Chapter 17 Multinational Capital Structure and Cost of Capital

1. Chapter 17Multinational Capital Structure and Cost of Capital 17.1 Capital Structure and the Cost of Capital 17.2 Project Valuation and the Cost of Capital 17.3 Sources of Funds for Multinational Operations 17.4 The International Evidence on Capital Structure 17.5 The Cost of Capital on Multinational Operations 17.6 Summary

2. Capital structure • Capital structure refers to the proportion of long-term debt and equity and the particular forms of capital chosen to finance the assets of the firm. • Management must choose • the proportions of debt and equity • the currency of denomination • fixed or floating rate interest payments • indenture provisions • conversion features • callability • seniority • maturity

3. Multinational financing opportunities

4. The weighted average cost of capital iWACC = (B/V)iB(1-TC)+(S/V)iS

5. The multinational’s cost of capital (given a particular set of investments)

6. Optimal capital structure Far better an approximate answer to the right question, which is often vague, than an exact answer to a wrong question, which can always be made precise. John W. Tukey

7. The perfect market assumptions • Perfect markets: • Frictionless markets • Equal access to market prices • Rational investors • Equal access to costless information

8. Modigliani-Miller’s irrelevance proposition • Equal access to perfect financial markets means that individual investors can replicate any financial action that the firm can take. • This leads to MM’s irrelevance proposition: • If financial markets are perfect, then corporate financial policy is irrelevant.

9. The converse of MM’s irrelevance proposition • If financial policy is to increase value, then it must either • increase the firm’s expected future cash flows or • decrease the discount rate in a way that cannot be replicated by individual investors.

10. Financial market integration vs. segmentation • In integrated financial markets, real after-tax rates of return on equivalent assets are equal. • Factors contributing to segmentation include: • prohibitive transactions costs • different legal and political systems • regulatory interference (e.g., barriers to financial flows) • differential taxes • informational barriers • home asset bias (a tendency to buy financial assets in the domestic market) • differential investor expectations

11. Project valuation and the cost of capital • Alternative approaches to project valuation • WACC: Weighted average cost of capital • APV: Adjusted present value • Use an asset-specific discount rate that reflects the opportunity cost of capital. • Cash flows denominated in the domestic (foreign) currency should be discounted at a domestic (foreign) discount rate. • Nominal (real) cash flows should be discounted at nominal (real) discount rate.

12. Weighted average cost of capital(WACC) NPV = St [ E[CFt] / (1+iWACC)t ] where iWACC = [(B/VL) iB (1-TC)] + [(S/VL)iS] and B = the market value of corporate bonds S = the market value of corporate stock VL = B + S = the market value of the firm iB = the required return on corporate bonds iS = the required return on corporate stock TC = the marginal corporate income tax rate

13. Adjusted present value(APV) APV = VU + PV(financing side effects) - initial investment where VU = the value of the unlevered or all-equity project PV(financing side effects) = value of tax shields from the use of debt net of costs of financial distress

14. Sources of funds for multinational operations • The financial pecking order: • Internally generated funds are the preferred source. • External sources of funds are accessed only after internal sources are exhausted. • External debt is the preferred external funding source. • New external equity is used only as a last resort.

15. Sources of funds for multinational operations

16. Targeted registered offerings • Registered versus bearer securities • Securities in the United States are issued in registered form. • The convention in Western European countries is to issue securities in bearer form. • U.S. corporations can issue bearer securities to international investors as targeted registeredofferings. • The registered owner must be a financial institution in another country. • Interest or dividends is paid to this registered financial institution. • The issuer must certify that it has no knowledge that a U.S. taxpayer owns the security. • The issuer and the registered foreign institutions must follow the certification procedures of the Securities and Exchange Commission.

17. The U.S. evidence on capital structure • Leverage increases with • Fixed assets • Firm size • Nondebt tax shields • Leverage decreases with • Growth opportunities • Profitability • Uniqueness of the firm’s product(s) • Earnings volatility • Advertising and R&D expenditures • Probability of bankruptcy or default

18. Balance sheets for nonfinancial firms

19. The international evidenceon capital structure • Leverage increases with • The proportion of fixed to total assets • Firm size • Leverage decreases with • Asset market-to-book ratios (~ growth opportunities) • Profitability

20. Diversifiable versus nondiversifiable risksand the multinational’s cost of capital • If operating risks are diversifiable, then they are not priced by investors and should not be reflected in capital costs. • If operating risks are nondiversifiable (systematic), then they should be reflected in capital costs. • The multinational corporation’s capital costs are increased if these risks are positively related to the market portfolio • The multinational corporation’s capital costs are decreased if these risks are negatively related to the market portfolio

21. The multinational corporation’s cost of capital • Mixed empirical evidence • MNCs have lower betas despite higher financial leverage Michel and Shaked, “Multinational Corporations vs. Domestic Corporations: Financial Performance and Characteristics,” Journal of International Business Studies, Fall 1986. • MNCs have higher betas after controlling for leverage, size and growth Reeb, Kwok and Baek, “Systematic Risk of the Multinational Corporation,” Journal of International Business Studies, No. 2, 1998.

22. The effect of financial market liberalizations on the cost of capital • Bekaert and Harvey (1998) find that financial market liberalizations tend to: • Increase the correlation of emerging market returns with world market returns. • Have little impact on emerging market volatility. • Decrease local firms’ capital costs by up to 1 percent. Source: Geert Bekaert and Campbell Harvey, “Foreign Speculators and Emerging Equity Markets,” Fuqua School of Business Working Paper, June 1998.