Multinational Capital Structure and Cost of Capital

Components of Multinational Capital

• Internal Sources of Capital     * Retained Earnings: An MNC’s parent and its subsidiaries commonly generate earnings. These funds can be retained and reinvested to support existing operations or facilitate corporate expansion.     * Strategic Allocation of Retained Earnings:         1. Operating Expenses: MNCs may allow subsidiaries to retain enough earnings to cover expected near-term operating expenses denominated in the same local currency.         2. International Expansion: Earnings can be used to establish new subsidiaries in other countries, creating an equity investment using internal cash.         3. Example: Starbucks uses retained earnings for international footprint expansion.

• External Sources of Debt     * Domestic Bond Offering: MNCs frequently issue bonds in their home country, with funds denominated in their local currency.     * Global Bond Offering: MNCs simultaneously sell bonds denominated in the currencies of multiple countries.         * Example: Apple has engaged in global offerings by issuing bonds denominated in Euros ($€$) and British Pounds ($£$).     * Private Placement of Bonds: MNCs may offer bonds directly to financial institutions in the home country or the host country of expansion.     * Loans from Financial Institutions: The parent company commonly borrows directly from banks or other financial institutions.

• External Sources of Equity     * Domestic Equity Offering: Issuing stock in the home country denominated in local currency.     * Global Equity Offering: Simultaneously accessing equity markets across multiple countries.         * Example: In 2014, Alibaba conducted the largest IPO at the New York Stock Exchange (NYSE) at that time, raising $24 billion ($24 imes 10^9$).     * Private Placement of Equity: Selling equity shares directly to specific financial institutions in home or foreign markets.     * Subsidiary’s Offering of Its Own Stock: With parent approval, a foreign subsidiary may engage in a public offering of its own shares.         * Example: Toyota Financial Services issued its own stock following approval from the parent company.

Influences on the MNC’s Capital Structure Decision

• Corporate Characteristics     * Cash Flow Stability: MNCs with stable, predictable cash flows can support higher debt levels due to the constant stream of inflows available to cover periodic interest payments.     * Credit Risk: MNCs with lower credit risk benefit from greater access to credit markets.     * Access to Retained Earnings: Highly profitable MNCs may finance most investments internally, leading to an equity-intensive capital structure.     * Guarantees on Debt: If a parent company backs/guarantees a subsidiary's debt, that subsidiary’s borrowing capacity increases.     * Agency Problems: Agency costs are higher if a foreign subsidiary cannot be easily monitored by investors in the parent’s country.

• Host Country Characteristics     * Interest Rates: MNCs may favor debt in countries where the cost of loanable funds is lower.     * Strength of Host Country Currencies:         1. Expected Weakness: If an MNC expects a host currency to depreciate, it may borrow in that currency to hedge against exchange rate risk rather than relying on parent financing.         2. Expected Appreciation: If a currency is expected to strengthen, the subsidiary may choose to retain and reinvest local earnings.     * Country Risk: If there is a threat of government confiscation of assets, a subsidiary may maximize debt financing in that host country to minimize its own equity exposure.     * Tax Laws: Foreign subsidiaries may be subject to withholding taxes when remitting earnings to the parent, influencing the decision to retain earnings vs. using debt.

• Dynamic Nature of Capital Structure     * Country characteristics vary between nations and change over time.     * Consequently, the ideal capital structure for an MNC is not static; it varies among different host countries and can change within a single country as economic conditions evolve.

Interaction Between Subsidiary and Parent Capital Structure

• Relative Financing Advantages: Conditions in different countries may lead one subsidiary to favor debt while another favors equity.

• Impact of High Subsidiary Debt: Heavy reliance on debt by a subsidiary reduces its need for internal equity (retained earnings).

• Impact of Low Subsidiary Debt: Lower debt levels force a subsidiary to use more internal financing, resulting in fewer funds remitted to the parent and reducing the pool of internal funds available for the parent's use.

• Limitations in Offsetting Leverage:     * An MNC might try to offset a highly leveraged subsidiary by having the parent or another subsidiary use more equity.     * However, foreign creditors may charge higher interest rates to a highly leveraged subsidiary regardless of the parent's global position because they fear the specific subsidiary's inability to meet high debt repayments.

Multinational Cost of Capital Estimation

• Cost of Debt ($k_d$): Dependent on the interest rate paid on borrowed funds. It is calculated as:     * $\text{Cost of Debt} = \text{Risk-free rate} + \text{Credit risk premium}$

• Cost of Equity ($k_e$): The required return to compensate equity investors for their risk. It involves a risk premium above the risk-free rate. Given the lower priority in cash flow distributions compared to debt, the cost of equity is typically higher than the cost of debt.

• Weighted Average Cost of Capital (WACC): Represented by the symbol $k_c$.     * Formula:     $k_c = \left( \frac{D}{D+E} \right) k_d(1 - t) + \left( \frac{E}{D+E} \right) k_e$     * Variables:         * $D$: Amount of the firm's debt.         * $E$: Amount of the firm's equity.         * $k_d$: Before-tax cost of debt.         * $t$: Corporate tax rate.         * $k_e$: Cost of financing with equity.

• WACC Calculation Example:     * Total Assets: $100\,million$     * Debt ($D$): $20\,million$     * Equity ($E$): $80\,million$     * Before-tax cost of debt ($k_d$): $12\%$     * Cost of equity ($k_e$): $15\%$     * Tax rate ($t$): $30\%$     * Calculation:     $k_c = \frac{20}{100} \times 0.12 \times (1 - 0.30) + \frac{80}{100} \times 0.15$     $k_c = \frac{20}{100} \times 0.12 \times 0.70 + \frac{80}{100} \times 0.15 = 0.1368$

Trade-offs in Capital Structure

• The Debt Advantage: Interest payments on debt are tax-deductible, making debt generally cheaper than equity.

• Bankruptcy Risk: As the proportion of debt increases, the interest expense rises, increasing the probability that the firm will fail to meet its expenses.

• Required Returns: As debt levels (leverage) increase, both creditors and new shareholders will require higher rates of return to compensate for the increased risk of bankruptcy.

Cost of Capital Comparison: MNCs vs. Domestic Firms

• Factors Reducing MNC Cost of Capital:     * Size of Firm: Large borrowing volumes often result in preferential treatment from creditors.     * Access to International Capital Markets: MNCs can scout for the lowest cost of funds globally, whereas domestic firms are limited to local markets.     * International Diversification: Diverse global cash inflows are more stable because they aren't tied to the health of a single economy.

• Factors Increasing MNC Cost of Capital:     * Exchange Rate Risk: High exposure to fluctuating exchange rates can make cash flows more volatile than those of a domestic peer.     * Country Risk: The potential for host governments to seize assets increases the risk premium required by investors.

Cost of Equity via Capital Asset Pricing Model (CAPM)

• CAPM Formula:     $k_e = R_f + \beta \times (R_m - R_f)$     * Variables:         * $k_e$: Required return on stock (cost of equity).         * $R_f$: Risk-free rate of return.         * $R_m$: Market return.         * $\beta$: Beta of the stock (sensitivity to market returns).

• CAPM Example (Wiley, Inc.):     * Beta ($\beta$): $1.3$     * Expected Market Return ($R_m$): $11\%$     * Treasury Bill Yield ($R_f$): $2\%$     * Calculation:     $k_e = 2\% + 1.3 \times (11\% - 2\%) = 13.7\%$     $\text{Result} = 0.137$

• Implications for MNCs:     * Beta Reduction: A U.S.-based MNC may reduce its beta by increasing international operations, as foreign cash flows may be less sensitive to U.S. market conditions (Lower project betas).     * Measurement: Using a "World Market Index" may be more appropriate than a strictly domestic index for determining the betas of global MNCs.

Global Variations in Cost of Capital

• Country Differences in Cost of Debt:     * Risk-Free Rate: The rate on government loans varies by country based on perceived default risk.     * Credit Risk Premium: Must compensate creditors for specific MNC default risk within that country.     * Correlation: There is often a positive correlation in cost-of-debt levels among developed markets over time.

• Country Differences in Cost of Equity:     * Risk-Free Rate Correlation: If local risk-free rates are high, equity investors demand significantly higher returns to justify the risk over safe investments.     * Equity Risk Premium: Influenced by local investment opportunities and country-specific risks.