International Financial Management

11th Edition
by Jeff Madura

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 Multinational Capital Structure and Cost of
17 Capital
Chapter Objectives

 Describe the key components of an MNC’s capital

 Identify the factors that affect an MNC’s capital structure
 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

2
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 Components of Capital

 An MNC’s parent may invest its own cash into the

subsidiary. The cash infusion in the subsidiary
represents an equity investment by the parent, so
that the parent is the sole owner of the subsidiary.
The subsidiary uses the cash infusion to develop its
business operations in the host country.
 An alternative method by which the subsidiary can build
more equity is to offer its own stock to the public.

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 External Sources of Debt

 Domestic Bond Offering - MNCs commonly engage in a

domestic bond offering in their home country in which the
funds are denominated in their local currency.
 Global Bond Offering - MNCs can engage in a global bond
offering, in which they simultaneously sell bonds
denominated in the currencies of multiple countries.
 Private Placement of Bonds - MNCs may offer a private
placement of bonds to financial institutions in their home
country or in the foreign country where they are expanding.
 Loans from Financial Institutions - An MNC’s parent
commonly borrows funds from financial institutions.

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 External Sources of Equity

 Domestic Equity Offering - MNCs can engage in a

domestic equity offering in their home country in which the
funds are denominated in their local currency.
 Global Equity Offering - Some MNCs pursue a global
equity offering in which they can simultaneously access
equity from multiple countries.
 Private Placement of Equity - Offer a private placement of
equity to financial institutions in their home country or in the
foreign country where they are expanding.

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 The MNC’s Capital Structure Decision

Influence of Corporate Characteristics

 Stability of MNC’s Cash Flows - MNCs with more stable cash flows
can handle more debt because there is a constant stream of cash inflows
to cover periodic interest payments on debt.
 MNC’s Credit Risk - MNCs that have lower credit risk have more
access to credit.
 MNC’s Access to Retained Earnings - Highly profitable MNCs may be
able to finance most of their investment with retained earnings and
therefore use an equity-intensive capital structure.
 MNC’s Guarantees on Debt - If the parent backs the debt of its
subsidiary, the subsidiary’s borrowing capacity might be increased.
 MNC’s Agency Problems - If a subsidiary in a foreign country cannot
easily be monitored by investors from the parent’s country, agency costs
are higher.
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 The MNC’s Capital Structure Decision

Influence of Host Country Characteristics

 Interest Rates in Host Countries – The cost of loanable funds may
be lower in some countries.
 Strength of Host Country Currencies - If an MNC expects
weakness of the currencies in its subsidiaries’ host countries, it may
borrow in those currencies rather than rely on parent financing. If the
subsidiary’s local currency is expected to appreciate, then the
subsidiary may retain and reinvest its earnings.
 Country Risk in Host Countries - If an MNC’s subsidiary is
exposed to the risk that the host government might confiscate its
assets, the subsidiary may use much debt financing in that host
country..
 Tax Laws in Host Countries - Foreign subsidiaries may be subject
to a withholding tax when they remit earnings.
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 Response to Changing Country Characteristics

The country characteristics:

 vary among countries
 change over time in any particular country

Therefore the ideal capital structure

 May vary among countries
 could change within any particular country over
time.

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 Subsidiary Versus Parent Capital Structure Decisions

Some subsidiaries are subject to conditions that favor debt

financing, while other subsidiaries are subject to conditions that
favor equity financing.
1. Impact of Increased Subsidiary Debt Financing - When a
subsidiary relies heavily on debt financing, its need for its internal
equity financing (retained earnings) is reduced.
2. Impact of Reduced Subsidiary Debt Financing - The subsidiary
will need to use more internal financing, will remit fewer funds to
the parent, and will reduce the amount of internal funds available
to the parent.
3. Limitations in Offsetting a Subsidiary’s Leverage - Foreign
creditors may charge higher loan rates to a subsidiary that uses a
highly leveraged local capital structure because they believe that
the subsidiary may be unable to meet its high debt repayments.
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 Multinational Cost of Capital

MNC’s Cost of Debt: An MNC’s cost of debt is

dependent on the interest rate that it pays when
borrowing funds.
MNC’s Cost of Equity: An MNC creates equity by
retaining earnings or by issuing new stock. An MNC’s
cost of equity contains a risk premium (above the
risk-free interest rate) that compensates the equity
investors for their willingness to invest in the equity.

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 Estimating an MNC’s Cost of Capital

 D   E 
kc   k d (1  t )    ke
 DE  DE
where
kc weighted average cost of capital
D amount of the firm’s debt
kd before-tax cost of its debt
t corporate tax rate
E firm’s equity
ke cost of financing with equity

11
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 Comparing Costs of Debt and Equity

 There is an advantage to using debt rather than equity as

capital because the interest payments on debt are tax
deductible.

 The greater the use of debt, however, the greater the interest
expense and the higher the probability that the firm will be
unable to meet its expenses.

 As an MNC increases its proportion of debt, the rate of

return required by potential new shareholders or creditors
will increase to reflect the higher probability of bankruptcy.

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 Exhibit 17.1 Searching for the Appropriate Capital
Structure

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 Cost of Capital for MNCs versus Domestic Firms

Cost of capital for MNCs may differ because of:

1. Size of firm - An MNC that often borrows substantial
amounts may receive preferential treatment from creditors,
thereby reducing its cost of capital.
2. Access to international capital markets - MNC’s access to
the international capital markets may allow it to obtain funds
at a lower cost than that paid by domestic firms.
3. International diversification - If a firm’s cash inflows
come from sources all over the world, those cash inflows
may be more stable because the firm’s total sales will not be
highly influenced by a single economy.

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 Cost of Capital for MNCs versus Domestic Firms

Cost of capital for MNC may differ because of:

4. 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 is highly exposed to exchange rate risk.
5. 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.

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 Exhibit 17.2 Summary of Factors that Cause the Cost of
Capital of MNCs to Differ from that of Domestic Firms

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 Cost of Equity Comparison Using the CAPM

ke = Rf + B(Rm – Rf)
Where ke = required return on stock
Rf = risk-free rate of return
Rm = market return
B = beta of stock
The CAPM suggests that required return is a positive function of:
 The risk-free rate of interest
 The market rate of return
 The stock’s beta
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 Example One

Blues, Inc. is an MNC located in the U.S. Blues would like to

estimate its weighted average cost of capital. On average, bonds
issued by Blues yield 9 percent. Currently, T-bond rates are 3
percent. Furthermore, Blues’ stock has a beta of 1.5, and the return
on the Wilshire 5000 stock index is expected to be 10 percent.
Blues’ target capital structure is 30 percent debt and 70 percent
equity. If Blues is in the 35 percent tax bracket, what is its
weighted average cost of capital?

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 Solution

First, estimate the cost of equity using the CAPM:

k e  R f  B ( Rm  R f )
3%  1.5(10%  3%)
.135
13.5%

Next, estimate the weighted average cost of capital:

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 Example

Nebraska Co. plans to pursue a project in Argentina that will generate revenue of 10
million Argentine pesos (AP) at the end of each of the next 4 years. It will have to pay
operating expenses of AP3 million per year.
The Argentine government will charge a 30% tax rate on profits. All after-tax profits
each year will be remitted to the U.S. parent and no additional taxes are owed. The
spot rate of the AP is presently $.20.
The AP is expected to depreciate by 10% each year for the next 4 years.
The salvage value of the assets will be worth AP40 million in 4 years after capital
gains taxes are paid. The initial investment will require $12 million, half of which will
be in the form of equity from the U.S. parent, and half of which will come from
borrowed funds. Nebraska will borrow the funds in Argentine pesos.
The annual interest rate on the funds borrowed is 14%. Annual interest (and zero
principal) is paid on the debt at the end of each year, and the interest payments can be
deducted before determining the tax owed to the Argentine government. The entire
principal of the loan will be paid at the end of year 4.
Nebraska requires a rate of return of at least 20% on its invested equity for this project
to be worthwhile. Determine the NPV of this project. Should Nebraska pursue the
project?

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 Year 0 Year 1 Year 2 Year 3 Year 4
AP10, AP10, AP10, AP10,
000,00 000,00 000,00 000,00
Revenue 0 0 0 0
AP AP AP AP
Operating (3,000, (3,000, (3,000, (3,000,
Expences 000) 000) 000) 000)
AP AP AP AP
Interest (4,200, (4,200, (4,200, (4,200,
payments 000) 000) 000) 000)
AP AP AP AP
2,800, 2,800, 2,800, 2,800,
Pre-tax profit 000 000 000 000
AP AP AP
After tax AP,96 1,960, 1,960, 1,960,
(30%) profit 0,000 000 000 000
AP
(30,00
Repay loan 0,000)
AP
40,000
Salvage value ,000
AP AP AP AP
Cash flow 1,960, 1,960, 1,960, 11,960
in AP 000 000 000 ,000

Exchange
Rate $0.20 $0.18 $0.162 $0.146 $0.131
Cash flow in $ $392,0 $352,8 $317,5 $1,743
to parent 00 00 20 ,768
PV (20% $326,6 $245,0 $183,7 $840,9
discount rate) 66 00 50 37
$6,000
Initial outlay ,000.0
in U.S. $ 0
- - - -
Cumulative $5,673 $5,428 $5,244 $4,403
NPV ,333 ,333 ,583 ,645

Year 0 Year 1 Year 2 Year 3 Year 4

Revenue AP10,000,000 AP10,000,000 AP10,000,000 AP10,000,000

Operating Expences AP (3,000,000) AP (3,000,000) AP (3,000,000) AP (3,000,000)

Interest payments AP (4,200,000) AP (4,200,000) AP (4,200,000) AP (4,200,000)

Pre-tax profit AP 2,800,000 AP 2,800,000 AP 2,800,000 AP 2,800,000

After tax (30%) profit AP1,960,000 AP 1,960,000 AP 1,960,000 AP 1,960,000

Repay loan AP (30,000,000)

Salvage value AP 40,000,000

Cash flow
in AP AP 1,960,000 AP 1,960,000 AP 1,960,000 AP 11,960,000

Exchange Rate $0.20 $0.18 $0.162 $0.146 $0.131

Cash flow in $ to parent $392,800 $317,520 $286,160 $1,566,760

PV (15% discount rate) $341,565 $240,091 $188,155 $895,800

Initial outlay
in U.S. $ $6,000,000.00

Cumulative NPV -$4,334,389

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 Initial investment of $12 million is supported by one-half debt, or $6
million. Debt financing requires AP30 million. The annual interest
payment is 14% of AP30 million = AP4,200,000.

 D   E 
kc   k d (1  t )    ke
 DE  DE

Cost of Capital = 0.5 (14%)(1-30%)+ 0.5 (20%)

= 15%

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 SUMMARY

 An MNC’s capital consists of debt and equity. MNCs

can access debt through domestic debt offerings, global
debt offerings, private placements of debt, and loans
from financial institutions. They can access equity by
retaining earnings and by issuing stock through
domestic offerings, global offerings, and private
placements of equity.
 If an MNC’s subsidiary’s financial leverage deviates
from the global target capital structure, the MNC can
still achieve the target if another subsidiary or the
parent take an offsetting position in financial leverage.
However, even with these offsetting effects, the cost of
capital might be affected.
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 SUMMARY (Cont.)

 An MNC’s capital structure decision is influenced by

corporate characteristics such as the stability of the
MNC’s cash flows, its credit risk, and its access to
earnings. The capital structure is also influenced by
characteristics of the countries where the MNC
conducts business, such as interest rates, strength of
local currencies, country risk, and tax laws. Some
characteristics favor an equity-intensive capital
structure because they discourage the use of debt.
Other characteristics favor a debt-intensive structure
because of the desire to protect against risks by
creating foreign debt.

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 SUMMARY (Cont.)

 The cost of capital may be lower for an MNC than for a

domestic firm because of characteristics peculiar to the
MNC, including its size, its access to international capital
markets, and its degree of international diversification. Yet
some characteristics peculiar to an MNC can increase the
MNC’s cost of capital, such as exposure to exchange rate
risk and to country risk.
 Costs of capital vary across countries because of country
differences in the components that comprise the cost of
capital. Specifically, there are differences in the risk-free
rate, the risk premium on debt, and the cost of equity
among countries. Countries with a higher risk-free rate
tend to exhibit a higher cost of capital.
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