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Optimal Capital Structure

in Multinational Corporations

by

Prof. Dr. Dr. Joachim Häcker

Content

1. Financial issues of multinational companies

2. Theoretical analysis on optimal capital structure

2.1. The leverage effect

2.2. The Modigliani Miller proposition

2.3. The traditional approach

3. Practical analysis on optimal capital structure

Optimal Capital Structure by Prof. Dr. Dr. Joachim Häcker
Page 2

Optimal Capital Structure by Prof.1. Dr. (MNC) „ Multinational: Parent company in home country and numerous subsidiaries or joint ventures in foreign countries. „ Cash management: Management of the levels and composition of the current assets of the firm (cash. inventories) and their proper funding. Dr. „ International: Goods produced in the domestic market and then Multinational Corporation exported to foreign buyers. „ Capital budgeting: Analysis of investment opportunities considered by the firm. receivables. Joachim Häcker Page 3 . Financial issues of multinational companies Financial Management Three core elements: Definition „ Capital structure: Determination of debt and equity properties necessary to maximize firm’s financial health and long-term competitiveness.

... Return on total capital i . Dr.. Joachim Häcker Page 4 .. Debt ROE ...... „ NI = ROE * E Note: „ ROE * E = ROC * (E + D) – i * D NI …... Interest rate D/E .... Dr. Net income E ..2.i) * D / E Optimal Capital Structure by Prof.. Equity „ ROE * E = ROC * E + ROC * D – i * D D .. Return on equity „ ROE * E = ROC * E + (ROC –i) * D ROC ... Debt to equity ratio ROE = ROC + (ROC .1 The leverage effect Definition: Leverage effect „ The “financial leverage effect“ describes the impact of the level of debt on return on equity.... Theoretical analysis on optimal capital structure 2...

The rate of ROE (ROC > i) increase is determined by the spread between the return on total capital and the interest rate on debt.i) * D / E Optimal Capital Structure by Prof. Dr. return on equity remains constant with an increasing debt-equity ratio. Dr. return on equity decreases with a higher debt-equity ratio (magnitude depends on spread). (ROC < i) „ (ROC < i): If return on total capital is lower than the D/E interest rate on debt. „ (ROC = i): If return on total capital equals the (ROC = i) interest rate on debt. return on equity increases in proportion to the debt-equity ratio. Joachim Häcker Page 5 . „ (ROC > i): If return on total capital is larger than the ROC versus interest rate interest rate on debt. ROE = ROC + (ROC .

Dr. average (ROC = 6%). Dr. 6%) * 1 = -2% investment risk. i) * D/E = ROE Besides business risk and ROC < i ROE (unfavourable) 2% + (2% . 6%) * 1 = 6% incurs a financial or capital ROC > i ROE (favourable) 14% + (14% . earn three different returns. or favourable (ROC = 14%) market development with equal probability.Example (1): Constant debt-equity ratio (D = E): „ Deployed capital can. the leverage equation gives the following returns on equity: 3 Cases ROE ROC + (ROC . Optimal Capital Structure by Prof. Joachim Häcker Page 6 . affected by an unfavourable (ROC = 2%). „ With a debt-equity ratio of 1 (D = E) and an interest rate on debt of i = 6%. „ The spread of percentage returns on equity is amplified. both the opportunity for a high return on equity and the risk of a low (negative) return on equity increases simultaneously. „ With a higher debt-equity ratio. the company ROC = i ROE (average) 6% + (6% . 6%) * 1 = 22% structure risk with the use of debt.

Joachim Häcker Page 7 . Dr. 3 Cases D/E 0/100 25/75 50/50 75/25 Lenders: ROC < i Unfavourable 2% 0. Dr. Optimal Capital Structure by Prof.Example (2): Different debt levels: Shareholders: Return on equity depends on the debt level „ Risk but also potential reward increase with growing level of debt. interest and principal payments are increasingly at risk.67% -2% -10% ROC = i Average 6% 6% 6% 6% „ Although interest payments are relatively safe at a low ROC > i Favourable 14% 16. „ With increasing debt levels. potentially leading to a total consumption of equity. negative returns on equity may occur with an increasing level of debt.67% 22% 38% level of debt.

„ What is the effect of the capital structure on return on Question: equity? „ With increasing leverage. D/E) If: ROC < i ROE (ROC-i. „ The outcome is a financial or capital structure risk: If: ROC > i ROE (ROC-i. D/E) If: ROC = i ROE (ROC-i. the potential reward (risk) of Answer increasing (decreasing) return on equity is amplified. Dr. Joachim Häcker Page 8 . D/E) Optimal Capital Structure by Prof. Dr.

until both valuations are again in equilibrium.e. Dr. If levered firms were priced too high. „ The arbitrage process would decrease the value of the levered firm and increase the value of the unlevered firm. I. investors are indifferent between investment choices. Joachim Häcker Page 9 . market values and not book values are relevant. „ Since the equilibrium price is derived on markets. Dr.2 The Modigliani Miller proposition „ The Modigliani / Miller proposition states that the market value of Market value any firm is independent of its capital structure.2. „ 2 companies that generate the same stream of operating income and differ only in capital structure will have the same valuation. rational investors would simply borrow on personal account to buy shares in unlevered firms. Optimal Capital Structure by Prof. thus duplicating the effects of corporate leverage.. changes in capital structure do not affect the stockholders’ welfare. Once again. „ Assuming perfect markets. the arbitrage argument ensures this Arbitrage equilibrium.

2.2 The Modigliani Miller proposition (cont’d) The Modigliani Miller proposition is based on the following Assumptions assumptions (perfect capital markets): (1) Every investor maximizes his financial utility (2) Corporations and individuals can borrow at the same interest rate (3) The borrowing interest rate equals the lending interest rate (4) No transaction costs (5) No bankruptcy costs (6) Debt instruments can be divided at the discretion of market participants (7) Taxation of all investment and debt instruments for all market participants is equal Optimal Capital Structure by Prof. Joachim Häcker Page 10 . Dr. Dr.

WACC „ Minimizing WACC equals maximizing i overall firm value. 2. Joachim Häcker Page 11 . Dr.3 The traditional approach „ Shows the dependence of ROE the required return on WACC ROE equity on the level of i debt. Dr. Optimal level of debt Debt ratio Optimal Capital Structure by Prof.

This fact will either be neglected by equity holders. and future cash flows are discounted with a higher WACC.Conclusion: „ The value of the company is derived by discounting future cash flows with the weighted average cost of capital (WACC). „ If a company gradually increases its debt level. company value increases. Dr. „ Maximum company value is derived at the minimum WACC. Dr. „ Only with a significant increase of the debt level – the exact threshold is unknown – equity holders act on the increase of risk. „ Debt holders act similarly but temporally delayed. Optimal Capital Structure by Prof. risk increases. they require a higher return on equity. Thus. „ Future cash flows will be discounted with the same WACC. or it seems to them to be negligible. expensive equity is replaced by cheap debt. Joachim Häcker Page 12 . Consequently. „ With increasing levels of debt.

. the firm value) optimal capital structure implies a fully levered firm „ If ROC < i. a fully unlevered firm is optimal Optimal Capital Structure by Prof.Comparison of theories The question regarding the existence of an optimal capital structure is not unequivocally answered in theory.e. Joachim Häcker Page 13 . Dr. Leverage Effect Modigliani Miller Traditional Approach „ With increasing debt „ The capital structure is „ There is an optimal levels the return on irrelevant for the market capital structure equity changes. Dr. value of a company „ This is the case at the depending on ROC „ I. there is no optimal minimum WACC (or and i capital structure the maximum overall „ If ROC > i.

253 54% 3% 4% 0% 0% DEGUSSA-HULS AG Major Chemicals 09/1998 5.886 26% 29% 48% 9% 17% BEIERSDORF AG Package Goods/Cosmetics 12/1998 5.795 52% -16% 10% -7% 5% HENKEL KGAA Package Goods/Cosmetics 12/1998 3.731 18% 25% 49% 5% 14% SCHERING AG Major Pharmaceuticals 12/1998 6. Pens.3.rkst. 63% 33% the DAX 38% 100 SAP AG Computer Software 12/1998 17.856 26% 33% 58% 21% 43% PREUSSAG AG Multi-Sector Companies 09/1998 8. excl.462 37% 2% 28% clear answer.697 27% 18% 51% 10% 34% WCM BETEIL&GRUNDBE Real Estate 12/1998 6.753 60%60% -40% -38% companies -3%are analysed-3% VOLKSWAGEN AG Motor Vehicles 12/1998 16. 12% HOECHST AG Major Pharmaceuticals 12/1998 24.970 59% 27% 28% 17% 18% LINDE AG Multi-Sector Companies 12/1998 4.672 27% 23% 49% 9% 23% BAYER AG Major Chemicals 12/1998 28. Joachim Häcker Page 14 ./ incl.229 32% 57% 59% 22% DAIMLERCHRYSLER AG Motor Vehicles 12/1998 68./ incl.019 40% 27% 35% 15% 21% Source: Extel.106 31% 18% 36% 9% 21% BASF AG Major Chemicals 12/1998 28. -21% -47% -6% BAYER MOTOREN WERK Motor Vehicles 12/1998 18. Dr.949 31% 35% 54% 27% 44% HEIDELBERGER ZEMEN Building Materials 12/1998 4.701 18% n. Pens.881 45% -66% 13% -13% 4% DEUTSCHE LUFTHANSA Airlines 12/1998 6.045 21% 58% „ As an example.909 16% 25% 48% 10% 24% THYSSEN KRUPP AG Multi-Sector Companies 09/1998 10. Euro) vom 17.704 46% -61% -4% -7% -1% HEIDELBERGER DRUCK Industrial Machinery/Components 03/1997 5.9. Practical analysis on optimal capital structure Marktwerte (Mio.739 44% 18% 37% the question9%of an optimal 21% VEBA AG Multi-Sector Companies 12/1998 28.99 Gearing I (Buchwert) Gearing II (Marktwert) Name Sector Jahr Marktwert Equity ratio excl.999 16% 43% 62% 29% 47% METRO AG Other Specialty Stores 12/1998 15.163 59% -12% 6% -4% 2% FRESENIUS MEDICAL Medical Specialties 12/1998 4.979 22% 39% 45% 14% 17% VIAG AG Multi-Sector Companies 12/1998 13. DEUTSCHE TELEKOM Other Telecommunications 12/1998 120.400 34% 39% 48% 19% 26% RWE AG Multi-Sector Companies 06/1997 19.0% let us analyse 4% SIEMENS AG Diversified Electronic Products 09/1998 47.479 50% -1% capital structure 23% -1% empirically. FactSet. year 2000 values Optimal Capital Structure by Prof.rkst. Dr.619 23% 41% „ Since theory 55% 24% does not 23% offer a 36% MANNESMANN AG Diversified Manufacture 12/1998 54.m.

n.342 21% 61% 66% providers 36% insurance (incl. Pens. 20% AGIV AG Industrial Machinery/Components 12/1998 718 28% n. Euro) vom 17.S. 12/1998 2.m. -62% -89% -31% KLOECKNER WERKE Specialty Chemicals 09/1998 688 15% 65% 72% 37% 44% 15% Source: Extel. 54% 20% 21% MERCK KGAA Other Pharmaceuticals 12/1998 1.9.145 33% 33% 34% 14% 15% BUDERUS AG Building Products 09/1998 1. n.494 27% 39% „ Excluded 53% were 11% financial 18% service SKW TROSTBERG AG Specialty Chemicals 12/1998 1.576 55% n.500 45% 16% 19% 5% 6% SGL CARBON AG Industrial Specialties 12/1998 1.m.m. ADIDAS-SALOMON AG Shoe Manufacturing 12/1998 3.595 38% 53% companies.571 31% 48% 59% 50% 61% DOUGLAS HLDG AG Other Specialty Stores 12/1998 1.102 32% -82% 18% companies -17% asset and 7% HOLZMANN(PHILIPP) Engineering & Construction 12/1998 913 12%12% 66% 71% 52% 58% SCHWARZ PHARMA AG Other Pharmaceuticals 12/1998 827 49% 29% management 32% companies) 14% 16% as well BILFINGER & BERGER Engineering & Construction 12/1998 857 22% n.771 14% 14% n.770 28% 48% 49% 28% 29% CONTINENTAL AG Auto Parts: O. 42% AVA ALLG HANDELS V Department Stores 12/1998 1.654 25% 42% „ 63% Definition: 21% 39% MAN AG Diversified Manufacture 06/1997 3. PROSIEBEN MEDIA AG Broadcasting 12/1998 756 49% 28% as28% real estate20% companies.m./ incl.rkst.E.m. -21% -10% BEWAG AG Non-U.rkst. Joachim Häcker Page 15 .551 29% -75% 13% -32% 8% HOCHTIEF AG Engineering & Construction 12/1998 2.M.745 23% 54% 64% 38% 48% ALTANA AG Other Pharmaceuticals 12/1998 2. FactSet Optimal Capital Structure by Prof. total -40% assets.m./ incl. n. Pens. „ -31% -18% Analysis of 77 DAX 100 -5% FRESENIUS AG Medical Specialties 12/1998 1. Utilities 06/1997 2. -17% minority 4% stakes / GEHE AG Medical/Dental Distributors 12/1998 2.m. Dr.m.249 28% n. 18% Equity incl.99 Gearing I (Buchwert) Gearing II (Marktwert) Name Sector Jahr Marktwert Equity ratio excl.670 38% 42% 44% 38% 40% IVG HOLDING AG Multi-Sector Companies 12/1998 1.m.975 32% n. Equity -138% ratio-66% = -34% METALLGESELLSCHAFT Multi-Sector Companies 09/1998 2.215 35% 13% 21% 11% 17% PORSCHE AG Motor Vehicles 07/1998 2. Dr.Marktwerte (Mio.753 16% 16% 77% 77% 31% 31% KARSTADT AG Department Stores 12/1998 3. -51% -61% -25% JENOPTIK AG Diversified Manufacture 12/1998 710 35% 28% 36% 17% 23% K & S AG Environmental Services 12/1998 723 34% n.m. excl.

M. -149% SPAR HANDELS AG Food Chains 12/1998 124 18% 21% 29% 41% 51% ESCADA AG Apparel 10/1998 98 29% 57% 57% 65% 65% KSB KL SCHANZ BECK Fluid Controls 12/1998 99 32% -19% 28% -29% 36% Source: Extel. n.a.99 Gearing I (Buchwert) Gearing II (Marktwert) Name Sector Jahr Marktwert Equity ratio excl.a. FactSet Optimal Capital Structure by Prof. Dr. n. WELLA AG Package Goods/Cosmetics 12/1998 658 28% 44% 56% 35% 47% SIXT AG Rental/Leasing Companies 12/1998 652 28% 21% 70% 70% 47% 47% GEA AG Industrial Machinery/Components 12/1998 637 32% -1% 17% -1% 13% FAG KUGELFISCHER Metal Fabrications 12/1998 588 26% 49% 65% 42% 58% DYCKERHOFF AG Building Materials 12/1998 463 39% 27% 39% 34% 47% SCHMALBACH LUBECA Containers/Packaging 12/1998 450 22% 52% 62% 52% 62% DEUTZ AG Industrial Machinery/Components 12/1998 418 16% 6% 67% 3% 44% BOSS (HUGO) AG Apparel 12/1998 413 n. n.m.a.rkst. n.9. n. 12/1998 340 44% 32% 35% 16% 18% DUERR AG Industrial Machinery/Components 12/1998 319 n.a.a./ incl. n.a.rkst. 0% 0% PUMA AG Shoe Manufacturing 12/1998 311 44% -5% 7% -2% 2% FIELMANN AG Other Specialty Stores 12/1998 304 61%61% 14% 14% 9% 9% VOSSLOH AG Diversified Electronic Products 12/1998 300 42% 29% 33% 21% 25% TARKETT SOMMER AG Building Products 12/1998 282 18% 72% 73% 64% 66% BRAU UND BRUNNEN Alcoholic Beverages 12/1998 269 15% 61% 78% 40% 60% RHEINMETALL AG Diversified Manufacture 12/1998 269 23% 27% 54% 30% 58% BABCOCK BORSIG AG Industrial Machinery/Components 09/1998 261 5% 5% 81% 87% 52% 64% JUNGHEINRICH Construction/Ag Equipment/Trucks 12/1998 221 34% 11% 29% 13% 34% PHOENIX AG Auto Parts: O.a.a.E. n. excl. Joachim Häcker Page 16 . Pens.M. Dr.E. 12/1998 211 35% 39% 44% 34% 39% KRONES AG Industrial Machinery/Components 12/1998 122 56% -48% -29% n.a. Euro) vom 17.a. 0% 0% RHON-KLINIKUM AG Medical/Nursing Services 12/1998 343 21% 54% 55% 34% 34% KIEKERT AG Auto Parts: O.Marktwerte (Mio.a. n./ incl. 0% 0% IWKA AG Industrial Machinery/Components 12/1998 396 28% -5% 23% -4% 17% SUDZUCKER AG Specialty Foods/Candy 02/1999 364 n. Pens. 0% 0% GROHE(FRIEDRICH)AG Building Products 12/1998 361 51% -46% 2% -34% 2% GERRESHEIMER GLAS Containers/Packaging 12/1998 361 n.a.

Cummulative number of companies (right axis) „ The European equity ratio (based on 14 90 13 13 Number of companies (left axis) EuroStoxx) averages 38%. Up to Up to Up to Up to Up to Up to Up to Up to Up to Up to Up to Up to Up to 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% Source: Extel. 5 5 30 4 „ Empirically. a large spread of optimal 3 3 20 2 equity ratios can be shown depending 2 1 10 on numerous factors such as sectors. FactSet. Joachim Häcker Page 17 . 80 12 11 70 „ The unlisted „German Mittelstand“ 10 9 60 equity ratio averages around 10% 8 50 „ Business practice supports the 6 6 6 40 traditional approach. Dr. „ The German equity ratio (for DAX Equity ratio of DAX 100 companies 100 companies) averages 31%. Dr. based on year 2000 numbers Optimal Capital Structure by Prof. 0 0 profitability and liquidity.

a.69 0.64 -12% 6% -4% 2% France 0.57 0. Dr.019 27% 35% 15% 21% Industry Mean 0.76 76% 35% 54% 27% 44% 12/1998 4.68 0.28 n.a.34 n. Brazil 0.58 0. Germany 0.77 3.58 0.46 countries.55 Benelux 0. Dr.64 0.63 Source: Sekely/Collins (1988) Optimal Capital Structure by Prof.49 0.International outlook Country Auto.a.17% 28% 18% 12/1998 4.a. n.57 0.73 0.55 0. Food Paper Debt Ratio motive Country „ Empirical study compares Mean debt ratios for 677 listed Singapore 0.163 0.37 0. 0.62 „ Neither industry nor size is Denmark n. 0.49 0.55 vary considerably from US 0.65 0.970 0.795 -16% 10% -7% 5% Italy 0.949 0.54 „ Capital structure standards UK 0.56 country to country.59 0.56 0.48 0.66 03/1997 0.58 0. firms in 9 industries in 23 Argentina 0.42 0. 0.66 0.56 0.a.85 5.67 0.35 0.22 0.38 Australia 0.74 0.62 0.74 4.63 -1% of an important determinant Spain 0.71 27% debt ratios.a.60 country.78 12/1998 0.58 similar for firms within a Switzerland n.50 0.a. 0.but are Canada n.85 12/1998 0.45 0.62 0.54 n.70 62% 0. Joachim Häcker Page 18 . 34% 0.

Capital structure decision for MNC „ Maintenance of desired debt ratio is facilitated by access to How does international availability of capital affect international capital markets. Dr. Joachim Häcker Page 19 . „ Therefore. the value of MNCs can exceed the value of its national peers Optimal Capital Structure by Prof. Dr. MNC? „ International availability of capital to a MNC may allow for lower cost of capital than what is available to a domestic firm. even when significant amounts the optimal debt ratio of a of new funds must be raised.

„ The individual subsidiary does not have an independent cost of capital. Optimal Capital Structure by Prof. Capital structure should be an issue of centralised management style. „ Better public relations with host country monetary authorities might result. MNCs should borrow at lowest cost. Dr. after adjusting for foreign exchange risk. Joachim Häcker Page 20 . the subsidiary’s cost of capital is relevant only to the degree that it has an effect on the overall goal. Thus. Dr. anywhere in the world without considering the impact on a particular subsidiary’s capital structure.Capital structure decision for MNC „ MNCs should choose a capital structure that minimizes Pro centralisation consolidated cost of capital. „ Localized capital structure for foreign subsidiary helps Contra centralisation management to evaluate ROE relative to local competitors.