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Multinational Capital Structure and Cost of Capital

Learning objectives  The MNC’s optimal capital structure  Project valuation and the cost of capital
– The impact of market imperfections – WACC versus APV – Systematic versus unsystematic risks

Chapter 15

 Sources of funds for multinational operations  The international evidence
Butler, Multinational Finance, 4e 15-1

Capital structure

Capital structure refers to the proportion of long-term debt and equity capital and the particular forms of capital chosen to finance the assets of the firm

The MNC’s optimal capital structure

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Capital structure
Managers must choose…
 

The proportions of debt and equity Features of the instruments
- Debt - fixed or floating rate interest payments, indenture provisions, conversion features, callability, seniority, and maturity

 

The location(s) where securities are issued The currency of denomination
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The MNC’s optimal capital structure

The MNC’s financing opportunities
%
Domestic firm’s cost of capital

MNC

MNC’s cost of capital

Investment opportunity set

Domestic firm
The MNC’s optimal capital structure

Capital budget
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Cost of capital (%)

The weighted average cost of capital
Cost of equity capital iS

iWACC =(B/V)iB(1-TC)+ (S/V)iS

Optimal range

After-tax cost of debt capital iB(1-TC)

Debt/equity
The MNC’s optimal capital structure 15-5

The MNC’s cost of capital
Cost of capital (%)
MNC iS Domestic iS

Domestic iWACC

MNC iWACC

Domestic iB(1-TC) MNC iB(1-TC)

Debt/equity ratio
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Optimal capital structure

Far better an approximate answer to the right question, which is often vague, than an exact answer to a wrong question, which can always be made precise. John W. Tukey

The MNC’s optimal capital structure

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The perfect market assumptions
 Frictionless

markets

- No transaction costs, taxes, government intervention, agency costs, or costs of financial distress
 Equal

access to market prices investors

- Everyone is a “price taker”
 Rational  Equal

- Return is good and risk is bad

access to costless information
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Project valuation and the cost of capital

MM’s irrelevance proposition
 With

equal access to perfect financial markets, individuals can replicate any financial action that the firm can take. This leads to Modigliani-Miller’s famous irrelevance proposition: If financial markets are perfect, then corporate financial policy is irrelevant.

Project valuation and the cost of capital

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The converse of MM’s irrelevance proposition
V = Σt E[CFt] / (1+i)t
 If

financial policy is to increase value, then it must either - increase expected future cash flows - decrease the discount rate in a way that cannot be replicated by individual investors.

Project valuation and the cost of capital

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Financial market integration

 In

an integrated financial market, real after-tax rates of return on equivalent assets are equal

Project valuation and the cost of capital

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Factors leading to financial market segmentation
- Different legal and political systems - Prohibitive transactions costs - Regulatory interference - Differential taxes - Informational barriers - Differential investor expectations - Home asset bias (a preference for domestic assets)
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Project valuation & cost of capital
 Two

approaches to project valuation

- WACC = Weighted average cost of capital - APV = Adjusted present value
 Use

an asset-specific discount rate

- Nominal cash flows should be discounted at a nominal discount rate Real cash flows should be discounted at a real discount rate - Domestic currency cash flows should be a discounted at a domestic currency discount rate Foreign currency cash flows should be a discounted at a foreign currency discount rate15-13 Project valuation and the cost of capital

Weighted average cost of capital (WACC)
NPV = Σt [ E[CFt] / (1+iWACC)t ]
iWACC = [(B/(B+S)) iB (1-TC)] + [(S/(B+S))iS] B = the market value of corporate bonds S = market value of corporate stock the

iB = Project valuation and the cost of capital required return on corporate bonds

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Adjusted present value (APV)
APV = VU + PV(financing side effects) – initial investment where VU
= the value of the unlevered or all-equity project

PV(financing side effects)
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Systematic vs unsystematic risks

Only systematic or nondiversifiable operating risks should be reflected in capital costs
- Capital costs are increased if these risks are positively related to the market portfolio - Capital costs are decreased if these risks are negatively related to the market portfolio

Operating risks that are unsystematic or diversifiable should not be priced by investors and should not be reflected in capital costs Project valuation and the cost of capital

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Country risks and equity returns
 Equity  Erb,

returns are related to country risks

Harvey and Viskanta find

- Prices go up (down) following a decrease (increase) in country risk - Countries with high country risk tend to have more volatile returns - Countries with high country risk tend to have lower betas (systematic risks)
Erb, Harvey, & Viskanta, “Political Risk, Financial Risk & Economic Risk,” Financial Analysts Journal, 1996.
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Liberalizations and the cost of capital
 Liberalizations  Financial

tend to benefit firms and investors in the liberalized market market liberalizations tend to
- Increase the correlation of emerging market and world market returns - Have little impact on emerging market return volatility - Decrease local firms’ capital costs by as much as 1 percent
Bekaert & Harvey, “Foreign Speculators and Emerging Equity Markets,” Journal of Finance, 2000.

Project valuation and the cost of capital

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http://www.ibbotson.com/
 

International CAPM: E[ri] = rF + βi (rworld - rF) Globally Nested CAPM: E[ri] is a function of systematic country risk plus regional systematic risk not included in the world factor Country Risk Rating Model: E[ri] based on country credit risk Country-Spread Model: Adds a countryspecific spread to a conventional cost of equity estimate

Relative Standard Deviation Model: Countries are assigned an equity premia in proportion Project valuation and the cost of capital

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Sources of funds for MNCs
The financial “pecking order”
 Internal

sources of funds are preferred by most managers sources of funds are accessed only after internal sources are exhausted
- External debt is the preferred external funding source - External equity is used only as a last resort

 External

Sources of funds for multinational operations

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Sources of funds for foreign ops
External foreign equity 16% External U.S. debt 2%

External foreign debt 45%

Internal equity 35%

Internal debt 2%

Adapted from Feldstein, “The Effects of Outbound Foreign Direct Investment on the Domestic Capital Stock,” in The Effects of Taxation on Multinational Corporations, edited by Feldstein, Hines, and Hubbard, 1995.
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MNC sources of funds
Internal sources External sources
MNC’s home country Cash flow from parent & affiliates in the parent’s guaranteed home country New debt or equity financing (perhaps issued or by the parent firm)

Foreign Cash flow from Local debt or equity project’s existing operations from institutions or host country in the host country markets in the host country International financing sources Cash flow from other foreign affiliates Project finance Eurobonds Euroequity
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Sources of funds for multinational operations

Registered vs bearer securities

Securities in the United States and Japan are issued in registered form The convention in Western European countries is to issue securities in bearer form

Sources of funds for multinational operations

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Targeted registered offerings
 Targeted

registered offerings allow U.S. corporations to issue bearer securities to international investors
- Owner must be a financial institution - Interest or dividends are paid to a registered institution - Issuer certifies it has no knowledge of US taxpayers owning the security - Issuer and the registered foreign institutions must follow SEC certification procedures

Sources of funds for multinational operations

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Global equity issues
 Domestic

markets tend to react negatively to equity issues, including IPOs & SEOs, in both the short and long run
- The usual explanation is that equity issues signal managers’ beliefs that equity is overvalued

 Global

equity offerings do not appear to suffer the same degree of post-issuance underperformance as domestic issues
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Sources of funds for multinational operations

Project finance
 Project

financing allows a project sponsor to raise external funds for a specific project characteristics:
- The project is a separate legal entity and relies heavily on debt financing - The debt is contractually linked to the cash flow generated by the project

 Distinguishing

- Governments participate through infrastructure support, operating or financial guarantees, rights-of-way, or assurances against political risk Sources of funds for multinational operations 15-26

The international evidence on capital structure
 Leverage

increases with

- Asset tangibility - Firm size
 Leverage

decreases with

- Growth opportunities - Profitability, esp. in emerging markets
Rajan and Zingales (“What Do We Know about Capital Structure? Some Evidence from International Data,” Journal of Finance, 1995.
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