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Lecture Multinational financial management: Lecture 17 - Dr. Umara Noreen

Lecture 17 - Multinational cost of capital and capital structure. After completing this chapter, students will be able to: To explain how corporate and country characteristics influence an MNC’s cost of capital; to explain why there are differences in the costs of capital across countries; and to explain how corporate and country characteristics are considered by an MNC when it establishes its capital structure. | Multinational Cost of Capital and Capital Structure 17 Lecture Chapter Objectives To explain how corporate and country characteristics influence an MNC’s cost of capital; To explain why there are differences in the costs of capital across countries; and To explain how corporate and country characteristics are considered by an MNC when it establishes its capital structure. Cost of Capital A firm’s capital consists of equity (retained earnings and funds obtained by issuing stock) and debt (borrowed funds). The cost of equity reflects an opportunity cost, while the cost of debt is reflected in the interest expenses. Firms want a capital structure that will minimize their cost of capital, and hence the required rate of return on projects. A firm’s weighted average cost of capital kc = ( D ) kd ( 1 _ t ) + ( E ) ke D + E D + E 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 t is the corporate tax rate ke is the cost of financing . | Multinational Cost of Capital and Capital Structure 17 Lecture Chapter Objectives To explain how corporate and country characteristics influence an MNC’s cost of capital; To explain why there are differences in the costs of capital across countries; and To explain how corporate and country characteristics are considered by an MNC when it establishes its capital structure. Cost of Capital A firm’s capital consists of equity (retained earnings and funds obtained by issuing stock) and debt (borrowed funds). The cost of equity reflects an opportunity cost, while the cost of debt is reflected in the interest expenses. Firms want a capital structure that will minimize their cost of capital, and hence the required rate of return on projects. A firm’s weighted average cost of capital kc = ( D ) kd ( 1 _ t ) + ( E ) ke D + E D + E 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 t is the corporate tax rate ke is the cost of financing with equity Comparing the Costs of Equity and Debt Cost of Capital Debt Ratio Searching for the Appropriate Capital Structure Interest payments on debt are tax deductible However, the tradeoff is that the probability of bankruptcy will rise as interest expenses increases. Factors that Cause the Cost of Capital for MNCs to Differ from That of Domestic Firms Exposure to exchange rate risk Exposure to country risk Greater access to international capital markets Possible access to low-cost foreign financing Larger size Preferential treatment from creditors & smaller per unit flotation costs Cost of capital International diversification Probability of bankruptcy The capital asset pricing model (CAPM) can be used to assess how the required rates of return of MNCs differ from those of purely domestic firms. CAPM: ke = Rf + b (Rm – Rf ) where ke = the required return on a stock Rf = risk-free rate of return Rm = market return b = the beta of the stock Cost-of-Equity Comparison Using the CAPM A