Description
Describes cost of capital across countries. It also explains how MNC's capital structure decision is influenced by various parameters.
? A firm’s 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.
?A firm’s weighted average cost of capital
k
c
= (
D
)
k
d
(
1
_
t
)
+
(
E
)
k
e
D + E D + E
where D is the amount of debt of the firm
E is the equity of the firm
k
d
is the before-tax cost of its debt
t is the corporate tax rate
k
e
is the cost of financing with equity
? 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.
Debt’s Tradeoff
C
o
s
t
o
f
C
a
p
i
t
a
l
Debt Ratio
• 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.
?Access 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. MNCs may have
more stable cash inflows due to international
diversification, and hence their probability of
bankruptcy may also reduce
?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. MNCs that have a
higher percentage of assets invested in foreign
countries are more exposed to country risk.
? 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, k
e
= R
f
+ | (R
m
– R
f
)
where k
e
= the required return on a stock
R
f
= risk-free rate of return
R
m
= market return
| = the beta of the stock
• A stock’s beta represents the sensitivity of the
stock’s returns to market returns, just as a
project’s beta represents the sensitivity of the
project’s cash flows to market conditions.
• The lower a project’s beta, the lower its
systematic risk, and the lower its required rate
of return, if its unsystematic risk can be
diversified away.
• An MNC that increases its foreign sales may be
able to reduce its stock’s 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 project’s required rate of return.
? Hence, we cannot be certain if an MNC will
have a lower cost of capital than a purely
domestic firm in the same industry.
? 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.
• 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.
? 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.
? Although the cost of debt may vary across
countries, there is some positive
correlation among country cost-of-debt
levels over time.
0
2
4
6
8
10
12
14
1990 1992 1994 1996 1998 2000 2002
Canada
U.S.
Germany
Japan
C
o
s
t
s
o
f
D
e
b
t
(
%
)
? A country’s 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.
? A country’s 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.
? 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.
? Foreign projects may have risk levels different
from that of the MNC, such that the MNC’s
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.
?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 firm’s 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.
? 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.
Corporate Characteristics
• Stability of cash flows. MNCs with more stable
cash flows can handle more debt.
• Credit risk. MNCs that have lower credit risk
have more access to credit.
• Access to retained earnings. Profitable MNCs
and MNCs with less growth may be able to
finance most of their investment with
retained earnings.
? Agency problems. Host country
shareholders may monitor a subsidiary,
though not from the parent’s perspective.
• Guarantees on debt. If the parent backs the
subsidiary’s debt, the subsidiary may be able
to borrow more.
Corporate Characteristics
Country Characteristics
? Stock restrictions. MNCs in countries where
investors have less investment opportunities
may be able to raise equity at a lower cost.
? Interest rates. MNCs may be able to obtain
loanable funds (debt) at a lower cost in some
countries.
? Country risk. If the host government is
likely to block funds or confiscate assets,
the subsidiary may prefer debt financing.
• Strength of currencies. MNCs tend to borrow
the host country currency if they expect it to
weaken, so as to reduce their exposure to
exchange rate risk.
Country Characteristics
? Tax laws. MNCs may use more local debt
financing if the local tax rates (corporate
tax rate, withholding tax rate, etc.) are
higher.
Country Characteristics
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.
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.
Amount of Internal Amount of
Local Debt Funds Debt
Host Country Financed by Available Financed
Conditions Subsidiary to Parent by Parent
Higher Country Risk Higher Higher Lower
Lower Interest Rates Higher Higher Lower
Expected Weakness
Higher Higher Lower
of Local Currency
Blockage of Funds Higher Higher Lower
Higher Taxes Higher Higher Lower
• An MNC may deviate from its “local” target
capital structure as necessitated by local
conditions.
• However, the proportions of debt and equity
financing in one subsidiary may be adjusted
to offset an abnormal degree of financial
leverage in another subsidiary.
• Hence, the MNC may still achieve its “global”
target capital structure.
? Note that a capital structure revision may
result in a higher cost of capital.
? Hence, an unusually high or low degree of
financial leverage should only be adopted if
the benefits outweigh the overall costs.
• 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, firms are shifting
from local bank loans to the use of debt
security and equity markets.
( ) ( ) | |
( )
¿
¿
¦
¦
)
¦
¦
`
¹
¦
¦
¹
¦
¦
´
¦
+
×
=
n
t
t
m
j
t j t j
k
1 =
1
, ,
1
ER E CF E
= Value
E (CF
j,t
) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ER
j,t
) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = weighted average cost of capital of the parent
Parent’s Capital Structure
Decisions
? Clearly risk and return are correlated.
? Political risk may exist along side of business
risk, necessitating an adjustment in the
discount rate.
? Projected cash flows among periods have
different degree of uncertainity ,hence they
are discounted seperately at different rates
? In the APV model, each cash flow has a
probability distribution associated with it.
? Hence, the realized value may be different
from what was expected.
? In sensitivity analysis, different estimates are
used for expected inflation rates, cost and
pricing estimates, and other inputs for the
APV to give the manager a more complete
picture of the planned capital investment.
? The application of options pricing theory to
the evaluation of investment options in real
projects is known as real options.
? A timing option is an option on when to make the
investment.
? A growth option is an option to increase the scale
of the investment.
? A suspension option is an option to temporarily
cease production.
? An abandonment option is an option to quit the
investment early.
? Initial investment – S$ 20 Million or $10
Million @ $.50 per Singapore dollar
? Project Life – Four years
? Price and Demand
Year Price per racket Demand in
Singapore
1 S$ 350 60000 units
2 S$ 350 60000 units
3 S$ 360 100000 units
4 S$ 380 100000 units
? Costs
? Office Space – S$ 1 Million per year
? Other annual overhead expenses – S$ 1 Million
? Exchange rates - @ $ 0.50 constant in future
? Tax rates
? Singapore @ 20% on income
? Withholding tax @ 10 % on remittances
? U. S. Govt – Allows
Year Variable costs per racket
1 S$ 200
2 S$ 200
3 S$ 250
4 S$ 260
? Cash flows from subsidiary to parent at the
end of each year
? Depreciation @ S$ 2 Million per year
? Salvage value S$ 12 Million at the end of four
years payable by Singapore Govt.
? Required rate of return – 15%
? Exchange rate Fluctuation-Analysis Using rate
scenario:Spartan Inc.
? Analysis using Alternative Financing
Arrangement (Parent Financing ):Spartan Inc.
? Analysis ofCapital budgeting with Blocked
Funds:Spartan Inc.
? Capital Budgeting when Prevailing Cash flows
are affected:Spartan Inc.
Year 0 1 2 3 4
1. Demand In S $ 60,000 60,000 1,00,000 1,00,000
2. Price per unit 350 350 360 380
3. Total Revenue= (1) * (2) 2,10,00,000 2,10,00,000 3,60,00,000 3,80,00,000
4. Variable cost per unit 200 200 250 260
5. Total variable cost= (1) * (4) 1,20,00,000 1,20,00,000 2,50,00,000 2,60,00,000
6. Annual lease expense 10,00,000 10,00,000 10,00,000 10,00,000
7. Other fixed annual expenses 10,00,000 10,00,000 10,00,000 10,00,000
8. Noncash expenses (Depriciation) 20,00,000 20,00,000 20,00,000 20,00,000
9. Total expenses = (5) + (6) + (7) + (8) 1,60,00,000 1,60,00,000 2,90,00,000 3,00,00,000
10. Before tax earnings of subsidiary = (3) - (9) 50,00,000 50,00,000 70,00,000 80,00,000
11. Host government tax (20%) 10,00,000 10,00,000 14,00,000 16,00,000
12. After tax earnings of subsidiary 40,00,000 40,00,000 56,00,000 64,00,000
13. Net cash flow to subsidiary= (12) + (8) 60,00,000 60,00,000 76,00,000 84,00,000
14. S$ remitted by subsidiary (100%) 60,00,000 60,00,000 76,00,000 84,00,000
15. Withholding tax (10%) 6,00,000 6,00,000 7,60,000 8,40,000
16. S$ remitted after withholding taxes 54,00,000 54,00,000 68,40,000 75,60,000
17. Salvage value 1,20,00,000
18. Exchange rate of S$ 0.50 0.50 0.50 0.50
19. Cash flows to parent In US $ 27,00,000 27,00,000 34,20,000 97,80,000
Thank You
doc_187471101.pptx
Describes cost of capital across countries. It also explains how MNC's capital structure decision is influenced by various parameters.
? A firm’s 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.
?A firm’s weighted average cost of capital
k
c
= (
D
)
k
d
(
1
_
t
)
+
(
E
)
k
e
D + E D + E
where D is the amount of debt of the firm
E is the equity of the firm
k
d
is the before-tax cost of its debt
t is the corporate tax rate
k
e
is the cost of financing with equity
? 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.
Debt’s Tradeoff
C
o
s
t
o
f
C
a
p
i
t
a
l
Debt Ratio
• 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.
?Access 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. MNCs may have
more stable cash inflows due to international
diversification, and hence their probability of
bankruptcy may also reduce
?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. MNCs that have a
higher percentage of assets invested in foreign
countries are more exposed to country risk.
? 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, k
e
= R
f
+ | (R
m
– R
f
)
where k
e
= the required return on a stock
R
f
= risk-free rate of return
R
m
= market return
| = the beta of the stock
• A stock’s beta represents the sensitivity of the
stock’s returns to market returns, just as a
project’s beta represents the sensitivity of the
project’s cash flows to market conditions.
• The lower a project’s beta, the lower its
systematic risk, and the lower its required rate
of return, if its unsystematic risk can be
diversified away.
• An MNC that increases its foreign sales may be
able to reduce its stock’s 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 project’s required rate of return.
? Hence, we cannot be certain if an MNC will
have a lower cost of capital than a purely
domestic firm in the same industry.
? 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.
• 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.
? 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.
? Although the cost of debt may vary across
countries, there is some positive
correlation among country cost-of-debt
levels over time.
0
2
4
6
8
10
12
14
1990 1992 1994 1996 1998 2000 2002
Canada
U.S.
Germany
Japan
C
o
s
t
s
o
f
D
e
b
t
(
%
)
? A country’s 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.
? A country’s 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.
? 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.
? Foreign projects may have risk levels different
from that of the MNC, such that the MNC’s
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.
?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 firm’s 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.
? 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.
Corporate Characteristics
• Stability of cash flows. MNCs with more stable
cash flows can handle more debt.
• Credit risk. MNCs that have lower credit risk
have more access to credit.
• Access to retained earnings. Profitable MNCs
and MNCs with less growth may be able to
finance most of their investment with
retained earnings.
? Agency problems. Host country
shareholders may monitor a subsidiary,
though not from the parent’s perspective.
• Guarantees on debt. If the parent backs the
subsidiary’s debt, the subsidiary may be able
to borrow more.
Corporate Characteristics
Country Characteristics
? Stock restrictions. MNCs in countries where
investors have less investment opportunities
may be able to raise equity at a lower cost.
? Interest rates. MNCs may be able to obtain
loanable funds (debt) at a lower cost in some
countries.
? Country risk. If the host government is
likely to block funds or confiscate assets,
the subsidiary may prefer debt financing.
• Strength of currencies. MNCs tend to borrow
the host country currency if they expect it to
weaken, so as to reduce their exposure to
exchange rate risk.
Country Characteristics
? Tax laws. MNCs may use more local debt
financing if the local tax rates (corporate
tax rate, withholding tax rate, etc.) are
higher.
Country Characteristics
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.
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.
Amount of Internal Amount of
Local Debt Funds Debt
Host Country Financed by Available Financed
Conditions Subsidiary to Parent by Parent
Higher Country Risk Higher Higher Lower
Lower Interest Rates Higher Higher Lower
Expected Weakness
Higher Higher Lower
of Local Currency
Blockage of Funds Higher Higher Lower
Higher Taxes Higher Higher Lower
• An MNC may deviate from its “local” target
capital structure as necessitated by local
conditions.
• However, the proportions of debt and equity
financing in one subsidiary may be adjusted
to offset an abnormal degree of financial
leverage in another subsidiary.
• Hence, the MNC may still achieve its “global”
target capital structure.
? Note that a capital structure revision may
result in a higher cost of capital.
? Hence, an unusually high or low degree of
financial leverage should only be adopted if
the benefits outweigh the overall costs.
• 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, firms are shifting
from local bank loans to the use of debt
security and equity markets.
( ) ( ) | |
( )
¿
¿
¦
¦
)
¦
¦
`
¹
¦
¦
¹
¦
¦
´
¦
+
×
=
n
t
t
m
j
t j t j
k
1 =
1
, ,
1
ER E CF E
= Value
E (CF
j,t
) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ER
j,t
) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = weighted average cost of capital of the parent
Parent’s Capital Structure
Decisions
? Clearly risk and return are correlated.
? Political risk may exist along side of business
risk, necessitating an adjustment in the
discount rate.
? Projected cash flows among periods have
different degree of uncertainity ,hence they
are discounted seperately at different rates
? In the APV model, each cash flow has a
probability distribution associated with it.
? Hence, the realized value may be different
from what was expected.
? In sensitivity analysis, different estimates are
used for expected inflation rates, cost and
pricing estimates, and other inputs for the
APV to give the manager a more complete
picture of the planned capital investment.
? The application of options pricing theory to
the evaluation of investment options in real
projects is known as real options.
? A timing option is an option on when to make the
investment.
? A growth option is an option to increase the scale
of the investment.
? A suspension option is an option to temporarily
cease production.
? An abandonment option is an option to quit the
investment early.
? Initial investment – S$ 20 Million or $10
Million @ $.50 per Singapore dollar
? Project Life – Four years
? Price and Demand
Year Price per racket Demand in
Singapore
1 S$ 350 60000 units
2 S$ 350 60000 units
3 S$ 360 100000 units
4 S$ 380 100000 units
? Costs
? Office Space – S$ 1 Million per year
? Other annual overhead expenses – S$ 1 Million
? Exchange rates - @ $ 0.50 constant in future
? Tax rates
? Singapore @ 20% on income
? Withholding tax @ 10 % on remittances
? U. S. Govt – Allows
Year Variable costs per racket
1 S$ 200
2 S$ 200
3 S$ 250
4 S$ 260
? Cash flows from subsidiary to parent at the
end of each year
? Depreciation @ S$ 2 Million per year
? Salvage value S$ 12 Million at the end of four
years payable by Singapore Govt.
? Required rate of return – 15%
? Exchange rate Fluctuation-Analysis Using rate
scenario:Spartan Inc.
? Analysis using Alternative Financing
Arrangement (Parent Financing ):Spartan Inc.
? Analysis ofCapital budgeting with Blocked
Funds:Spartan Inc.
? Capital Budgeting when Prevailing Cash flows
are affected:Spartan Inc.
Year 0 1 2 3 4
1. Demand In S $ 60,000 60,000 1,00,000 1,00,000
2. Price per unit 350 350 360 380
3. Total Revenue= (1) * (2) 2,10,00,000 2,10,00,000 3,60,00,000 3,80,00,000
4. Variable cost per unit 200 200 250 260
5. Total variable cost= (1) * (4) 1,20,00,000 1,20,00,000 2,50,00,000 2,60,00,000
6. Annual lease expense 10,00,000 10,00,000 10,00,000 10,00,000
7. Other fixed annual expenses 10,00,000 10,00,000 10,00,000 10,00,000
8. Noncash expenses (Depriciation) 20,00,000 20,00,000 20,00,000 20,00,000
9. Total expenses = (5) + (6) + (7) + (8) 1,60,00,000 1,60,00,000 2,90,00,000 3,00,00,000
10. Before tax earnings of subsidiary = (3) - (9) 50,00,000 50,00,000 70,00,000 80,00,000
11. Host government tax (20%) 10,00,000 10,00,000 14,00,000 16,00,000
12. After tax earnings of subsidiary 40,00,000 40,00,000 56,00,000 64,00,000
13. Net cash flow to subsidiary= (12) + (8) 60,00,000 60,00,000 76,00,000 84,00,000
14. S$ remitted by subsidiary (100%) 60,00,000 60,00,000 76,00,000 84,00,000
15. Withholding tax (10%) 6,00,000 6,00,000 7,60,000 8,40,000
16. S$ remitted after withholding taxes 54,00,000 54,00,000 68,40,000 75,60,000
17. Salvage value 1,20,00,000
18. Exchange rate of S$ 0.50 0.50 0.50 0.50
19. Cash flows to parent In US $ 27,00,000 27,00,000 34,20,000 97,80,000
Thank You
doc_187471101.pptx