Multinational Cost of Capital and Structure

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.