The document discusses the capital structure decisions of multinational firms (MNCs). It explains that MNCs consider both corporate characteristics, such as cash flow stability and access to retained earnings, and country characteristics, such as interest rates and tax laws, when determining the capital structure of their subsidiaries. The overall capital structure of an MNC combines the structures of the parent company and its subsidiaries. A subsidiary's debt financing decisions can impact the level of internal funds available to the parent company.

1. THE STRUCTURE OF THE
MULTINATIONAL FIRM AND ITS
COST OF CAPITAL

2. Chapter ObjectivesChapter Objectives
 To explain the Reasons for the Growth of MNCsTo explain the Reasons for the Growth of MNCs
 To explain how corporate and country characteristicsTo explain how corporate and country characteristics
influence an MNCinfluence an MNC’’s cost of capital;s cost of capital;
 To explain why there are differences in the costs ofTo explain why there are differences in the costs of
capital across countries; andcapital across countries; and
 To explain how corporate and country characteristicsTo explain how corporate and country characteristics
are considered by an MNC when it establishes itsare considered by an MNC when it establishes its
capital structure.capital structure.

3. Real and Financial SectorsReal and Financial Sectors
 Real Sector: Production and sale of goods andReal Sector: Production and sale of goods and
services; acquisition and divestiture of capitalservices; acquisition and divestiture of capital
assets.assets.
 Financial Sector: Transactions in financialFinancial Sector: Transactions in financial
assets: currency, bank deposits, bonds, stocks,assets: currency, bank deposits, bonds, stocks,
futures and options, etc.futures and options, etc.

4. International Economic IntegrationInternational Economic Integration
 International economic integration refers to theInternational economic integration refers to the
extent and strength of real- sector and financial-extent and strength of real- sector and financial-
sector linkages among national economies.sector linkages among national economies.
Real-sector linkages occur through theReal-sector linkages occur through the
international transactions in goods and servicesinternational transactions in goods and services
while the financial-sector linkages occur throughwhile the financial-sector linkages occur through
international transactions in financial assets.international transactions in financial assets.

5. The Rise of Multinational FirmsThe Rise of Multinational Firms
 Changes our definition of comparative AdvantageChanges our definition of comparative Advantage
 Relative value-added -- product development, design,Relative value-added -- product development, design,
logistics, assembly, marketing -- depends less on nationallogistics, assembly, marketing -- depends less on national
differences and more on firm-specific competencies anddifferences and more on firm-specific competencies and
investments, although these latter reflect national differencesinvestments, although these latter reflect national differences
in factor endowmentsin factor endowments
 The range of a nationThe range of a nation’’s exports is equivalent to the range ofs exports is equivalent to the range of
its exportsits exports
 Comparative Advantage in a world of multinationalsComparative Advantage in a world of multinationals
 Most cross-border trade involves intermediate products, much of itMost cross-border trade involves intermediate products, much of it
takes place within the boundaries of a single firm (a single Barbie dolltakes place within the boundaries of a single firm (a single Barbie doll
is made in 12 countries)is made in 12 countries)

6.  A multinational that is going to do a business inA multinational that is going to do a business in
4countries what are the models that the4countries what are the models that the
company may uses to establish some businesscompany may uses to establish some business
forms to do its business?forms to do its business?

7. 1st Alternative1st Alternative
 They may form a company which is a holding companyThey may form a company which is a holding company
in 1 country that performs I. & Financial activities forin 1 country that performs I. & Financial activities for
their subsidiaries.their subsidiaries.
 In fact, multinational affiliates are legally distinct,In fact, multinational affiliates are legally distinct,
entities, the capital structure decision of these affiliatesentities, the capital structure decision of these affiliates
cannot be considered separately from the capitalcannot be considered separately from the capital
structure decision of their parents.structure decision of their parents.
 The capital structure of the affiliates vary according toThe capital structure of the affiliates vary according to
the relative prices of distinct financing instruments inthe relative prices of distinct financing instruments in
different locations, the affiliates take advantage ofdifferent locations, the affiliates take advantage of
opportunities to minimise the cost of capital.opportunities to minimise the cost of capital.

8. BenefitsBenefits
Control over the subsidiaries.Control over the subsidiaries.
Access to local financeAccess to local finance
Reduce of cost of capitalReduce of cost of capital

9. Diversification reducesDiversification reduces
unsystematic risk.unsystematic risk.

11. Cost of CapitalCost of Capital
 A firmA firm’’ss capitalcapital consists ofconsists of equityequity (retained(retained
earnings and funds obtained by issuing stock)earnings and funds obtained by issuing stock)
andand debtdebt (borrowed funds).(borrowed funds).
 The cost of equity reflects an opportunity cost,The cost of equity reflects an opportunity cost,
while the cost of debt is reflected in interestwhile the cost of debt is reflected in interest
expenses.expenses.
 Firms want a capital structure that will minimizeFirms want a capital structure that will minimize
their cost of capital, and hence the required ratetheir cost of capital, and hence the required rate
of return on projects.of return on projects.

12. Cost of Capital for MNCsCost of Capital for MNCs
 The cost of capital for MNCs may differ fromThe cost of capital for MNCs may differ from
that for domestic firms because of the followingthat for domestic firms because of the following
differences.differences.
Size of Firm.Size of Firm. Because of their size, MNCs areBecause of their size, MNCs are
often given preferential treatment by creditors.often given preferential treatment by creditors.
They can usually achieve smaller per unitThey can usually achieve smaller per unit
flotation costs too.flotation costs too.

13. Acess to International Capital Markets.Acess to International Capital Markets. MNCs areMNCs are
normally able to obtain funds throughnormally able to obtain funds through
international capital markets, where the cost ofinternational capital markets, where the cost of
funds may be lower.funds may be lower.
International Diversification.International Diversification. MMNCs may have moreNCs may have more
stable cash inflows due to internationalstable cash inflows due to international
diversification, such that their probability ofdiversification, such that their probability of
bankruptcy may be lower.bankruptcy may be lower.
Cost of Capital for MNCsCost of Capital for MNCs

14. Exposure to Exchange Rate Risk.Exposure to Exchange Rate Risk. MNCs may beMNCs may be
more exposed to exchange rate fluctuations,more exposed to exchange rate fluctuations,
such that their cash flows may be moresuch that their cash flows may be more
uncertain and their probability of bankruptcyuncertain and their probability of bankruptcy
higher.higher.
Exposure to Country Risk.Exposure to Country Risk. MMNCs that have aNCs that have a
higher percentage of assets invested in foreignhigher percentage of assets invested in foreign
countries are more exposed to country risk.countries are more exposed to country risk.
Cost of Capital for MNCsCost of Capital for MNCs

15.  The capital asset pricing model (CAPM) can beThe capital asset pricing model (CAPM) can be
used to assess how the required rates of returnused to assess how the required rates of return
of MNCs differ from those of purely domesticof MNCs differ from those of purely domestic
firms.firms.
 According to CAPM,According to CAPM, kkee == RRff ++ ββ ((RRmm –– RRff))
wherewhere kkee == the required return on a stockthe required return on a stock
RRff == risk-free rate of returnrisk-free rate of return
RRmm == market returnmarket return
ββ == the beta of the stockthe beta of the stock
Cost of Capital for MNCsCost of Capital for MNCs

16.  A stockA stock’’s beta represents the sensitivity of thes beta represents the sensitivity of the
stockstock’’s returns to market returns, just as as returns to market returns, just as a
projectproject’’s beta represents the sensitivity of thes beta represents the sensitivity of the
projectproject’’s cash flows to market conditions.s cash flows to market conditions.
 The lower a projectThe lower a project’’s beta, the lower itss beta, the lower its
systematic risk, and the lower its required rate ofsystematic risk, and the lower its required rate of
return, if its unsystematic risk can be diversifiedreturn, if its unsystematic risk can be diversified
away.away.
Cost of Capital for MNCsCost of Capital for MNCs

17.  An MNC that increases its foreign sales may beAn MNC that increases its foreign sales may be
able to reduce its stockable to reduce its stock’’s beta, and hence thes beta, and hence the
return required by investors. This translates intoreturn required by investors. This translates into
a lower overall cost of capital.a lower overall cost of capital.
 However, MNCs may consider unsystematic riskHowever, MNCs may consider unsystematic risk
as an important factor when determining aas an important factor when determining a
foreign projectforeign project’’s required rate of return.s required rate of return.
Cost of Capital for MNCsCost of Capital for MNCs

18. Costs of Capital Across CountriesCosts of Capital Across Countries
 The cost of capital may vary across countries,The cost of capital may vary across countries,
such that:such that:
 MNCs based in some countries may have aMNCs based in some countries may have a
competitive advantage over others;competitive advantage over others;
 MNCs may be able to adjust their internationalMNCs may be able to adjust their international
operations and sources of funds to capitalize on theoperations and sources of funds to capitalize on the
differences; anddifferences; and
 MNCs based in some countries may have a moreMNCs based in some countries may have a more
debt-intensive capital structure.debt-intensive capital structure.

19. Costs of Capital Across CountriesCosts of Capital Across Countries
 The cost of debt to a firm is primarilyThe cost of debt to a firm is primarily
determined bydetermined by  the prevailing risk-free interestthe prevailing risk-free interest
rate of the borrowed currency andrate of the borrowed currency and  the riskthe risk
premium required by creditors.premium required by creditors.
 The risk-free rate is determined by theThe risk-free rate is determined by the
interaction of the supply and demand for funds.interaction of the supply and demand for funds.
It may vary due to different tax laws,It may vary due to different tax laws,
demographics, monetary policies, and economicdemographics, monetary policies, and economic
conditions.conditions.

20. Costs of Capital Across CountriesCosts of Capital Across Countries
 The risk premium compensates creditors for theThe risk premium compensates creditors for the
risk that the borrower may be unable to meet itsrisk that the borrower may be unable to meet its
payment obligations.payment obligations.
 The risk premium may vary due to differentThe risk premium may vary due to different
economic conditions, relationships betweeneconomic conditions, relationships between
corporations and creditors, governmentcorporations and creditors, government
intervention, and degrees of financial leverage.intervention, and degrees of financial leverage.

21. Costs of Capital Across CountriesCosts of Capital Across Countries
 Although the cost of debt may vary acrossAlthough the cost of debt may vary across
countries, there is some positive correlationcountries, there is some positive correlation
among country cost-of-debt levels over time.among country cost-of-debt levels over time.

22. Using the Cost of CapitalUsing the Cost of Capital
for Assessing Foreign Projectsfor Assessing Foreign Projects
 Foreign projects may have risk levels differentForeign projects may have risk levels different
from that of the MNC, such that the MNCfrom that of the MNC, such that the MNC’’ss
weighted average cost of capital (WACC) mayweighted average cost of capital (WACC) may
not be the appropriate required rate of return.not be the appropriate required rate of return.
 There are various ways to account for this riskThere are various ways to account for this risk
differential in the capital budgeting process.differential in the capital budgeting process.

23. Using the Cost of CapitalUsing the Cost of Capital
for Assessing Foreign Projectsfor Assessing Foreign Projects
Derive NPVs based on the WACC.Derive NPVs based on the WACC.
 The probability distribution of NPVs can beThe probability distribution of NPVs can be
computed to determine the probability that thecomputed to determine the probability that the
foreign project will generate a return that is at leastforeign project will generate a return that is at least
equal to the firmequal to the firm’’s WACC.s WACC.
Adjust the WACC for the risk differential.Adjust the WACC for the risk differential.
 The MNC may estimate the cost of equity and theThe MNC may estimate the cost of equity and the
after-tax cost of debt of the funds needed to financeafter-tax cost of debt of the funds needed to finance
the project.the project.

24. The MNCThe MNC’’ss
Capital Structure DecisionCapital Structure Decision
 The overall capital structure of an MNC isThe overall capital structure of an MNC is
essentially a combination of the capitalessentially a combination of the capital
structures of the parent body and itsstructures of the parent body and its
subsidiaries.subsidiaries.
 The capital structure decision involves theThe capital structure decision involves the
choice of debt versus equity financing, and ischoice of debt versus equity financing, and is
influenced by both corporate and countryinfluenced by both corporate and country
characteristics.characteristics.

25. The MNCThe MNC’’ss
Capital Structure DecisionCapital Structure Decision
Corporate CharacteristicsCorporate Characteristics
 Stability of cash flows.Stability of cash flows. MNCs with more stable cashMNCs with more stable cash
flows can handle more debt.flows can handle more debt.
 Credit risk.Credit risk. MNCs that have lower credit riskMNCs that have lower credit risk
have more access to credit.have more access to credit.
 Access to retained earnings.Access to retained earnings. Profitable MNCs andProfitable MNCs and
MNCs with less growth may be able to financeMNCs with less growth may be able to finance
most of their investment with retained earnings.most of their investment with retained earnings.

26. The MNCThe MNC’’ss
Capital Structure DecisionCapital Structure Decision
 Agency problems.Agency problems. Host country shareholders mayHost country shareholders may
monitor a subsidiary, though not from themonitor a subsidiary, though not from the
parentparent’’s perspective.s perspective.
 Guarantees on debt.Guarantees on debt. If the parent backs theIf the parent backs the
subsidiarysubsidiary’’s debt, the subsidiary may be ables debt, the subsidiary may be able
to borrow more.to borrow more.
Corporate CharacteristicsCorporate Characteristics

27. Country CharacteristicsCountry Characteristics
 Stock restrictions.Stock restrictions. MNCs in countries whereMNCs in countries where
investors have less investment opportunitiesinvestors have less investment opportunities
may be able to raise equity at a lower cost.may be able to raise equity at a lower cost.
 Interest rates.Interest rates. MNCs may be able to obtainMNCs may be able to obtain
loanable funds (debt) at a lower cost in someloanable funds (debt) at a lower cost in some
countries.countries.
The MNCThe MNC’’ss
Capital Structure DecisionCapital Structure Decision

28.  Country risk.Country risk. If the host government is likely toIf the host government is likely to
block funds or confiscate assets, the subsidiaryblock funds or confiscate assets, the subsidiary
may prefer debt financing.may prefer debt financing.
The MNCThe MNC’’ss
Capital Structure DecisionCapital Structure Decision
 Strength of currencies.Strength of currencies. MNCs tend to borrow theMNCs tend to borrow the
host country currency if they expect it tohost country currency if they expect it to
weaken, so as to reduce their exposure toweaken, so as to reduce their exposure to
exchange rate risk.exchange rate risk.
Country CharacteristicsCountry Characteristics

29.  Tax laws.Tax laws. MNCs may use more local debtMNCs may use more local debt
financing if the local tax rates (corporate tax rate,financing if the local tax rates (corporate tax rate,
withholding tax rate, etc.) are higher.withholding tax rate, etc.) are higher.
The MNCThe MNC’’ss
Capital Structure DecisionCapital Structure Decision
Country CharacteristicsCountry Characteristics

30. Interaction Between SubsidiaryInteraction Between Subsidiary
and Parent Financing Decisionsand Parent Financing Decisions
Increased debt financing by the subsidiaryIncreased debt financing by the subsidiary
⇒A larger amount of internal funds may beA larger amount of internal funds may be
available to the parent.available to the parent.
⇒The need for debt financing by the parent mayThe need for debt financing by the parent may
be reduced.be reduced.
 The revised composition of debt financing mayThe revised composition of debt financing may
affect the interest charged on debt as well as theaffect the interest charged on debt as well as the
MNCMNC’’s overall exposure to exchange rate risk.s overall exposure to exchange rate risk.

31. Interaction Between SubsidiaryInteraction Between Subsidiary
and Parent Financing Decisionsand Parent Financing Decisions
Reduced debt financing by the subsidiaryReduced debt financing by the subsidiary
⇒A smaller amount of internal funds may beA smaller amount of internal funds may be
available to the parent.available to the parent.
⇒The need for debt financing by the parent mayThe need for debt financing by the parent may
be increased.be increased.
 The revised composition of debt financing mayThe revised composition of debt financing may
affect the interest charged on debt as well as theaffect the interest charged on debt as well as the
MNCMNC’’s overall exposure to exchange rate risk.s overall exposure to exchange rate risk.

32. FOREXFOREX

33.  It is not a physical exchange but a globalIt is not a physical exchange but a global
telecommunications market.telecommunications market.
 It is the worldIt is the world’’s largest financial market withs largest financial market with
transactions volume more than $2,500 billiontransactions volume more than $2,500 billion
per day!per day!

34.  If a company is operating in different countriesIf a company is operating in different countries
when it produces in a country A and the totalwhen it produces in a country A and the total
cost for a unit of its product is 10$, it can sell incost for a unit of its product is 10$, it can sell in
country B by Euro, therefore the company facescountry B by Euro, therefore the company faces
Currency Exchange Risk.Currency Exchange Risk.
 These companies need to hedge the currencyThese companies need to hedge the currency
Risk.Risk.
 Hedging:Hedging: is protecting the position from theis protecting the position from the
unexpected price moves..unexpected price moves..

35. Public Tender form different entitiesPublic Tender form different entities
for a planfor a plan
 Alternative 1: 2buy the needed currency thatAlternative 1: 2buy the needed currency that
covers the plan price just after accepting thecovers the plan price just after accepting the
offer.offer.
 Alternative 2: Take the currency riskAlternative 2: Take the currency risk
 Alternative 3: Hedge the risk by buying aAlternative 3: Hedge the risk by buying a
future contracts, that ll allow to buy thefuture contracts, that ll allow to buy the
required currency on predeterminedrequired currency on predetermined
exchange rate for a future date.exchange rate for a future date.

36. Hedging the RiskHedging the Risk
 Take the form of fixing the exchange rateTake the form of fixing the exchange rate
by having any contracts such as:by having any contracts such as:
 Options contractsOptions contracts
 Future ContractsFuture Contracts
 Forward ContractsForward Contracts
 SWAPSSWAPS

37. Thank YouThank You