multinational cost of capital

8/6/2019 Multinational Cost of Capital

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Multinational Cost of

Capital

Prepared by:


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Background on Cost of

Capital h e c o s t o f c a p ita lis a term used in the fieldof

fin a n cia l in ve stm e n t to re fe r to th e co st o f a(co m p a n y's fu n d s p ro p o rtio n o f debtversus equity

), "financing or from an investor's point of view theshareholder's required return on a portfolio of all

the company's existing securities". It is used toevaluate new projects of a company as it is theminimum return that investors expect for providing

,capital to the company thus setting a benchmark that.a new project has to meet
http://en.wikipedia.org/wiki/Debthttp://en.wikipedia.org/wiki/Equity_(finance)http://en.wikipedia.org/wiki/Equity_(finance)http://en.wikipedia.org/wiki/Equity_(finance)http://en.wikipedia.org/wiki/Debt


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An advantage to using debt rather than equity ascapital is that the interest payments on debt

are tax deductible, ,however it increases the&interest expense the probability that the

.firm will be unable to meet its expenses


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Searching for the appropriatecapital structure

cost of capital

x D e b t R a tio


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This shows that the firms cost ofcapital initially decreases as the ratio ofdebt t total capital increases. However,after some point (point x), the cost f

capital rises as the ratio of debt to totalcapital increases.


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omes c rm ue o e o ow ng c arac er s csthat differentiate MNCs from domestic firms:

1- Size of firm: An MNC that often borrows

substantial amounts may receive preferentialtreatment from creditors, thereby reducing its cost ofcapital. Note, however , that this advantage is due tothe MNCs size and not to its internationalized

business. MNCs may achieve growth more easily toreach the necessary size to receive preferentialtreatment from creditors.2-Access to international capital markets:MNCs are able to obtain funds through the

international capital markets. Since the cost of fundscan vary among markets, the MNCs may obtain fundsat a lower cost than that paid by domestic firms. Inaddition, subsidiaries may be able to obtain funds

locally at a lower cost than that available to thearent if the revailin interest rates in the host


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n ows come rom sources a over e wor , osecash inflows may be more stable because the firmstotal sales will not be highly influenced by a singleeconomy . To the extent that individual economies are

independent of each other, net cash flows from aportfolio of subsidiaries should exhibit less variability,which may reduce the probability of bankruptcy andtherefore reduce the cost of capital.4- Exposure to exchange rate risk: An MNCs cash

flows could be more volatile than those of a domesticfirm in the same industry if it is highly exposed toexchange rate risk. If foreign earnings are remitted tothe US parent of an MNC, they will not be worth as

much when the US dollar is strong against majorcurrencies. Thus the capacity of making interestpayments on outstanding debt is reduced, and theprobability of bankruptcy is higher. This could forcecreditors and shareholders to require a higher return,

which increases the MNCs cost of capital.


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- :x p o s u re to c o u n try ris k A n M N C th ate sta b lish e s fo re ig n su b sid ia rie s is su b je ct to th e

p o ssib ility th a t a h o st co u n try g o ve rn m e n t m a y se ize .a su b sid ia ry s a sse ts T h e p ro b a b ility o f su ch a n,o ccu rre n ce is in flu e n ce d b y m a n y fa cto rs in clu d in g

th e a ttitu d e o f th e h o st co u n try g o ve rn m e n t a n d th e.in d u stry o f co n ce rn if a sse ts a re seized a n d fa ir

,co m p e n sa tio n is n o t p ro vid e d th e p ro b a b ility o f th e .M N C s g o in g b a n kru p tcy in cre a ses h e h ig h e r th ee rc e n ta g e o f a n M N C s a s s e ts in v e ste d ino re ig n c o u n trie s a n d th e h ig h e r th e o v e ra ll

,o u n try ris k o f o p e ra tin g in th e s e c o u n trie s th eig h e r w ill b e th e M N C s p ro b a b ility o f.a n k r u p t c y,O th e r fo rm s of co u n try risk su ch a s ch a n g e s in a h o st

.g o ve rn m e n t s ta x la w s


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Summary of factors that cause the cost of capitalof MNCs to differ from that of domestic firms.

Large size

.cess to int capital markets

ational diversification

re to exchange rate risk

osure to country risk

Preferential treatment from creditors

-Possible access to low cost foreign financing

Reduced probability of bankruptcy

Increased probability of bankruptcy

Cost of capital


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Cost of Equity comparison usingthe CAPM

To assess how required rates of return ofMNCs differ from those of purely domesticfirms, the capital asset pricing model

(CAPM) can be applied. ost of Equity k E = rf + ( rM - rf) ...where

Ke

=the required rate of return on a stock

rf= the 'Risk Free' rate of return= ;the firm's 'Beta' the correlationbetween the firm's returns and the

market" "


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The CAPM suggests that therequired return on afirms stock is a positive functionof:(1) the risk free rate of interest,(2) the market rate of return, and

(3) the stocks beta.The Beta represents the sensitivity of the

stocks returns to market returns. The lower a projects beta, the lower its

systematic risk, and the lower its required rateof return, if its unsystematic risk can bediversified away.( a stock index is normally used as a proxy for themarket)


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For a well-diversified firm with cashflows generated by several projects,

each project contains two types ofrisk:(1) unsystematic variability in cash

flows unique to the firm, and(2) systematic risk, also known as

undiversified risk.


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y s te m a tic ris k refers to the risk common to all . .se cu ritie s i e m a rke t risk .n s y s te m a tic ris k is th e risk a sso cia te d w ith

.in d ivid u a l a sse ts It ca n b e d ive rsifie daway tosm a lle r le ve ls b y in clu d in g a g re a te r n u m b e r o f a sse ts

( " ").in th e p o rtfo lio sp e cific risks a ve ra g e o u t T h esa m e is n o t p o ssib le fo r syste m a tic risk w ith in o n e. ,m a rke t D e p e n d in g o n th e m a rke t a p o rtfo lio o f

-a p p roxim a te ly 3 0 4 0 se cu ritie s in d e ve lo p e d m a rke tssu ch a s U K o r U S w ill re n d e r th e p o rtfo lio su fficie n tly

d ive rsifie d su ch th a t risk e xp o su re is lim ite d to.syste m a tic risk o n ly In d e ve lo p in g m a rke ts a la rg e r,n u m b e r is re q u ire d d u e to th e h ig h e r a sset

.vo la tilitie s
http://en.wikipedia.org/wiki/Market_riskhttp://en.wikipedia.org/wiki/Market_riskhttp://en.wikipedia.org/wiki/Diversification_(finance)http://en.wikipedia.org/wiki/Diversification_(finance)http://en.wikipedia.org/wiki/Market_risk


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m p l i c at i o n s o f t h e C A P M f o r a nN C s R i s k An MNC that increases its foreign sales may be able

,to reduce its stock s beta and hence reduce the return. ,required by investors In this way it will reduce its

.cost of capital

If projects of MNCs exhibit lower betas than projects,of purely domestic firms then the required rates of .return on the MNCs projects should be lower This

.translates into a lower overall cost of capital ,However ome MNCs consider unsystematicroject risk to be importantin determining a

.project s required return


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If investors purchase stocks across many countries,

their stocks will be substantially affected by worldmarket conditions, not just U.S. market conditions.Consequently, to achieve more diversificationbenefits, investors will prefer to invest in firms that

have low sensitivity to world market conditions.When MNCs adopt projects that are isolated fromworld market conditions, they may be able to reducetheir overall sensitivity to these conditions andtherefore could be viewed as desirable investments

by investors.


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,In su m m a ry w e ca n n o t say w ith ce rta in tyw h e th e r a n M N C w ill h a ve a lo w e r co st o f

ca p ita l th a n a p u re ly d o m e stic firm in th e. ,sa m e in d u stry H o w e ve r w e can u n d e rsta n d

h o w a n M N C can ta ke fu lla d va n ta g e o f th efa vo ra b le a sp e cts th a t re d u ce its co st o f

,ca p ita l w h ile m in im izin g exp o su re to th e

u n fa vo ra b le a sp e cts th a t in cre a se its co st o f

.ca p ita l


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o s t o f C a p ita l A c ro s s C o u n trie s h e c o s t o f c a p ita l c a n v a ry a c ro s s c o u n trie so r th re e :e a s o n s MNCs based in some countries have a competitive

; &advantage over others as technology resources, .differ across countries so does the cost of capital(some MNCs will have a large set of feasible positive

)net present value projects because their cost of, ,capital is lower thus these MNCs can more easily

.increase their world market share MNCs may be able to adjust their internationaloperations and

sources of funds to capitalize on the differences in;the cost of capital among countries and


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,Thirdly differences in the costs of each capital( & )component dept equity can help explain why MNCs

-based in some countries tend to use a more debt.intensive capital structure than MNCs based elsewhere


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o u n t r y D i f f e r e n c e s i n t h e C o s t o fD e b t

f i r m s c o s t o f d e b t i s d e t e r m i n e d:y -he prevailing risk free interest rate of,he borrowed currency and .he risk premium required by creditors

- the cost of debt for firms is higher in somecountries than in others because the corresponding-risk free rate is higher at a specific point in time

.or because the risk premium is higher


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- :i f f e r e n c e s i n t h e r i s k f r e e r a t e -The risk free rate is determined by the interaction of

.the supply of and demand for funds

/ny factors that influence the supply and or- .emand will affect the risk free rate:These factors include , ,tax laws demographics monetary

, , .policies economic conditions etc- a x l a w s in some countries offer more incentives to

,save than those in others which can influence the, , .supply of savings and therefore interest rates- c o u n t r y s d e m o g r a p h i c s influence the supply of

savings available and the amount of loanable funds.demanded Countries with younger populations are likely

to experience higher interest rates because younger.households tend to save less and borrow more


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-A monetary policyimplemented by a countryscentral bank influences the supply of loanable funds

and therefore influences interest rates.One exception is the set of European countries thatrely on the European central bank to control thesupply of Euros. All these countries now have thesame risk-free rate because they use the same

currency.- Since economic conditions influence interestrates, they can cause interest rates to vary acrosscountries. The cost of debt is much higher in many

less developed countries than in industrializedcountries


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Differences in the riskpremium:

The risk premium on debt must be large enough tocompensate creditors for the risk that the borrower maybe unable to meet his payment obligations. This risk canvary across countries because of differences ineconomic conditions, relationships betweencorporations and creditors, government intervention,

and degree of financial leverage.- When a countrys economic conditions tend to be stable,the risk of a recession in that country is relatively low. Thus, theprobability that a firm might not meet its obligations is lower,allowing for a lower risk premium.

- Corporations and creditors have a closer relationships in

some countries than in others. In Japan, creditors stand readyto extend credit in the event of a corporations financial distress, which reduces the risk of illiquidity.

- Governments in some countries are more willing to interveneand rescue failing firms. For example, in the UK many firmsare partially owned by the government.


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o m p a r a t i v e C o s t o f D e b tc r o s s C o u n t r i e sThere is some positive correlation between country cost of debt.levels over time


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o u n t r y D i f f e r e n c e s i n t h e C o s t o fE q u i t y firm s return on equity can be measured by-he risk free interest rate plus a premium.hat reflects the risk of the firm- -s risk free interest rates vary among, .ountries so does the cost of equity he cost of equity represents an opportunity,ost and is thus also based on the availablenvestment opportunities in the country of.oncern t can be estimated by applying a price

.arnings multiple to a stream of earnings igh PE multiple low cost of equityfinancing- n a country with many investment,pportunities potential returns may be,elatively high resulting in a high, ,pportunity cost of funds and therefore a

The impact of the


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The impact of theEuro- the adoption of the euro has facilitated the

integration of European stock markets becauseinvestors from each country are more willing to investin other countries where the euro is used as thecurrency.- Investors in one euro zone country no longer need tobe concerned about exchange rate risk when they buystock of a firm based in another euro zone country.- the Euro allows the valuations of firms to be moretransparent because firms throughout the euro zone

can be more easily compared since their values are alldenominated in the same currency.- given the increased willingness of European investorsto invest in stocks, MNCs based in Europe may obtainequity financing at a lower cost.

it


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equityTo derive the overall cost of capital, the costs of

debt and equity are combined, using the relativeproportions of debt and equity as weightGiven the differences in the costs of debt & equityacross countries, it is understandable that the cost ofcapital may be lower for firms based in specific

countries.Japan, for example, commonly has arelatively low cost of capital. It usually has arelatively low risk-free interest rate, which notonly affects the cost of debt but also indirectly affects

the cost of equity. MNCs can attempt to access capitalfrom countries where capital costs are low, butwhen the capital is used to support operations in othercountries, the cost of using that capital is exposed toexchange rate risk. Thus, the cost of capital may

ultimately turn out to be higher than expected.

equity


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equity

Lexon co. is a successful U.S. based MNC, isconsidering how to obtain funding for a project in

Argentina during the next year. It considers thefollowing information:- U.S. risk- free rate = 6 %- Argentine risk-free rate = 10%- risk premium on dollar-denominated debt provided by U.S.

creditors = 3%- risk premium on Argentina peso- denominated debtprovided Argentine creditors = 5%- beta of the project ( expected sensitivity of project returns )= 1.5

- expected U.S. market return = 14%- U.S. corporate tax rate = 30%- Argentine corporate tax rate = 30%- creditors will likely allow no more than 50% of the financingto be in the form of debt, which implies that equity must

provide at least half of the financing.


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Lexons cost of eachcomponent of capital

- cost of dollar- denominated debt = (6% + 3%) * (1 -0.3) = 6.3%

- cost of Argentine peso-denominated debt = (10% +5%) * (1 - 0.3) = 10.5%- cost of dollar-denominated equity = 6% + 1.5 (14% -6%) = 18%


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e x o n ss tim a te d W e ig h te d A v e ra g e C o s t o f C a p ita l( )A C Co r F in a n c in g a P ro je c t

exo n con sid ers fou r d ifferen t cap ital stru ctu res fo r th e n ew.ro je ct


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This table shows that lowest estimate of theWACC results from a capital structure of 50%

U.S. debt & 50% equity.The estimated WACC does not account for the

exposure to exchange rate risk. Thus, lexon will not

necessarily choose the capital structure with thelowest estimated WACC, lexon can attempt to

incorporate the exchange rate effects in variousways


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multinational cost of capital

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