COST OF CAPITAL & CAPITAL STRUCTURE For MNCs

Multinational Financial Management By Alan Shapiro (Wiley Eastern Publication, 8th Edition) International Financial Management Jeff Madura (Cengage Learning) International Financial Management By P G Apte (Tata McGraw Hill)

WACC
WACC = Rd (1 T) D/V + Re E/V Must reflect target capital structure based on market value weights. Advantage of debt:

Tax Shield Increased chances of bankruptcy increases the cost of equity capital
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Disadvantage of debt:

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HOW WACC BEHAVES

Initially WACC falls with increasing debt as long as tax shield advantage outweighs increased cost of equity capital. At some point cost of equity capital increases more than the benefits of debt due to increased probability of distress. There exists an optimum capital structure.

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COST OF CAPITAL
Cost

WACC
Cost of Equity

R0 WACC Cost of debt Level of Debt

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VALUE OF THE FIRM

Similarly, the value of the firm increases with increasing debt as firm enjoys the tax shield of debt. When amount of debt becomes larger than warranted, increased debt beyond a point adds to the cost of distress, causing the value of the firm to decline. Least cost of capital implies maximum value for the firm

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CAPITAL STRUCTURE
VALUE OF THE FIRM
Value

Levered Firm; VL

PV of Tax Shield Vu Unlevered Firm Optimal

PV of Financial Distress

Level of Debt
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COST OF CAPITAL MNCs vs. Pure Domestic

FACTORS LEADING TO REDUCTION IN COST Size of the firm: Usually much larger, Issue size too is large reducing floatation cost. Access to international markets: Greater options, more opportunities available to mobilise funds. International diversification: Greater the diversification lesser the cost as risk premium reduces.
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COST OF CAPITAL MNCs vs. Pure Domestic

FACTORS LEADING TO INCREASE IN COST Exposure to exchange rate risk: Increases the cost of capital, but with hedging instruments available is easily controllable. Exposure to country risk: Would need extra premium for the extra risk assumed.
Cost of capital for MNC is likely to be lower than that of domestic firm Implies greater business opportunities for MNCs compared to the domestic firms
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EXPANDED OPPORTUNITY SET

Cost/Return MNC vs Domestic Firm

IRR of Projects

WACC for domestic firm WACC for MNC

Increased business opportunities Investment

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CONVENTIONAL CAP-M
Cost of equity given by CAPM Re = Rf + (Rm Rf) Parameters of risk free rate, risk premium, and are required on global basis rather than local basis. Assets are priced as per CAPM which implies reward for only systematic risk since unsystematic risk can be diversified away by investors in their individual capacities.
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INTL CAP-M
Much of the risk faced by investors in MNCs is unsystematic. Risk across countries cannot be diversified away by investors themselves. MNCs while doing business in different nations can derive the benefits of diversification. The economies must have low degrees of correlation.

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RISK FREE RATE

Risk free rate depends upon Tax laws and tax rates Monetary policies Economic conditions Efficiency of debt and capital markets
Cost of debt in developed nations is found to be lower than that of less developed countries.
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RISK PREMIUM
Risk Premium
Economic conditions Govts willingness to support Degree of operating leverage

Cost of equity:
PE multiple Maturity of capital markets

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PROJECTS BETA
Finding subsidiarys Beta: Use pure play approach: Unlevering and relevering of beta for operational leverage and financial leverage. Identify pure play local firm rather than using MNCs beta. Incorporate separate premium for country risk.
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COST OF EQUITY ACROSS BORDERS

Depends upon whether capital markets are integrated or segmented. If integrated the cost of capital will equalize across borders One mechanism of integrating the financial markets of the world is CROSS BORDER LISTING

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CROSS BORDER LISTING

Advantages:

Expanded investor base; higher stock price and lower cost of equity More avenues for raising capital Increased liquidity Increased visibility providing marketing edge Increased cost of listing Increased compliances and cost of administration Increased disclosure requirements Increased threat of take-over
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Disadvantages:

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INTL CAP-M
For Internationally tradable assets Assets are priced as per International CAPM as per systematic risk of the portfolio consisting of securities across the world. Take world market portfolio, and its Beta. Cost of debt will be same across borders if markets are integrated.
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EXAMPLE: INTL CAP-M

For IBM shares In USA: Rf = 6% Rm = 12% USA = 1.0 Cost of equity = 6 + 1.0 (12 6) = 12% Integrated world markets: Rf = 6% Rm = 12% w = 0.80 Cost of equity = 6 + 0.8 (12 6) = 10.8%
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NON TRADED ASSETS

Cost of equity is partially priced as per international systematic risk and partly priced as per domestic systematic risk. A non tradable asset (only domestically listed firm) gets the partial benefit of the international listing by another firm. Companies listed on the domestic market alone get the advantage of other firms listing abroad. Free ride due to interplay of domestic and world markets offered by internationally listed share. International markets are neither fully integrated nor fully segmented.
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RESTRICTION ON FOREIGN EQUITY HOLDING

Phenomena of Pricing To Market (PTM) Differential pricing due to restrictions on the equity holding pattern based on nationality of the investors. Case of NESTLE Capital
Registered Stock (68%): Only Swiss nationals could hold Bearer Stock (32%): Any one could hold

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CASE - NESTLE
November 17, 1988: Nestle lifted ban on foreign holding due to:

International criticism for foreign acquisitions. Management thought that local shares were underpriced. Due to underpricing of the registered shares the cost of capital was higher.

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RESTRICTIONS ON FOREIGN HOLDING

Price Bearer >8,000 Registered 4,000 17 Nov. 88
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NESTLE SHARES

-25% +35%

Time
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IMPACT ON PRICES

Bearer shares fell by 25% and registered shares rose by 35%. Since registered shares constituted 68% the overall cost of capital came down for Nestle. Price of bearer shares fell:
Because additional supply of shares was available to investors.

Price of registered shares rose???

Because investors visualised lesser risk with registered shares and hence the risk premium came down.

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APPLYING CAP-M
Assume: In Swiss market: Rf = 4.6% Rm = 9.8% Swiss = 0.9 Cost of equity = 4.6 + 0.9 (9.8 4.6) = 9.28% With restrictions removed: Rf = 4.5% Rm = 10.5% w = 0.60 Cost of equity = 4.5 + 0.6 (10.5 4.5) = 8.1% The price of the share P = D/(r - g); Two different r will give two different prices.
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COST OF CAPITAL among nations

Developed vs. Less Developed

Cost of capital is lower in LDCs (India vs. USA) Developmental financial institutions have played much greater role in financing the corporate in LDCs, while developed nations rely more on venture capital and equity markets. High degree of leverage is acceptable in developing countries than the developed. Keirutsu approach of financing In contrast, for developed nations equity/venture capital plays major developmental role, rather than debt.
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CAPITAL STRUCTURE DECISION

Corporate Characteristics:

Stability of Cash flows Credit Risk Access to retained earnings Issue of guarantees on debt Agency problems Legal environment Exchange control rules Strength of the currency Country/Political risk Norms differ across nations
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Country Characteristics:

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IMPACT OF CAPITAL STRUCTURE OF SUBSIDIARY

Increased debt financing of the subsidiary Increases financial leverage for the parent. Increases foreign exchange exposure for the parent. Causes of increased leverage in the subsidiary: Countries may not allow listing of foreign shares. Countries may pose great political risk.

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CHOICES FOR THE CAPITAL STRUCTURE OF SUBSIDIARY

THREE ALTERNATIVES AVAILABLE Conform to parents capital structure Conform to local norms Take Advantage of local financing options

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SUBSIDIARYS CAPITAL STRUCTURE

If parent is responsible in case of default by the subsidiary: Parents capital structure is important. When not, capital structure of subsidiary matters. As long as parent feels legally or morally obligated not to let the subsidiary default on its financial commitments, the capital structure of the subsidiary seems irrelevant. Also capital structure of the subsidiary seems irrelevant for the overall capital structure of the parent, since outlays on subsidiaries are relatively small.

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SUGGESTED CAPITAL STRUCTURE

Avail local financing opportunities

Management of political risk Reduce currency risk to the extent the funds are to be used locally If local taxes are high tax shield on debts will be high

Avail low cost subsidised debt Avail subsidies In such a case the capital structure of the MNC becomes RESIDUAL.
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