Cost of Capital of Mncs

8/13/2019 Cost of Capital of Mncs

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A firms capitalconsists of:Retained EarningsEquity (existing or newly issued)Preferred StockDebt (borrowed funds)

The firms cost of retained earningsreflectsthe

opportunity cost - what existing shareholderscould

have earned if they invested the fundsthemselves.

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it is the minimum rate of return expected by an

investor.

In other word it is defined as the cost of obtaining the

funds.

It is also called cut off rate, Target rate, Hurdle rate or

minimum required rate of return.

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Helpful in designing Capital Structure.

Helpful in taking capital budgeting decisions.

Helpful in evaluation of financial efficiency of top

management.

Helpful in comparative analysis of various source of finance.

Helpful in taking other financial decision.

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The firms cost ofnew equityalso reflects an

opportunity cost - what the new shareholderscould

have earned if they had invested their funds

elsewhere.

The cost of new equity exceeds the cost of retained

earnings by the floatation costs.

The firms cost of debtincreases with the level of

debt.

Increases in the level of debt also increases the

probability of default.


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Tax deductibility of interest payments on debtsenhances the attractiveness of debt financing.

A firm must maintain a proper balance betweenthe tax advantage of debt and its disadvantage(greater probability of bankruptcy).

The firms weighted average cost of capital(WACC) can be computed as:(Total Capital = Debt + Equity + Pref. Stock)

WACC = WdKd 1-t) + WpKp + WeKe

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where:D = Proportion of capital (D+E) made

up of debt,E = The proportion of equity,

Kd = Cost of debt,Ke = Cost of Equity andt = tax rate.

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ed

KED

EtK

ED

DWACC

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Capital Asset Pricing Method: This methodtakes risk free rate of return and the riskfactor is added while calculating cost ofequity capital.

Retained earning have Opportunity Cost.

Kr= Ke( 1- %Brokerage)

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Size of the Firm: The larger the size of the firm,the larger the amount that is borrowed. Inaddition, larger issues of stocks or bonds allowfor reduced percentage flotation costs.

Access to International Capital Markets: Accessto international capital markets allows MNCs toattract funds at lower costs than purelydomestic firms.

International Diversification: Diversified cashflow sources result in more stable cash inflowsfor MNCs which may reduce the probability ofbankruptcy and therefore reduce the cost ofcapital.

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Exposure to Exchange Rate Risk: Firms thatare highly exposed to exchange rate riskmay experience greater cash inflowvolatility.

However, exposure to a basket ofcurrencieswill mitigate or eliminate such aproblem.

Exposure to Country Risks: To the extent towhich country risks are not diversifiable,increased cash inflow volatility may resultwith attendant higher cost of capital.

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Cost of Capital Across Countries:

Variations in the cost of capital across countries may help

to explain why MNCs are able to adjust their international

operations and sources of funds.

Differences in the cost of each capital component across

countries may explain why MNCs based in some

countries use more debt-intensive capital structure thanMNCs based elsewhere.

Differences in the Risk-Free Interest Rate:

The risk-free rate is frequently proxied by the yield on3-month T-bills.

The rate is determined by supply and demand conditions

in each country, tax laws, monetary policies,

demographics, and economic conditions.


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Differences in the Risk Premium:

The risk premium is affected by the relationship betweenborrowers and creditors (e.g.. Japans Keiretsu), and the

propensity of governments to intervene and rescue ailingor failing firms (compare US. to UK).

Also firms in some countries have greater borrowingcapacity because creditors are tolerant of higher degrees

of financial leverage (e.g. Japanese and German firmshave higher degrees of financial leverage than US. firms).

Country Differences in the Cost of Equity:

The cost of equity is related to investment opportunitiesin each country.

In a country with many investment opportunities,potential returns may be relatively high resulting in a

relatively high opportunity cost of funds.


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International Differences in Cost of EquityCapital Effectiveness of a ountrys Legal Institutions:Well-functioning legal systems protect

investors, reduce monitoring and enforcementcosts to investors, reduces a firms cost ofcapital by leveling the playing field among

investors. Differences in Securities Regulation:Requirement of, and enforcement of, certain

financial disclosures help to reduce asymmetricinformation between the firm and its investorsand among investors.

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Conform to the capital structure of ParentCompany.

Reflect the capitalization norm of eachforeign country

Vary to take advantage of opportunities tominimize the MNCs cost of capital.

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Some of the firm specific characteristics that

affect MNCs capital structure include:

Stability of MNCs cash flows.

MNC credit risk - a MNC with assetsacceptable

as collateral has greater access to loans.

Level of retained earnings.

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Entry and cross-border barriers to investing.

Interest rates in host countries are affectedby capital controls, tax rates & country risks.

A MNCs preference for debt or equity maydepend

on relative costs in a particular country.

Host country currency innovations. Country risks.

Relative tax laws.

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MNCs may deviate from their target capitalstructure in host countries but still able toachieve their target capital structure on aconsolidated basis.

i.e., MNCs may ignore local target capitalstructure in favor of a global target capitalstructure.

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When MNCs allow (or are forced to allow)foreign subsidiaries to issue stocks to localinvestors, such a subsidiary becomes partiallyowned by the parent.This can affect MNCs capital structure.

In some countries, a MNC will be allowed toestablish a subsidiary only if it meets theminimum percentage of ownership by localinvestors.

A minority interest in a subsidiary by localinvestors may, however, offer some protectionagainst threats of any adverse action by thehost government.

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Firms in Japan and Germany tend to use a

higher degree of financial leverage than U.S orU.K firms.

The system of interlocking ownership in Japanmay encourage a greater use of leverage.

Other International Factors Stock restrictions in host countries

Interests rates in host countries Strength of host country currencies

Country risk in host countries

Tax laws in host countries19

Cost of Capital of Mncs

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