MBA (Finance specialisation)

&
MBA Banking and Finance
(Trimester)
Term VI
Module : International Financial Management
Unit III: Financial Management of Multinational firm
Lesson 3.1
(Cost of capital and Capital Structure Decision of the Multinational firm)

Introduction
The cost of capital for a domestic firm is the rate that must be earned in
order to satisfy the required rate of return of the firms investors.
Simply put, it is the minimum acceptable rate of return for capital
investments.
The cost of capital has a major impact on the firms value.
The determination of the cost of capital for international projects is a
complex issue in international finance because of the difficulties
associated with estimating the risks posed by each foreign project.
Cost of Capital - MNC

Importance of Cost of capital
The determination of the firm's cost of capital is important because it:
I. Provides the very basis for financial appraisal of new capital
expenditure proposals and thus serves as acceptance criterion for
capital expenditure projects,
II. Helps the managers in determining the optimal capital structure of
the firm,
III. Serves as the basis for evaluating the financial performance of top
management,
IV. Helps in formulating dividend policy and working capital policy, and
V. Can serve as capitalization rate which can be used to determine
capitalization of a new firm.

Cost of Capital - MNC
Difference in Practice MNC and Domestic companies
Scale of Operations: MNCs generally being larger in size as compared to the domestic firms may
be in a privileged position to garner funds both through stocks and bonds at lower cost because
they are accorded preferential treatment due to their size.

Access to International Capital Markets: In view of easier access to international capital markets,
MNCs are in a position to obtain funds at lower cost than that paid by the domestic firms. Further,
international availability permits MNCs to maintain the desired ratio, even if substantially large
funds are required.

International Diversification:MNCs, by virtue of their diversified operations, are in a better
position to reduce their cost of capital in comparison to domestic firms for at least two reasons:
A firm with cash inflows pouring in from different sources across the world enjoys relatively
greater stability, for the fact that total sales will not be greatly influenced by a single economy.
Less cash flow volatility causes the firm to support a higher debt ratio leading to lower cost of
capital;
International diversification (by country and by product) should lower the systematic risk of the
firms, thus lowering its beta coefficient and consequently the cost of equity.

Cost of Capital - MNC
Difference in Practice MNC and Domestic companies
Exposure to Exchange Rate Risk: Operations of MNCs and their cash flows are
exposed to higher exchange rate fluctuations than domestic firms leading to
greater possibility of bankruptcy. As a result, creditors and stockholders demand a
higher return, which enhances the MNC's cost of capital.

Exposure to Country Risk: The total country risk of foreign investment, as noted
earlier, is greater in the case of foreign investment than in similar domestic
investment because of the additional cultural, political and financial risks of foreign
investments.
Cost of Capital - MNC
Variation of Cost of Capital across countries Reasons

Cost of capital mainly contains two important components :

Risk free rate of return
Amount of premium for risk

These two components may vary from country to country as a
result of which cost of capital also vary.

There are various reasons for country differences in the risk-free rate and
in the risk premium.

Cost of Capital - MNC
Variation of Cost of Capital across countries Reasons
The risk free rate of return may vary due to following reasons
Tax laws in different countries differ in terms of tax rate, exemption and
incentives, thus influencing differently the supply of funds to the corporate sector
and hence the interest rate.
Demographic condition of a country impacts demand and supply of funds and
thereby the interest rate. A country with a majority of population being younger
will have higher interest rate, for the fact that youngsters are relatively less thrifty
and demand more money to satisfy their varied needs.
Monetary policy of Central bank of a country directly influences interest rate at
which funds can be borrowed by MNCs. The Central bank following tight monetary
policy to curb inflationary tendencies in the country will raise bank rate and hence
the interest rate.
Because of varying levels of economic development, interest rates differ across
countries. Thus, in relatively advanced countries and so also highly developed and
integrated financial markets interest rate on debt is always lower than the less
developed nations.
Cost of Capital - MNC
Variation of Cost of Capital across countries Reasons
The risk premium may vary due to following reasons:
In case of economic stability, possibility of the country experiencing recession is relatively
low and so also the borrowers defaulting in repayment. Under such a situation, risk
premium is likely to be low.

Risk premium will be relatively lower in countries where the relationships between
corporations and creditors are very cordial . When creditors are ready to help their client to
get over the illiquidity crisis. In such a situation amount of risk premium will be less.

Governments in some countries like the UK and India intervene actively to rescue failing
firms, particularly those partly owned by them and provide all kinds of financial support to
them. However, in the USA, the probability of Government intervention to rescue firms from
incipient sickness is low. Hence, risk premium in the case of the former will be lower than
the latter.

Risk premium also differs across countries because of varying degree of financial leverage
of firms in those countries. For instance, firms in Japan and Germany have a higher degree
of financial leverage than firms in the USA. Obviously, the high leverage firms would have to
pay a higher risk premium, with other factors being equal. In fact, the reason for higher
leverage of the firm is their unique relationship with creditors and governments.
Capital Structure
The capital structure of any firm (MNC or domestic) is function of following variables:

a) Weight of each of kind of capital ( Debt, equity, preference shares , retained earnings)
b) Cost of these components of capital.

Weighted Average Cost of capital (WACC) = Kd X Wd + Ke X We + Kp X Wp

Since one of the important component of capital structure is the cost of capital of
individual source of funds, therefore, factors determining capital structure of MNC are
also distinct from domestic companies just as we have observed in case of cost of
capital.



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

Capital Structure and Cost of Capital
A firms weighted average cost of capital
k
c
= (
D
)

k
d
(

1

_

t

)

+

(
E
)

k
e

D + E D + E
where Dis 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

Capital Structure
Formulae for calculating cost of capital of different components :

Cost of Debt
K
d
= [(Interest) / (sale value )] ( 1 tax rate)

Cost of Equity

Constant Dividend Growth model : K
e
= [D
1
/ P
0
] + g

Capital Asset Pricing Model :
Cost of Preference Shares

K
e
= [D

/ P
0
( 1- f)]

-
j f j m f
R = R + (R R )
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.
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
Cost-of-Equity Comparison
Using the CAPM
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.
Implications of the CAPM
for an MNCs Risk
An MNC that increases its foreign sales may
be able to reduce its stocks beta, and
hence reduce the required return.
However, some MNCs consider
unsystematic project risk to be important in
determining a projects required return.
Hence, we cannot say whether an MNC will
have a lower cost of capital than a purely
domestic firm in the same industry.
Implications of the CAPM
for an MNCs Risk
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.
The MNCs
Capital Structure Decision
Corporate Characteristics
Stability of MNCs cash flows More stable cash flows
the MNC can handle more debt
MNCs access to
retained earnings
Profitable / less growth opportunities
more able to finance with earnings
MNCs credit risk Lower risk more access to credit
The MNCs
Capital Structure Decision
Country Characteristics
Stock restrictions Less investment opportunities
lower cost of raising equity
Strength of host country
currency
Expect to weaken borrow host country currency to
reduce exposure
Tax laws
Higher tax rate
prefer local debt financing
Interest rates Lower rate lower cost of debt
Country risk Likely to block funds prefer local debt financing
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 MNCs 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 MNCs overall exposure to exchange rate
risk.
Cost of Capital in Segmented Markets
Market Segmentation is the process of splitting customers in a market into different
groups , or in which customer share a similar level of interest.
Firms located in a segmented market usually have a higher cost of capital and less
availability of capital for long-term debt and equity needs. Such firms need to devise
strategies to escape dependence on that market so that they can raise capital from
cheaper sources.

Main reasons for Market Segmentation:
Imperfect flow of information between domestic and foreign based investors.
Lack of transparency in the markets
A high degree of anticipated foreign exchange risk
Country risk and Political risk
Lack of good corporate governance.
Practical Problems
Example 1 : The systematic risk (beta) of Grand Pet stock is 0.9 when measured against the
Morgan Stanley Capital International (MSCI) world market index and 1.2 against the
London Financial Times 100 (or FTSE 100) stock index. The annual risk free rate in the
United Kingdom is 5%.
a) If the required return on the MSCI world market index is 12%, what is the required
return on Grand Pet stock in an integrated financial market.
b) Suppose the U.K. financial markets are segmented from rest of the World. If the
required return on the FTSE 100 is 10%, what is the required return on Grand Pet
stock?

Solution
a) Using CAPM model
Re = Rf + (Rm Rf)
Re = 5% + 0.9 ( 12% - 5% ) = 11.30%
b) Again , Using CAPM model
Re = Rf + (Rm Rf)
Re = 5% + 1.2( 10% - 5% ) = 11.00%

Practical Problems
Example 2 : ABC (MNC) has a market value debt to value ratio of 45 percent. ABC
pretax borrowing cost on new long-term debt in France is 8%. ABC beta relative to the
French Stock market is 1.5. The risk free rate is 7%. Interest is deductible in France at the
marginal corporate income tax of 38 percent. The required return on the world market
portfolio is 15% . What is the ABC weighted average cost of captial in the French market?
Solution
WACC = ( Weight of Debt x Cost of Debt + Weight of equity X cost of equity)
Weight of Debt = 45%
Weight of Equity = 55%
Cost of Debt = I ( 1- t) = 8% ( 1 38%) = 4.96%
Cost of Equity , using CAPM model
Re = Rf + (Rm Rf)
Re = 7% + 1.5 ( 15% - 7% ) = 19%
Substituting these values in the above formula , we have
WACC = (45% x 4.96 % + 55% x 19% ) = 12.68 %


Practical Problems

Problem 1: The systematic risk (beta) of Fairfield Corporation is 1.3 when measured
against the world stock market index and 1.5 against French Stock index. The annual risk
free rate in France is 6%.
a) If the required return on the World market index is 11%, what is the required return on
Fairfield stock in an integrated financial market.
b) Suppose the French financial markets are segmented from rest of the World. If the
required return on the French Market is 10%, what is the required return on Fairfield
stock?

Problem 2: ABC (MNC) can borrow in the Euro market at pretax cost of 8 percent.
International investors will tolerate a 50% debt to value mix. With a 50 percent debt to-
value ratio, the beta of ABC is 1.4. The required return on the world market portfolio is 15
percent. Interest is deductible at the marginal corporate income tax of 30 percent. The
required return on the world market portfolio is 18% .What is the ABC s weighted
average cost of capital under these circumstances ? (Assume risk free rate of return as 6%)