Chapter 17: MNC Capital Structure and Cost of Capital

What are the key components of an MNC's capital?

An MNC's capital can be increased internally through retained earnings or externally through debt or equity.

How can retained earnings be used by an MNC?

Retained earnings can cover expected operating expenses or be reinvested to expand operations, such as establishing new subsidiaries.

What is a domestic bond offering?

A domestic bond offering is when an MNC issues bonds in its home country, denominated in its local currency.

What is a global bond offering?

A global bond offering involves selling bonds denominated in multiple currencies simultaneously.

What is a private placement of bonds?

A private placement of bonds is when an MNC offers bonds to financial institutions either in its home country or in the foreign country where it is expanding.

What are the sources of equity for an MNC?

Sources of equity include domestic equity offerings, global equity offerings, private placements, and subsidiary stock offerings.

What influences an MNC's capital structure decision?

Factors include cash flow stability, credit risk, access to retained earnings, guarantees on debt, and agency problems.

How does cash flow stability affect an MNC's capital structure?

MNCs with stable cash flows can handle more debt due to a consistent stream of cash inflows for interest payments.

What is the impact of credit risk on an MNC's financing?

MNCs with lower credit risk have better access to credit markets.

How can an MNC's guarantees on debt influence its subsidiaries?

If the parent company backs a subsidiary's debt, it can increase the subsidiary's borrowing capacity.

What role do host country characteristics play in an MNC's capital structure?

Host country characteristics such as interest rates, currency strength, country risk, and tax laws can significantly influence financing decisions.

How do interest rates in host countries affect MNC financing?

Lower interest rates in host countries can reduce the cost of loanable funds for MNCs.

What is the significance of currency strength for an MNC's subsidiaries?

If a subsidiary's local currency is expected to weaken, the MNC may borrow in that currency instead of relying on parent financing.

What is country risk in the context of MNC financing?

Country risk refers to the risk that a host government might confiscate an MNC's assets, influencing the use of debt financing.

What tax considerations do foreign subsidiaries face?

Foreign subsidiaries may be subject to withholding taxes when remitting earnings back to the parent company.

What is a global equity offering?

A global equity offering allows an MNC to access equity from multiple countries simultaneously.

What is the role of agency problems in an MNC's capital structure?

Agency problems arise when a subsidiary in a foreign country is difficult to monitor, potentially increasing agency costs.

How can retained earnings be reinvested by an MNC?

Retained earnings can be reinvested to support existing operations or to fund new projects, such as international expansion.

What is the benefit of a subsidiary's offering of its own stock?

A subsidiary can raise capital by offering its own stock, provided it has the parent company's approval.

What is the significance of domestic equity offerings?

Domestic equity offerings allow MNCs to raise capital in their home market using local currency.

What factors can lead to an MNC using an equity-intensive capital structure?

Highly profitable MNCs may finance most investments with retained earnings, leading to an equity-intensive capital structure.

What is the purpose of loans from financial institutions for MNCs?

MNCs often borrow funds from financial institutions to finance their operations and expansion.

What is the relationship between cash inflows and operating expenses for subsidiaries?

Subsidiaries may retain earnings to cover expected operating expenses in the same currency as their cash inflows.

What factors can influence a country's ideal capital structure?

Country characteristics that vary among countries and change over time.

How does increased subsidiary debt financing affect internal equity financing?

It reduces the need for internal equity financing (retained earnings).

What is the impact of reduced subsidiary debt financing?

The subsidiary will need more internal financing, remit fewer funds to the parent, and reduce internal funds available to the parent.

Why might foreign creditors charge higher loan rates to a subsidiary?

Because they believe the subsidiary may be unable to meet its high debt repayments due to a highly leveraged local capital structure.

What is the cost of debt for a multinational corporation (MNC) dependent on?

The interest rate it pays when borrowing funds, which includes the risk-free rate and a credit risk premium.

How does an MNC create equity?

By retaining earnings or issuing new stock.

What is the relationship between the cost of equity and the cost of debt?

The cost of equity is typically higher than the cost of debt due to the priority of cash flow payments.

What is the formula for estimating an MNC's cost of capital?

Kc = (D/V) * kd * (1 - t) + (E/V) * ke

What does 'Kc' represent in the cost of capital formula?

The weighted average cost of capital.

What are the components of the cost of capital formula?

D: amount of debt, kd: before-tax cost of debt, t: corporate tax rate, E: equity, ke: cost of financing with equity.

What advantage does using debt have over equity for MNCs?

Interest payments on debt are tax-deductible.

What is a potential downside of increasing debt for an MNC?

Higher interest expenses and increased probability of bankruptcy.

How can the size of an MNC affect its cost of capital?

Larger MNCs may receive preferential treatment from creditors, reducing their cost of capital.

What advantage does access to international capital markets provide to MNCs?

It may allow MNCs to obtain funds at a lower cost than domestic firms.

How does international diversification impact an MNC's cash inflows?

It stabilizes cash inflows as total sales are less influenced by a single economy.

What risk might an MNC face due to exposure to exchange rate fluctuations?

Cash flows could be more volatile compared to domestic firms.

What is a potential risk for MNCs with foreign subsidiaries?

The possibility of host country governments seizing a subsidiary's assets.

What is the effect of increased debt on the required rate of return for shareholders?

It increases the required rate of return due to higher bankruptcy risk.

What does CAPM stand for?

Capital Asset Pricing Model

What is the formula for calculating the required return on stock (Ke) using CAPM?

Ke = Ff + B(Um - ra)

What does the variable 'Ff' represent in the CAPM formula?

The risk-free rate of return

What does ‘Kc' represent in the CAPM formula?

The market return

What is the significance of 'B' in the CAPM formula?

B is the beta of the stock, indicating its volatility relative to the market.

How do U.S.-based MNCs potentially reduce their beta according to the CAPM implications?

By increasing their international business.

What is the relationship between a U.S.-based MNC's projects and general U.S. market conditions?

Their cash flows are less sensitive to U.S. market conditions, leading to lower project betas.

Why might a world market index be more appropriate than a U.S. market for determining betas of U.S.-based MNCs?

Because many projects are located in foreign countries.

What are the two main factors influencing differences in the cost of debt across countries?

Differences in the risk-free rate and the credit risk premium.

What does the risk-free rate represent?

The interest rate charged on loans to a government perceived to have no risk of default.

What is the equity risk premium?

The additional return required by investors to hold equity over the risk-free rate.

What factors influence the equity risk premium in a country?

Investment opportunities and country risk.

What components constitute an MNC's capital?

Debt and equity.

How can MNCs access debt?

Through domestic debt offerings, global debt offerings, private placements, and loans.

What external factors can influence an MNC's capital structure?

Interest rates, currency strength, country risk, and tax laws.

What happens if an MNC's subsidiary's financial leverage deviates from the global target?

The MNC can achieve the target if another subsidiary or the parent takes an offsetting position.

Why might the cost of capital be lower for an MNC than for a domestic firm?

Due to size, access to international capital markets, and international diversification.

What can increase an MNC's cost of capital?

Exposure to exchange rate risk and country risk.

What is the correlation between country risk-free rates and costs of capital?

Countries with higher risk-free rates tend to have higher costs of capital.

What is the implication of a high risk-free rate on equity investment?

Investors require a higher potential return to invest in equity.