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Multinational Cost of Capital

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Background on Cost of Capital

T h e co st o f ca p ita l is a term used in the fieldof fi a n ci l i ve stm e n t to re fe r to th e co st o f a n a n co m p a n y' fu n d s ( p ro p o rti n o f debt versus equity s o financing),or from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities". It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.

For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital.

WHY IS COST OF CAPITAL IMPORTANT? If financing cost is reduced => NPV increases => more projects end up with NPV > 0 => more wealth created to shareholders .
To determine a company's cost of capital, We must calculate both the cost of debt and the cost of equity .

# cost of debt is the effective rate that a company pays on its current debt. The debt formula can be written as ( Rf + credit risk rate ) ( 1 - T ) , where T is the

most easily ) calculated using the CAPM ( Capital Asset Pricing Model ).T c )*( D / V )+ r E *( E / V ) Where .T c ) = The Tax adjustment for interest expense Interest paid on debt reduces Net Income .# The cost of equity is more challenging to calculate as equity does not pay a set return to its investors. r D = The required return of the firm's Debt financing This should reflect the CURRENT MARKET rates the firm pays for debt .. at least . and therefore reduces tax payments for the firm . ( E / V ) = ( Equity / Total Value ) The % of the firm's value that is comprised of Equity . This value of this 'interest tax shield' depends on the firm's tax rate .. .day market cap ( stock price x shares outstanding ). ( D / V ) = ( Debt / Total Value ) The % of the firm's value that is comprised of debt . ( 1 . This is based on the firm's intra . Comparing the costs of Equity & Debt : WACC = r D ( 1 . r E = the firm's cost of equity The firm's cost of equity is best ( or .

. however.An advantage to using debt rather than equity as capital is that the interest payments on debt are tax deductible. it increases the interest expense & the probability that the firm will be unable to meet its expenses.

Searching for the appropriate capital structure  cost of capital      x D e b t R a ti o .

This shows that the firm’s cost of capital initially decreases as the ratio of debt t total capital increases. the cost f capital rises as the ratio of debt to total capital increases. However. after some point ( point x ). .

subsidiaries may be able to obtain funds locally at a lower cost than that available to the parent if the prevailing interest rates in the host . Note. Since the cost of funds can vary among markets. however . MNCs may achieve growth more easily to reach the necessary size to receive preferential treatment from creditors.Access to international capital markets: MNCs are able to obtain funds through the international capital markets.Size of firm: An MNC that often borrows substantial amounts may receive preferential treatment from creditors. thereby reducing its cost of capital. the MNCs may obtain funds at a lower cost than that paid by domestic firms. 2. In addition.domestic firm due to the following characteristics that differentiate MNCs from domestic firms: 1. that this advantage is due to the MNC’s size and not to its internationalized business.

Exposure to exchange rate risk: An MNC’s cash flows could be more volatile than those of a domestic firm in the same industry if it is highly exposed to exchange rate risk. Thus the capacity of making interest payments on outstanding debt is reduced.inflows come from sources all over the world. which increases the MNC’s cost of capital. those cash inflows may be more stable because the firm’s total sales will not be highly influenced by a single economy . If foreign earnings are remitted to the US parent of an MNC. To the extent that individual economies are independent of each other. . they will not be worth as much when the US dollar is strong against major currencies. 4. which may reduce the probability of bankruptcy and therefore reduce the cost of capital. net cash flows from a portfolio of subsidiaries should exhibit less variability. and the probability of bankruptcy is higher. This could force creditors and shareholders to require a higher return.

O th e r fo rm s o f co u n try ri . T h e p ro b a b i i o f su ch a n d a l ty o ccu rre n ce i i fl e n ce d b y m a n y fa cto rs.5 . th e p ro b a b i i o f th e o s d l ty M N C ’ s g o i g b a n kru p tcy i cre a se s. i a sse ts a re se i d a n d fa i n f ze r co m p e n sa ti n i n o t p ro vi e d . i cl d i g s n u n u n th e a tti d e o f th e h o st co u n try g o ve rn m e n t a n d th e tu i d u stry o f co n ce rn .E x p o su re to co u n try risk : A n M N C th a t e sta b l sh e s fo re i n su b si i ri s i su b j ct to th e i g d a e s e p o ssi i i th a t a h o st co u n try g o ve rn m e n t m a y se i b l ty ze a su b si i ry ’ s a sse ts. th e h ig h e r w ill b e th e M N C ’ s p ro b a b ility o f b a n k ru p tcy . su ch a s ch a n g e s i a h o st sk n g o ve rn m e n t’ s ta x l w s. T h e h ig h e r th e n n p e rce n ta g e o f a n M N C ’ s a sse ts in v e ste d in fo re ig n co u n trie s a n d th e h ig h e r th e o v e ra ll co u n try risk o f o p e ra tin g in th e se co u n trie s . a .

capital markets Possible access to low-cost foreign financing Cost of capital national diversification Reduced probability of bankruptcy ure to exchange rate risk Increased probability of bankruptcy posure to country risk . Large size Preferential treatment from creditors ccess to int.Summary of factors that cause the cost of capital of MNCs to differ from that of domestic firms.

.Cost of Equity comparison using the CAPM To assess how required rates of return of MNCs differ from those of purely domestic firms. the capital asset pricing model (CAPM) can be applied.  Ke= the required rate of return on a stock     r f = the 'Risk Free' rate of return    β = the firm's 'Beta'. the correlation between the firm's returns and the market .. Cost of Equity k ( E = rf + β rM .rf)   where.

the lower its systematic risk. ( a stock index is normally used as a proxy for the market) . and the lower its required rate of return. (2) the market rate of return. • The lower a project’s beta. and (3) the stock’s beta.The CAPM suggests that the required return on a firm’s stock is a positive function of: (1) the risk free rate of interest. The Beta represents the sensitivity of the stock’s returns to market returns. if its unsystematic risk can be diversified away.

For a well-diversified firm with cash flows generated by several projects. . also known as undiversified risk. each project contains two types of risk: (1) unsystematic variability in cash flows unique to the firm. and (2) systematic risk.

4 0 se cu ri e s i d e ve l p e d m a rke ts m y ti n o su ch a s U K o r U S w i lre n d e r th e p o rtfo l o su ffi e n tl l i ci y d i rsi e d su ch th a t ri exp o su re i l m i d to ve fi sk s i te syste m a ti ri o n l . sk U n sy ste m a tic risk i th e ri a sso ci te d w i s sk a th i d i d u a l a sse ts. a p o rtfo l o o f n i a p p roxi a te l 3 0 . d u e to th e h i h e r a sse t s re g vo l ti i e s. m a rke t ri . ti .S y ste m a tic risk refers to the risk common to all se cu ri e s—i e . I ca n b e d i rsi e d away to n vi t ve fi sm a l e r l ve l b y i cl d i g a g re a te r n u m b e r o f a sse ts l e s n u n i th e p o rtfo l o ( sp e ci c ri n i fi sks " a ve ra g e o u t" ). I d e ve l p i g m a rke ts a l rg e r c sk y n o n a n u m b e r i re q u i d . T h e sa m e i n o t p o ssi l fo r syste m a ti ri w i i o n e s b e c sk th n m a rke t. D e p e n d i g o n th e m a rke t. a l ti .

A sse t p ricin g O n ce th e exp e cte d / re q u i d ra te o f re tu rn . Capital asset pricing theory suggests that the unsystematic risk of projects can be ignored because it will be diversified away. . However. we can compare this required rate of return to the asset's estimated rate of return over a specific investment horizon to determine whether it would be an appropriate investment . the lower is the project’s systematic risk and the lower its required rate of return. E( Ri). The lower a project’s beta. is re calculated using CAPM. systematic risk is not diversified away because all projects are similarly affected.

some MNCs consider unsystematic project risk to be important in determining a project’s required return. and hence reduce the return required by investors. it will reduce its cost of capital.Implications of the CAPM for an MNC ’ s Risk  An MNC that increases its foreign sales may be able to reduce its stock’s beta. In this way.  However. This translates into a lower overall cost of capital. . then the required rates of return on the MNCs’ projects should be lower. If projects of MNCs exhibit lower betas than projects of purely domestic firms.

When MNCs adopt projects that are isolated from world market conditions. their stocks will be substantially affected by world market conditions. Consequently. not just U.S. market conditions. investors will prefer to invest in firms that have low sensitivity to world market conditions. to achieve more diversification benefits. . they may be able to reduce their overall sensitivity to these conditions and therefore could be viewed as desirable investments by investors.If investors purchase stocks across many countries.

H o w e ve r. w e ca n n o t sa y w i ce rta i ty n th n w h e th e r a n M N C w i lh a ve a l w e r co st o f l o ca p i lth a n a p u re l d o m e sti fi i th e ta y c rm n sa m e i d u stry. . w e ca n u n d e rsta n d n h o w a n M N C ca n ta ke fu l d va n ta g e o f th e la fa vo ra b l a sp e cts th a t re d u ce i co st o f e ts ca p i l w h i e m i i i n g exp o su re to th e ta . l n m zi u n fa vo ra b l a sp e cts th a t i cre a se i co st o f e n ts ca p i l ta . I su m m a ry .

and .C o st o f C a p ita l A cro ss C o u n trie s  T h e co st o f ca p ita l ca n v a ry a cro ss co u n trie s fo r th re e reasons : MNCs based in some countries have a competitive advantage over others. thus. these MNCs can more easily increase their world market share. some MNCs will have a large set of feasible (positive net present value) projects because their cost of capital is lower. as technology & resources differ across countries. MNCs may be able to adjust their international operations and sources of funds to capitalize on the differences in the cost of capital among countries. so does the cost of capital.

differences in the costs of each capital component (dept & equity) can help explain why MNCs based in some countries tend to use a more debtintensive capital structure than MNCs based elsewhere. .Thirdly.

Country Differences in the Cost of Debt A firm ’ s cost of debt is determined by :   the prevailing risk . and  the risk premium required by creditors . . .free interest rate of the borrowed currency .the cost of debt for firms is higher in some countries than in others because the corresponding risk-free rate is higher at a specific point in time or because the risk premium is higher.

. .Differences in the risk .A country ’ s demographics influence the supply of savings available and the amount of loanable funds demanded. Any factors that influence the supply and / or demand will affect the risk . Countries with younger populations are likely to experience higher interest rates because younger households tend to save less and borrow more.free rate . which can influence the supply of savings and. demographics. These factors include: tax laws.free rate :  The risk-free rate is determined by the interaction of the supply of and demand for funds.Tax laws in some countries offer more incentives to save than those in others. interest rates. economic conditions. monetary policies. etc. . therefore.

One exception is the set of European countries that rely on the European central bank to control the supply of Euros. they can cause interest rates to vary across countries. All these countries now have the same risk-free rate because they use the same currency.A monetary policy implemented by a country’s central bank influences the supply of loanable funds and therefore influences interest rates.. The cost of debt is much higher in many less developed countries than in industrialized countries . .Since economic conditions influence interest rates.

This risk can vary across countries because of differences in economic conditions. which reduces the risk of illiquidity. in the UK many firms are partially owned by the government. . and degree of financial leverage. .When a country’s economic conditions tend to be stable. allowing for a lower risk premium. creditors stand ready to extend credit in the event of a corporation’s financial distress .Governments in some countries are more willing to intervene and rescue failing firms. . the probability that a firm might not meet its obligations is lower. government intervention.Differences in the risk premium: The risk premium on debt must be large enough to compensate creditors for the risk that the borrower may be unable to meet his payment obligations. . Thus. In Japan. relationships between corporations and creditors.Corporations and creditors have a closer relationships in some countries than in others. the risk of a recession in that country is relatively low. For example.

.Comparative Cost of Debt Across Countries There is some positive correlation between country cost of debt levels over time.

Interest rates in various countries tend to move in same direction. some rates change to a greater degree than others. . The disparity in the cost of debt among the countries is due primarily to the disparity in their risk-free interest rates. However.

free interest rates vary among countries . so does the cost of equity . a .As risk . therefore . potential returns may be relatively high .  High PE multiple low cost of equity financing .Country Differences in the Cost of Equity  A firm ’ s return on equity can be measured by the risk . and is thus also based on the available investment opportunities in the country of concern .  The cost of equity represents an opportunity cost .  It can be estimated by applying a price earnings multiple to a stream of earnings . .In a country with many investment opportunities .free interest rate plus a premium that reflects the risk of the firm . resulting in a high opportunity cost of funds and .

.the adoption of the euro has facilitated the integration of European stock markets because investors from each country are more willing to invest in other countries where the euro is used as the currency. . MNCs based in Europe may obtain equity financing at a lower cost.Investors in one euro zone country no longer need to be concerned about exchange rate risk when they buy stock of a firm based in another euro zone country.given the increased willingness of European investors to invest in stocks.the Euro allows the valuations of firms to be more transparent because firms throughout the euro zone can be more easily compared since their values are all denominated in the same currency. .The impact of the Euro . .

. Thus. the cost of using that capital is exposed to exchange rate risk. It usually has a relatively low risk-free interest rate. but when the capital is used to support operations in other countries. which not only affects the cost of debt but also indirectly affects the cost of equity. the cost of capital may ultimately turn out to be higher than expected. for example. Japan.Combining the costs of debt & equity To derive the overall cost of capital. MNCs can attempt to access capital from countries where capital costs are low. using the relative proportions of debt and equity as weight Given the differences in the costs of debt & equity across countries. it is understandable that the cost of capital may be lower for firms based in specific countries. the costs of debt and equity are combined. commonly has a relatively low cost of capital.

Argentine risk-free rate = 10% .S. creditors = 3% .U.risk premium on dollar-denominated debt provided by U.denominated debt provided Argentine creditors = 5% .beta of the project ( expected sensitivity of project returns ) = 1.equity Lexon co. risk.free rate = 6 % .creditors will likely allow no more than 50% of the financing to be in the form of debt.U.S.expected U. . is considering how to obtain funding for a project in Argentina during the next year. market return = 14% . corporate tax rate = 30% . based MNC. It considers the following information: . is a successful U.S. which implies that equity must provide at least half of the financing.5 .risk premium on Argentina peso.S.S.Argentine corporate tax rate = 30% .

cost of Argentine peso-denominated debt = (10% + 5%) * (1 .0.cost of dollar-denominated equity = 6% + 1.Lexon’s cost of each component of capital .5% .cost of dollar.3) = 6.3) = 10.denominated debt = (6% + 3%) * (1 0.3% .5 (14% 6%) = 18% .

.Lexo n ’s E stim a te d W e ig h te d A v e ra g e C o st o f C a p ita l ( WACC ) fo r F in a n cin g a P ro je ct L e x o n co n sid e rs fo u r d iffe re n t ca p ita l stru ctu re s fo r th e n e w p ro je ct.

Thus. lexon will not necessarily choose the capital structure with the lowest estimated WACC. debt & 50% equity. lexon can attempt to incorporate the exchange rate effects in various ways .This table shows that lowest estimate of the WACC results from a capital structure of 50% U.S. The estimated WACC does not account for the exposure to exchange rate risk.

Thank you .