Multinational Cost of Capital & Capital Structure PDF

Multinational Cost of Capital and Capital Structure UNWE, IFM Course, T. Tzanov, Ph.D. References: Madura, J., IFM, 12e ©  Outline ◼ To explain theoretical prerequisites for capital structure; ◼ To explain how corporate and country characteristics inf...

Multinational Cost of Capital and Capital Structure UNWE, IFM Course, T. Tzanov, Ph.D. References: Madura, J., IFM, 12e ©  Outline ◼ To explain theoretical prerequisites for capital structure; ◼ To explain how corporate and country characteristics influence an MNC’s cost of capital; ◼ To explain why there are differences in the costs of capital across countries; and ◼ To explain how corporate and country characteristics are considered by an MNC when it establishes its capital structure. IFM - 2  Cost of capital A firm’s capital consists of equity (funds obtained by issuing stock and retained earnings) and debt (borrowed funds). The cost of equity reflects an opportunity cost, while the cost of debt is reflected in the interest expenses. Shareholders participate in ownership of the firm, so they share in business risk and risk of bankruptcy – higher rate of return on their equity. Firms strive to a capital structure that will minimize their cost of capital, and hence the required rate of return on projects. IFM - 3  Capital structure The combination of debt and equity used to finance firm’s projects (assets). “The capital structure of a firm could be measured with different ratios determining the proportion between debt and equity, debt and capital” (Brealey, Myers, Allen, 2008): D/E (debt ratio); D/C = (LTD + STD) /(D+E). Capital vs. Financial structure (short-term borrowings included). ‘Target capital structure’ maximizing the value of the company. IFM - 4  Cost of equity – CAPM The cost of equity is calculated using the capital asset pricing model (CAPM). By Treynor. J.; Sharpe, W.; Lintner, J.; Mossin, J. CAPM = Rf + Beta x (RM – Rf) Rf = risk-free rate (10, 20, or 30 yrs treasury notes) RM = market rate (Expected return on the market portfolio) RM – Rf = market risk premium (return above the risk-free rate) ¤ Calculated by taking an average of data points over many years in order to incorporate a large sample of events ¤ Most banks get this rate from Ibbotson Associates (source for risk premium) – nowadays part of Morningstar Investment Management. IFM - 5  Cost of equity – beta coefficient Beta is the measure of volatility, or systematic risk influencing the price of a security/stock compared to the market as a whole (e.g. S&P 500). Beta measures the degree to which equity’s returns vary with the return of market as a whole. Beta of 1 signals that 1% rise in the market translates into 1% rise in the stock. Beta of -1 signals that 1% rise in the market translates into 1% decline in the stock. Betas outside of a range of 0.5 to 2.5 should be reviewed for reasonableness. Firms use 2-year betas to 5-year beta. IFM - 6  Cost of debt Similar to the cost of equity, the cost of debt represents the return a lender would require in a security of similar risk. A company’s overall cost of debt is calculated by averaging (weighted) the coupon/interest rates of its various pieces of debt: $50M of 4.25%, bonds due in 2 yrs $25M of 3.00%, senior notes due in 3 yrs $30M of 3.50%, debt due in 5 yrs Cost of debt = 3.74% All other things being equal, the cost of debt is lower than the cost of equity. Tax shield! IFM - 7  Weighted average cost of capital A firm’s weighted average cost of capital D _ WACC = ( ) kd ( 1 T ) + ( E ) ke D+E D+E Whereas, D is the amount of debt of the firm E is the equity of the firm kd is the before-tax cost of its debt T is the corporate tax rate ke is the cost of financing with equity IFM - 8 Searching for the appropriate capital structure – theoretical issues Cost of Capital Debt Ratio Interest payments on debt are tax deductible. However, the tradeoff is that the probability of bankruptcy will rise as interest expenses increases. There is an optimum capital structure which minimizes the weighted average cost of capital. IFM - 9  International capital structure International capital structure – combined capital structure of the parent and its subsidiaries. Differences in cost of capital. Thus, an important step – conversion of the WACC reflecting CF and returns in different currencies. For instance, in BGN and pounds – for purposes of discounting pound cash flows, and in case the interest rate parity rule holds:  1 + WACC£   1 + RUK    =    1 + WACCBGN   1 + RBG  or  1 + RUK  WACC£ = (1 + WACCBGN )  − 1  1 + RBG  R – risk-free rate of return. IFM - 10  International capital structure (2) If your weighted average cost of capital is 11.05% in BGN, the U.K government bonds yield 3.0% and in BG 4.5%, your WACC in pounds is: 𝟏.𝟎𝟑 𝟏. 𝟏𝟏𝟎𝟓 − 𝟏 = ?% 𝟏.𝟎𝟒𝟓 reflecting the lower expected Rf/ inflation rate in the U.K. When risk free treasuries are not available, the expected inflation rates may be substituted for the interest rates: That is use PPP instead of IRP. IFM - 11  Factors that cause the cost of capital for MNCs to differ from that of domestic firms Preferential Larger size treatment from creditors & Greater access smaller per unit to international flotation costs capital markets Possible Cost of International access to low- capital diversification cost foreign financing Exposure to exchange rate Probability of risk bankruptcy Exposure to country risk IFM - 12  Cost of capital across countries The cost of capital can vary across countries, such that:  MNCs based in some countries 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 tend to use a debt-intensive capital structure. IFM - 13 Country differences in the cost of debt A firm’s cost of debt is 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 of and demand for funds. It is thus influenced by tax laws, demographics, monetary policies, economic conditions, etc. Country risk! IFM - 14 Country differences in the cost of equity A firm’s cost of equity can be measured by the risk-free interest rate plus a premium that reflects: ¤ Country risk; ¤ Sector characteristics; ¤ The risk of the firm (for instance, in relation to its size). The cost of equity represents an opportunity cost and is thus also based on the available investment opportunities. IFM - 15  Using the cost of capital for assessing foreign projects When the risk level of a foreign project is different from that of the MNC, the MNC’s weighted average cost of capital (WACC) may not be the appropriate required rate of return for the project. There are various ways to account for this risk differential in the capital budgeting process. IFM - 16  Using the cost of capital for assessing foreign projects (2)  Derive NPVs based on the WACC. ¤ Compute the probability distribution of NPVs to determine the probability that the foreign project will generate a return that is at least equal to the firm’s WACC.  Adjust the WACC for the risk differential. ¤ If the project is riskier, add a risk premium to the WACC to derive the required rate of return on the project. IFM - 17  The MNC’s capital structure decision – overview 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. IFM - 18  The MNC’s capital structure decision Corporate Characteristics Stability of MNC’s More stable cash flows cash flows  the MNC can handle more debt MNC’s credit risk Lower risk  more access to credit MNC’s access to Profitable / less growth opportunities retained earnings  more able to finance with earnings MNC’s guarantee Subsidiary debt is backed by parent on debt  the subsidiary can borrow more MNC’s agency Not easy to monitor subsidiary problems  issue stock in host country (Note: there is a potential conflict of interest) IFM - 19  The MNC’s capital structure decision (2) Country Characteristics Stock restrictions Less investment opportunities  lower cost of raising equity Interest rates Lower rate  lower cost of debt Strength of host Expect to weaken  borrow host country currency country currency to reduce exposure Country risk Likely to block funds / confiscate assets  prefer local debt financing Tax laws Higher tax rate  prefer local debt financing IFM - 20  Revising the capital structure in response to changing conditions As economic and political conditions and the MNC’s business change, the costs and benefits of each component cost of capital will change too. An MNC may revise its capital structure in response to the changing conditions. For example, some MNCs revise their capital structures to reduce their withholding taxes on remitted earnings. IFM - 21  Adjusting the multinational capital structure to reduce withholding taxes Initial Situation Large Equity Investment (E I ) Foreign Parent Subsidiary Large Sum of Remitted Funds (RF) Strategy of Increased Debt Financing by Subsidiary Small E I Foreign Loans Local Bank in Parent Subsidiary Host Country Small RF Interest Payments Strategy of Increased Equity Financing by Subsidiary Invest in Small E I Foreign Stock Host Country Parent Subsidiary Shareholders Small RF Dividend Payments IFM - 22  Interaction between subsidiary and parent financing decisions Increased debt financing by the subsidiary A larger amount of internal funds may be available to the parent.  The need for debt financing by the parent may be reduced. The revised composition of debt financing may affect the interest charged on debt as well as the MNC’s overall exposure to exchange rate risk. IFM - 23  Interaction between subsidiary and parent financing decisions (2) Reduced debt financing by the subsidiary A smaller amount of internal funds may be available to the parent.  The need for debt financing by the parent may be increased. The revised composition of debt financing may affect the interest charged on debt as well as the MNC’s overall exposure to exchange rate risk. IFM - 24  Effect of global conditions on financing Local debt Internal Debt financing funds financing Host country by available provided conditions subsidiary to parent by parent Higher country risk Higher Higher Lower Higher interest rates Lower Lower Higher Lower Interest rates Higher Higher Lower Local currency Higher Higher Lower expected to weaken Local currency Lower Lower Higher expected to strengthen Blocked funds Higher Higher Lower Higher withholding tax Higher Higher Lower Higher corporate tax Higher Higher Lower IFM - 25  Local versus global target capital structure An MNC may deviate from its “local” target capital structure when local conditions and project characteristics are taken into consideration. If the proportions of debt and equity financing in the parent or some other subsidiaries can be adjusted accordingly, the MNC may still achieve its “global” target capital structure. IFM - 26  Local versus global target capital structure (2) For example, a high degree of financial leverage is appropriate when the host country is in political turmoil, while a low degree is preferred when the project will not generate net cash flows for some time.  A capital structure revision may result in a higher cost of capital. So, an unusually high or low degree of financial leverage should be adopted only if the benefits outweigh the overall costs. IFM - 27 Using a target capital structure on a local versus global basis The volumes of debt and equity issued in financial markets vary across countries, indicating that firms in some countries (such as Japan) have a higher degree of financial leverage on average. However, conditions may change over time. In Germany for example, MNCs were shifting from local bank loans to the use of debt security and equity markets. IFM - 28 Impact of multinational capital structure decisions on an MNC’s value Parent’s Capital Structure Decisions  n  n  E (CFj, t ) E (ER j, t )  j =1  Value =    t =1  (1 + k ) t    E (CFj,t ) = expected cash flows in currency j to be received by the parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = WACC (generally of the parent) IFM - 29  Capital structure – ratios ◼ Solvency (Indebtedness) ratios: D/E (debt to equity ratio) = Total debt/ total equity Variations: LTD/E. LT debt (LT portion in ST debt included). Risky in case of overpassing 1. Levels rate-term financial autonomy ratios E/ Liabilities (patrimonial solvency) E/A (Total equity to total assets ratio). Independence in financing assets with own funds. Favorable > 0.5. E/A = 1, full independence of external financing of assets. ◼ Management effectiveness in line with financial leverage: ROE (Return on equity) = NI/ total equity (DuPont version): 𝑵𝑰 𝑹𝒆𝒗𝒆𝒏𝒖𝒆 𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔 𝑹𝑶𝑬 = х х 𝑹𝒆𝒗𝒆𝒏𝒖𝒆 𝑻𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔 𝑻𝒐𝒕𝒂𝒍 𝒆𝒒𝒖𝒊𝒕𝒚 IFM - 30 THANK YOU FOR YOUR ATTENTION! IFM - 31