Chapter 4 - Multinational Capital Structure and Cost of Capital

OBJECTIVES
❖The specific objectives of this chapter are to:

❖■■ Describe the key components of an MNC’s capital.
CHAPTER 17 ❖■■ Identify the factors that affect an MNC’s capital structure.
❖■■ Explain the interaction between a subsidiary and parent in

capital structure decisions.
❖■■ Explain how the cost of capital is estimated.
❖■■ Explain why the cost of capital varies among countries.
Lecturer: Dr. Tien Trung, Nguyen 1 Lecturer: Dr. Tien Trung, Nguyen 2
LEARNING OBJECTIVES
❖Multinational corporations (MNCs) rely on capital to
Explain the interaction
finance their expansion of existing subsidiaries, the
Describe the key components Identify the factors affecting between subsidiary and
of MNC’s capital MNC’s capital structure parent in capital structure creation of new subsidiaries, and other projects.
decisions
❖Because the MNC’s decisions regarding its capital structure
Explain why the cost of

determine its cost of capital and the cost of capital affects
Estimate the cost of capital capital varies among the profitability of its projects, the MNC’s capital structure
countries
decisions affect its value.
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1. Retained Earnings
❖ An MNC’s parent and its subsidiaries commonly generate earnings, which can be
retained and reinvested to support existing oper.ations or expansion
❖ First, the MNC might allow each subsidiary to retain sufficient earnings to cover its
expected operating expenses denominated in the same currency in the near future.
PART 1 ❖ This strategy allows each subsidiary to use its recent cash inflows to cover its future
cash outflows.
❖ Because this strategy minimizes the earnings remitted to the parent and parent
financing of subsidiary operations, it minimizes the amount of cash flows between the
subsidiary and the parent that must be converted into a different currency.
1. Retained Earnings 2. Sources of Debt

❖Alternatively, the parent might require that the subsidiaries remit their ❖When MNCs decide to finance their operations with debt,
earnings to cover the parent’s operating expenses in the near future.
they consider the following sources.
❖If the parent invested its own cash to create each subsidiary, it may
External sources of debt
view the remitted earnings as a return on its initial investment in the
subsidiary. Domestic bond offering
❖The MNC might also use retained earnings to further expand its Global bond offering
operations internationally by establishing a new subsidiary in another Private placement of bonds
country, in which it again invests some cash to create an equity
Loans from financial institutions
investment.
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2.1 Domestic Bond Offering 2.2 Global Bond Offering
❖ Multinational corporations often engage in a domestic bond offering in
❖An MNC can engage in a global bond offering (with the
their home country in which the funds are denominated in their local
currency → provide financing to any of its foreign subsidiaries help of an investment bank) in which it simultaneously
❖ They hire an investment bank to help determine the amount of the sells bonds denominated in the currencies of multiple
offering and the price at which the bonds can be sold.
countries.
❖ The investment bank also provides for distribution by selling the bonds to
many institutional investors. ❖In this case, the focus is on obtaining funds from a few
❖ Maturities on the debt typically range from 10 to 20 years.
countries where large subsidiaries need financing
❖ Investors who purchase the bonds do not have to hold them until maturity,
as they can sell the bonds to other investors in the secondary market.
2.2 Global Bond Offering 2.3 Private Placement of Bonds

❖ For example: ❖Another source of debt for MNCs is to offer a private placement of
❖ an offering by a U.S.-based MNC may consist of $20 million in bonds sold bonds to financial institutions in their home country or in the foreign
to U.S. investors to finance its home operations, British pound– country where they are expanding.
denominated bonds valued at £15 million sold to British investors to finance
❖Private placements of debt may reduce transaction costs because the
its subsidiaries that conduct business in the United Kingdom, and Swiss
franc–denominated bonds valued at SF10 million sold to Swiss investors to debt is placed with a small number of large investors.
finance its subsidiaries that conduct business in Switzerland. ❖Privately placed bonds may carry some restrictions on their resale in
❖ Investors who purchase any of these bonds can sell them before maturity the secondary market.
to other investors in the secondary market.
❖Thus, they may offer limited liquidity to investors.
3
2.4 Loans from Financial Institutions
❖ An MNC commonly borrows funds from financial institutions. In doing so, it not only
❖Example: page 527
benefits from access to funds, but also establishes a business relationship with the
financial institutions, giving it access to other services such as foreign exchange and
cash management.
❖ Subsidiaries of an MNC borrow funds from local financial institutions in their
respective host countries and may also rely on other services from these financial
institutions
❖ Loans from financial institutions to MNCs typically specify an adjustable interest rate
that changes every six months or every year in accordance with the annualized
interbank loan rate (called the London Interbank Offer Rate [LIBOR]) in the same
currency.
3. External Sources of Equity 3.1. Domestic Equity Offering

When MNCs need to obtain external equity, they consider the following ❖Multinational corporations can engage in a domestic equity
sources.
offering in their home country in which the funds are
External sources of equity denominated in their local currency.
Domestic equity offering ❖Subsequently, they may distribute a portion of the proceeds to
Global equity offering their subsidiaries.
Private placement of equity ❖Any funds transferred to subsidiaries must be converted into
Subsidiary’s Offering of Its Own Stock the subsidiary’s local currency at the prevailing exchange rate.
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3.2 Global Equity Offering Example
❖ Most MNCs obtain equity funding in their home country, but some pursue a global equity ❖ Georgia Co. engages in a global offering in which a portion of its stock is denominated in
offering in which they can simultaneously access equity from multiple countries. dollars. It will use the proceeds from selling the dollar-denominated stock to support the
❖ Their efforts in placing the stock will focus on a few countries where they have large operations of subsidiaries in the United States. This stock is placed with investors in the United
subsidiaries that need financing. States, who can easily sell the stock in the future because it is listed on U.S. stock exchanges
❖ The stock will be listed on an exchange in the foreign country and denominated in the local ❖ Another portion of the global stock offering is denominated in Japanese yen, and the proceeds
currency so that investors there can sell their holdings of the stock in the local stock market. of this portion are used to support the operations of Georgia’s Japanese subsidiary. This stock
is placed with Japanese investors, who can easily sell the stock in the future because it is
❖ Investors in a foreign country will be more willing to purchase shares in a global equity
listed on a Japanese stock exchange.
offering if the MNC places a large number of shares in that country because this strategy
ensures a more active and liquid secondary market for the stock in that country. ❖ Another portion of Georgia’s global stock offering is denominated in euros, and the proceeds
of this portion are used to support the operations of Georgia’s European subsidiary. This stock
❖ Hence those investors can more easily sell their shares in the secondary market in the future.
is placed with European investors, who can easily sell the stock in the future because it is
listed on a European stock exchange.
3.2 Global Equity Offering 3.3 Private Placement of Equity
❖To successfully issue stock globally, MNCs should be large ❖Another source of equity for MNCs is a private placement
firms that have global name recognition. of equity with financial institutions in their home country or
❖A global equity offering may be ineffective in countries in the foreign country where they are expanding.
characterized by weak disclosure laws, weak shareholder ❖Like private placements of debt, private placements of
protection laws, and weak enforcement of the securities equity may reduce transaction costs.
laws, because investors in such countries may have limited ❖However, MNCs may not be able to obtain all the funds
demand for the MNC’s stock. that they need with this approach.
5
3.4 Subsidiary’s Offering of Its Own Stock
❖A foreign subsidiary of the MNC could engage in a public

offering of its own stock, assuming that it receives
approval from the parent.
PART II
❖If shares of the subsidiary’s stock are sold to investors in
the host country, the subsidiary would no longer be wholly
owned by the parent, although the parent would likely
remain as the majority owner
1 Influence of Corporate Characteristics
❖An MNC’s capital structure decision involves the choice of ❖Characteristics unique to
Corporate characteristics
debt versus equity financing within all of its subsidiaries. each MNC can influence its
Cash Flow Stability
❖The advantages of using debt as opposed to equity vary capital structure, as
Credit risk
with corporate characteristics specific to each MNC and described next.
Access to retained earnings
specific to the countries where the MNC has established
Guarantees on debt
subsidiaries.
Agency problems
6
1 Influence of Corporate Characteristics 1 Influence of Corporate Characteristics
❖Cash Flow Stability Multinational corporations with more ❖Credit Risk Multinational corporations that have lower credit risk (risk
of default on loans provided by creditors) have more access to credit.
stable cash flows can handle more debt because they have
❖An MNC with assets that serve as acceptable collateral (such as
a constant stream of cash inflows to cover their periodic
buildings and adaptable machinery) can more easily secure loans and
interest payments on the debt. so may prefer to emphasize debt financing.
❖In contrast, MNCs with assets that do not represent adequate
collateral may need to use a higher proportion of equity financing.
1 Influence of Corporate Characteristics 1 Influence of Corporate Characteristics

❖ Access to Retained Earnings Highly profitable MNCs may be able to finance ❖Guarantees on Debt If the parent backs the debt of its
most of their investment with retained earnings and, therefore, may use an
equity- intensive capital structure; in contrast, MNCs that generate small
subsidiary, it increases the subsidiary’s borrowing capacity. In
levels of earnings may rely mainly on debt financing. that case, the subsidiary would need less equity financing.
❖ Growth-oriented MNCs may commonly need more funds than can be
❖At the same time, the parent’s borrowing capacity might be
accessed from retained earnings, so they tend to rely on debt financing.
❖ In contrast, MNCs with less growth may be able to rely on retained
reduced because creditors will be less willing to provide funds
earnings (equity) rather than debt. to the parent if those funds might be needed to rescue the
subsidiary.
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1 Influence of Corporate Characteristics 2. Influence of Host Country Characteristics
❖In addition to characteristics
❖Agency Problems If investors from the parent’s country
unique to each MNC, Host country characteristics
cannot easily monitor a subsidiary in a foreign country, the following characteristics Interest rates
agency costs will be higher. unique to each host
Strength of currencies
country can influence the
❖In such a case, the parent may require the subsidiary to Country risk
MNC’s choice of debt versus
rely more on debt financing, because this will force the
equity financing, thereby Tax laws
subsidiary to be disciplined to cover its periodic loan influencing the MNC’s
payments. capital structure.
❖ Strength of Host Country Currencies If an MNC is concerned about the potential weakness of
❖Interest Rates in Host Countries The interest rate can vary the currencies in its subsidiaries’ host countries, it may instruct these subsidiaries to finance a
large proportion of their operations by borrowing in those currencies instead of relying on
across countries. parent financing. With this approach, the subsidiaries will remit a smaller amount of their
earnings to the parent because they will use some of their earnings to make interest payments
❖Consequently, an MNC’s preference for debt may depend on local debt. This strategy reduces the MNC’s exposure to exchange rate risk.
on the cost of debt in the countries where it operates. If ❖ If the parent believes that a subsidiary’s local currency will appreciate against the parent’s
currency, then it may have the subsidiary retain and reinvest more of its earnings.
the interest rate in a subsidiary’s country appears ❖ As a result, the subsidiary may ultimately remit earnings in future years after its currency has
appreciated. This strategy of relying on retained earnings means that the subsidiary can
excessive, the parent may prefer to provide its own reduce its reliance on local debt financing.
financing for projects implemented by the subsidiary.

8
❖Country Risk in Host Countries A relatively mild form of country ❖Tax Laws in Host Countries Foreign subsidiaries of an MNC may be
risk is the possibility that the host government will temporarily subject to a withholding tax when they remit earnings to the parent.
block funds to be remitted by the subsidiary to the parent. ❖When they use local debt financing instead of relying on parent
financing, they will make interest payments on the local debt, which
❖Subsidiaries that are prevented from remitting earnings over
in turn reduces the amount of funds to be remitted periodically to the
some periods may prefer to use local debt financing.
parent.
❖This strategy reduces the amount of funds that are blocked
❖Thus, the subsidiary reduces the withholding taxes by using more
because the subsidiary can use some of the funds to pay local debt financing.
interest on local debt.
Response to Changing Country Characteristics Example

❖ Plymouth Co. has subsidiaries in several countries that have just revised their capital
❖The country characteristics just described vary among
structure levels as follows:
countries and also can change over time in any particular ❖ ■ Plymouth Co. is concerned that the Japanese yen will depreciate substantially over
the next two years. The company instructs its subsidiary in Japan to remit all earnings
country. to the parent over the next year, before the yen depreciates. Consequently, the
Japanese subsidiary cannot rely on retained earnings (equity) to support its
❖Thus, these characteristics explain not only why the ideal operations and must rely more heavily on local debt.
capital structure may vary among countries, but also how ❖ ■ Plymouth Co. has a subsidiary in Thailand, where the government has announced it
will impose a withholding tax on remitted funds. This subsidiary will borrow more local
the ideal capital structure could change within any funds in the future, so that it will have less earnings to remit to the parent in the
future and, therefore, will be subject to lower withholding taxes.
particular country over time.
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Example
❖ ■ Plymouth Co. has a subsidiary in Chile, where the government has announced it will
block the remission of funds for the next year. This subsidiary will use the blocked
funds that it would otherwise have remitted to pay off its local debt in Chile. This
subsidiary’s capital structure will become more equity intensive.
❖ ■ Plymouth Co. has a subsidiary in Argentina, where local interest rates have PART III
increased, thereby boosting the cost of local debt. This subsidiary will rely more on
retained earnings than on issuing new debt.
❖ Overall, country conditions caused two of the subsidiaries to use a more debt-
intensive capital structure, while causing two other subsidiaries to use a more equity-
intensive capital structure.
1. Impact of Increased Subsidiary Debt Financing

❖The capital structure of an MNC’s subsidiaries may vary because some ❖ When a subsidiary relies heavily on debt financing, it reduces its need for
subsidiaries are subject to conditions that favor debt financing, internal equity financing (retained earnings). Consequently, the parent will
itself have a larger amount of internal funds to use, so it can reduce its
whereas others face conditions that favor equity financing.
reliance on debt financing.
❖Of course, the more earnings that a subsidiary retains (as a form of
❖ In this way, the increased use of debt financing by the subsidiary is offset
equity financing), the less earnings that it can remit to the parent. by the reduced debt financing of the parent.
❖Therefore, subsidiary capital structure decisions affect the amount of ❖ Because the subsidiary may have more financial leverage than is desired
earnings to be received by the parent, which in turn influences the for the MNC overall, the parent may use less financial leverage to finance
parent’s capital structure. its own operations to achieve its overall (“global”) target capital structure.
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2. Impact of Reduced Subsidiary Debt Financing 3. Limitations in Offsetting a Subsidiary’s Leverage
❖ When global conditions encourage the subsidiary to use less debt financing, it will need to use ❖ The strategy of offsetting a subsidiary’s shift in financial leverage to achieve a global
more internal financing. target capital structure makes sense as long as it is acceptable to foreign creditors
❖ The subsidiary will therefore remit fewer funds, reducing the amount of internal funds and investors.
available to the parent.
❖ However, foreign creditors may charge higher loan rates to a subsidiary that uses a
❖ If the parent’s operations absorb all internal funds and require some debt financing, then this highly leveraged local capital structure (even if the MNC’s global capital structure is
scenario will have offsetting effects on the capital structures of the subsidiary and parent; that
more balanced) because they believe that the subsidiary may be unable to meet its
is, the subsidiary’s reduced use of debt financing will be offset by the parent’s increased use.
high debt repayments.
❖ Thus, even though a local (specific subsidiary) capital structure has changed, it is seldom
❖ If the parent guarantees debt repayment to the creditors of its foreign subsidiaries,
necessary for the MNC’s global capital structure to change.
that promise may reduce the perceived credit risk of the foreign subsidiaries and
❖ An MNC may still achieve its target capital structure by offsetting one subsidiary’s change in
could lower their cost of the debt. Many MNC parents stand ready to financially back
financial leverage with an opposite change in the financial leverage of another subsidiary or of
the parent. their subsidiaries because, if they did not, their subsidiaries would be unable to obtain
adequate financing.
SUBSIDIARY VS PARENT
CAPITAL STRUCTURE DECISION
Increased debt financing Decreased debt financing
PART IV
Increased debt financing by the
The subsidiary’s decreased debt
subsidiary is offset by the
financing is offset by the
reduced debt financing of the
parent’s increased use
parent
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1. MNC’s Cost of Debt
MULTINATIONAL COST OF CAPITAL
❖An MNC’s cost of debt depends on the interest rate that it pays when
Cost of debt Cost of equity borrowing funds.
Borrowing interest rate Interest rates ❖The interest rate that it pays is equal to the risk-free rate at the time
it borrows funds along with a credit risk premium that compensates
Risk-free rate Strength of currencies
creditors for accepting credit (default) risk when extending credit to
Credit risk premium Country risk the MNC.
Tax deduction Tax laws ❖Because interest expenses incurred by corporations are deductible
when determining a corporation’s taxable income, debt carries a tax
advantage.
2. MNC’s Cost of Equity 3. Estimating an MNC’s Cost of Capital

❖ An MNC creates equity by retaining earnings or by issuing new stock. The ❖ The cost of an MNC’s capital (denoted kc) can be measured as the cost of its debt
firm’s cost of retained earnings reflects an opportunity cost, which plus the cost of its equity, with appropriate weights applied to reflect the percentage
of the MNC’s capital represented by debt and equity, respectively:
represents what the existing shareholders could have earned if they had
received the earnings as dividends and invested the funds themselves.
❖ The MNC’s cost of new equity (from issuing new common stock) also
reflects an opportunity cost of what the new shareholders could have
earned if they had invested their funds elsewhere instead of in the stock.
❖ This cost exceeds that of retained earnings because it also includes the
expenses (known as “flotation costs”) associated with selling the new
stock.
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4. Comparing Costs of Debt and Equity MULTINATIONAL COST OF CAPITAL
❖ There is an advantage to using debt rather than equity as capital because ❖ Exhibit 17.1 illustrates the trade-off between
debt’s advantage (tax deductibility of
the interest payments on debt are tax deductible as long as they meet the interest payments up to the legal maximum)
requirements of the 2017 tax law. and its disadvantage (increased likelihood of
bankruptcy).
❖ The greater the MNC’s use of debt is, however, the greater the interest
❖ The graph shows the relationship between
expense will be, the higher the probability that the firm will be unable to the firm’s degree of financial leverage (as
meet its expenses, and the less likely that all of the interest expense will be measured by the ratio of debt to total capital
on the horizontal axis) and the cost of
tax deductible. capital (on the vertical axis).
❖ Consequently, as an MNC increases its proportion of debt, the rate of ❖ When the ratio of debt to total capital is low,
investors have little concern that the firm will
return required by potential new shareholders or creditors will increase to
go bankrupt because the firm should be able
reflect the greater likelihood of bankruptcy. to cover its debt payments easily.
5. Cost of Capital for MNCs versus Domestic Firms
❖Size of Firm An MNC that often borrows substantial ❖Access to International Capital Markets Multinational corporations are
usually able to obtain funds through the international capital markets.
amounts may receive preferential treatment from
❖Because the cost of funds can vary among markets, an MNC’s access
creditors, thereby reducing its cost of capital. Furthermore,
to the international capital markets may allow it to obtain funds at a
its relatively large issues of stocks or bonds allow for lower cost than that paid by domestic firms.
reduced flotation costs (as a percentage of the amount of ❖In addition, subsidiaries may be able to obtain funds locally at a lower
financing). cost than that available to the parent if the prevailing interest rates in
the host country are relatively low.
13
❖International Diversification As explained earlier, a firm’s cost of ❖ Exposure to Exchange Rate Risk An MNC’s cash flows could be more volatile than
those of a domestic firm in the same industry if it has high exposure to exchange rate
capital is affected by the probability that it will go bankrupt.
risk. If as subsidiary remits its foreign earnings to the U.S. parent, those cash flows
❖If a firm’s cash inflows come from sources all over the world, those will not be worth as much when the U.S. dollar is strong against major currencies.
cash inflows may be more stable because the firm’s total sales will not ❖ This reduces the firm’s ability to make interest payments on its outstanding debt,
which increases the likelihood of bankruptcy. In addition, an MNC that is more
be strongly influenced by a single economy.
exposed to exchange rate fluctuations will usually have a wider (more dispersed)
❖To the extent that individual economies are independent of each distribution of possible cash flows in future periods.
other, net cash flows from a portfolio of subsidiaries should exhibit ❖ This could lead creditors and shareholders to require a higher return, which would
increase the MNC’s cost of capital.
less variability, which may reduce the probability of bankruptcy and,
therefore, reduce the cost of capital.
❖ Exposure to Country Risk An MNC that establishes foreign subsidiaries is subject to

the possibility that a host country government may seize a subsidiary’s assets. Many
factors influence the probability of such an event, including the industry in which the
MNC operates and the attitude of the host country government. COST OF CAPITAL
❖ If assets are seized and fair compensation is not provided, the probability of the
MNC’s going bankrupt increases. MNCs vs DOMESTIC
❖ The higher the percentage of an MNC’s assets invested in foreign countries and the
higher the overall country risk of operating in these countries, the higher will be the
FIRMS
MNC’s probability of bankruptcy (and therefore its cost of capital), other things being
equal.
14
Cost-of-Equity Comparison Using the CAPM
❖ To assess how the cost of equity for an MNC differs from the corresponding ❖The CAPM suggests that the required return on a firm’s stock
cost for a purely domestic firm, analysts can apply the capital asset pricing
is a positive function of
model (CAPM). This model defines the required return (ke) on a stock as:
❖(1) the risk-free rate of interest,
❖(2) the market rate of return, and
❖(3) the stock’s beta.
❖The beta refers to the sensitivity of a stock’s returns to market
returns, where a U.S. stock index is typically used as a proxy
for the market when assessing the stock of a U.S. company.
❖ Implications of the CAPM for an MNC’s Projects Advocates of the CAPM may suggest that the
❖Implications of the CAPM for an MNC’s Risk
MNC can use a project’s beta to determine the required rate of return for that project.
❖A U.S.-based MNC that increases ❖ The beta of a U.S.-based firm’s project represents the sensitivity of the project’s cash flow to
U.S. market conditions.
❖the amount of its international business may be able to reduce the
❖ For a well-diversified firm with cash flows generated by several projects, each project contains
sensitivity of its stock returns to a stock index, thereby reducing its two types of risk:
stock’s beta. ❖ (1) systematic risk, which is the project risk due to general market conditions, and
❖ (2) unsystematic risk, which is the risk unique to the specific project.
❖According to the previous equation, an MNC that can reduce its beta
❖ Capital asset pricing theory suggests that the MNC can ignore the unsystematic risk of projects
(for example, by increasing its international business) will be able to because it will be diversified away if a firm engages in many projects. However, the systematic
reduce the return required by investors. In this way, the MNC can risk of the firm’s projects cannot be diversified away because all the firm’s projects are
exposed to this risk.
reduce its cost of equity and, in turn, its cost of capital.
15
❖Applying the CAPM with a World Market Index The CAPM as
presented here is based on the sensitivity of project cash flows
to a U.S. stock index.
❖If U.S. investors invest mostly in the United States, then their
PART V
investments will be systematically affected by the U.S. market.
❖In such a case, MNCs may be more capable of pursuing
international projects with cash flows that are not sensitive to
the U.S. market.
❖ Differences in the Risk-Free Rate The risk-free rate is the interest rate charged on loans to a
❖An MNC’s cost of capital is influenced by the countries where it
borrower that is perceived to have no risk of defaulting on the loans.
operates because of country characteristics that affect its cost of debt ❖ Many country governments are presumed to have no credit risk because they can increase
and cost of equity, as explained next. taxes or reduce expenditures if necessary to obtain funds to repay their debts.
❖ Any factors that influence the supply of or the demand for loanable funds within a country will
❖An MNC’s cost of debt is primarily determined by the prevailing risk-
affect the risk-free rate. These factors include tax laws, demographics, monetary policies, and
free interest rate in the currency borrowed and the debt risk premium economic conditions, all of which differ among countries.
required by creditors. ❖ Tax laws in some countries offer more incentives to save than those in others, which can
increase the supply of savings and allow for lower interest rates. A country’s corporate tax
❖The cost of debt for firms is higher in some countries than in others laws may also affect the corporate demand for loanable funds. Holding other factors constant,
low corporate tax rates should encourage corporations to identify more projects that they
because the corresponding risk-free rate is higher or because the
judge to be feasible. The strong corporate demand for funds may cause interest rates to be
credit risk premium is higher. relatively high.
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❖ Differences in the Credit Risk Premium
❖Comparative Costs of Debt across Countries Exhibit 17.3 shows the
❖ Most MNCs must pay a credit premium above the prevailing risk-free rate in the country where
they obtain loans. The credit risk premium paid by an MNC must be large enough to
before-tax cost of debt (as measured by high-rated corporate bond
compensate creditors for taking the risk that the MNC may not meet its payment obligations. yields) for various countries.
❖ The credit risk premium on an MNC’s loans is strongly affected by characteristics of the
❖As can be seen in the exhibit, some positive correlation exists
creditors’ country, such as its economic conditions, the relationship between its creditors and
borrowers, and its government’s willingness to rescue troubled companies. When a country’s between country cost-of-debt levels over time. Notice how interest
economic conditions tend to be stable, the risk of a recession in that country is relatively low.
rates in various countries tend to move in the same direction.
❖ Hence the probability that a firm might not meet its debt obligations is lower, which allows for
a lower credit risk premium. ❖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 cost of equity represents an opportunity cost:

what shareholders could earn on alternative investments
with similar risk. The cost of equity among firms per
country can vary because of differences in country
characteristics.
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❖ Differences in the Risk-Free Rate Because risk-free interest rates vary ❖ Differences in the Equity Risk Premium The equity risk premium is partially
among countries, so does the cost of equity. ❖ based on investment opportunities in the country of concern.
❖ When the country’s risk-free interest rate is high, local investors would ❖ In a country where firms have many investment opportunities, potential
invest in equity only if the potential return is sufficiently higher than what returns may be relatively high. Firms are able to sell stock at relatively high
they can earn at the risk-free rate. prices, which means that they can obtain equity funding at a low cost (they
❖ Thus, to attract equity funding, firms must compensate the local investors pay a relatively small equity premium).
by offering a high return. In contrast, if the country’s interest rate is low, ❖ Conversely, in a country with limited investment opportunities, investors
local investors may be more willing to consider equity investments because will be less willing to invest in equity. Firms would have to sell stock at
they do not give up much by switching away from risk-free government relatively low prices, which means that they can obtain equity funding only
securities. at a high cost (they pay a large equity premium).
WHY IS COST OF CAPITAL DIFFERENT

ACROSS COUNTRIES?
Cost of debt Cost of equity

THE END
Risk-free rate Risk-free rate
Credit risk premium Equity risk premium
18
Questions and applications Questions and applications
Exercise 1: Exercise 2:
An MNC has total assets of $100 million and debt of $20 Wiley Inc. has a beta of 1.3. The US stock market is
million. The firm’s before-tax cost of debt is 12 percent, expected to generate an annual return of 11 percent.
and its cost of financing with equity is 15 percent. The Currently, Treasury bonds yield 2 percent. Based on this
MNC has a corporate tax rate of 40 percent. What is this information, what is Wiley’s estimated cost of equity?
firm’s weighted average cost of capital?

Exercise 3:
Exercise 4:
Blues Inc. would like to estimate its weighted average cost of capital. On
average, bonds issued by Blues yield 9 percent. Currently, T-bill rates are Orlando Co. has its US business funded with dollars with a
3 percent. Furthermore, Blues’ stock has a beta of 1.5, and the return on capital structure of 60 percent debt and 40 percent equity.
the Wilshire 5000 stock index is expected to be 10 percent. Blues’ target It has its Thailand business funded with Thai baht with a
capital structure is 30 percent debt and 70 percent equity. If Blues is in capital structure of 50 percent debt and 50 percent equity.
the 35 percent tax bracket, what is its weighted average cost of capital?
The corporate tax rate on US earnings and on Thailand
earnings is 30 percent.
19
Exercise 4: Exercise 4:
The annualized 10-year risk-free interest rate is 6 percent in the Orlando expects that the U.S. stock market return will be 10
United States and 21 percent in Thailand. The annual real rate percent per year, and the Thailand stock market return will be
of interest is about 2 percent in the United States and 2 percent 28 percent per year. Its business in the United States has a beta
in Thailand. Interest rate parity exists. Orlando pays 3 of .8 relative to the U.S. market, while its business in Thailand
percentage points above the risk-free rates when it borrows, so has a beta of 1.1 relative to the Thai market. The equity used to
its before-tax cost of debt is 9 percent in the United States and support Orlando’s Thai business was created from retained
24 percent in Thailand. earnings by the Thailand subsidiary in previous years.

Exercise 5:
Exercise 4:
Vogl Co. is a US firm that conducts major importing and exporting
However, Orlando Co. is considering a stock offering in business in Japan, whereby all transactions are invoiced in dollars. It
Thailand that is denominated in Thai baht and targeted at obtained debt in the United States at an interest rate of 10 percent per
year. The long-term risk-free rate in the United States is 8 percent. The
Thai investors.
stock market return in the United States is expected to be 14 percent
Estimate Orlando’s cost of equity in Thailand that would annually. Vogl’s beta is 1.2. Its target capital structure is 30 percent
debt and 70 percent equity. Vogl Co. is subject to a 25 percent
result from issuing stock in Thailand.
corporate tax rate. Estimate the cost of capital to Vogl Co.
20
Questions and applications
Exercise 6:
Measuring the Cost of Capital Messan Co. (a U.S. firm) borrows
U.S. funds at an interest rate of 10 percent per year. Its beta is
1.0. The long-term annualized risk-free rate in the United States
is 6 percent. The stock market return in the United States is
expected to be 16 percent annually. Messan’s target capital
structure is 40 percent debt and 60 percent equity. Messan Co.
is subject to a 30 percent corporate tax rate. Estimate the cost
of capital to Messan Co.
Lecturer: Dr. Tien Trung, Nguyen 81
21

Chapter 4 - Multinational Capital Structure and Cost of Capital

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OBJECTIVES

❖The specific objectives of this chapter are to:

❖■■ Explain the interaction between a subsidiary and parent in

Explain why the cost of

1. Retained Earnings 2. Sources of Debt

2.2 Global Bond Offering 2.3 Private Placement of Bonds

3. External Sources of Equity 3.1. Domestic Equity Offering

3.2 Global Equity Offering 3.3 Private Placement of Equity

❖A foreign subsidiary of the MNC could engage in a public

1 Influence of Corporate Characteristics

1 Influence of Corporate Characteristics 1 Influence of Corporate Characteristics

financing for projects implemented by the subsidiary.

Response to Changing Country Characteristics Example

1. Impact of Increased Subsidiary Debt Financing

Increased debt financing Decreased debt financing

2. MNC’s Cost of Equity 3. Estimating an MNC’s Cost of Capital

5. Cost of Capital for MNCs versus Domestic Firms

❖ Exposure to Country Risk An MNC that establishes foreign subsidiaries is subject to

Country Differences in the Cost of Equity

❖A firm’s cost of equity represents an opportunity cost:

WHY IS COST OF CAPITAL DIFFERENT

Cost of debt Cost of equity

Credit risk premium Equity risk premium

Questions and applications Questions and applications

Questions and applications Questions and applications

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