Transcript C H A P T E R 17

FINC3240
International Finance
Chapter 17
Multinational Cost of Capital
and Capital Structure
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Chapter Objectives
This chapter will:
A. Explain how corporate and country
characteristics influence an MNC’s cost of
capital
B. Explain why there are differences in the
costs of capital among countries
C. Explain how corporate and country
characteristics are considered by an MNC
when it establishes its capital structure
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Balance Sheet
Assets
Liquidity
Cash
Marketable securities
Accounts Receivable
Inventories
Total Current Assets
Gross Fixed Assets
(less Accum. Depreciation)
Net Fixed Assets
Total Assets
Assets
Liabilities and Owners Equity
Notes Payable
Accounts Payable
Accrued Expenses
Current Portion of LTD
Total Current Liabilities
Long term (L.T.) Debt
Total Liabilities
Preferred Stock
Common Stock
Retained Earnings
Total Liabilities and equity
Claims on Assets
S.T.
Funds
L.T.
Capital
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Capital Components
Capital
Debt
Preferred
Stock
Common
Stock
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weighted average cost of
capital (WACC)
WACC = wdrd(1-T) + were
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The w’s refer to the firm’s capital structure
weights.
The r’s refer to the cost of each component.
d: debt; e: equity
T: tax rate
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Component cost of debt
WACC = wdrd(1-T) + were
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rd is the cost of debt capital.
why rd(1-T)?
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focus on after-tax capital costs
Because interest is tax deductible.
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Income Statement
Company Name
For the time period ending date
•Earnings before
taxes (EBT)
Net Sales
- Cost of Goods Sold
- Operating Expenses
- Depreciation
= Operating Profit
- Interest Expense
= Profit Before Taxes
- Taxes
= Net Income
•Operating income
•Earnings before
interest & taxes (EBIT)
•Earnings
•Net profit
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Component cost of equity
WACC = wdrd(1-T) + were
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re is the cost of common equity
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Example
If weight of debt =40%, weight of
equity =60%, cost of debt=10%, cost
of equity=14%, tax rate=30%,
WACC =
=
=
=
wdrd(1-T) + were
0.4(10%)(1-0.3) + 0.6(14%)
0.028 + 0.084
0.112=11.2%
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Searching for the Appropriate Capital
Structure
17.1
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Difference in WACC
between MNC and Domestic firms
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Firm size
Access to international financial
markets
International diversification lowers
the cost of capital
Exposure to exchange rate risk
Exposure to country risk
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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
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Exhibit 17.3 Cost of Debt across Countries
Source: Federal Reserve
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Using the Cost of Capital for
Assessing Foreign Projects
1. Derive Net Present Values Based on the
Weighted Average Cost of Capital
2. Adjust the Weighted Average Cost of
Capital for the Risk Differential
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Exhibit 17.4 Lexon’s Estimated Weighted
Average Cost of Capital (WACC) for Financing
a Project
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Foreign Project NPV
and Capital Structure
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MNC’s Capital Structure Decision
1. Influence of Corporate Characteristics
a. Stability of MNC’s Cash Flows
b. MNC’s Credit Risk
2. Influence of Host Country Characteristics
Stock Restrictions in Host Countries
Interest Rates in Host Countries
Strength of Host country Currencies
Country Risk in Host Countries
Tax Laws in Host Countries
3. Revising the Capital Structure in Response to
Changing Conditions
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Example
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In recent years, several U.S. firms have
penetrated Mexico’s market. One of the
biggest challenges is the cost of capital to
finance business in Mexico. Mexican
interest rates tend to be much higher than
U.S. interest rates. In some periods, the
Mexican government does not attempt to
lower the interest rates because higher
rates may attract foreign investment in
Mexican securities.
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Question 1
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How might U.S.-based MNCs expand in
Mexico without incurring high Mexican
interest expenses when financing the
expansion? Are any disadvantages
associated with this strategy?
ANSWER: The parents of the MNCs could provide funding
for the subsidiaries by investing their own capital. This
involves converting dollars to pesos for use in Mexico. In
this case, the parent has more at stake. As the Mexican
subsidiary remits funds back to the U.S. parent, the MNC is
exposed to a higher level of exchange rate risk.
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Question 2
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Are there any additional alternatives for
the Mexican subsidiary to finance its
business itself after it has been well
established? How might this strategy
affect the subsidiary’s capital structure?
ANSWER: Once the subsidiary has generated earnings, it
can retain the earnings and reinvest them to finance future
operations. This strategy emphasizes equity financing and
would result in an equity-intensive capital structure for the
subsidiary.
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Homework 11
Chapter 17: 2,5,8,9,10,12,21
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