diversification: Diversified cash flow
sources result in more stable cash inflows for MNCs
which may reduce the probability of bankruptcy and
therefore reduce the cost of capital.
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Exposure to Exchange Rate Risk: Firms that are
highly exposed to exchange rate risk may experience
greater cash inflow volatility.

However, exposure to a basket of currencies will
mitigate or eliminate such a problem.

Exposure to Country Risks: To the extent to which
country risks are not diversifiable, increased cash
inflow volatility may result with attendant higher
cost of capital.

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Cost of Capital Across Countries:
Variations in the cost of capital across countries may help
to explain why MNCs are able to adjust their international
operations and sources of funds.
Differences in the cost of each capital component across
countries may explain why MNCs based in some
countries use more debt-intensive capital structure than
MNCs based elsewhere.
Differences in the Risk-Free Interest Rate:
The risk-free rate is frequently proxied by the yield on
3-month T-bills.
The rate is determined by supply and demand conditions
in each country, tax laws, monetary policies,
demographics, and economic conditions.
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Differences in the Risk Premium:
The risk premium is affected by the relationship between
borrowers and creditors (e.g.. Japans Keiretsu), and the
propensity of governments to intervene and rescue ailing
or failing firms (compare US. to UK).
Also firms in some countries have greater borrowing
capacity because creditors are tolerant of higher degrees
of financial leverage (e.g. Japanese and German firms
have higher degrees of financial leverage than US. firms).

Country Differences in the Cost of Equity:
The cost of equity is related to investment opportunities
in each country.
In a country with many investment opportunities,
potential returns may be relatively high resulting in a
relatively high opportunity cost of funds.
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International Differences in Cost of Equity Capital

Effectiveness of a Countrys Legal Institutions:

Well-functioning legal systems protect investors,
reduce monitoring and enforcement costs to investors,
reduces a firms cost of capital by leveling the playing
field among investors.

Differences in Securities Regulation:

Requirement of, and enforcement of, certain financial
disclosures help to reduce asymmetric information
between the firm and its investors and among
investors.

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Some of the firm specific characteristics that affect
MNCs capital structure include:

Stability of MNCs cash flows.

MNC credit risk - a MNC with assets acceptable
as collateral has greater access to loans.

Level of retained earnings.

Multinational Capital Structure:
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Entry and cross-border barriers to investing.
Interest rates in host countries are affected by capital
controls, tax rates & country risks.

A MNCs preference for debt or equity may depend
on relative costs in a particular country.

Host country currency innovations.
Country risks.
Relative tax laws.

Influence of Country Characteristics
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MNCs may deviate from their target capital structure
in host countries but still able to achieve their target
capital structure on a consolidated basis.
i.e., MNCs may ignore local target capital structure
in favor of a global target capital structure.

Multinational Target Capital Structure
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When MNCs allow (or are forced to allow) foreign
subsidiaries to issue stocks to local investors, such a
subsidiary becomes partially owned by the parent.
This can affect MNCs capital structure.

In some countries, a MNC will be allowed to establish
a subsidiary only if it meets the minimum percentage
of ownership by local investors.

A minority interest in a subsidiary by local investors
may, however, offer some protection against threats
of any adverse action by the host government.
Partially Owned Subsidiaries :
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Firms in Japan and Germany tend to use a higher
degree of financial leverage than U.S or U.K firms.

The system of interlocking ownership in Japan may
encourage a greater use of leverage.

Other International Factors
Stock restrictions in host countries
Interests rates in host countries
Strength of host country currencies
Country risk in host countries
Tax laws in host countries
Capital Structure Across Countries
Qu. 1: The following are major factors in multinational
cost of capital except:
Size of the firm
Access to international capital markets
International diversification of firm
Exposure to exchange risk
Exposure to country risk

Qu. 2: Which of the following is not a factor accounting
for variations in the cost of capital across countries:
Differences in risk free interest rate
Differences in risk premium
Differences in cost of equity
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