Chapter 6

Financing
Decisions of
MNC’s
Intl FM Chapter 6 Financing Decision of MN 1
Cs Tadele H. (PhD)
Capital Structure and MNCs
• Capital structure refers to the amount of debt
vs. equity that a firm is willing and able to
maintain as capital on its balance sheet
without being overly leveraged.
• A firm’s capital consists of equity (retained
earnings and funds obtained by issuing stock)
and debt (bank loans or floating bonds).
• Firms target or attempt to use a specific
capital structure, or mix of capital
components, that will minimize their cost of
capital and hence the required rate of return
on projects..
Intl FM Chapter 6 Financing Decision of MN 2
Cs Tadele H. (PhD)
 Cost of Capital for
MNCs
Cost of capital is the weighted
cost of equity and debt where the
weights reflect the firm’s capital
structure.
• It is the minimum rate of return an
investment project must generate in
order to pay its financing costs.

Intl FM Chapter 6 Financing Decision of MN 3

Cs Tadele H. (PhD)
 …Cost of Capital for
• MNCs
Cost of equity reflects the opportunity
cost for investors in a country and will depend
on investment alternatives and risk profile.
• Cost of debt is the net interest expense,
i.e., net of taxes which vary with country.
MNCs take advantage of differences in interest
and tax rates among countries to minimize
their cost of debt and capital.
• The firm’s cost of debt is easier to measure
because the firm incurs interest expenses as a
result of borrowing funds.
• Note that the cost of equity reflects an
Intl FM Chapter 6 Financing Decision of MNCs
opportunity cost, while the cost of debt
Tadele H. (PhD)
4
 …Cost of Capital for
MNCs
• The lower a firm’s cost of capital, the
lower is its required rate of return on
a given proposed project.
• Firms estimate their cost of capital
before they conduct capital
budgeting because the net present
value of any project is partially
dependent on the cost of capital.

Intl FM Chapter 6 Financing Decision of MN 5

Cs Tadele H. (PhD)
 …Cost ofCapital
Cost of Capitalfor
for
MNCs
MNCs…cont
• A firm’s weighted average cost
of capital

where
•D is the amount of debt of the
firm
•E is the equity of the firm
•kd is the before-tax cost of its
debt Intl FM Chapter 6 Financing Decision of MN 6
Cs Tadele H. (PhD)
 Cost of
…Cost ofCapital
Capitalfor for
•
MNCs…cont
MNCs
These ratios reflect the percentage of capital
represented by debt and equity, respectively.
• There is an advantage to using debt rather
than equity as capital because the interest
payments on debt are tax deductible.
• The greater the use of debt, however, the
greater the interest expense and the higher
the probability that the firm will be unable to
meet its expenses.
• Consequently, the rate of return required by
potential new shareholders or creditors will
increase to reflect the higher probability of
Intl FM Chapter 6 Financing Decision of MN 7
bankruptcy. Cs Tadele H. (PhD)
 Cost of Capital for
•
MNCs…cont
The cost of capital for MNCs may differ
from that for domestic firms because
of the following characteristics that
differentiate MNCs from domestic firms
1. Size of firm.
2. Access to international capital
markets.
3. International diversification.
4. Exposure to exchange rate risk.
5. Exposure to country risk.
Intl FM Chapter 6 Financing Decision of MN 8
Cs Tadele H. (PhD)
 …Cost
Cost of ofCapital
Capitalfor
for
MNCs…cont
1. Size of firm.
MNCs
An MNC that often borrows substantial amounts may
receive preferential treatment from creditors, thereby
reducing its cost of capital. Furthermore, its relatively
large issues of stocks or bonds allow for reduced
flotation costs (as a percentage of the amount of
financing).
Note, however, that these advantages are due to the
MNC’s size and not to its internationalized business.
A domestic corporation may receive the same treatment if
it is large enough. Nevertheless, a firm’s growth is
more restricted if it is not willing to operate
internationally. Because MNCs may more easily achieve
growth, they may be more able than purely domestic
firms to reach the necessary size to receive preferential
treatment from creditors.
Intl FM Chapter 6 Financing Decision of MN
Cs Tadele H. (PhD)
9
 Cost of
…Cost ofCapital
Capitalfor for
MNCs…cont
MNCs
2. Access to international capital markets.
MNCs are normally able to obtain funds through
the international capital markets. Since the
cost of funds can vary among markets, the
MNC’s access to the international capital
markets may allow it to obtain funds at a lower
cost than that paid by domestic firms.
In addition, 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 country are relatively low.

Intl FM Chapter 6 Financing Decision of MN 10

Cs Tadele H. (PhD)
 Cost of
…Cost ofCapital
Capitalfor for
MNCs…cont
MNCs
3. International diversification.
As explained earlier, a firm’s cost of capital is
affected by the probability that it will go bankrupt.
If a firm’s cash inflows come from sources all over
the world, those cash inflows may be more stable
because the firm’s total sales will not be highly
influenced by a single economy.
To the extent that individual economies are
independent of each other, net cash flows from a
portfolio of subsidiaries should exhibit less
variability, which may reduce the probability of
bankruptcy and therefore reduce the cost of
capital.
Intl FM Chapter 6 Financing Decision of MN 11
Cs Tadele H. (PhD)
 Cost ofofCapital
…Cost Capitalfor for
MNCs…cont
MNCs
4. Exposure to exchange rate risk.
If foreign earnings are remitted to the U.S.
parent of an MNC, they will not be worth as
much when the U.S. dollar is strong
against major currencies.
• Thus, the capability of making interest
payments on outstanding debt is reduced,
and the probability of bankruptcy is higher.
This could force creditors and shareholders
to require a higher return, which increases
the MNC’s cost of capital.
Intl FM Chapter 6 Financing Decision of MN 12
Cs Tadele H. (PhD)
 …Cost of Capital for
MNCs
5. Exposure to country risk.
An MNC that establishes foreign
subsidiaries is subject to the possibility
that a host country government may
seize a subsidiary’s assets.
The probability of such an occurrence is
influenced by many factors, including
the attitude of the host country
government and the industry of
concern.
• If assets Csare seized and
Tadele H. (PhD) fair
Intl FM Chapter 6 Financing Decision of MN 13
 …Cost of Capital for
MNCs
• The higher the percentage of an MNC’s
assets invested in foreign countries and the
higher the overall country risk of operating in
these countries, the higher will be the MNC’s
probability of bankruptcy (and therefore its
cost of capital), other things being equal.
• Other forms of country risk, such as changes
in a host government’s tax laws, could also
affect an MNC’s subsidiary’s cash flows.
• These risks are not necessarily incorporated
into the cash flow projections because there
is no reason toIntlbelieve that they will arise. 14
FM Chapter 6 Financing Decision of MN
Cs Tadele H. (PhD)
Summary of Factors That Cause
the Cost of Capital of MNCs to
Differ from That
of Domestic Firms

Intl FM Chapter 6 Financing Decision of MN 15

Cs Tadele H. (PhD)
 Cost-of-Equity Comparison Using the CAPM

• The capital asset pricing model (CAPM) can

be used to assess how the required rate of
return of MNCs differ from those of purely
domestic firms.
• CAPM: ke = Rf +ß(Rm – Rf)
• where ke = the required return on a stock
• Rf = risk-free rate of return
• Rm = market return
• ß = the beta of the stock
Intl FM Chapter 6 Financing Decision of MN 16
Cs Tadele H. (PhD)
 …Cost-of-Equity Comparison Using the CAPM

• A stock’s beta represents the sensitivity of

the stock’s returns to market premium, just
as a project’s beta represents the sensitivity
of the project’s cash flows to market
conditions.
• The lower a project’s beta, the lower its
systematic risk, and the lower its required
rate of return, if its unsystematic risk can be
diversified away.
• MNCs that increase their foreign sales may be
able to reduce its stock’s beta, and hence
reduce the required
Intl FM Chapter 6return.
Cs
Financing Decision of MN
Tadele H. (PhD)
17
 Estimating the Cost of Debt and Equity

• When financing new projects, MNCs

estimate their cost of debt and equity from
various sources. They consider these
estimates when they decide on the capital
structure to use for financing the projects.
• The after-tax cost of debt can be estimated
with reasonable accuracy using public
information on the present costs of debt
(bond yields) incurred by other firms whose
risk level is similar to that of the project.
Intl FM Chapter 6 Financing Decision of MN 18
Cs Tadele H. (PhD)
 …Estimating the Cost of Debt and Equity

• The cost of equity is an opportunity cost: what

investors could earn on alternative equity
investments with similar risk.
• The MNC can attempt to measure the
expected return on a set of stocks that exhibit
the same risk as its project. This expected
return can serve as the cost of equity.
• The required rate of return on the project will
be the project’s weighted cost of capital,
based on the estimates as explained here.
Intl FM Chapter 6 Financing Decision of MN 19
Cs Tadele H. (PhD)
 Estimating the Cost of Debt and
…Estimating the Cost of Debt
Equity…cont
and Equity
EXAMPLE
Lexon Co., a successful U.S.-based MNC, is
considering how to obtain funding for a project
in Argentina during the next year. It considers
the following information:
• U.S. risk-free rate 6%.
• Argentine risk-free rate 10%.
• Risk premium on dollar-denominated debt
provided by U.S. creditors 3%.
• Risk premium on Argentine peso–denominated
debt provided by Argentine creditors 5%.
Intl FM Chapter 6 Financing Decision of MN 20
Cs Tadele H. (PhD)
 …Estimating the Cost of Debt
Estimating the Cost of Debt and Equity…cont
and Equity
• Beta of project (expected sensitivity of
project returns to U.S. investors in
response to the U.S. market) 1.5.
• Expected U.S. market return 14%.
• U.S. corporate tax rate 30%.
• Argentine corporate tax rate 30%.
• Creditors will likely allow no more than
50 percent of the financing to be in the
form of debt, which implies that equity
must provide at least half of the
financing. Intl FM Chapter 6 Financing Decision of MN
Cs Tadele H. (PhD)
21
…Estimating the Cost of Debt
Estimating the Cost of Debt and Equity…cont
and Equity

Intl FM Chapter 6 Financing Decision of MN 22

Cs Tadele H. (PhD)
 …Estimating the Cost of Debt
and Equity
Lexon’s Estimated Weighted Average Cost of
Capital (WACC) for Financing a Project

Intl FM Chapter 6 Financing Decision of MN 23

Cs Tadele H. (PhD)
 Using the Cost of Capital
for Assessing Foreign Projects

• When the risk level of a foreign

project is different from that of the
MNC, the MNC’s weighted average
cost of capital (WACC) may not be
the appropriate required rate of
return for the project.
• There are various ways to account
for this risk differential in the capital
budgeting process.
Intl FM Chapter 6 Financing Decision of MN 24
Cs Tadele H. (PhD)
 …Using the Cost of Capital
for Assessing Foreign Projects
1. Derive NPVs based on the WACC
• Lexon estimated that its WACC will be 12.15 % if it
uses 50 percent dollar-denominated debt and 50
percent equity.
• It considers assessing the project in Argentina
based on a required rate of return of 12.15%. Yet,
by financing the Argentine project completely with
dollars, Lexon will likely be highly exposed to
exchange rate movements.
• It can attempt to account for how expected
exchange rate movements will affect its cash
flows when it conducts its capital budgeting
analysis.. Intl FM Chapter 6 Financing Decision of MN
Cs Tadele H. (PhD)
25
 …Using the Cost of Capital
for Assessing Foreign Projects
• Furthermore, Lexon could account for the risk
within its cash flow estimates by incorporating
many possible values for each input variable
(such as demand, price, labor cost, etc.) to
estimate net present values (NPVs) under
alternative scenarios and then derive a
probability distribution of the NPVs.
• When the WACC is used as the required rate of
return, the probability distribution of NPVs can
be assessed to determine the probability that
the foreign project will generate a return that is
at least equal to the firm’s WACC.
• If the probability distribution
Intl FM Chapter 6 Financing Decision of MN contains some
26
Cs Tadele H. (PhD)
 …Using the Cost of Capital
for Assessing Foreign Projects
2. Adjust the WACC for the risk differential.
• If the project is riskier, add a risk premium to the WACC
to derive the required rate of return on the project.
• Example. Lexon estimated that its WACC will be
12.15% if it uses the capital structure of 50 percent
dollar-denominated debt and 50 percent equity.
• But it recognizes that its Argentine project will be
exposed to exchange rate risk and that this project is
exposed to more risk than its normal operations. Lexon
considers adding a risk premium of 6 percentage
points to the estimated WACC to derive the required
rate of return. In this case, the required rate of return
would be
12.15%+ 6% =18.15%. Intl FM Chapter 6 Financing Decision of
27
MNCs Tadele H. (PhD)
 …Using the Cost of Capital
for Assessing Foreign Projects
3. Derive the NPV of the equity investment.
• The two methods described up to this point
discount cash flows based on the total cost of the
project’s capital.
• That is, they compare the NPV of the project’s cash
flows to the initial capital outlay. They ignore debt
payments because the cost of debt is captured
within the required rate of return on the capital to
be invested in the project.
• When an MNC is considering financing a portion of
the foreign project within that country, these
methods are less effective because they do not
measure how the debt payments could affect dollar
cash flows. Intl FM Chapter 6 Financing Decision of MN
Cs Tadele H. (PhD)
28
 …Using the Cost of Capital
for Assessing Foreign Projects
• To explicitly account for the exchange rate
effects, an MNC can assess the project by
measuring the NPV of the equity investment
in the project.
• All debt payments are explicitly accounted
for when using this method, so the analysis
fully accounts for the effects of expected
exchange rate movements.
• Then, the present value of all cash flows
received by the parent can be compared to
the parent’s initial equity investment in the
project. The Intl
MNC
Cs
FM Chapter 6 can conduct
Financing Decision
Tadele H. (PhD)
of MN this same
29
 …Using the Cost of Capital
for Assessing Foreign Projects

Intl FM Chapter 6 Financing Decision of MN 30

Cs Tadele H. (PhD)
 Cost of Capital Across Countries

The cost of capital can vary across countries,

such that:
1. MNCs based in some countries have a
competitive advantage (taxes) over others;
2. MNCs may be able to adjust their
international operations and sources of
funds to capitalize on those differences;
and
3. MNCs based in some countries tend to use
a debt intensive capital structure.
Intl FM Chapter 6 Financing Decision of MN 31
Cs Tadele H. (PhD)
 Country Differences in the Cost of
Debt

A firm’s cost of debt is determined by:

1. The prevailing risk-free interest rate of
the borrowed currency, and
2. The risk premium required by creditors
in that country.
• The risk-free rate is determined by the
interaction of the supply of and demand for
funds in a country.
• It is thus influenced by tax laws,
demographics, monetary policies, economic
conditions, etc.
Intl FM Chapter 6 Financing Decision of MN 32
Cs Tadele H. (PhD)
 …Country Differences in the Cost of
Debt

• The risk premium compensates

creditors for the risk that the borrower
may default on its payments.
• The risk premium is influenced by
economic conditions, the relationships
between corporations and creditors,
government intervention, the degree of
financial leverage, etc.

Intl FM Chapter 6 Financing Decision of MN 33

Cs Tadele H. (PhD)
…Country Differences in the Cost of
Equity

• A firm’s return on equity can be measured

by the risk-free interest rate plus a
premium that reflects the risk of the firm.
• The cost of equity represents an
opportunity cost, and is thus also based
on the available investment opportunities.
• It can be estimated by applying a price-
earnings multiple to a stream of earnings.
• High PE multiple low cost of equity

Intl FM Chapter 6 Financing Decision of MN 34

Cs Tadele H. (PhD)
 The MNC’s Capital Structure Decision

• An MNC’s capital structure decision involves

the choice of debt versus equity financing
within all of its subsidiaries.
• The overall capital structure of an MNC is
essentially a combination of the capital
structures of the parent body and its
subsidiaries.
• The capital structure decision involves the
choice of debt versus equity financing, and is
influenced by both corporate and country
characteristics.
Intl FM Chapter 6 Financing Decision of MN 35
Cs Tadele H. (PhD)
…The MNC’s Capital Structure
Decision

Intl FM Chapter 6 Financing Decision of MN 36

Cs Tadele H. (PhD)
…The MNC’s Capital Structure
Decision

Intl FM Chapter 6 Financing Decision of MN 37

Cs Tadele H. (PhD)
Revising the Capital Structure
in Response to Changing
Conditions
• As economic and political conditions and
the MNC’s business strategy change, the
costs and benefits of each cost of capital
component will change as well.
• An MNC may revise its capital structure
in response to the changing conditions.
• For example, some MNCs have revised
their capital structures to reduce their
withholding taxes on remitted earnings.

Intl FM Chapter 6 Financing Decision of MN 38

Cs Tadele H. (PhD)
Effect of Global Conditions on
Financing

Intl FM Chapter 6 Financing Decision of MN 39

Cs Tadele H. (PhD)
 Local versus Global
Target Capital Structure

• An MNC may deviate from its “local”

target capital structure when local
conditions and project characteristics
are taken into consideration.
• If the proportions of debt and equity
financing in the parent or some other
subsidiaries can be adjusted
accordingly, the MNC may still achieve
its “global” target capital structure.
Intl FM Chapter 6 Financing Decision of MN 40
Cs Tadele H. (PhD)
 Local versus Global
Target Capital Structure

• For example, a high degree of financial

leverage is appropriate when the host
country is in political turmoil, while a low
degree is preferred when the project will
not generate net cash flows for some
time.
– A capital structure revision may result in a
higher cost of capital.
– So, an unusually high or low degree of
financial leverage should be adopted only if
the benefits outweigh the overall costs.
Intl FM Chapter 6 Financing Decision of MN 41
Cs Tadele H. (PhD)
End of
Chapter
Intl FM Chapter 6 Financing Decision of MN 42
Cs Tadele H. (PhD)