Multinational Cost of Capital and Structure

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Questions and Answers

What does the cost of equity reflect in a firm's financial operations?

The total revenue generated by the firm

Interest expenses on borrowed funds

An opportunity cost for shareholders (correct)

Operational costs of the business

Which of the following ratios is used to measure a firm's capital structure?

Price to earnings ratio (P/E)

Debt to equity ratio (D/E) (correct)

Return on equity (ROE)

Current ratio (CR)

How is the cost of equity typically calculated?

Based on historical profit margins

Through the weighted average cost of capital

By applying the capital asset pricing model (CAPM) (correct)

Using the dividend discount model

What role does beta play in the calculation of cost of equity?

It measures the relative volatility or systematic risk of a stock Signup and view all the answers

What is the primary goal of a firm when establishing its capital structure?

To maximize shareholder wealth Signup and view all the answers

What factors contribute to a firm's cost of equity?

Country risk, sector characteristics, and firm risk Signup and view all the answers

When might the MNC's weighted average cost of capital (WACC) be inappropriate for a foreign project?

When the project's risk level differs from the MNC's overall risk Signup and view all the answers

Which method adjusts the WACC for risk differential in capital budgeting?

Adding a risk premium to the WACC Signup and view all the answers

What does an MNC's overall capital structure typically comprise?

The capital structures of both the parent body and subsidiaries Signup and view all the answers

Which characteristic influences the capital structure decision of an MNC?

Corporate characteristics and country characteristics Signup and view all the answers

How does the stability of cash flows impact an MNC's capital structure decision?

More stable cash flows enable the MNC to handle more debt. Signup and view all the answers

What is one significant issue related to MNCs issuing stock in host countries?

Potential conflict of interest for subsidiary management. Signup and view all the answers

Why might MNCs prefer local debt financing in certain countries?

To reduce risks associated with confiscation of assets. Signup and view all the answers

How do higher interest rates affect an MNC’s financing decisions?

Higher interest rates result in a lower preference for debt financing. Signup and view all the answers

What may MNCs do in response to changes in economic and political conditions?

Revise their capital structures to optimize financial outcomes. Signup and view all the answers

Study Notes

Multinational Cost of Capital and Capital Structure

The presentation outlines theoretical prerequisites for capital structure.
It explains how corporate and country characteristics influence a multinational corporation's (MNC) cost of capital.
It explores the reasons for differences in capital costs across countries.
It explains how MNCs consider corporate and country characteristics when establishing their capital structure.

Cost of Capital

A firm's capital comprises equity (stock, retained earnings) and debt (borrowed funds).
Equity cost reflects an opportunity cost; debt cost is reflected in interest expenses.
Shareholders share business risk and bankruptcy risk, requiring a higher equity return.
Firms aim for a capital structure that minimizes their cost of capital and the required rate of return on projects.

Capital Structure

Capital structure combines debt and equity to finance a firm's projects.
Capital structure can be measured via ratios, such as D/E (debt ratio) and D/C (debt to capital).
Short-term borrowings are often incorporated into financial structure calculations.
The desired capital structure aims to maximize the company's value.

Cost of Equity - CAPM

The capital asset pricing model (CAPM) calculates the cost of equity.
CAPM formula: Rf + Beta x (Rm – Rf)
Rf represents the risk-free rate (e.g., treasury notes).
Rm represents the market rate (Expected return on the market portfolio).
Rm - Rf reflects the market risk premium.
Data for calculating the risk premium is typically averaged over several years for a large sample of events.
Ibbotson Associates is a frequent source of risk premium data.

Cost of Equity - Beta Coefficient

Beta measures a security's volatility relative to the overall market (e.g., S&P 500).
A beta of 1 suggests a security's return moves proportionally with the market.
A beta of -1 signifies that a security moves inversely to the market.
Beta values outside the 0.5 to 2.5 range typically warrant review.
Firms commonly use 2-5 year beta periods for analysis.

Cost of Debt

Similar to the cost of equity, the cost of debt represents the required return for lenders.
Companies calculate their overall debt cost by averaging coupon/interest rates across different debt instruments.
Example figures are provided in US dollars; $ amounts and rates

Weighted Average Cost of Capital (WACC)

WACC reflects a firm's average cost of financing.
WACC formula: (D/(D+E)) * kd * (1-T) + (E/(D+E)) * ke
D represents the firm's debt; E represents the firm's equity.
kd represents the before-tax cost of debt; T represents the corporate tax rate.
ke is the cost of financing with equity.

Searching for the Appropriate Capital Structure

Interest payments on debt are tax deductible.
Higher debt usage increases bankruptcy risk.
The optimal capital structure minimizes WACC.

International Capital Structure

International capital structure combines the capital structures of the parent company and its subsidiaries.
Converting WACC across currencies for discounting cash flows is crucial.
Interest rate parity rule can apply. Formulae are provided.

International Capital Structure (Continued)

Example calculation for calculating a WACC in a different currency is shown.
When risk-free treasuries aren't available, using expected inflation rates might be appropriate.

Factors Causing Differences in MNC Capital Costs

Larger size and access to international capital markets can influence capital costs.
International diversification, exposure to exchange and country risk also impact costs.
Preferential treatment from creditors and lower flotation costs are other considerations.
Differences in the probability of bankruptcy impact relative costs.

Cost of Capital Across Countries

MNCs operating in distinct countries might exhibit varying capital costs.
MNCs can adjust their international operations and funding sources based on such differences.
Some MNCs tend to employ a debt-intensive capital structure.

Country Differences in the Cost of Debt

A firm's debt cost is influenced by the risk-free interest rate of the borrowed currency and the risk premium.
The risk-free rate is affected by factors like tax laws, demographics, and economic conditions (Country risk!).

Country Differences in the Cost of Equity

A firm's cost of equity is determined by the risk-free rate plus a premium reflecting country risk, sector characteristics, and the firm’s size.
The cost of equity corresponds to an opportunity cost.

Using the Cost of Capital to Assess Foreign Projects

When a foreign project's risk level differs from the MNC's, the firm's WACC may not be the appropriate required rate of return for the project.
Several approaches can account for such risk differentials in capital budgeting.

Using the Cost of Capital to Assess Foreign Projects (Continued)

One way to account for risk differentials is using the WACC as a basis and calculating probability distributions for NPVs.
Another is adjusting the WACC by adding a risk premium

The MNC's Capital Structure Decision – Overview

The overall capital structure of an MNC is fundamentally a blend of the parent corporation and its subsidiaries' capital structures.
Capital structure decisions involve selecting between debt and equity financing.

The MNC's Capital Structure Decision

MNC credit risk, agency problems, profitability, and access to retained earnings all affect a company’s capital structure.

The MNC's Capital Structure Decision (Continued)

Country characteristics (stock restrictions, interest rates, host country currency strength, country risk, tax laws) can also influence the international capital structure

Revising the Capital Structure in Response to Changing Conditions

MNCs might alter their capital structures in response to changing economic and political conditions as well as business conditions.
Revising structures may, for example, aim to reduce withholding taxes on remitted earnings.

Adjusting the Multinational Capital Structure to Reduce Withholding Taxes

Strategies for increasing debt or equity financing by subsidiaries to minimize withholding taxes are illustrated.

Interaction Between Subsidiary and Parent Financing Decisions

Increased debt financing by subsidiaries could reduce the need for parent company borrowing.
Conversely, reduced debt financing by subsidiaries can lead to a greater need for debt financing by the parent.

Effect of Global Conditions on Financing

This section demonstrates how host country conditions influence financing options as indicated in the provided table.

Local Versus Global Target Capital Structure

MNCs may adapt their "local" target capital structure to consider local conditions and project characteristics.

Local Versus Global Target Capital Structure (Continued)

Illustrative examples are shown, like high financial leverage in politically unstable countries versus more conservative structures when future cash flow generation may be uncertain or delayed.

Using a Target Capital Structure on a Local Versus Global Basis

Volumes of debt and equity funding vary across countries, impacting financial leverage in different regions.
MNCs often adapt their financing methods depending on prevailing conditions.

Impact of Multinational Capital Structure Decisions on an MNC's Value

Capital structure decisions influence an MNC's overall value.
A formula to assess this influence is included. Formulae account for factors such as expected cash flows, currency exchange rates, and firm-specific WACC.

Capital Structure Ratios

Key ratios (e.g., debt-to-equity, debt-to-assets) and their implications for solvency and financial autonomy are outlined.
Ratios can help assess and compare the financial risks/strengths associated with MNC financing structures.

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Description

This quiz explores the theoretical foundations of capital structure and its significance in multinational corporations (MNCs). It examines how corporate and country characteristics impact the cost of capital across different countries. Additionally, it discusses the composition of capital through equity and debt, emphasizing the importance of an optimal capital structure for MNCs.