COST OF CAPITAL

& CAPITAL STRUCTURE

For MNCs
Multinational Financial Management
By Alan Shapiro (Wiley Eastern Publication, 8th Edition)
International Financial Management
Jeff Madura (Cengage Learning)
International Financial Management
By P G Apte (Tata McGraw Hill)
WACC

WACC = Rd (1 T) D/V + Re E/V

Must reflect target capital structure based
on market value weights.
Advantage of debt:
Tax Shield
Disadvantage of debt:
Increased chances of bankruptcy increases the
cost of equity capital

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HOW WACC BEHAVES

Initially WACC falls with increasing debt as

long as tax shield advantage outweighs
increased cost of equity capital.
At some point cost of equity capital
increases more than the benefits of debt
due to increased probability of distress.
There exists an optimum capital structure.

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COST OF CAPITAL
WACC
Cost
Cost of Equity

R0

WACC

Cost of debt

Level of Debt

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VALUE OF THE FIRM

Similarly, the value of the firm increases with

increasing debt as firm enjoys the tax shield of
debt.
When amount of debt becomes larger than
warranted, increased debt beyond a point adds
to the cost of distress, causing the value of the
firm to decline.
Least cost of capital implies maximum value
for the firm
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CAPITAL STRUCTURE
VALUE OF THE FIRM

Value
Levered Firm; VL
PV of
Financial
Distress
PV of Tax
Shield

Vu Unlevered Firm

Optimal

Level of Debt

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COST OF CAPITAL
MNCs vs. Pure Domestic
FACTORS LEADING TO REDUCTION IN COST
Size of the firm:
Usually much larger, Issue size too is large
reducing floatation cost.
Access to international markets:
Greater options, more opportunities available to
mobilise funds.
International diversification:
Greater the diversification lesser the cost as risk
premium reduces.
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COST OF CAPITAL
MNCs vs. Pure Domestic
FACTORS LEADING TO INCREASE IN COST
Exposure to exchange rate risk:
Increases the cost of capital, but with hedging
instruments available is easily controllable.
Exposure to country risk:
Would need extra premium for the extra risk assumed.
Cost of capital for MNC is likely to be lower than that of
domestic firm
Implies greater business opportunities for MNCs compared
to the domestic firms
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EXPANDED OPPORTUNITY SET

MNC vs Domestic Firm

Cost/Return

IRR of Projects
WACC for domestic firm

WACC for MNC

Increased business opportunities

Investment

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CONVENTIONAL CAP-M

Cost of equity given by CAPM

Re = Rf + (Rm Rf)
Parameters of risk free rate, risk premium, and
are required on global basis rather than local
basis.
Assets are priced as per CAPM which implies
reward for only systematic risk since
unsystematic risk can be diversified away by
investors in their individual capacities.
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INTL CAP-M

Much of the risk faced by investors in MNCs

is unsystematic.
Risk across countries cannot be diversified
away by investors themselves.
MNCs while doing business in different
nations can derive the benefits of
diversification. The economies must have low
degrees of correlation.
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RISK FREE RATE
Risk free rate depends upon
Tax laws and tax rates
Monetary policies
Economic conditions
Efficiency of debt and capital markets
Cost of debt in developed nations is found to
be lower than that of less developed countries.

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RISK PREMIUM

Risk Premium
Economic conditions
Govts willingness to support

Degree of operating leverage

Cost of equity:
PE multiple
Maturity of capital markets

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PROJECTS BETA

Finding subsidiarys Beta:

Use pure play approach:
Unlevering and relevering of beta for
operational leverage and financial leverage.
Identify pure play local firm rather than
using MNCs beta.
Incorporate separate premium for country
risk.
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COST OF EQUITY
ACROSS BORDERS
Depends upon whether capital markets are
integrated or segmented.
If integrated
the cost of capital will equalize across
borders
One mechanism of integrating the financial
markets of the world is CROSS BORDER
LISTING
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CROSS BORDER LISTING
Advantages:
Expanded investor base; higher stock price and lower cost
of equity
More avenues for raising capital
Increased liquidity
Increased visibility providing marketing edge
Disadvantages:
Increased cost of listing
Increased compliances and cost of administration
Increased disclosure requirements
Increased threat of take-over
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INTL CAP-M
For Internationally tradable assets
Assets are priced as per International
CAPM as per systematic risk of the portfolio
consisting of securities across the world.
Take world market portfolio, and its Beta.
Cost of debt will be same across borders if
markets are integrated.

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EXAMPLE: INTL CAP-M
For IBM shares In USA:
Rf = 6% Rm = 12% USA = 1.0
Cost of equity = 6 + 1.0 (12 6)
= 12%
Integrated world markets:
Rf = 6% Rm = 12% w = 0.80
Cost of equity = 6 + 0.8 (12 6)
= 10.8%
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 NON TRADED ASSETS
Cost of equity is partially priced as per international
systematic risk and partly priced as per domestic systematic
risk.
A non tradable asset (only domestically listed firm) gets the
partial benefit of the international listing by another firm.
Companies listed on the domestic market alone get the
advantage of other firms listing abroad. Free ride due to
interplay of domestic and world markets offered by
internationally listed share.
International markets are neither fully integrated nor fully
segmented.

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RESTRICTION ON FOREIGN
EQUITY HOLDING
Phenomena of Pricing To Market (PTM)
Differential pricing due to restrictions on the
equity holding pattern based on nationality of
the investors.
Case of NESTLE
Capital
Registered Stock (68%): Only Swiss nationals
could hold
Bearer Stock (32%): Any one could hold
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CASE - NESTLE

November 17, 1988:

Nestle lifted ban on foreign holding due to:
International criticism for foreign acquisitions.
Management thought that local shares were
underpriced.
Due to underpricing of the registered shares
the cost of capital was higher.

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RESTRICTIONS ON FOREIGN
HOLDING
NESTLE SHARES
Price

Bearer
>8,000 -25%
+35%
Registered
4,000

17 Nov. 88 Time

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IMPACT ON PRICES
Bearer shares fell by 25% and registered shares
rose by 35%.
Since registered shares constituted 68% the overall
cost of capital came down for Nestle.
Price of bearer shares fell:
Because additional supply of shares was available to
investors.
Price of registered shares rose???
Because investors visualised lesser risk with registered
shares and hence the risk premium came down.

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 APPLYING CAP-M
Assume: In Swiss market:
Rf = 4.6% Rm = 9.8% Swiss = 0.9
Cost of equity = 4.6 + 0.9 (9.8 4.6) = 9.28%
With restrictions removed:
Rf = 4.5% Rm = 10.5% w = 0.60
Cost of equity = 4.5 + 0.6 (10.5 4.5) = 8.1%
The price of the share P = D/(r - g);
Two different r will give two different prices.

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COST OF CAPITAL
among nations
Developed vs. Less Developed
Cost of capital is lower in LDCs (India vs. USA)
Developmental financial institutions have played much greater
role in financing the corporate in LDCs, while developed
nations rely more on venture capital and equity markets.
High degree of leverage is acceptable in developing countries
than the developed.
Keirutsu approach of financing
In contrast, for developed nations equity/venture capital
plays major developmental role, rather than debt.
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CAPITAL STRUCTURE DECISION

Corporate Characteristics:
Stability of Cash flows
Credit Risk
Access to retained earnings
Issue of guarantees on debt
Agency problems
Country Characteristics:
Legal environment
Exchange control rules
Strength of the currency
Country/Political risk
Norms differ across nations

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IMPACT OF CAPITAL STRUCTURE OF
SUBSIDIARY
Increased debt financing of the subsidiary
Increases financial leverage for the parent.
Increases foreign exchange exposure for the
parent.
Causes of increased leverage in the subsidiary:
Countries may not allow listing of foreign shares.
Countries may pose great political risk.

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CHOICES FOR THE CAPITAL
STRUCTURE OF SUBSIDIARY

THREE ALTERNATIVES AVAILABLE

Conform to parents capital structure
Conform to local norms
Take Advantage of local financing options

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SUBSIDIARYS CAPITAL
STRUCTURE
If parent is responsible in case of default by the subsidiary:
Parents capital structure is important. When not, capital
structure of subsidiary matters.
As long as parent feels legally or morally obligated not to let
the subsidiary default on its financial commitments, the capital
structure of the subsidiary seems irrelevant.
Also capital structure of the subsidiary seems irrelevant for the
overall capital structure of the parent, since outlays on
subsidiaries are relatively small.

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SUGGESTED CAPITAL
STRUCTURE
Avail local financing opportunities
Management of political risk
Reduce currency risk to the extent the funds are to be
used locally
If local taxes are high tax shield on debts will be high
Avail low cost subsidised debt
Avail subsidies
In such a case the capital structure of the
MNC becomes RESIDUAL.

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