Mn cs cost of capital

THE STRUCTURE OF THE MULTINATIONAL FIRM AND ITS

COST OF CAPITAL

THE STRUCTURE OF THE MULTINATIONAL FIRM AND ITS

COST OF CAPITAL

Chapter ObjectivesChapter Objectives

To explain the Reasons for the Growth of To explain the Reasons for the Growth of MNCsMNCs

To explain how corporate and country To explain how corporate and country characteristics influence an MNCcharacteristics influence an MNC’’s cost of s cost of capital;capital;

To explain why there are differences in To explain why there are differences in the costs of capital across countries; andthe costs of capital across countries; and

To explain how corporate and country To explain how corporate and country characteristics are considered by an MNC characteristics are considered by an MNC when it establishes its capital structure.when it establishes its capital structure.

Real and Financial SectorsReal and Financial Sectors

Real Sector: Production and sale of Real Sector: Production and sale of goods and services; acquisition and goods and services; acquisition and divestiture of capital assets.divestiture of capital assets.

Financial Sector: Transactions in Financial Sector: Transactions in financial assets: currency, bank financial assets: currency, bank deposits, bonds, stocks, futures and deposits, bonds, stocks, futures and options, etc.options, etc.

International Economic International Economic IntegrationIntegration

International economic integration International economic integration refers to the extent and strength of refers to the extent and strength of real- sector and financial-sector real- sector and financial-sector linkages among national economies. linkages among national economies. Real-sector linkages occur through the Real-sector linkages occur through the international transactions in goods and international transactions in goods and services while the financial-sector services while the financial-sector linkages occur through international linkages occur through international transactions in financial assets.transactions in financial assets.

The Rise of Multinational The Rise of Multinational FirmsFirms

Changes our definition of comparative Changes our definition of comparative AdvantageAdvantage Relative value-added -- product development, Relative value-added -- product development,

design, logistics, assembly, marketing -- depends design, logistics, assembly, marketing -- depends less on national differences and more on firm-less on national differences and more on firm-specific competencies and investments, although specific competencies and investments, although these latter reflect national differences in factor these latter reflect national differences in factor endowmentsendowments

The range of a nationThe range of a nation’’s exports is equivalent to the s exports is equivalent to the range of its exportsrange of its exports

Comparative Advantage in a world of multinationalsComparative Advantage in a world of multinationals Most cross-border trade involves intermediate products, Most cross-border trade involves intermediate products,

much of it takes place within the boundaries of a single much of it takes place within the boundaries of a single firm (a single Barbie doll is made in 12 countries)firm (a single Barbie doll is made in 12 countries)

A multinational that is going to do a A multinational that is going to do a business in 4countries what are the business in 4countries what are the models that the company may uses models that the company may uses to establish some business forms to to establish some business forms to do its business?do its business?

1st Alternative1st Alternative They may form a company which is a holding They may form a company which is a holding

company in 1 country that performs I. & company in 1 country that performs I. & Financial activities for their subsidiaries.Financial activities for their subsidiaries.

In fact, multinational affiliates are legally In fact, multinational affiliates are legally distinct, entities, the capital structure decision of distinct, entities, the capital structure decision of these affiliates cannot be considered separately these affiliates cannot be considered separately from the capital structure decision of their from the capital structure decision of their parents.parents.

The capital structure of the affiliates vary The capital structure of the affiliates vary according to the relative prices of distinct according to the relative prices of distinct financing instruments in different locations, the financing instruments in different locations, the affiliates take advantage of opportunities to affiliates take advantage of opportunities to minimise the cost of capital.minimise the cost of capital.

BenefitsBenefits

Control over the subsidiaries.Control over the subsidiaries.

Access to local finance Access to local finance

Reduce of cost of capitalReduce of cost of capital

Diversification Diversification reduces reduces

unsystematic unsystematic risk.risk.

Cost of CapitalCost of Capital

A firmA firm’’s s capitalcapital consists of consists of equityequity (retained earnings and funds obtained by (retained earnings and funds obtained by issuing stock) and issuing stock) and debtdebt (borrowed funds). (borrowed funds).

The cost of equity reflects an opportunity The cost of equity reflects an opportunity cost, while the cost of debt is reflected in cost, while the cost of debt is reflected in interest expenses.interest expenses.

Firms want a capital structure that will Firms want a capital structure that will minimize their cost of capital, and hence minimize their cost of capital, and hence the required rate of return on projects.the required rate of return on projects.

Cost of Capital for Cost of Capital for MNCsMNCs

The cost of capital for MNCs may The cost of capital for MNCs may differ from that for domestic firms differ from that for domestic firms because of the following differences.because of the following differences.

Size of Firm.Size of Firm. Because of their size, Because of their size, MNCs are often given preferential MNCs are often given preferential treatment by creditors. They can treatment by creditors. They can usually achieve smaller per unit usually achieve smaller per unit flotation costs too.flotation costs too.

Acess to International Capital Markets.Acess to International Capital Markets. MNCs are normally able to obtain funds MNCs are normally able to obtain funds through international capital markets, through international capital markets, where the cost of funds may be lower.where the cost of funds may be lower.

International Diversification.International Diversification. M M NCs NCs may have more stable cash inflows due may have more stable cash inflows due to international diversification, such to international diversification, such that their probability of bankruptcy may that their probability of bankruptcy may be lower.be lower.


Exposure to Exchange Rate Risk.Exposure to Exchange Rate Risk. MNCs MNCs may be more exposed to exchange rate may be more exposed to exchange rate fluctuations, such that their cash flows fluctuations, such that their cash flows may be more uncertain and their may be more uncertain and their probability of bankruptcy higher.probability of bankruptcy higher.

Exposure to Country Risk.Exposure to Country Risk. M M NCs that NCs that have a higher percentage of assets have a higher percentage of assets invested in foreign countries are more invested in foreign countries are more exposed to country risk.exposed to country risk.


The capital asset pricing model (CAPM) The capital asset pricing model (CAPM) can be used to assess how the required can be used to assess how the required rates of return of MNCs differ from rates of return of MNCs differ from those of purely domestic firms.those of purely domestic firms.

According to CAPM, According to CAPM, kkee = = RRff + + ((RRmm –– RRff ))

wherewhere kkee == the required return on a stockthe required return on a stock

RRff == risk-free rate of returnrisk-free rate of return

RRmm == market returnmarket return

== the beta of the stockthe beta of the stock


A stockA stock’’s beta represents the sensitivity s beta represents the sensitivity of the stockof the stock’’s returns to market returns, s returns to market returns, just as a projectjust as a project’’s beta represents the s beta represents the sensitivity of the projectsensitivity of the project’’s cash flows to s cash flows to market conditions.market conditions.

The lower a projectThe lower a project’’s beta, the lower its s beta, the lower its systematic risk, and the lower its systematic risk, and the lower its required rate of return, if its required rate of return, if its unsystematic risk can be diversified unsystematic risk can be diversified away.away.


An MNC that increases its foreign An MNC that increases its foreign sales may be able to reduce its sales may be able to reduce its stockstock’’s beta, and hence the return s beta, and hence the return required by investors. This translates required by investors. This translates into a lower overall cost of capital.into a lower overall cost of capital.

However, MNCs may consider However, MNCs may consider unsystematic risk as an important unsystematic risk as an important factor when determining a foreign factor when determining a foreign projectproject’’s required rate of return.s required rate of return.


Costs of Capital Across Costs of Capital Across CountriesCountries

The cost of capital may vary across The cost of capital may vary across countries, such that:countries, such that: MNCs based in some countries may have MNCs based in some countries may have

a competitive advantage over others;a competitive advantage over others; MNCs may be able to adjust their MNCs may be able to adjust their

international operations and sources of international operations and sources of funds to capitalize on the differences; funds to capitalize on the differences; andand

MNCs based in some countries may have MNCs based in some countries may have a more debt-intensive capital structure.a more debt-intensive capital structure.


The cost of debt to a firm is primarily The cost of debt to a firm is primarily determined by determined by the prevailing risk-free the prevailing risk-free interest rate of the borrowed currency interest rate of the borrowed currency and and the risk premium required by the risk premium required by creditors.creditors.

The risk-free rate is determined by the The risk-free rate is determined by the interaction of the supply and demand for interaction of the supply and demand for funds. It may vary due to different tax funds. It may vary due to different tax laws, demographics, monetary policies, laws, demographics, monetary policies, and economic conditions.and economic conditions.


The risk premium compensates The risk premium compensates creditors for the risk that the borrower creditors for the risk that the borrower may be unable to meet its payment may be unable to meet its payment obligations.obligations.

The risk premium may vary due to The risk premium may vary due to different economic conditions, different economic conditions, relationships between corporations and relationships between corporations and creditors, government intervention, and creditors, government intervention, and degrees of financial leverage.degrees of financial leverage.


Although the cost of debt may vary Although the cost of debt may vary across countries, there is some across countries, there is some positive correlation among country positive correlation among country cost-of-debt levels over time.cost-of-debt levels over time.

Using the Cost of CapitalUsing the Cost of Capital for Assessing Foreign for Assessing Foreign

ProjectsProjects Foreign projects may have risk Foreign projects may have risk

levels different from that of the levels different from that of the MNC, such that the MNCMNC, such that the MNC’’s weighted s weighted average cost of capital (WACC) may average cost of capital (WACC) may not be the appropriate required rate not be the appropriate required rate of return.of return.

There are various ways to account There are various ways to account for this risk differential in the capital for this risk differential in the capital budgeting process. budgeting process.

Using the Cost of CapitalUsing the Cost of Capital for Assessing Foreign for Assessing Foreign

ProjectsProjectsDerive NPVs based on the WACC.Derive NPVs based on the WACC.

The probability distribution of NPVs can be The probability distribution of NPVs can be computed to determine the probability that computed to determine the probability that the foreign project will generate a return the foreign project will generate a return that is at least equal to the firmthat is at least equal to the firm’’s WACC.s WACC.

Adjust the WACC for the risk Adjust the WACC for the risk differential. differential. The MNC may estimate the cost of equity The MNC may estimate the cost of equity

and the after-tax cost of debt of the funds and the after-tax cost of debt of the funds needed to finance the project.needed to finance the project.

The MNCThe MNC’’ssCapital Structure Capital Structure

DecisionDecision The overall capital structure of an The overall capital structure of an

MNC is essentially a combination of MNC is essentially a combination of the capital structures of the parent the capital structures of the parent body and its subsidiaries. body and its subsidiaries.

The capital structure decision The capital structure decision involves the choice of debt versus involves the choice of debt versus equity financing, and is influenced equity financing, and is influenced by both corporate and country by both corporate and country characteristics.characteristics.


DecisionDecisionCorporate CharacteristicsCorporate Characteristics Stability of cash flows.Stability of cash flows. MNCs with more MNCs with more

stable cash flows can handle more debt.stable cash flows can handle more debt. Credit risk.Credit risk. MNCs that have lower MNCs that have lower

credit risk have more access to credit.credit risk have more access to credit. Access to retained earnings.Access to retained earnings. Profitable Profitable

MNCs and MNCs with less growth may MNCs and MNCs with less growth may be able to finance most of their be able to finance most of their investment with retained earnings.investment with retained earnings.


DecisionDecision

Agency problems.Agency problems. Host country Host country shareholders may monitor a shareholders may monitor a subsidiary, though not from the subsidiary, though not from the parentparent’’s perspective.s perspective.

Guarantees on debt.Guarantees on debt. If the parent If the parent backs the subsidiarybacks the subsidiary’’s debt, the s debt, the subsidiary may be able to borrow subsidiary may be able to borrow more.more.

Corporate CharacteristicsCorporate Characteristics

Country CharacteristicsCountry Characteristics Stock restrictions.Stock restrictions. MNCs in MNCs in

countries where investors have less countries where investors have less investment opportunities may be investment opportunities may be able to raise equity at a lower cost.able to raise equity at a lower cost.

Interest rates.Interest rates. MNCs may be able to MNCs may be able to obtain loanable funds (debt) at a obtain loanable funds (debt) at a lower cost in some countries.lower cost in some countries.


DecisionDecision

Country risk.Country risk. If the host government is If the host government is likely to block funds or confiscate assets, likely to block funds or confiscate assets, the subsidiary may prefer debt financing. the subsidiary may prefer debt financing.


DecisionDecision

Strength of currencies.Strength of currencies. MNCs MNCs tend to borrow the host country tend to borrow the host country currency if they expect it to currency if they expect it to weaken, so as to reduce their weaken, so as to reduce their exposure to exchange rate risk. exposure to exchange rate risk.

Country CharacteristicsCountry Characteristics

Tax laws.Tax laws. MNCs may use more local MNCs may use more local debt financing if the local tax rates debt financing if the local tax rates (corporate tax rate, withholding tax (corporate tax rate, withholding tax rate, etc.) are higher.rate, etc.) are higher.


DecisionDecision

Country CharacteristicsCountry Characteristics

Interaction Between Interaction Between Subsidiary and Parent Subsidiary and Parent Financing DecisionsFinancing Decisions

Increased debt financing by the subsidiaryIncreased debt financing by the subsidiary A larger amount of internal funds may be A larger amount of internal funds may be

available to the parent.available to the parent. The need for debt financing by the parent The need for debt financing by the parent

may be reduced.may be reduced. The revised composition of debt financing The revised composition of debt financing

may affect the interest charged on debt may affect the interest charged on debt as well as the MNCas well as the MNC’’s overall exposure to s overall exposure to exchange rate risk.exchange rate risk.

Interaction Between Interaction Between Subsidiary and Parent Subsidiary and Parent Financing DecisionsFinancing Decisions

Reduced debt financing by the subsidiaryReduced debt financing by the subsidiary A smaller amount of internal funds may A smaller amount of internal funds may

be available to the parent.be available to the parent. The need for debt financing by the The need for debt financing by the

parent may be increased.parent may be increased. The revised composition of debt The revised composition of debt

financing may affect the interest financing may affect the interest charged on debt as well as the MNCcharged on debt as well as the MNC’’s s overall exposure to exchange rate risk.overall exposure to exchange rate risk.

FOREXFOREX

It is not a physical exchange but a It is not a physical exchange but a global telecommunications market.global telecommunications market.

It is the worldIt is the world’’s largest financial s largest financial market with transactions volume market with transactions volume more than $2,500 billion per day!more than $2,500 billion per day!

If a company is operating in different If a company is operating in different countries when it produces in a country countries when it produces in a country A and the total cost for a unit of its A and the total cost for a unit of its product is 10$, it can sell in country B product is 10$, it can sell in country B by Euro, therefore the company faces by Euro, therefore the company faces Currency Exchange Risk.Currency Exchange Risk.

These companies need to hedge the These companies need to hedge the currency Risk.currency Risk.

Hedging: Hedging: is protecting the position is protecting the position from the unexpected price moves..from the unexpected price moves..

Public Tender form Public Tender form different entities for a plandifferent entities for a plan

Alternative 1: 2buy the needed Alternative 1: 2buy the needed currency that covers the plan price currency that covers the plan price just after accepting the offer.just after accepting the offer.

Alternative 2: Take the currency riskAlternative 2: Take the currency risk Alternative 3: Hedge the risk by Alternative 3: Hedge the risk by

buying a future contracts, that ll buying a future contracts, that ll allow to buy the required currency allow to buy the required currency on predetermined exchange rate for on predetermined exchange rate for a future date.a future date.

Hedging the RiskHedging the Risk

Take the form of fixing the Take the form of fixing the exchange rate by having any exchange rate by having any contracts such as:contracts such as:

Options contractsOptions contracts Future ContractsFuture Contracts Forward ContractsForward Contracts SWAPSSWAPS

Thank YouThank You

Mn cs cost of capital

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