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Multinational Cost of Capital

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Background on Cost of Capital

T h e co st o f ca p ita l is a term used in the fieldof fi a n ci l i ve stm e n t to re fe r to th e co st o f a n a n co m p a n y' fu n d s ( p ro p o rti n o f debt versus equity s o financing),or from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities". It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.

For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital.

WHY IS COST OF CAPITAL IMPORTANT? If financing cost is reduced => NPV increases => more projects end up with NPV > 0 => more wealth created to shareholders .
To determine a company's cost of capital, We must calculate both the cost of debt and the cost of equity .

# cost of debt is the effective rate that a company pays on its currentdebt. The debt formula can be written as ( Rf + credit risk rate ) ( 1 - T ) , where T is the

# The cost of equity is more challenging to calculate as equity does not pay a set return to its investors. Comparing the costs of Equity & Debt : WACC = r D ( 1 - T c )*( D / V )+ r E *( E / V ) Where ...

r D = The required return of the firm's Debt financing This should reflect the CURRENT MARKET rates the firm pays for debt . ( 1 - T c ) = The Tax adjustment for interest expense Interest paid on debt reduces Net Income , and therefore reduces tax payments for the firm . This value of this 'interest tax shield' depends on the firm's tax rate . ( D / V ) = ( Debt / Total Value ) The % of the firm's value that is comprised of debt . r E = the firm's cost of equity The firm's cost of equity is best ( or , at least , most easily ) calculated using the CAPM ( Capital Asset Pricing Model ). ( E / V ) = ( Equity / Total Value ) The % of the firm's value that is comprised of Equity . This is based on the firm's intra - day market cap ( stock price x shares outstanding ).

An advantage to using debt rather than equity as capital is that the interest payments on debt are tax deductible, however, it increases the interest expense & the probability that the firm will be unable to meet its expenses.

Searching for the appropriate capital structure

cost of capital

x D e b t R a ti o

This shows that the firms cost of capital initially decreases as the ratio of debt t total capital increases. However, after some point ( point x ), the cost f capital rises as the ratio of debt to total capital increases.

domestic firm due to the following characteristics that differentiate MNCs from domestic firms: 1- Size of firm: An MNC that often borrows substantial amounts may receive preferential treatment from creditors, thereby reducing its cost of capital. Note, however , that this advantage is due to the MNCs size and not to its internationalized business. MNCs may achieve growth more easily to reach the necessary size to receive preferential treatment from creditors. 2- Access to international capital markets: MNCs are able to obtain funds through the international capital markets. Since the cost of funds can vary among markets, the MNCs may obtain funds at a lower cost than that paid by domestic firms. In addition, subsidiaries may be able to obtain funds locally at a lower cost than that available to the parent if the prevailing interest rates in the host

inflows come from sources all over the world, those cash inflows may be more stable because the firms total sales will not be highly influenced by a single economy . To the extent that individual economies are independent of each other, net cash flows from a portfolio of subsidiaries should exhibit less variability, which may reduce the probability of bankruptcy and therefore reduce the cost of capital. 4- Exposure to exchange rate risk: An MNCs cash flows could be more volatile than those of a domestic firm in the same industry if it is highly exposed to exchange rate risk. If foreign earnings are remitted to the US parent of an MNC, they will not be worth as much when the US dollar is strong against major currencies. Thus the capacity of making interest payments on outstanding debt is reduced, and the probability of bankruptcy is higher. This could force creditors and shareholders to require a higher return, which increases the MNCs cost of capital.

5 - E x p o su re to co u n try risk : A n M N C th a t e sta b l sh e s fo re i n su b si i ri s i su b j ct to th e i g d a e s e p o ssi i i th a t a h o st co u n try g o ve rn m e n t m a y se i b l ty ze a su b si i ry s a sse ts. T h e p ro b a b i i o f su ch a n d a l ty o ccu rre n ce i i fl e n ce d b y m a n y fa cto rs, i cl d i g s n u n u n th e a tti d e o f th e h o st co u n try g o ve rn m e n t a n d th e tu i d u stry o f co n ce rn . i a sse ts a re se i d a n d fa i n f ze r co m p e n sa ti n i n o t p ro vi e d , th e p ro b a b i i o f th e o s d l ty M N C s g o i g b a n kru p tcy i cre a se s. T h e h ig h e r th e n n p e rce n ta g e o f a n M N C s a sse ts in v e ste d in fo re ig n co u n trie s a n d th e h ig h e r th e o v e ra ll co u n try risk o f o p e ra tin g in th e se co u n trie s , th e h ig h e r w ill b e th e M N C s p ro b a b ility o f b a n k ru p tcy . O th e r fo rm s o f co u n try ri , su ch a s ch a n g e s i a h o st sk n g o ve rn m e n t s ta x l w s. a

Summary of factors that cause the cost of capital of MNCs to differ from that of domestic firms.
Large size Preferential treatment from creditors

ccess to int. capital markets Possible access to low-cost foreign financing Cost of capital

national diversification Reduced probability of bankruptcy

ure to exchange rate risk Increased probability of bankruptcy

posure to country risk

Cost of Equity comparison using the CAPM


To assess how required rates of return of MNCs differ from those of purely domestic firms, the capital asset pricing model (CAPM) can be applied. Cost of Equity k ( E = rf + rM - rf) where... Ke= the required rate of return on a stock

r f = the 'Risk Free' rate of return = the firm's 'Beta'; the correlation between the firm's returns and the market

The CAPM suggests that the required return on a firms stock is a positive function of: (1) the risk free rate of interest,
(2) the market rate of return, and (3) the stocks beta.
The Beta represents the sensitivity of the stocks returns to market returns. 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. ( a stock index is normally used as a proxy for the market)

For a well-diversified firm with cash flows generated by several projects, each project contains two types of risk: (1) unsystematic variability in cash flows unique to the firm, and (2) systematic risk, also known as undiversified risk.

S y ste m a tic risk refers to the risk common to all se cu ri e si e . m a rke t ri . ti . sk U n sy ste m a tic risk i th e ri a sso ci te d w i s sk a th i d i d u a l a sse ts. I ca n b e d i rsi e d away to n vi t ve fi sm a l e r l ve l b y i cl d i g a g re a te r n u m b e r o f a sse ts l e s n u n i th e p o rtfo l o ( sp e ci c ri n i fi sks " a ve ra g e o u t" ). T h e sa m e i n o t p o ssi l fo r syste m a ti ri w i i o n e s b e c sk th n m a rke t. D e p e n d i g o n th e m a rke t, a p o rtfo l o o f n i a p p roxi a te l 3 0 - 4 0 se cu ri e s i d e ve l p e d m a rke ts m y ti n o su ch a s U K o r U S w i lre n d e r th e p o rtfo l o su ffi e n tl l i ci y d i rsi e d su ch th a t ri exp o su re i l m i d to ve fi sk s i te syste m a ti ri o n l . I d e ve l p i g m a rke ts a l rg e r c sk y n o n a n u m b e r i re q u i d , d u e to th e h i h e r a sse t s re g vo l ti i e s. a l ti

A sse t p ricin g O n ce th e exp e cte d / re q u i d ra te o f re tu rn , E( Ri), is re calculated using CAPM, we can compare this required rate of return to the asset's estimated rate of return over a specific investment horizon to determine whether it would be an appropriate investment . Capital asset pricing theory suggests that the unsystematic risk of projects can be ignored because it will be diversified away. However, systematic risk is not diversified away because all projects are similarly affected. The lower a projects beta, the lower is the projects systematic risk and the lower its required rate of return.

Implications of the CAPM for an MNC s Risk


An MNC that increases its foreign sales may be able to reduce its stocks beta, and hence reduce the return required by investors. In this way, it will reduce its cost of capital. If projects of MNCs exhibit lower betas than projects of purely domestic firms, then the required rates of return on the MNCs projects should be lower. This translates into a lower overall cost of capital. However, some MNCs consider unsystematic project risk to be important in determining a projects required return.

If investors purchase stocks across many countries, their stocks will be substantially affected by world market conditions, not just U.S. market conditions. Consequently, to achieve more diversification benefits, investors will prefer to invest in firms that have low sensitivity to world market conditions. When MNCs adopt projects that are isolated from world market conditions, they may be able to reduce their overall sensitivity to these conditions and therefore could be viewed as desirable investments by investors.

I su m m a ry , w e ca n n o t sa y w i ce rta i ty n th n w h e th e r a n M N C w i lh a ve a l w e r co st o f l o ca p i lth a n a p u re l d o m e sti fi i th e ta y c rm n sa m e i d u stry. H o w e ve r, w e ca n u n d e rsta n d n h o w a n M N C ca n ta ke fu l d va n ta g e o f th e la fa vo ra b l a sp e cts th a t re d u ce i co st o f e ts ca p i l w h i e m i i i n g exp o su re to th e ta , l n m zi u n fa vo ra b l a sp e cts th a t i cre a se i co st o f e n ts ca p i l ta .

C o st o f C a p ita l A cro ss C o u n trie s


T h e co st o f ca p ita l ca n v a ry a cro ss co u n trie s fo r th re e reasons : MNCs based in some countries have a competitive advantage over others; as technology & resources differ across countries, so does the cost of capital. some MNCs will have a large set of feasible (positive net present value) projects because their cost of capital is lower, thus, these MNCs can more easily increase their world market share. MNCs may be able to adjust their international operations and sources of funds to capitalize on the differences in the cost of capital among countries; and

Thirdly, differences in the costs of each capital component (dept & equity) can help explain why MNCs based in some countries tend to use a more debtintensive capital structure than MNCs based elsewhere.

Country Differences in the Cost of Debt


A firm s cost of debt is determined by :
the prevailing risk - free interest rate of the borrowed currency , and the risk premium required by creditors . - the cost of debt for firms is higher in some countries than in others because the corresponding risk-free rate is higher at a specific point in time or because the risk premium is higher.

Differences in the risk - free rate :

The risk-free rate is determined by the interaction of the supply of and demand for funds. Any factors that influence the supply and / or demand will affect the risk - free rate . These factors include: tax laws, demographics, monetary policies, economic conditions, etc. - Tax laws in some countries offer more incentives to save than those in others, which can influence the supply of savings and, therefore, interest rates. - A country s demographics influence the supply of savings available and the amount of loanable funds demanded. Countries with younger populations are likely to experience higher interest rates because younger households tend to save less and borrow more.

- A monetary policy implemented by a countrys central bank influences the supply of loanable funds and therefore influences interest rates. One exception is the set of European countries that rely on the European central bank to control the supply of Euros. All these countries now have the same risk-free rate because they use the same currency. - Since economic conditions influence interest rates, they can cause interest rates to vary across countries. The cost of debt is much higher in many less developed countries than in industrialized countries

Differences in the risk premium:


The risk premium on debt must be large enough to compensate creditors for the risk that the borrower may be unable to meet his payment obligations. This risk can vary across countries because of differences in economic conditions, relationships between corporations and creditors, government intervention, and degree of financial leverage. - When a countrys economic conditions tend to be stable, the risk of a recession in that country is relatively low. Thus, the probability that a firm might not meet its obligations is lower, allowing for a lower risk premium. - Corporations and creditors have a closer relationships in some countries than in others. In Japan, creditors stand ready to extend credit in the event of a corporations financial distress , which reduces the risk of illiquidity. - Governments in some countries are more willing to intervene and rescue failing firms. For example, in the UK many firms are partially owned by the government.

Comparative Cost of Debt Across Countries


There is some positive correlation between country cost of debt levels over time.

Interest rates in various countries tend to move in same direction. However, some rates change to a greater degree than others. The disparity in the cost of debt among the countries is due primarily to the disparity in their risk-free interest rates.

Country Differences in the Cost of Equity


A firm s return on equity can be measured by the risk - free interest rate plus a premium that reflects the risk of the firm . - As risk - free interest rates vary among countries , so does the cost of equity . The cost of equity represents an opportunity cost , and is thus also based on the available investment opportunities in the country of concern . It can be estimated by applying a price earnings multiple to a stream of earnings . High PE multiple low cost of equity financing - In a country with many investment opportunities , potential returns may be relatively high , resulting in a high opportunity cost of funds and , therefore , a

The impact of the Euro - the adoption of the euro has facilitated the
integration of European stock markets because investors from each country are more willing to invest in other countries where the euro is used as the currency. - Investors in one euro zone country no longer need to be concerned about exchange rate risk when they buy stock of a firm based in another euro zone country. - the Euro allows the valuations of firms to be more transparent because firms throughout the euro zone can be more easily compared since their values are all denominated in the same currency. - given the increased willingness of European investors to invest in stocks, MNCs based in Europe may obtain equity financing at a lower cost.

Combining the costs of debt & equity


To derive the overall cost of capital, the costs of debt and equity are combined, using the relative proportions of debt and equity as weight Given the differences in the costs of debt & equity across countries, it is understandable that the cost of capital may be lower for firms based in specific countries. Japan, for example, commonly has a relatively low cost of capital. It usually has a relatively low risk-free interest rate, which not only affects the cost of debt but also indirectly affects the cost of equity. MNCs can attempt to access capital from countries where capital costs are low, but when the capital is used to support operations in other countries, the cost of using that capital is exposed to exchange rate risk. Thus, the cost of capital may ultimately turn out to be higher than expected.

equity
Lexon co. is a successful U.S. based MNC, is considering how to obtain funding 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 dollar-denominated debt provided by U.S. creditors = 3% - risk premium on Argentina peso- denominated debt provided Argentine creditors = 5% - beta of the project ( expected sensitivity of project returns ) = 1.5 - expected U.S. market return = 14% - U.S. corporate tax rate = 30% - Argentine corporate tax rate = 30% - creditors will likely allow no more than 50% of the financing to be in the form of debt, which implies that equity must provide at least half of the financing.

Lexons cost of each component of capital


- cost of dollar- denominated debt = (6% + 3%) * (1 0.3) = 6.3% - cost of Argentine peso-denominated debt = (10% + 5%) * (1 - 0.3) = 10.5% - cost of dollar-denominated equity = 6% + 1.5 (14% 6%) = 18%

Lexo n s E stim a te d W e ig h te d A v e ra g e C o st o f C a p ita l ( WACC ) fo r F in a n cin g a P ro je ct


L e x o n co n sid e rs fo u r d iffe re n t ca p ita l stru ctu re s fo r th e n e w p ro je ct.

This table shows that lowest estimate of the WACC results from a capital structure of 50% U.S. debt & 50% equity. The estimated WACC does not account for the exposure to exchange rate risk. Thus, lexon will not necessarily choose the capital structure with the lowest estimated WACC, lexon can attempt to incorporate the exchange rate effects in various ways

Thank you

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