Part 3: Financing the Global

Firm
International Capital Structure
And the Cost of Capital
 Lesson 7: MNC Financial Structure
• Global Integration of Capital Markets
• Cost of Capital and its Availability
• Effect of Market Liquidity and Segmentation on the
Cost of Capital
• Compare the Cost of Capital for an MNC with its
Domestic Counterpart
• International Capital Structure
 The Long-Term Financial Gap
Uses of Cash Flow Sources of Cash Flow
(100%) (100%)

Capital Internal cash

spending flow (retained
earnings plus Internal
depreciation) Financing
68%
Financial
deficit
Net
working
capital plus Long-term External
other uses debt and Financing
equity 32%
 Long-Term Financing
• MNCs need continuous access to capital markets
Component
Costs & WACC

Form of Capital: Debt/Equity

Debt and Equity Mix

Capital
Structure

Practical Issues Optimal

in Financing Financing
 Availability of Capital
• Capital expenditures often exceed USD 1 billion each
year. For example, Honda spends US$ 3-5 billion on its
motorcycle and automotive businesses
• Four basic sources of long-term funds available to the
firms: long-term debt, preferred stock, retained
earnings and common stock
• Free cash flows (i.e. internally generated funds) is
important and preferred but may not be adequate
• External funds tend to be accessed only after internal
funds (e.g. retained earnings) have been exhausted
 Availability of Capital
• Global integration of capital markets gives firms
access to new and cheaper sources of funds
beyond their home markets
• By shifting the marginal cost of capital to the right,
MNCs can raise more capital at lower cost
• It is not true for most domestic firms (as they do
not have equal access to capital markets) nor for
MNCs located in countries with illiquid, small and
segmented capital markets (unless they have
gained a global cost and availability of capital)
 Investment Decision
and Cost of Capital
• A firm that can reduce its
Investment
cost of capital will afford

return/cost of
Opportunity
more capital to invest on Schedule

capital (%)
profitable projects and to
WACC
increase the wealth of the
domestic
shareholders.
• Internationalize the firm’s WACC
cost of capital by sourcing MNC
equity and debt globally with
an optimal mix.
Idomestic IMNC Investment ($)
 Pecking Order of Raising Funds
• Firms prefer internal sources of funds (e.g.
retained earnings, deferred taxes) to avoid the
discipline of the financial markets and transaction
costs.

External
External
Internally foreignequity
foreign
generated debt
funds
48%
16%
36%
 Issues of MNC External Financing
(Advantages)
• Size: mostly an advantage because it lets firms tap
wholesale markets (a lower cost of capital); it also
provides fixed assets as collateral
• Name Recognition: an advantage with enhanced
visibility in foreign markets to increase liquidity for
debt and equity issues
• Diversification of Cash Flows: reduces asset risk (and
default risk to creditors) and makes financing easier
• Greater access to local companies and assets: reduced
political risk due to greater support from investors in
their local markets
Issues of MNC External Financing
(Constraints)
• Country and Currency Risks: MNCs are exposed and in
extreme circumstances difficulties in one location can
jeopardize the overall business
• Costs and risks of international sources of funds
– Language differences and other information barriers
– Capital flow restrictions in some countries
– Greater disclosure requirements on some international
exchanges
– Filing and listing fees
– Difference in legal systems, and exposure to judicial
processes in foreign markets
– Dilution of domestic ownership and control
Summary of Factors That Cause the Cost of Capital of MNCs to
Differ From That of Domestic Firms

17.2
 Other Issues of MNC Financing
• Securities market imperfection:
– If market is small, securities are priced on the basis of
domestic rather than international standards
– If market is illiquid, investors cannot trade securities quickly
at close to the current quoted prices
– If market is segmented, foreign investors may not be
allowed to participate
– All these financial market imperfections result in a higher
cost of capital and less availability of capital
– But market imperfections do not necessarily imply the
national securities markets are inefficient
Market Liquidity, Segmentation, and Cost of Capital

Cost of capital
and rate of return

WACCF
WACCD WACCU

kD
20% kF
15% kU
13%
IOS
10%

Budget
10 20 30 40 50 60 (millions of $)
Factors for Capital Market Segmentation
• Excessive regulatory control
• Perceived political risk
• Anticipated foreign exchange risk
• Lack of transparency
• Asymmetric availability of information
between domestic and foreign investors
• Corporate governance differences
• High securities transaction costs
 Sources of Debt Financing:
(1) Bank Financing
• Traditional source of funding, more important in certain
countries, e.g. Keiretsus in Japan
• More appropriate for short-term uses
• Observe in euro-currency markets
• Large loans are often syndicated
• Despite high financing costs and transaction size, many
advantages:
– Privacy
– Flexibility
– Low Renegotiation Costs
 Sources of Debt Financing:
(2) Debt (Bond) Financing
• A form of public financing (tap investors), cheaper than private financing
(banks)
• Raise larger amounts at low cost
• Bonds come in many varieties (coupon structure, market, denomination
currency)
• Domestic bond: markets are burdensomely regulated with a C$
denomination sold in Canada
• Large AAA firms may consider foreign bonds (sold outside Canada in its
local currency) or Eurobonds (sold in a non-Canadian country not in its
local currency)
• Cost can vary across countries because: 1) difference in the risk-free rate,
2) difference in the risk premium, and 3) difference in demographics
 Debt Financing Alternatives
• What kind of debt? Some considerations:
• Fixed/Floating
– How certain are the cash flows? Are operating profits linked to
interest rates or inflation?
• Currency
– Consider currency of the assets: currency of denomination vs.
currency of location vs. currency of determination
• Maturity or Availability
– Are the assets short-term or long-term? Should the firm assume
ease of refinancing, or buy an option on access to financing?
 Sources of Equity Financing:
Equity Issues
• Internal equity is important for growth firms with low
transaction costs by holding back operating cash flows
for investments (i.e. retained earnings)
• External equity issues usually take the form of seasoned
offerings (post IPO) with overpricing concerns
• Equity financing requires firms to go through a lot of
hoops, so firms may seek bridge loans in preparation
• Cross-listing opens possibility for large and global pool
of capital by establishing a broader investor base
 Component Cost
• (1) Cost of Debt: Expected Return on Bonds
– For most large, healthy firms, financial managers
use the yield-to-maturity (YTM) on the bonds as the
expected return for long-term lenders on new
borrowing.
– YTM is the market-based interest rate that firms
must pay on their current borrowing; thus, YTM
represents the firm’s the before-tax cost of debt.
– Coupon rate tells what the firm’s cost of debt was
back when the bonds were issued, not what the
cost of debt is today.
 EXAMPLE
A 22-year, 9% semiannual, $1,000 par bond sells for $850.
Transaction cost is $14.58 What’s the pretax all-in cost of debt r d?

0 r=? 1 2 44
...
-835.42 45 45 45 + 1,000

INPUTS 44 -835.42 45 1000

N I/YR PV PMT FV
OUTPUT 5.5% x 2 = rd = 11%
 Example: AYTM
• Use a computation formula to find the pre-tax
cost of debt for bonds
• AYTM = [I + (M – Nd)/n]/[(M + Nd)/2] where I =
periodic interest payments, M = face value, Nd
= net proceed, n = periods to maturity
• With I = $45, M = $1,000, Nd = $835.42 = 850 –
14.58, n = 44, AYTM = $48.74/$917.71 = 5.31%
per 6 month, equivalent to 10.62% annually
 After-tax Cost of Debt
• Since interest expense is tax deductible, with a
corporate tax rate of 40%, the after-tax cost of debt is:
– rd after-tax = (rd before-tax) × (1 - T)
– rd after-tax = 11% × (1 - 0.4) = 6.6%
• Therefore, external debt is the more preferred external
funding sources
• Flotation costs of debt issues are relatively small so
that they can be ignored.
• Cost of debt among countries changes overtime and
these changes are positively correlated
 Component Cost
• (2) Cost of equity capital (rs) of a firm is the
expected return on its stock investors require
• CAPM formula: E ( R )  rS  rF   S  rM  rF 
 SM s
S    sm 
M 2
m
• Example: Equity has a sigma of 40% and a correlation
of 0.4 with the market. The market sigma is 12%. Risk-
free rate is 6% and the market expected return is 15%.

• Solution: beta β = (0.4*40%*12%)/(12%)2 = 1.33;

therefore, rS= 6% + 1.33*(15% - 6%) = 18%
 Example
Given: Risk-free rate rRF = 7%, Market risk premium MRPM

= 6% = (Rm – rRF) , Systematic risk (β) of the asset relative

to the market portfolio = 1.2

Expected return = Risk-free rate + Risk premium

E(R) rS = rRF + β×(RM – rRF) = 7.0% + (6.0%)×(1.2) = 14.2%
 Cost of Equity Capital in Segmented versus
Integrated Markets
• If securities markets are segmented, then investors
can only invest domestically. This means that the
market portfolio (M) in the CAPM formula would be
the domestic portfolio instead of the world portfolio
R i  RF   iCAD   RCAD  RF 
R i  RF   W   RW  RF 
• Clearly integration or segmentation of international
financial markets has major implications for
determining the cost of capital
 International CAPM
• Key difference lies in the market index representing
the market portfolio
• ICAPM requires a global market index which is difficult
to find
• Implementation issues:
– Convert values to the same currency
– Determining market risk premium may be challenging
• If a firm has weak correlation with an international
market index, ICAPM may overstate true cost of
capital
 Example
• Cross-listing on foreign exchanges, shares are priced according to the
world systematic risk as if international capital markets are fully
integrated
RF = 5% Rogers Canada World SD (σ) E(R)
Rogers 1.00 0.90 0.60 18% ?
Canada 1.00 0.75 15% 14%
World 1.00 11% 12%

• βrogersCanada = [(18)(15)(0.9)]/(15)2 = 1.08

• As the Canadian stock market moves by 1%, Rogers stock return will
move by 1.08%
• βrogersWorld = [(18)(11)(0.6)]/(11)2 = 0.98
• Smaller world beta suggests less volatility leading to lower required
return
 Example
• When the Canadian stock market is segmented from
the rest of the world, cost of equity capital, Rs = 5 + (14
– 5)(1.08) = 14.72%
• If shares are cross-listed and traded internationally,
equity capital cost = 5 + (12 – 5)(0.98) = 11.86%
• If a stock becomes internationally tradable upon cross-
listing, the required return on the stock is likely to go
down because the stock will be priced according to the
international systematic risk rather than the local
systematic risk
 Does the Cost of Capital Differ Among
Countries?
• There do appear to be differences in the cost of capital
in different countries.
• When markets are imperfect, international financing
can lower the firm’s cost of capital.
• One way to achieve this is to internationalize the firm’s
ownership structure to increase the global risk sharing.
• A higher home bias is associated with a higher cost of
capital because the global risk sharing between
domestic and foreign investors will be reduced.

29
Implied Cost of Capital versus Home Bias

30
Weighted Average Cost of Capital (WACC)

• A firm normally finds its weighted average cost

of capital (WACC) by combining the cost of
equity with the after-tax cost of debt in
proportion to the relative weight of each in
k

the firm’s market value V = D + E:

D E
WACC  rd (1  T )   rs 
V V
 Example
• A firm has cost of equity of 15% and a cost of debt of
9%. The firm is financed with one-third equity and the
rest is debt. Tax rate is 30%. What is WACC?

2 1
WACC   9%  1  30%    15%  9.2%
3 3
• The cost of capital is the minimum rate of returns an
investment project must generate in order to pay its
financing costs
 WACC: Remarks
• Tax effects associated with financing can be incorporated
either in cash flows or cost of capital.
• Most firms incorporate tax effects in the cost of capital.
Therefore, focus on after-tax costs. Only cost of debt
needs to be adjusted.
• The cost of capital is used primarily to make decisions
that involve raising and investing new capital. So, focus
on marginal (new) costs.
• The embedded (i.e. historical) cost is important for
decisions such as setting rate for profit regulation, not for
investment.
Is MNCWACC > or < Domestic FirmWACC ?

WACC = rs
[ Equity
Value ] + rd ( 1 – t )
[ Debt
Value ]
• Determining whether a MNCs cost of capital is higher or
lower than a domestic counterpart is a function of the
overall cost of capital, capital availability and the
opportunity set of projects.
• While the MNC may have a lower component cost than a
domestic firm for certain reasons, empirical studies show
the opposite resulting from additional risks and
complexities associated with foreign operations.
 Is MNCWACC > or < Domestic FirmWACC ?
• The cost of equity required by investors is higher for MNCs than for
domestic firms. Possible explanations are higher levels of political risk,
foreign exchange risk, and higher agency costs of doing business in a
multinational managerial environment. However, at relatively high levels
of the optimal capital budget, the MNC would have a lower cost of capital.

• With better access to the Euro markets, MNCs have a lower component
cost of debt than domestic counterparts, indicating MNCs have a lower
cost of capital.

• In theory, MNCs should have a debt-intensive capital structure as they are

well diversified. Empirical studies find MNCs have a lower debt ratio than
domestic counterparts indicating they are under-levered suffering a
higher cost of capital.
 Is MNCWACC > or < Domestic FirmWACC ?
• As the opportunity set of projects increases, the firm
will eventually need to increase its capital budget to
the point where its marginal cost of capital is
increasing.
• The optimal capital budget will be at the intersection
where the rising MCC equals the declining rate of
return on the opportunity set of projects.
• This will be at a higher WACC than would have
occurred for a lower level of the optimal capital
budget.
 Is MNCWACC > or < Domestic FirmWACC ?
• If both MNCs and domestic firms do actually limit
their capital budgets to what can be financed without
increasing their marginal cost of capital, then the
empirical findings argue that MNCs may have higher
WACC stands
• If the domestic firm has such good growth
opportunities that it chooses undertake growth,
despite with an increasing MCC, then the MNC would
have a lower WACC
• In conclusion, the larger an MNC, the lower its cost of
capital is likely to be
 Cost of Capital for MNC &
Domestic Company
Cost of capital or
Required rate of return
WACCDomestic

20%

15% WACCMNC

10%

5% IOS2
IOS1
Budget
100 140 300 350 400 ($)
 Optimal Financial Structure
• The weighted average cost of capital (WACC) varies with
the amount of debt employed.
• As the debt ratio increases, the overall cost of capital
(kWACC) decreases because of the heavier weight of low-
cost (due to tax-deductibility) debt [kd(1-t)] compared to
high cost equity (ke).
• When tax benefits and bankruptcy costs are considered,
a firm has an optimal financial structure determined by
that particular mix of debt and equity that minimizes the
firm’s cost of capital for a given level of business risk.
WACC and Financial Structure
Cost of Capital (%) Rs = cost of equity
30
28 Minimum cost
26 of capital range WACC = weighted average
24 after-tax cost of capital
22
20
18
16
14 Rd(1 –T) = after-tax cost of
12 debt
10
8
6
4
2

0 20 40 60 80 100

Total Debt (D)

Debt Ratio (%) =
Total Assets (V)
 Optimal Financial Structure: MNC
• Global capital structure: the overall capital mixes for a
particular MNC including all subsidiaries.
• Evidence from Developed Capital Markets
– Leverage is positively related to asset tangibility and firm size
– Leverage is negatively related to growth opportunities and
profitability
• Evidence from Emerging Capital Markets
– Similar influences of asset tangibility, firm size, growth
opportunities and profitability
– Profitable firms use less debt in emerging markets
 Optimal Financial Structure:
Foreign Subsidiaries
• When minimizing the cost of capital for a given level of
business risk and capital budget is an objective should be
implemented from the perspective of the consolidated
MNC, the financial structure of each subsidiary is
relevant only to the extent that it affects this overall goal
• If an individual subsidiary does not really have an
independent cost of capital, its financial structure should
not be based on an objective of minimizing WACC.
• Local target capital structure refers to the desired capital
mix of a subsidiary of a particular MNC
 Optimal Financial Structure:
Foreign Subsidiaries
• Advantages to implementing a financial
structure that conforms to local norms:
– Reduction in criticisms
– Improvement in the ability of management to
evaluate return on equity (ROE) relative to local
competitors
– Determinations as to whether or not resources are
being misallocated (cost of local debt financing
versus returns generated by the assets financed)
 Optimal Financial Structure:
Foreign Subsidiaries
• Disadvantages to localization:
– MNCs are expected to have a competitive advantage over
local firms in overcoming imperfections in national capital
markets; there would then be no need to dispose of this
competitive advantage and conform
– Consolidated balance sheet structure may not conform to
any country’s norm (increasing perceived financial risk
and cost of capital to the parent)
– Local debt ratios are really only cosmetic as lenders will
ultimately look to the parent, and its consolidated
worldwide cash flow as the source of debt repayment
 Optimal Financial Structure:
Foreign Subsidiaries
• In addition to choosing an appropriate financial structure for
foreign subsidiaries, financial managers of MNCs must choose
among alternative sources of funds to finance the foreign
subsidiary
• These funds can be either internal to the MNC or external to the
MNC
• Ideally the choice should minimize the cost of external funds (after
adjusting for foreign exchange risk) and should choose internal
sources in order to minimize worldwide taxes and political risk
• Simultaneously, the firm should ensure that managerial motivation
in the foreign subsidiaries is geared toward minimizing the firm’s
worldwide cost of capital
Internal Financing of the Foreign Subsidiary
Cash
Equity
Real goods
Funds from
Funds parent company Debt -- cash loans
From
Within Leads & lags on intra-firm payables
the
Multinational
Debt -- cash loans
Enterprise Funds from
(MNE) sister subsidiaries
Leads & lags on intra-firm payables

Subsidiary borrowing with parent guarantee

Depreciation & non-cash charges

Funds Generated Internally by the
Foreign Subsidiary
Retained earnings
External Financing of the Foreign Subsidiary

Banks & other financial institutions

Borrowing from sources
in parent country
Security or money markets

Funds
External Local currency debt
to
Borrowing from sources
the Third-country currency debt
outside of parent country
Multinational
Enterprise Eurocurrency debt

(MNE)
Individual local shareholders
Local equity
Joint venture partners
 Currency Considerations
• Due to the growth of the Euro markets and currency
derivatives, firms have many choices in currency
denomination for the debt financing to exploit temporary
violations of parity.
• If parity conditions hold, the choice of currency does not
matter. A lower interest cost will be offset by burden of
repayment in a stronger currency
• In reality, the ex-post costs will not be identical. However,
if parity holds, ex ante financing costs in home country
terms are invariant.
Home Country Cost of Financing
• If a firm takes foreign debt, its cost is r*
• Home country cost of debt is given by:

• Currency returns can increase or decrease home

country cost ‘r’
• Violation of parity conditions can ex-ante create
favorable financing opportunities in certain countries
 Ex-ante and Ex-post Financing Cost: Example
Consider a US based MNC that obtained a 1 year loan of JPY 30 million at a rate of 3%.
When the loan is obtained, spot JPYUSD = 0.0090. At that time, the MNC expected the
JPYUSD spot rate to equal 0.0091 in 1-year. One year hence, at maturity, the actual value
of JPYUSD is 0.0092. Calculate the ex-ante and ex-post financing cost in USD terms.
Ex-Ante and Ex-Post Financing Costs
t=0 t=1
Predicted Actual
(ex-ante) (ex-post)

JPY flows 30,000,000 -30,900,000 -30,900,000

Currency:
JPYUSD 0.009 0.0091 0.0092
% change 1.11% 2.22%

USD flows 270,000 -281,190 -284,280

Cost (USD) 4.14% 5.29%

 Equation Approach: Example
*
rB  (1  rB )  (1  % s ) - 1

0.0091
E(s)   1  1.11 %
0.0090
0.0092
s  1  2.22%
0.0090
Ex - ante rB  (1  3%)  (1  1.11%)  4.14%
Ex - post rB  (1  3%)  (1  2.22%)  5.29%

Ex-post cost of financing depends on the foreign

cost of financing and the foreign currency’s rate of
appreciation or depreciation.