Chapter 15

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
 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 15-2

 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

The MNC’s optimal capital structure 15-3

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

MNC

MNC’s
Investment opportunity set
cost of capital

Domestic firm Capital budget

The MNC’s optimal capital structure 15-4
 The weighted average cost of
capital
Cost of capital (%)

Cost of equity capital iS

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

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

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
The MNC’s optimal capital structure 15-6
 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 15-7

 The perfect market assumptions

 Frictionless markets
- No transaction costs, taxes,
government intervention, agency costs,
or costs of financial distress
 Equal access to market prices
- Everyone is a “price taker”
 Rational investors
- Return is good and risk is bad
 Equal access to costless information

Project valuation and the cost of capital 15-8

 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 15-9

 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 15-10
 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 15-11

 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)

Project valuation and the cost of capital 15-12

 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 = the
market value of corporate stock
iB =
required
Project valuation and return on corporate bonds
the cost of capital 15-14
 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)
Project valuation and the cost of capital 15-15
 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 15-16
 Country risks and equity returns

 Equity returns are related to country risks

 Erb, 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.

Project valuation and the cost of capital 15-17

 Liberalizations and the cost of
capital
 Liberalizations tend to benefit firms and
investors in the liberalized market
 Financial 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 15-18

 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 country-
specific 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 15-19
 Sources of funds for MNCs

The financial “pecking order”

 Internal sources of funds are preferred
by most managers
 External 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
Sources of funds for multinational operations 15-20
 Sources of funds for foreign ops
External
External
U.S. debt
foreign
2%
equity
16%
External
foreign
debt
45% Internal
Internal debt
equity 2%
35%

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.
Sources of funds for multinational operations 15-21
 MNC sources of funds

Internal sources External sources

MNC’s home Cash flow from New debt or equity
country parent & affiliates financing (perhaps
in the parent’s issued or
guaranteed
home country 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 Cash flow from Project finance
financing other foreign Eurobonds
sources affiliates Euroequity
Sources of funds for multinational operations 15-22
 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 15-23

 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 15-24

 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
Sources of funds for multinational operations 15-25
 Project finance

 Project financing allows a project sponsor

to raise external funds for a specific
project
 Distinguishing 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
- Governments participate through infrastructure
support, operating or financial guarantees,
rights-of-way, or assurances against political
riskfor multinational operations
Sources of funds 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.

The international evidence on capital structure 15-27