Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-1 Chapter 17 Multinational Capital Structure and Cost of Capital 17.1Capital Structure and the Cost of Capital 17.2Project Valuation and the Cost of Capital 17.3Sources of Funds for Multinational Operations 17.4The International Evidence on Capital Structure 17.5The Cost of Capital on Multinational Operations 17.6Summary

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-2 Capital structure F 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. F 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 opportunities

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-4 The weighted average cost of capital i WACC = (B/V)i B (1  T C )+(S/V)i S

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-5 The multinational’s cost of capital (given a particular set of investments)

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-6 Optimal 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 assumptions F 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 proposition F Equal access to perfect financial markets means that individual investors can replicate any financial action that the firm can take. F 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 MM’s irrelevance proposition F 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.

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e Financial market integration vs. segmentation Financial market integration vs. segmentation F In integrated financial markets, real after-tax rates of return on equivalent assets are equal. F 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 Project valuation and the cost of capital Project valuation and the cost of capital F Alternative approaches to project valuation »WACC: Weighted average cost of capital »APV: Adjusted present value F 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 Weighted average cost of capital (WACC) Weighted average cost of capital (WACC) NPV =  t [ E[CF t ] / (1+i WACC ) t ] where i WACC = [(B/V L ) i B (1-T C )] + [(S/V L )i S ] and B= the market value of corporate bonds S= the market value of corporate stock V L = B + S = the market value of the firm i B = the required return on corporate bonds i S = the required return on corporate stock T C = the marginal corporate income tax rate

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e Adjusted present value (APV) Adjusted present value (APV) APV = V U + PV(financing side effects) - initial investment whereV U =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 Sources of funds for multinational operations F The financial pecking order: »Internally generated funds are the preferred source. »External sources of funds are accessed only after internal sources are exhausted. u External debt is the preferred external funding source. u New external equity is used only as a last resort.

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e Sources of funds for multinational operations

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e Targeted registered offerings F 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. F 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 The U.S. evidence on capital structure F Leverage increases with »Fixed assets »Firm size »Nondebt tax shields F 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 Balance sheets for nonfinancial firms

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e The international evidence on capital structure F Leverage increases with »The proportion of fixed to total assets »Firm size F Leverage decreases with »Asset market-to-book ratios (~ growth opportunities) »Profitability

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e Diversifiable versus nondiversifiable risks and the multinational’s cost of capital F If operating risks are diversifiable, then they are not priced by investors and should not be reflected in capital costs. F 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 The multinational corporation’s cost of capital F Mixed empirical evidence »MNCs have lower betas despite higher financial leverage Michel and Shaked, “Multinational Corporations vs. Domestic Corporations: Financial Performance and Characteristics,” Journal of International Business Studies, Fall »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 The effect of financial market liberalizations on the cost of capital F 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.