Description
This is a presentation describes 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
Multinational Cost of Capital
& Capital Structure
Chapter Objectives
• 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.
Cost of Capital
• 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.
Cost of Capital
• 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
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.
Cost of Capital
Debt’s Tradeoff
C
o
s
t
o
f
C
a
p
i
t
a
l
Debt Ratio
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.
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. MNCs may have
more stable cash inflows due to international
diversification, such that their probability of
bankruptcy may be lower.
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. MNCs that have a
higher percentage of assets invested in foreign
countries are more exposed to country risk.
Cost of Capital for MNCs
Possible
access to low-
cost foreign
financing
Preferential
treatment from
creditors
Greater access
to international
capital markets
Larger size
International
diversification
Exposure to
exchange rate
risk
Exposure to
country risk
Cost of
capital
Probability of
bankruptcy
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, 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
If capital markets are segmented, then investors can only invest domestically.
This means that the market portfolio (M) in the CAPM formula would be the
domestic portfolio instead of the world portfolio.
) (
f
US
US
i f i
R R ? R R ÷ + =
) (
f
W
W
i f i
R R ? R R ÷ + =
versus
Clearly integration or segmentation of international financial markets has
major implications for determining the cost of capital.
Capital Asset Pricing under cross-
listings
The definition of beta:
) Var(
) , Cov(
M
M i
i
R
R R
? =
The CAPM formula can be
recalibrated as:
) Var(
) , Cov(
) (
M
M i
f
M
f i
R
R R
R R R R ÷ + =
We can develop a measure of aggregate risk aversion, A
M
) Var(
) (
M
f
M
M
R
R R
M A
÷
=
We can restate the CAPM using A
M
) , Cov(
M i
M
f i
R R M A R R + =
This equation indicates that, given investors’ aggregate risk-aversion
measure, the expected rate of return on an asset increases as the
asset’s covariance with the market portfolio increases.
In fully integrated capital markets, each asset will be priced according
to the world systematic risk.
) , Cov(
W i
W
f i
R R W A R R + =
Cost of Capital for MNCs
• 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.
Cost of Capital for MNCs
• 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.
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.
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.
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.
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.
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.
Costs of Capital Across Countries
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
(
%
)
Costs of Capital Across Countries
• 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.
Costs of Capital Across Countries
• 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.
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.
Example
• Lexon Co., a successful U.S. based MNC , is considering hoe to obtain
financing for a project in Argentina during the next year. It considers the
following information :-
• U.S. risk free-rate = 6%
• Argentine risk-free rate = 10%
• Risk premium on $ denominated debt = 3%
• Risk premium on Peso denominated debt = 5%
• Beta of the project (expected sensitivity of project returns to U.S. investors in
response to U.S. markets) = 1.5
• Expected U.S. market return = 14%
• U.S. corporate tax rate = 30%, Argentine corporate tax rate = 30%
• Creditors will not allow more than 50% of financing to be in the form of debt.
Cost of $-denominated debt = (6% + 3%)*(1-0.3) = 6.3%
Cost of AP-denominated debt = (10% + 5%)*(1–0.3)= 10.5%
Cost of $-denominated equity = 6% + 1.5*(14% - 6%) = 18%
Hence Lexon’s cheapest source of funds is $-denominated debt.
Estimated WACC for financing
Possible
Capital
Structure
U.S. Debt
(Cost =
6.3%)
Argentine
Debt (Cost =
10.5%)
Equity
( Cost =
18%)
Estimated
WACC
30% U.S.
debt, 70%
equity
30%*6.3% =
1.89%
70%*18% =
12.6%
14.49%
50% U.S.
debt, 50%
U.S. equity
50%*6.3%=3.
15%
18%*50%=
9%
12.15%
20% U.S.
debt,30%
Argentine
debt, 50%
U.S. equity
20%*6.3%=
1.26%
30%*10.5%=
3.15%
50%*18%=
9%
13.41%
50%
Argentine
debt, 50%
U.S. equity
50%*10.5% =
5.25%
50%*18%=
9%
14.25%
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 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.
Derive the Net Present Value of the Equity
Investment
– All debt payments are explicitly accounted for in this method
Example – Derivation of NPVs based
on the WACC
In the Lexon example the least WACC obtained was 12.15% if it uses 50% debt and
50% equity. However by financing the Argentine project completely with dollars,
Lexon will be highly exposed to exchange rate risk.
Lexon could account for risk within the cash flow estimates. Many possible valued
for each in put variable (such as demand, price, labor, cost etc.) can be
incorporated to estimated Net Present Values (NPV). When the WACC is used as
the required rate of return, the probability distribution of the NPVs can be
assessed to determine the probability that the foreign project will generate a
return that is at least equal to the firm’s WACC. If the probability distribution
contains some possible negative NPVs, this suggests that the project could fail.
Example – Adjusted WACC for Risk
Differential
• If Lexon recognizes that its Argentine project
will be exposed to exchange rate risk and this
project is riskier than normal operations, it will
consider adding a risk premium of 6
percentage points (say). In this case the
required rate of return will be
= 12.15% + 6% = 18.15%
Example – Derive the NPV of Equity
Investment
• LexonCo. which might finance the Argentine project with partial financing
from Argentina. Assume Lexon needs to issue 80 million Argentine Pesos (AP)
in the project. Since the Peso is currently worth $0.50, Lexon needs the
equivalent of $30 million. It will use debt to obtain the remaining capital.It can
either borrow Dollars and convert the funds into Pesos or borrow Pesos; the
project will be terminated in 1 year after which the debt will be repaid and any
earnings generated be remitted to Lexon’s Parent in U.S. The project is
expected to result in revenue of AP200 million and operating expenses in
Argentina will be AP10 million. Lexon expects the Peso to be valued at $0.40 in
a year. The project does not generate any revenue in the U.S. but Lexon
expects to incur operating expenses of $10 million in the United States. It will
incur $ denominated expenses if it finances the project with $ denominated
debt. Any $ denominated debt provide tax benefits. Select the optimal
financing approach.
Rely on U.S. Debt
($20 Million
Borrowed) , Equity of
20 million
Rely on U.S. Debt ($20
Million Borrowed) ,
Equity of 20 million
Argentine revenue AP200 AP200
- Argentine operating expenses -AP10 -AP10
-Argentine interest expenses (15% rate) -AP0 -AP6
=Argentine Earnings after taxes =AP133 =AP128.8
- Prinicipal payments on Argentine debt -AP0 -AP40
=Amount of debt to be remitted =AP133 =AP88.8
* Expected exchange rate of Peso *$0.40 *$0.40
=Amount of USD by converting Pesos = $53.2 = $35.52
- U.S. operating expenses -$10 -$10
- U.S. interest expenses (9% rate) -$1.8 -$0
+ U.S. tax benefits (30% rate) +$3.54 +$3
- Principal Payments on U.S. debt -$20 -$0
= Dollar cash flows =$24.94 =$28.52
Present value of $ cash flows, discounted @
cost of equity (18%)
$21.135 $28.52
- Initial equity outlay $20 $20
=NPV = $1.135 =$4.17
The MNC’s
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.
The MNC’s
Capital Structure Decision
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.
The MNC’s
Capital Structure Decision
• 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
The MNC’s
Capital Structure Decision
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.
The MNC’s
Capital Structure Decision
• 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
The MNC’s
Capital Structure Decision
• 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
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.
Interaction Between Subsidiary and
Parent Financing Decisions
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.
Interaction Between Subsidiary and
Parent Financing Decisions
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
Using a Target Capital Structure on a
Local versus Global Basis
• 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.
Using a Target Capital Structure on a
Local versus Global Basis
• 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.
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, firms are shifting from
local bank loans to the use of debt security
and equity markets.
Impact of Multinational Capital Structure Decisions on
an MNC’s Value
( ) ( ) | |
( )
¿
¿
¦
¦
)
¦
¦
`
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
doc_149649896.pptx
This is a presentation describes 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
Multinational Cost of Capital
& Capital Structure
Chapter Objectives
• 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.
Cost of Capital
• 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.
Cost of Capital
• 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
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.
Cost of Capital
Debt’s Tradeoff
C
o
s
t
o
f
C
a
p
i
t
a
l
Debt Ratio
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.
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. MNCs may have
more stable cash inflows due to international
diversification, such that their probability of
bankruptcy may be lower.
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. MNCs that have a
higher percentage of assets invested in foreign
countries are more exposed to country risk.
Cost of Capital for MNCs
Possible
access to low-
cost foreign
financing
Preferential
treatment from
creditors
Greater access
to international
capital markets
Larger size
International
diversification
Exposure to
exchange rate
risk
Exposure to
country risk
Cost of
capital
Probability of
bankruptcy
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, 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
If capital markets are segmented, then investors can only invest domestically.
This means that the market portfolio (M) in the CAPM formula would be the
domestic portfolio instead of the world portfolio.
) (
f
US
US
i f i
R R ? R R ÷ + =
) (
f
W
W
i f i
R R ? R R ÷ + =
versus
Clearly integration or segmentation of international financial markets has
major implications for determining the cost of capital.
Capital Asset Pricing under cross-
listings
The definition of beta:
) Var(
) , Cov(
M
M i
i
R
R R
? =
The CAPM formula can be
recalibrated as:
) Var(
) , Cov(
) (
M
M i
f
M
f i
R
R R
R R R R ÷ + =
We can develop a measure of aggregate risk aversion, A
M
) Var(
) (
M
f
M
M
R
R R
M A
÷
=
We can restate the CAPM using A
M
) , Cov(
M i
M
f i
R R M A R R + =
This equation indicates that, given investors’ aggregate risk-aversion
measure, the expected rate of return on an asset increases as the
asset’s covariance with the market portfolio increases.
In fully integrated capital markets, each asset will be priced according
to the world systematic risk.
) , Cov(
W i
W
f i
R R W A R R + =
Cost of Capital for MNCs
• 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.
Cost of Capital for MNCs
• 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.
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.
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.
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.
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.
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.
Costs of Capital Across Countries
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
(
%
)
Costs of Capital Across Countries
• 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.
Costs of Capital Across Countries
• 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.
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.
Example
• Lexon Co., a successful U.S. based MNC , is considering hoe to obtain
financing for a project in Argentina during the next year. It considers the
following information :-
• U.S. risk free-rate = 6%
• Argentine risk-free rate = 10%
• Risk premium on $ denominated debt = 3%
• Risk premium on Peso denominated debt = 5%
• Beta of the project (expected sensitivity of project returns to U.S. investors in
response to U.S. markets) = 1.5
• Expected U.S. market return = 14%
• U.S. corporate tax rate = 30%, Argentine corporate tax rate = 30%
• Creditors will not allow more than 50% of financing to be in the form of debt.
Cost of $-denominated debt = (6% + 3%)*(1-0.3) = 6.3%
Cost of AP-denominated debt = (10% + 5%)*(1–0.3)= 10.5%
Cost of $-denominated equity = 6% + 1.5*(14% - 6%) = 18%
Hence Lexon’s cheapest source of funds is $-denominated debt.
Estimated WACC for financing
Possible
Capital
Structure
U.S. Debt
(Cost =
6.3%)
Argentine
Debt (Cost =
10.5%)
Equity
( Cost =
18%)
Estimated
WACC
30% U.S.
debt, 70%
equity
30%*6.3% =
1.89%
70%*18% =
12.6%
14.49%
50% U.S.
debt, 50%
U.S. equity
50%*6.3%=3.
15%
18%*50%=
9%
12.15%
20% U.S.
debt,30%
Argentine
debt, 50%
U.S. equity
20%*6.3%=
1.26%
30%*10.5%=
3.15%
50%*18%=
9%
13.41%
50%
Argentine
debt, 50%
U.S. equity
50%*10.5% =
5.25%
50%*18%=
9%
14.25%
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 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.
Derive the Net Present Value of the Equity
Investment
– All debt payments are explicitly accounted for in this method
Example – Derivation of NPVs based
on the WACC
In the Lexon example the least WACC obtained was 12.15% if it uses 50% debt and
50% equity. However by financing the Argentine project completely with dollars,
Lexon will be highly exposed to exchange rate risk.
Lexon could account for risk within the cash flow estimates. Many possible valued
for each in put variable (such as demand, price, labor, cost etc.) can be
incorporated to estimated Net Present Values (NPV). When the WACC is used as
the required rate of return, the probability distribution of the NPVs can be
assessed to determine the probability that the foreign project will generate a
return that is at least equal to the firm’s WACC. If the probability distribution
contains some possible negative NPVs, this suggests that the project could fail.
Example – Adjusted WACC for Risk
Differential
• If Lexon recognizes that its Argentine project
will be exposed to exchange rate risk and this
project is riskier than normal operations, it will
consider adding a risk premium of 6
percentage points (say). In this case the
required rate of return will be
= 12.15% + 6% = 18.15%
Example – Derive the NPV of Equity
Investment
• LexonCo. which might finance the Argentine project with partial financing
from Argentina. Assume Lexon needs to issue 80 million Argentine Pesos (AP)
in the project. Since the Peso is currently worth $0.50, Lexon needs the
equivalent of $30 million. It will use debt to obtain the remaining capital.It can
either borrow Dollars and convert the funds into Pesos or borrow Pesos; the
project will be terminated in 1 year after which the debt will be repaid and any
earnings generated be remitted to Lexon’s Parent in U.S. The project is
expected to result in revenue of AP200 million and operating expenses in
Argentina will be AP10 million. Lexon expects the Peso to be valued at $0.40 in
a year. The project does not generate any revenue in the U.S. but Lexon
expects to incur operating expenses of $10 million in the United States. It will
incur $ denominated expenses if it finances the project with $ denominated
debt. Any $ denominated debt provide tax benefits. Select the optimal
financing approach.
Rely on U.S. Debt
($20 Million
Borrowed) , Equity of
20 million
Rely on U.S. Debt ($20
Million Borrowed) ,
Equity of 20 million
Argentine revenue AP200 AP200
- Argentine operating expenses -AP10 -AP10
-Argentine interest expenses (15% rate) -AP0 -AP6
=Argentine Earnings after taxes =AP133 =AP128.8
- Prinicipal payments on Argentine debt -AP0 -AP40
=Amount of debt to be remitted =AP133 =AP88.8
* Expected exchange rate of Peso *$0.40 *$0.40
=Amount of USD by converting Pesos = $53.2 = $35.52
- U.S. operating expenses -$10 -$10
- U.S. interest expenses (9% rate) -$1.8 -$0
+ U.S. tax benefits (30% rate) +$3.54 +$3
- Principal Payments on U.S. debt -$20 -$0
= Dollar cash flows =$24.94 =$28.52
Present value of $ cash flows, discounted @
cost of equity (18%)
$21.135 $28.52
- Initial equity outlay $20 $20
=NPV = $1.135 =$4.17
The MNC’s
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.
The MNC’s
Capital Structure Decision
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.
The MNC’s
Capital Structure Decision
• 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
The MNC’s
Capital Structure Decision
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.
The MNC’s
Capital Structure Decision
• 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
The MNC’s
Capital Structure Decision
• 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
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.
Interaction Between Subsidiary and
Parent Financing Decisions
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.
Interaction Between Subsidiary and
Parent Financing Decisions
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
Using a Target Capital Structure on a
Local versus Global Basis
• 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.
Using a Target Capital Structure on a
Local versus Global Basis
• 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.
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, firms are shifting from
local bank loans to the use of debt security
and equity markets.
Impact of Multinational Capital Structure Decisions on
an MNC’s Value
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Parent’s Capital Structure
Decisions
doc_149649896.pptx