Multinational Cost of Capital and Capital Structure

1. Multinational Cost of Capital and Capital Structure

2. Chapter Outline • Cost of Capital • Cost of Capital in Segmented vs. Integrated Markets • Does the Cost of Capital Differ Among Countries? • The Effect of Foreign Equity Ownership Restrictions • Capital structure • The Financial Structure of Subsidiaries

3. Cost of Capital • The cost of capital is the minimum rate of return an investment project must generate in order to pay its financing costs. • For a levered firm, the financing costs can be represented by the weighted average cost of capital: K = (1 –)Kl + (1 – t)i

4. Weighted Average Cost of Capital Where K = weighted average cost of capital Kl = cost of equity capital for a levered firm i = pretax cost of debt  = debt to total market value ratio t = marginal corporate income tax rate K = (1 –)Kl + (1 – t)i

5. Klocal Kglobal IRR Ilocal Iglobal The Firm’s Investment Decision and the Cost of Capital cost of capital (%) Investment ($)

6. 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 risk-free rate is determined by the interaction of the supply of and demand for funds. It is thus influenced by tax laws, demographics, monetary policies, economic conditions, etc.

7. Country Differences in the Cost of Debt • The risk premium compensates creditors for the risk that the borrower may default on its payments. • The risk premium is influenced by economic conditions, the relationships between corporations and creditors, government intervention, the degree of financial leverage, etc.

8. Effective Real After-Tax Cost of Debt

9. Ri = Rf + bi(RM – Rf) Cov(Ri ,RM) where bi= Var(RM) Cost of Equity in Segmented vs. Integrated Markets • The cost of equity capital (Ke) of a firm is the expected return on the firm’s stock that investors require. • This return is frequently estimated using the Capital Asset Pricing Model (CAPM):

10. Ri = Rf + bi (RU.S. – Rf) Ri = Rf + bi (RW – Rf) U.S. W Cost of Equity in Segmented vs. Integrated Markets 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. versus Clearly integration or segmentation of international financial markets has major implications for determining the cost of capital.

11. Cost of Equity

12. Does the Cost of Capital Differ among Countries? • There do appear to be differences in the cost of capital in different countries. • When markets are imperfect, international financing can lower the firm’s cost of capital. • One way to achieve this is to internationalize the firm’s ownership structure.

13. Real After-Tax Cost of Funds

14. The Effect of Foreign Equity Ownership Restrictions • While companies have incentives to internationalize their ownership structure to lower the cost of capital and increase market share, they may be concerned with the possible loss of corporate control to foreigners. • In some countries, there are legal restrictions on the percentage of a firm that foreigners can own. • These restrictions are imposed as a means of ensuring domestic control of local firms.

15. Pricing-to-Market Phenomenon • Suppose foreigners, if allowed, would like to buy 30 percent of a Korean firm. • But they are constrained by ownership constraints imposed on foreigners to purchase at most 20 percent. • Because this constraint is effective in limiting desired foreign ownership, foreign and domestic investors many face different market share prices. • This dual pricing is the pricing-to-market phenomenon.

16. 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.

17. Corporate Characteristics Stability of MNC’s cash flows More stable cash flows  the MNC can handle more debt MNC’s credit risk Lower risk  more access to credit MNC’s access to retained earnings Profitable / less growth opportunities  more able to finance with earnings MNC’s guarantee on debt Subsidiary debt is backed by parent  the subsidiary can borrow more MNC’s agency problems Not easy to monitor subsidiary  issue stock in host country (Note: there is a potential conflict of interest) The MNC’s Capital Structure Decision

18. Country Characteristics Stock restrictions Less investment opportunities  lower cost of raising equity Interest rates Lower rate  lower cost of debt Strength of host country currency Expect to weaken  borrow host country currency to reduce exposure Country risk Likely to block funds / confiscate assets  prefer local debt financing Tax laws Higher tax rate  prefer local debt financing The MNC’s Capital Structure Decision

19. 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.

20. 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.