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17

Chapter

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 + (Rm Rf )

where
Rf
Rm

ke
=
=
=

= 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.

Adjust the WACC for the risk differential.

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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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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