International Financial Management

Abridged 10th Edition

by Jeff Madura

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 17
Multinational Cost of Capital and
Capital Structure
Chapter Objectives
This chapter will:
A. Explain why the cost of capital of MNCs differs from that of
domestic firms
B. Explain why there are differences in the costs of capital
among countries
C. Explain how to account for the cost of capital when assessing
new international projects
D. Explain how corporate and country characteristics are
considered by an MNC when it establishes its capital
structure
E. Explain the interaction between subsidiary and parent
2 financing decisions
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 Background on Cost of Capital

1. Equity:
a. Cost of retained earnings: opportunity cost of what the
existing shareholders could have earned if they had received
dividends.
b. Cost of new common equity: opportunity cost of what the
existing shareholders could have earned if they had invested
their funds elsewhere
2. Debt:
a. Advantage: interest payments are tax deductible
b. Disadvantage: higher interest expense could lead to higher
probability that the firm will be unable to meet expenses.

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 Comparing the Costs of Equity and Debt

 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

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 Domestic versus MNC Cost of Capital

Cost of capital for MNC may differ because of:

1. Size of firm
2. Access to international capital markets
3. International diversification
4. Exposure to exchange rate risk
5. Exposure to country risk

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 Exhibit 17.1 Searching for the Appropriate
Capital Structure

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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

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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 The CAPM

1. The CAPM suggests that required return is a positive

function of:
a. The risk-free rate of interest
b. The market rate of return
c. The stock’s beta

2. Implications of the CAPM for an MNC’s risk:

a. MNC may have lower cost of capital than domestic firms
b. If financial markets are segmented, then MNC offer
diversification benefits

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 Costs of Capital Across Countries

1. Country differences in the cost of debt

a. Differences in the risk-free rate
b. Differences in the risk premium
c. Comparative costs of debt across countries
2. Country differences in the cost of equity
a. Impact of the Euro
3. Combining the costs of debt and equity
4. Estimating the cost of debt and equity

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 Cost of Capital of Foreign Projects

1. Derive NPV based on the WACC

2. Adjust the WACC for the risk differential
3. Derive the Net Present Value of the Equity
Investment

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 Net Present Value Considerations

1. Relationship between NPV and capital structure

2. Tradeoff when financing in developing countries
3. Accounting for multiple periods
4. Comparing alternative debt compositions
5. Assessing alternative exchange rate scenarios
6. Considering foreign stock ownership

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 The MNC’s Capital Structure Decision:
Influence of Corporate Characteristics
1. Stability of MNC’s cash flows
2. MNC’s credit risk
3. MNC’s access to retained earnings
4. MNC’s guarantees on debt
5. MNC’s agency problems

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 The MNC’s Capital Structure Decision:
Influence of Country Characteristics
1. Stock restrictions in host countries
2. Stock valuation in host countries
3. Interest rates in host countries
4. Strength of host countries
5. Strength of host country currencies
6. Country risk in host countries
7. Tax laws in host countries

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 Revising the Capital Structure

MNC may revise capital structure based on:

1. Discontinued business operations
2. Tax reductions in home country
3. Interest rates in foreign country increase
4. Interest rates in foreign country decrease
5. Political risk increases

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 Subsidiary versus Parent Capital Financing

1. Impact of subsidiary debt financing

2. Impact of reduced subsidiary debt financing
3. Limitations in offsetting a subsidiary’s leverage
4. Factors that affect subsidiary financing decisions

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 Exhibit 17.7 Effect of Global Conditions on
Financing

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as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.