Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-1

Chapter 17Chapter 17Multinational Capital Structure Multinational Capital Structure

and Cost of Capitaland Cost of Capital

17.1 Capital Structure and the Cost of Capital

17.2 Project Valuation and the Cost of Capital

17.3 Sources of Funds for Multinational Operations

17.4 The International Evidence on Capital Structure

17.5 The Cost of Capital on Multinational Operations

17.6 Summary

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-2

Capital structureCapital structure

Capital structure refers to the proportion of long-term debt and equity and the particular forms of capital chosen to finance the assets of the firm.

Management must choose – the proportions of debt and equity

– the currency of denomination

– fixed or floating rate interest payments

– indenture provisions

– conversion features

– callability

– seniority

– maturity

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-3

Multinational financing opportunitiesMultinational financing opportunities

MNC’scost of capital

Investment opportunity set

Domestic firm’scost of capital

Domestic firm Capital budget

%

MNC

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-4

The weighted average cost of capitalThe weighted average cost of capital

Weighted average cost of capital iWACC

After-tax cost ofdebt capital iB(1-TC)

Cost of equity capital iS

Range of optimal capital structure Debt/equity ratio

Cost of capital (%) iWACC = (B/V)iB(1TC)+(S/V)iS

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-5

The multinational’s cost of capital The multinational’s cost of capital (given a particular set of investments)(given a particular set of investments)

Debt/equity ratio

Cost of capital (%)

Domestic iS

Multinational iS

Multinational iWACC

Multinational iB(1 TC)

Domestic iWACC

Domestic iB(1 TC)

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-6

Optimal capital structureOptimal 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

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-7

The perfect market assumptionsThe perfect market assumptions

Perfect markets:

» Frictionless markets

» Equal access to market prices

» Rational investors

» Equal access to costless information

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-8

Modigliani-Miller’s irrelevance propositionModigliani-Miller’s irrelevance proposition

Equal access to perfect financial markets means that individual investors can replicate any financial action that the firm can take.

This leads to MM’s irrelevance proposition:

» If financial markets are perfect, then corporate financial policy is irrelevant.

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-9

The converse of The converse of MM’s irrelevance propositionMM’s irrelevance proposition

If financial policy is to increase value, then it must either

» increase the firm’s expected future cash flows

or

» decrease the discount rate

in a way that cannot be replicated by individual investors.

V =E[CF ]

(1 + i)

t

tt

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-10

Financial market integration vs. segmentationFinancial market integration vs. segmentation

In integrated financial markets, real after-tax rates of return on equivalent assets are equal.

Factors contributing to segmentation include:» prohibitive transactions costs

» different legal and political systems

» regulatory interference (e.g., barriers to financial flows)

» differential taxes

» informational barriers

» home asset bias (a tendency to buy financial assets in the domestic market)

» differential investor expectations

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-11

Project valuation and the cost of capitalProject valuation and the cost of capital

Alternative approaches to project valuation

» WACC: Weighted average cost of capital

» APV: Adjusted present value

Use an asset-specific discount rate that reflects the opportunity cost of capital.» Cash flows denominated in the domestic (foreign)

currency should be discounted at a domestic (foreign) discount rate.

» Nominal (real) cash flows should be discounted at nominal (real) discount rate.

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-12

Weighted average cost of capitalWeighted average cost of capital(WACC)(WACC)

NPV = t [ E[CFt] / (1+iWACC)t ]

where iWACC = [(B/VL) iB (1-TC)] + [(S/VL)iS]

and B = the market value of corporate bonds

S = the market value of corporate stock

VL = B + S = the market value of the firm

iB = the required return on corporate bonds

iS = the required return on corporate stock

TC = the marginal corporate income tax rate

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-13

Adjusted present valueAdjusted present value(APV)(APV)

APV = VU + PV(financing side effects)

- initial investment

where VU = the value of the unlevered

or all-equity project

PV(financing side effects)

= value of tax shields from the use of debt

net of costs of financial distress

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-14

Sources of funds for multinational operationsSources of funds for multinational operations

The financial pecking order:

» Internally generated funds are the preferred source.

» External sources of funds are accessed only after internal sources are exhausted.

External debt is the preferred external funding source.

New external equity is used only as a last resort.

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-15

Sources of funds for multinational operationsSources of funds for multinational operations

Internal sources External sources

Multinational Cash flow from the parent New debt or equity financingcorporation’s and from affiliates in the (perhaps issued or guaranteedhome country parent’s home country by the parent corporation)

Foreign project’s Cash flow from existing Local debt or equity fromhost country operations in the host institutions or markets in the

country host country

International Cash flow redistributed Eurobondsfinancing sources from other foreign Euroequity

affiliates Project finance

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-16

Targeted registered offeringsTargeted registered offerings

Registered versus bearer securities» Securities in the United States are issued in registered

form. » The convention in Western European countries is to issue

securities in bearer form.

U.S. corporations can issue bearer securities to international investors as targeted registered offerings.

» The registered owner must be a financial institution in another country.

» Interest or dividends is paid to this registered financial institution.» The issuer must certify that it has no knowledge that a U.S.

taxpayer owns the security.» The issuer and the registered foreign institutions must follow the

certification procedures of the Securities and Exchange Commission.

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-17

The U.S. evidence on capital structureThe U.S. evidence on capital structure

Leverage increases with» Fixed assets

» Firm size

» Nondebt tax shields

Leverage decreases with» Growth opportunities

» Profitability

» Uniqueness of the firm’s product(s)

» Earnings volatility

» Advertising and R&D expenditures

» Probability of bankruptcy or default

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-18

Balance sheets for nonfinancial firmsBalance sheets for nonfinancial firms

$ ¥ DM Franc Lira £ C$

Current assets 48.0 57.7 59.4 58.3 56.5 54.7 33.2Fixed assets 54.2 40.3 39.9 41.2 41.0 44.9 63.6Assets - other 5.8 2.9 0.7 0.7 3.3 0.5 3.7Assets -- total 100.0 100.0 100.0 100.0 100.0 100.0 100.0

Current liabilities 33.4 42.2 30.0 43.4 43.2 40.0 23.1Long-term debt 23.3 18.9 9.8 15.7 12.1 12.4 28.1Other liabiliites 9.6 5.8 32.8 11.5 12.5 5.4 7.0Liabilities -- total 66.1 66.8 72.0 68.8 67.4 57.8 60.3

Shareholders equity 34.1 33.2 28.0 31.2 32.6 42.2 39.7Total liabilities & equity 100.0 100.0 100.0 100.0 100.0 100.0 100.0

Longterm debt to capitaladjusted for accountingdifferences

33% 37% 18% 34% 39% 16% 37%

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-19

The international evidenceThe international evidenceon capital structureon capital structure

Leverage increases with

» The proportion of fixed to total assets» Firm size

Leverage decreases with

» Asset market-to-book ratios (~ growth opportunities)

» Profitability

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-20

Diversifiable versus nondiversifiable risksDiversifiable versus nondiversifiable risksand the multinational’s cost of capitaland the multinational’s cost of capital

If operating risks are diversifiable, then they are not priced by investors and should not be reflected in capital costs.

If operating risks are nondiversifiable (systematic), then they should be reflected in capital costs.

» The multinational corporation’s capital costs are increased if these risks are positively related to the market portfolio

» The multinational corporation’s capital costs are decreased if these risks are negatively related to the market portfolio

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-21

The multinational corporation’s cost of capitalThe multinational corporation’s cost of capital

Mixed empirical evidence

» MNCs have lower betas despite higher financial leverageMichel and Shaked, “Multinational Corporations vs. Domestic Corporations: Financial Performance and Characteristics,” Journal of International Business Studies, Fall 1986.

» MNCs have higher betas after controlling for leverage, size and growth

Reeb, Kwok and Baek, “Systematic Risk of the Multinational Corporation,” Journal of International Business Studies, No. 2, 1998.

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-22

The effect of financial market The effect of financial market liberalizations on the cost of capitalliberalizations on the cost of capital

Bekaert and Harvey (1998) find that financial market liberalizations tend to:

» Increase the correlation of emerging market returns with world market returns.

» Have little impact on emerging market volatility.

» Decrease local firms’ capital costs by up to 1 percent.

Source: Geert Bekaert and Campbell Harvey, “Foreign Speculators

and Emerging Equity Markets,” Fuqua School of Business

Working Paper, June 1998.