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 firm’s investors.

Simply put, it is the minimum acceptable rate of return for capital

investments.

The cost of capital has a major impact on the firm’s 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 - MNCDifference in Practice – MNC and Domestic companiesScale 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 - MNCDifference in Practice – MNC and Domestic companiesExposure 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 - MNCVariation of Cost of Capital across countries – Reasons

Cost of capital mainly contains two important components :

Risk free rate of returnAmount 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 - MNCVariation of Cost of Capital across countries – ReasonsThe risk free rate of return may vary due to following reasonsTax 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 – ReasonsThe 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 firm’s 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 firm’s weighted average cost of capital

kc = ( D ) kd ( 1 _ t ) + ( E ) ke D + E D + EwhereD is the amount of debt of the firm

E is the equity of the firmkd is the before-tax cost of its debtt is the corporate tax rateke is the cost of financing with equity

Capital Structure

Formulae for calculating cost of capital of different components :

Cost of Debt Kd = [(Interest) / (sale value )] ( 1 – tax rate)

Cost of Equity

Constant Dividend Growth model : Ke = [D1 / P0 ] + g

Capital Asset Pricing Model :

Cost of Preference Shares

Ke = [D / P0( 1- f)]

-j f j m fR = 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: ke = Rf + (Rm – Rf ) where ke = the required return on a stock

Rf = risk-free rate of return

Rm = market return

= the beta of the stock

Cost-of-Equity ComparisonUsing the CAPM

• A stock’s beta represents the sensitivity of the stock’s returns to market returns, just as a project’s beta represents the sensitivity of the project’s cash flows to market conditions.

• The lower a project’s 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 CAPMfor an MNC’s Risk

• An MNC that increases its foreign sales may be able to reduce its stock’s beta, and hence reduce the required return.

• However, some MNCs consider unsystematic project risk to be important in determining a project’s 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 CAPMfor an MNC’s Risk

The MNC’sCapital 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 MNC’sCapital Structure Decision

Corporate CharacteristicsStability of MNC’s cash flows More stable cash flows

the MNC can handle more debt

MNC’s access toretained earnings

Profitable / less growth opportunities more able to finance with earnings

MNC’s credit risk Lower risk more access to credit

The MNC’sCapital Structure Decision

Country CharacteristicsStock 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 MNC’s 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 MNC’s 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 marketsA high degree of anticipated foreign exchange riskCountry risk and Political riskLack 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 c) Using CAPM model Re = Rf + β (Rm – Rf)Re = 5% + 0.9 ( 12% - 5% ) = 11.30%b) Again , Using CAPM model Re = Rf + β (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 + β (Rm – Rf)Re = 7% + 1.5 ( 15% - 7% ) = 19%Substituting these values in the above formula , we haveWACC = (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%)