Cost of Capital of Mncs

A firms capital consists of:
Retained Earnings
Equity (existing or newly issued)
Preferred Stock
Debt (borrowed funds)

The firms cost of retained earnings reflects
the
opportunity cost - what existing shareholders
could
have earned if they invested the funds
themselves.

1
it is the minimum rate of return expected by an
investor.
In other word it is defined as the cost of obtaining the
funds.
It is also called cut off rate, Target rate, Hurdle rate or
minimum required rate of return.

2
Helpful in designing Capital Structure.
Helpful in taking capital budgeting decisions.
Helpful in evaluation of financial efficiency of top
management.
Helpful in comparative analysis of various source of finance.
Helpful in taking other financial decision.

3
4
The firms cost of new equity also reflects an
opportunity cost - what the new shareholders could
have earned if they had invested their funds
elsewhere.

The cost of new equity exceeds the cost of retained
earnings by the floatation costs.

The firms cost of debt increases with the level of
debt.
Increases in the level of debt also increases the
probability of default.
Tax deductibility of interest payments on debts
enhances the attractiveness of debt financing.

A firm must maintain a proper balance between
the tax advantage of debt and its disadvantage
(greater probability of bankruptcy).
The firms weighted average cost of capital
(WACC) can be computed as:
(Total Capital = Debt + Equity + Pref. Stock)

WACC = W
d
K
d
(1-t) + W
p
K
p
+ W
e
K
e

5

where:
D = Proportion of capital (D+E) made
up of debt,
E = The proportion of equity,
K
d
= Cost of debt,
K
e
= Cost of Equity and
t = tax rate.

6
( )
e d
K
E D
E
t K
E D
D
WACC
|
.
|
\
|
+
+
|
.
|
\
|
+
= 1
Capital Asset Pricing Method: This method
takes risk free rate of return and the risk
factor is added while calculating cost of
equity capital.
Retained earning have Opportunity Cost.
Kr= Ke( 1- %Brokerage)

7
8
Size of the Firm: The larger the size of the firm,
the larger the amount that is borrowed. In
addition, larger issues of stocks or bonds allow
for reduced percentage flotation costs.
Access to International Capital Markets: Access
to international capital markets allows MNCs to
attract funds at lower costs than purely
domestic firms.
International Diversification: Diversified cash
flow sources result in more stable cash inflows
for MNCs which may reduce the probability of
bankruptcy and therefore reduce the cost of
capital.
9
Exposure to Exchange Rate Risk: Firms that
are highly exposed to exchange rate risk
may experience greater cash inflow
volatility.

However, exposure to a basket of
currencies will mitigate or eliminate such a
problem.

Exposure to Country Risks: To the extent to
which country risks are not diversifiable,
increased cash inflow volatility may result
with attendant higher cost of capital.

10
11
Cost of Capital Across Countries:
Variations in the cost of capital across countries may help
to explain why MNCs are able to adjust their international
operations and sources of funds.
Differences in the cost of each capital component across
countries may explain why MNCs based in some
countries use more debt-intensive capital structure than
MNCs based elsewhere.
Differences in the Risk-Free Interest Rate:
The risk-free rate is frequently proxied by the yield on
3-month T-bills.
The rate is determined by supply and demand conditions
in each country, tax laws, monetary policies,
demographics, and economic conditions.
12
Differences in the Risk Premium:
The risk premium is affected by the relationship between
borrowers and creditors (e.g.. Japans Keiretsu), and the
propensity of governments to intervene and rescue ailing
or failing firms (compare US. to UK).
Also firms in some countries have greater borrowing
capacity because creditors are tolerant of higher degrees
of financial leverage (e.g. Japanese and German firms
have higher degrees of financial leverage than US. firms).

Country Differences in the Cost of Equity:
The cost of equity is related to investment opportunities
in each country.
In a country with many investment opportunities,
potential returns may be relatively high resulting in a
relatively high opportunity cost of funds.
International Differences in Cost of Equity
Capital
Effectiveness of a Countrys Legal Institutions:
Well-functioning legal systems protect
investors, reduce monitoring and enforcement
costs to investors, reduces a firms cost of
capital by leveling the playing field among
investors.
Differences in Securities Regulation:
Requirement of, and enforcement of, certain
financial disclosures help to reduce asymmetric
information between the firm and its investors
and among investors.

13
Conform to the capital structure of Parent
Company.
Reflect the capitalization norm of each
foreign country
Vary to take advantage of opportunities to
minimize the MNCs cost of capital.

14
Some of the firm specific characteristics that
affect MNCs capital structure include:
Stability of MNCs cash flows.
MNC credit risk - a MNC with assets
acceptable
as collateral has greater access to loans.
Level of retained earnings.

15
Entry and cross-border barriers to investing.
Interest rates in host countries are affected
by capital controls, tax rates & country risks.

A MNCs preference for debt or equity may
depend
on relative costs in a particular country.
Host country currency innovations.
Country risks.
Relative tax laws.

16

MNCs may deviate from their target capital
structure in host countries but still able to
achieve their target capital structure on a
consolidated basis.
i.e., MNCs may ignore local target capital
structure in favor of a global target capital
structure.

17
When MNCs allow (or are forced to allow)
foreign subsidiaries to issue stocks to local
investors, such a subsidiary becomes partially
owned by the parent.
This can affect MNCs capital structure.
In some countries, a MNC will be allowed to
establish a subsidiary only if it meets the
minimum percentage of ownership by local
investors.
A minority interest in a subsidiary by local
investors may, however, offer some protection
against threats of any adverse action by the
host government.
18
Firms in Japan and Germany tend to use a
higher degree of financial leverage than U.S or
U.K firms.

The system of interlocking ownership in Japan
may encourage a greater use of leverage.

Other International Factors
Stock restrictions in host countries
Interests rates in host countries
Strength of host country currencies
Country risk in host countries
Tax laws in host countries
19

Cost of Capital of Mncs

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A firms capital consists of:

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