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Lecture Multinational financial management: Lecture 18 - Dr. Umara Noreen

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 18 Lecture 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 Lexon’s Estimated Weighted Average Cost of Capital (WACC) for Financing a Project To derive the overall cost of capital, the costs of debt and equity are combined, using the relative proportions of debt and equity as weights. 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 . | Multinational Cost of Capital and Capital Structure 18 Lecture 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 Lexon’s Estimated Weighted Average Cost of Capital (WACC) for Financing a Project To derive the overall cost of capital, the costs of debt and equity are combined, using the relative proportions of debt and equity as weights. 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. Using the Cost of Capital for Assessing Foreign Projects Derive NPVs based on the WACC. Compute the probability distribution of NPVs to determine the probability that the foreign project will generate a return that is at least equal to the firm’s WACC. 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. Using the Cost of Capital for Assessing Foreign Projects Derive the NPV of the equity investment. Explicitly account for the MNC’s debt payments (especially those in the foreign country), so as to fully account for the effects of expected exchange rate movements. Lexon’s Project: Two Financing Alternatives The MNC’s Capital Structure Decision 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 .