1. © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. International Financial Management Abridged 10 th Edition by Jeff Madura 1

2. © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2 17 Multinational Cost of Capital and Capital Structure Chapter Objectives This chapter will: A.Explain why the cost of capital of MNCs differs from that of domestic firms B.Explain why there are differences in the costs of capital among countries C.Explain how to account for the cost of capital when assessing new international projects D.Explain how corporate and country characteristics are considered by an MNC when it establishes its capital structure E.Explain the interaction between subsidiary and parent financing decisions 2

3. © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 Background on Cost of Capital 1.Equity: a.Cost of retained earnings: opportunity cost of what the existing shareholders could have earned if they had received dividends. b.Cost of new common equity: opportunity cost of what the existing shareholders could have earned if they had invested their funds elsewhere 2.Debt: a.Advantage: interest payments are tax deductible b.Disadvantage: higher interest expense could lead to higher probability that the firm will be unable to meet expenses.

4. © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4 Comparing the Costs of Equity and Debt where k c weighted average cost of capital D amount of the firm’s debt k d before-tax cost of its debt t corporate tax rate E firm’s equity k e cost of financing with equity 4

5. © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5 Domestic versus MNC Cost of Capital Cost of capital for MNC may differ because of: 1.Size of firm 2.Access to international capital markets 3.International diversification 4.Exposure to exchange rate risk 5.Exposure to country risk

6. © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 6 Exhibit 17.1 Searching for the Appropriate Capital Structure 6

7. © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 7 Exhibit 17.2 Summary of Factors That Cause the Cost of Capital of MNCs to Differ From That of Domestic Firms 7

8. © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 8 Cost of Equity Comparison Using the CAPM k e = R f + B(R m – R f ) Where k e = required return on stock R f = risk-free rate of return R m = market return B = beta of stock

9. © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 9 The CAPM 1.The CAPM suggests that required return is a positive function of: a.The risk-free rate of interest b.The market rate of return c.The stock’s beta 2.Implications of the CAPM for an MNC’s risk: a.MNC may have lower cost of capital than domestic firms b.If financial markets are segmented, then MNC offer diversification benefits

10. © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 10 Costs of Capital Across Countries 1.Country differences in the cost of debt a.Differences in the risk-free rate b.Differences in the risk premium c.Comparative costs of debt across countries 2.Country differences in the cost of equity a.Impact of the Euro 3.Combining the costs of debt and equity 4.Estimating the cost of debt and equity

11. © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 11 Cost of Capital of Foreign Projects 1.Derive NPV based on the WACC 2.Adjust the WACC for the risk differential 3.Derive the Net Present Value of the Equity Investment

12. © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 12 Net Present Value Considerations 1.Relationship between NPV and capital structure 2.Tradeoff when financing in developing countries 3.Accounting for multiple periods 4.Comparing alternative debt compositions 5.Assessing alternative exchange rate scenarios 6.Considering foreign stock ownership

13. © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 13 The MNC’s Capital Structure Decision: Influence of Corporate Characteristics 1.Stability of MNC’s cash flows 2.MNC’s credit risk 3.MNC’s access to retained earnings 4.MNC’s guarantees on debt 5.MNC’s agency problems

14. © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 14 The MNC’s Capital Structure Decision: Influence of Country Characteristics 1.Stock restrictions in host countries 2.Stock valuation in host countries 3.Interest rates in host countries 4.Strength of host countries 5.Strength of host country currencies 6.Country risk in host countries 7.Tax laws in host countries

15. © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 15 Revising the Capital Structure MNC may revise capital structure based on: 1.Discontinued business operations 2.Tax reductions in home country 3.Interest rates in foreign country increase 4.Interest rates in foreign country decrease 5.Political risk increases

16. © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 16 Subsidiary versus Parent Capital Financing 1.Impact of subsidiary debt financing 2.Impact of reduced subsidiary debt financing 3.Limitations in offsetting a subsidiary’s leverage 4.Factors that affect subsidiary financing decisions

17. © 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 17 Exhibit 17.7 Effect of Global Conditions on Financing