Naheda Halawa

139119244

ITM 300.1.01

Cost of Capital for Multinational Companies Compared to Domestic Firms

Abstract:

The purpose of this project is to establish a clear distinction between the cost of capital in global

corporations and local corporations. additionally, the cost structure of both firms, as well as

highlighting the hazards that each type of corporation may face. Because of the added cultural,

political, and financial risks of foreign investments, the total nation risk of foreign investment is

higher than that of identical domestic ventures. As a result, risks increase the unpredictability of

returns on foreign investment, which is typical of the multinational company's harm. The size of

capital market segmentation and how extensively the firm's investments are locally or

internationally diversified will determine how much international diversification reduces the

effect of country-specific and currency-specific risks. MNCs, by virtue of their varied activities,

are in a better position to lower their cost of capital than domestic enterprises, because a

corporation with cash inflows from several sources throughout the world has relative higher

stability because total sales are not impacted by a single economy. Because the firm's cash flow

is less volatile, it can tolerate a greater debt ratio, which lowers the cost of capital.

Keywords: Capital structure, Foreign Investment, Currency-specific risk, International

diversification.
The goal of the Project

The project's major goal is to identify the unique characteristics of an MNC in terms of the cost

of capital and compare them to the cost of capital for local enterprises. Describe the method of

calculating the cut-off rate for international project assessment, as well as how it affects

multinational and local corporations. last, to investigate the factors that influence the cost of

capital in different nations and how it affects domestic and global firms.

Introduction.

In the past two decades, the world has witnessed tremendous economic, financial, and

commercial developments and changes. Soon after as these developments and variables were

clearly manifested in the internationalization of companies and the development of cross-border

participating companies and the increase in the number of multinational companies, the

expansion of the volume of exchanges trade, additionally the expansion of the volume of

international cash flows that accompany the flows of goods and services, the diversification of

sources of financing used in foreign direct investment and other international business,

furthermore the spread of the phenomenon of globalization in the field of financial markets, the

adoption of fluctuating or floating exchange rates and increasing financial risks is a result of

contemporary financial crises. As a result of these developments and changes, the financial

management had to move from its concepts, objectives and traditional methods as a function of

local companies specialized in organizing the flow of funds, coordination, planning, and control,

to a concept-based international financial management and modern methods derived from the

reality of international environmental conditions, developments, and variables. Often the tasks of

the international financial management are to carry out financial coordination between the parent

companies and their branches abroad and then take financial decisions regarding the operations
of financing branches abroad. International project financing operations, determining the cost of

capital and the financial structure of companies, and taking financial decisions related to

investing money as an effective economic investment, whether in existing projects

for the purposes of its expansion or in new projects, and to take short-term financial decisions.

There are some systems, rules, and procedural methods that are required for international

financial management in multinational companies to interact with them in order to achieve their

financial, economic, and social goals. The cost of capital is a company's computation of the

minimal return required to justify a capital budgeting project, such as the construction of a new

company. Analysts and investors use the term "cost of capital," but it always refers to a

calculation of whether the expense of a proposed choice can be justified. To finance business

development, many organizations utilize a combination of loans and equity. The weighted

average cost of all capital sources is used to calculate the total cost of capital for such businesses.

The cost of capital of a company is primarily used to assess investment opportunities. It denotes

the lowest rate of return on new investments that is acceptable. The degree of risk connected

with the business, the taxes it must pay, and the availability and demand of various sources of

financing are the primary elements driving the cost of capital for a firm. MNCs are able to

receive funding at cheaper costs than local enterprises due to better access to foreign capital

markets. Furthermore, MNCs can retain the target percentage even if very huge sums are

necessary due to worldwide availability. In the case of domestic businesses, however, this is not

the case. They must either rely on domestically produced cash or borrow from commercial banks

for the short and medium-term. Furthermore, if the prevailing interest rates in the host nation are

quite low, subsidiaries may be able to get money locally at a cheaper cost than the parent

business.
Discussion and findings

Firstly, a company's ability to react to national and local market conditions improves when it

takes decisions concerning international operations that boost national and local responsiveness.

The greater the amount of standardization, both inside and across markets, the higher the level of

global efficiency that may be achieved. In many circumstances, choosing a foreign site results in

distinct benefits known as location advantages. Better access to raw materials, less expensive

labor, important suppliers, key customers, energy, and natural resources are all advantages of

location. Operating in more than one country might have a variety of consequences for a

company's financial decisions. Most crucially, being international appears to have an impact on

both the cost of borrowing and access to capital for businesses during difficult economic times.

Multinational enterprises have greater flexibility in their possible sources of financing than local

firms, which is one of the main reasons for their financial advantages. In theory, any company

might borrow money from any bank around the globe or issue stock or debt in any nation. For a

variety of reasons, however, it is typically considerably more cost-effective for businesses to

obtain money in the places where they operate. The multinational firm is supposed to finance its

overseas subsidies in such a way that its incremental weighted cost of capital is kept as low as

possible. This value will be considered to be the same as the domestic firm's marginal cost of

capital. Because of their improved access to global capital markets and risk diversification across

nations, financial theory predicts that multinational businesses and multinational companies

should have a lower cost of capital and a greater leverage level than domestic corporations.

However, empirical data suggests that the answer is dependent on factors such as capital market

growth, institutional framework, and political stability in the MNCs' home and host countries.

While this holds for MNCs headquartered in emerging nations, it does not hold for US MNCs
expanding into less secure economies. In the 1990s, greater globalization of the product and

capital markets lessened the cost of the capital difference between MNCs and DCs, and this trend

is expected to continue. Over and above that, Different nations' tax policies differ in terms of tax

rates, exemptions, and incentives, impacting the availability of money to the business sector and

consequently the interest rate in different ways. Because of allowances for depreciation and

investment tax credits, corporate demand for capital may fluctuate, and as a result, interest rates

may shift. The Central Bank of a country's monetary policy has a direct impact on the interest

rate at which MNCs can borrow capital. The central bank will hike the bank rate, and hence the

interest rate, as part of its tight monetary policy to combat inflationary tendencies in the country.

The demand and supply of money, and hence the interest rate, are influenced by a country's

demographic situation. A country with a younger population will have a higher interest rate due

to the fact that young people are less frugal and require more money to meet their various

requirements. Interest rates vary per country due to various degrees of economic growth. As a

result, interest rates on debt are usually lower in comparably advanced countries, as well as

highly developed and integrated financial systems.

Capital investment decisions are long-term decisions aimed at financing companies according to

their fixed assets and capital structure. Those decisions depend on many criteria. Corporate

management aims to enhance the value of the company by investing in projects that positively

generate a net present value when valued using an appropriate discount rate. These projects must

also be adequately funded. Long-term decisions and methods, and short-term decisions and

methods. Capital investment decisions are long-term choices through which projects obtain a

return on investment, and the decision is either to finance this investment with capital, or debt or

to distribute it to shareholders in the form of profits. Each project is usually valued using a

discounted cash flow (DCF). The opportunity with the highest value measured using the net

present value (NPV) is then selected. This requires estimating the size and timing of all

incremental cash flows generated by the project. These future cash flows are then discounted to

determine their present value. These present values are then summed up, and then this net

amount of initial investment expenditures becomes the net present value. Multinational

corporations have a variety of options for funding their worldwide operations. Some people

prefer to raise money through the stock market, issuing shares on domestic or international stock

exchanges. Others choose debt financing through banks or bond markets rather than selling their

company to avoid giving up ownership. Companies undertaking international investments, on the

other hand, must be mindful of the complete financial picture, which includes the tax

environment. The information asymmetry between lenders and borrowers is reduced when they

are geographically closer to the capital provider. Multinationals can more readily obtain funds

from different nations since they have assets in multiple countries. The location of capital raising

is a critical corporate financial choice for international corporations. International bonds are most
commonly issued in the United States and Europe, and many issuers are multinational

corporations from countries with less liquid financial markets. The majority of big bank loans are

syndicated, and the participating institutions are generally from other nations. As a result, loans

are frequently made up of funds from several nations.

Financing a domestic company

Domestic capital markets play a critical role in attracting private money for domestic growth.

Domestic capital markets can eliminate currency mismatches for borrowers and hence lower

systemic risks by allowing enterprises to borrow domestically in local currencies. At the same

time, government bond markets provide significant price benchmarks and instruments for

managing macroeconomic and fiscal risk. Monitoring the growth of domestic capital markets in

the short and medium-term should concentrate on efforts taken to create a legal, regulatory, and

operational enabling environment, increase capacity, and enhance the quality of oversight,

clearing, settlement, and risk management. In addition, evaluating the extent of new and

outstanding fundraising in nominal terms and relative to gross domestic product (GDP), the

number and type of issuers to see if access has expanded in targeted sectors, and the percent of

investment portfolios invested in different types of capital market products are all part of

determining the ultimate impact of bond market development. Bid-ask spreads and turnover

ratios are examples of liquidity indicators. Market volatility may be measured by looking at the

price volatility of major topics. Implied volatility can also be used as an input in nations where

options markets aren't well-functioning. Foreign investment in domestic markets data differs by

nation and instrument type. This necessitates a shift in incentives for all market participants,

including investors, brokers, advisers, and rating agencies. New technologies and data collecting

methods have the potential to help domestic countries improve their finances.
The formula for cost of capital

Types of cost of capital

The rate of return a company expects to receive on its investment in order to raise its market

value is known as the cost of capital. In other words, it is the rate of return that capital providers

want as compensation for their capital input. The weighted average of the cost of debt and the

cost of equity is used to calculate the cost of capital. A company's cost of capital should be lower

than or equal to that of its rivals in the same industry if it is running efficiently. The cost of

equity capital is the rate of return required by a firm to determine if an investment fulfills its

capital return criteria. The market's need for remuneration in exchange for holding the asset and

facing the risk of ownership is represented by a company's cost of equity. The dividend

capitalization model and the capital asset pricing model are two conventional costs of equity

formulas. It is frequently used as a capital budgeting benchmark for the needed rate of return by

businesses. The effective interest rate that a firm pays on its obligations, such as bonds and loans,

is known as the cost of debt. The cost of debt can refer to either the before-tax cost of debt or the

after-tax cost of debt. The incremental or differential cost of capital is another name for it. In

other words, it is defined as the relevant cost of additional money that the firm has to raise.
International diversification

International diversification is a notion that originated in international economics and the theory

of foreign direct investment to get greater returns to size and scope. Management's capacity to

create an array of firm-specific, physical and intangible assets whose production can be sold

across multiple markets and whose essentially fixed expenses may, as a result, be amortized over

more output results in increased value. Diversification is a business strategy that may take many

forms, ranging from product diversity to market and geographic diversification. In general,

investors believe that organizations with a higher level of diversity have a lower risk profile than

businesses with a lower level of diversification. The idea is that diverse companies are less

vulnerable to a drop in a particular market or geographic location. The disadvantage is that when

a single market has a boom or growth spurt, a corporation trades off its capacity to generate a

huge profit. Another disadvantage of diversity is that by reducing risk, diversified portfolios

reduce reward. As a result, investors must carefully construct their portfolios such that their

opposing stocks act as a parachute during downturns but not as a stumbling block during upturns.

A globally diverse network allows the company to take advantage of market circumstances. A

transnational production network enables production to move in response to any large-scale

changes in relative pricing that may occur on a global scale. Because of this cost structure

flexibility, the average marginal cost of global production is lower than that of exclusively

domestic manufacturing, resulting in bigger profit margins or market share. When demand

shocks are not completely linked, a similar logic applies to average output prices across foreign

markets. Depending on the expenses of establishing and sustaining a corporate network that is

diversified across international-based risks and the fluctuation of comparable pricing, such a
network can bring value to the business by allowing it to leverage a wider range of market

situations.

How external factors can affect financing a multinational company

While being a multinational has advantages such as diversifying capital sources and allowing for

cross-border tax arbitrage, it also has drawbacks. Multinational corporations incur political risks

that are likely to be greater than those encountered by domestic corporations. The size of capital

market segmentation and how extensively the firm's investments are locally or internationally

diversified will determine how much international diversification reduces the effect of country-

specific and currency-specific risks. Country-specific and currency-specific hazards cannot be

diversified and thus the firm's exposure to these risks cannot be minimized when a firm's

investment is concentrated in a local economy and markets are partially separated from other

capital markets. Economic nationalism is described as a preference for the native over the

foreigner, and it has a direct and indirect economic influence on acquisitions, as well as a stifling

effect on international capital flows. Governments have used a variety of tactics to combat

foreign acquisition bids, including playing for time by delaying regulatory approvals, using

golden shares in previously privatized companies, using moral persuasion by publicly opposing

the deals, and providing financing to rival bidders from national banks. Even if a multinational

corporation is operating in a country where the government treats it well, there is always the

possibility of a policy shift, which might occur when the government changes, which could have

an impact on the international firm. Exchange-rate risk is also a concern for multinational

corporations. They get revenues in a variety of currencies and have liabilities in a variety of

currencies, both in terms of production costs and interest payments. As a result, changes in

currency rates cause a mismatch between the company's income and its liabilities, necessitating
the need to hedge foreign exchange risk. Interest rates are another important factor that

influences the cost of financing for multinational companies. At its most basic level, one may

assume that the relative cost of borrowing will follow the global central bank base rate. In

general, investors will settle for the investment that provides the maximum return for the risk

profile of the investment. As a result, a company's cost of capital will change depending on the

success of others in the industry; for example, if the market as a whole has fared well, one would

anticipate the equity side of the equation's cost of capital to rise. This is because the said firm

must be able to provide a comparable return to those in the industry. In contrast, if the market as

a whole or a particular sector performs poorly, a company's cost of capital will reduce as

investors' expectations for stocks diminish. The cost of capital across countries may vary as

multinational companies based in some countries may have a competitive advantage over others.

When a company obtains or creates a feature or set of features that allows it to outperform its

competitors, it gains a competitive advantage. Access to natural resources, such as high-grade

ores or low-cost power, or access to highly educated and talented human resources, are examples

of these traits. New technologies, such as robots and information technology, will either be

included in the product or will be used to aid in its creation. Moreover, they may be able to

adjust their international operations and sources of funds to capitalize on differences, and some

multinational corporations based in some countries may have a more debt-intensive capital

structure.

The capital structure of a multinational company

An MNC's overall capital structure is essentially a mix of the parent company's and subsidiaries'

capital structures. The capital structure decision is impacted by both business and national

variables, and it involves the choice of debt vs equity financing. The costs and advantages of
each cost of the capital component will fluctuate as economic and political situations change, as

will the MNC's business plan. In reaction to changing conditions, an MNC may modify its

capital structure. Some multinational corporations, for example, have restructured their capital

structures to lower withholding taxes on remitted revenues. The corporate characteristics include

stability of cash flow and that is due to MNCs being able to handle more debt. MNCs also have a

lower risk because they have higher access to credit. They also experience profits from retained

earnings from different countries giving them a higher margin of profitability. Additionally, they

have a guarantee on debt. The subsidiary debt is backed by the parent country and so the

subsidiary can borrow more. However, MNCs can experience some agency problems as its

difficult to monitor subsidiaries moreover there could be a potential conflict of interest when

issuing stock in the host country. They could also experience stock restrictions due to the lower

cost of raising equity which results in less growth and investment opportunities. Furthermore, the

strength of the host country’s currency could affect the company. If expected to weaken they

would borrow the host country’s currency to reduce exposure. In terms of interest rate, the lower

the rate the lower the cost of debt for the multinational company. In terms of tax laws, the higher

the tax rate the company would prefer local debt financing. Lastly, when the company is

threatened by country risk, they are likely to block funds or in other words confiscate assets and

would be more partial to local debt financing. When local conditions and project features are

taken into account, an MNC may depart from its "local" target capital structure. The MNC may

still be able to attain its "global" goal capital structure if the proportions of debt and equity

financing in the parent or other subsidiaries can be changed suitably. When the host country is

under political turbulence, a high degree of financial leverage is desirable, whereas a low degree

is recommended when the project will not create net cash flows for a long period. A change in
capital structure might lead to a higher cost of capital. As a result, abnormally high or low

financial leverage should only be used if the advantages outweigh the costs.

The capital structure of a domestic company

The firm's capital structure is investigated in a domestic setting under increasingly less restrictive

assumptions. After that, allowances are made for agency costs and information inconsistencies.

The domestic capital structure hypothesis is applied to a multinational setting and experimentally

tested. Domestic enterprises have a greater debt capital share in their financial structure. One of

the most important factors to consider when deciding on capital structure is tax. For debt to be

tax deductible at the business level, the trade-off between the greater risk associated with higher

leverage must be recognized. The present value of future growth potential accounts for a

significant portion of any local or international company's leverage. The value of future growth

is increased to the extent that a company may exploit flaws in the product factor or financial

markets. MNCs are in a better position to take advantage of market defects than local enterprises.

Financial resources are commonly viewed as an internal resources, and the emphasis on internal

capital accumulation has led to the usage of company size or age as a proxy for financial

resources in empirical investigations. Lack of financial resources can be a significant

impediment to expansion since it stops businesses from making the required expenditures to

strengthen their operations. Generally, businesses prefer to use self-financing first, then debt, and

ultimately external finance.

How currency-specific risk can affect MNCs and domestic companies?

Changes in exchange rates have a significant impact on firms' operations and profitability in the

current era of increased globalization and increased currency volatility. Exchange rate volatility

impacts small and medium-sized firms, including those that exclusively operate in their own
country, as well as multinationals, major organizations, and businesses that trade on worldwide

markets. Currency volatility exposes businesses to three categories of risk: transaction exposure,

translation vulnerability, and economic or operational exposure. Operational and currency risk

mitigation measures can help mitigate the hazards of operating or economic vulnerability. The

impact of exchange rate variations on a company's obligations to make or receive payments

denominated in foreign currency is known as transaction exposure. If a company's input costs or

product prices are both affected by currency changes, operating vulnerability is increased. If both

costs and prices are affected by currency changes, the impacts cancel one other out, reducing

operating risk. Moreover. Diversification would reduce the danger of having manufacturing or

sales facilities concentrated in just one or two markets. The disadvantage is that the corporation

may be forced to forsake economies of scale. A firm with international operations will need to

convert the foreign currency values of these assets and liabilities into the company's own

currency. Before it can publish its consolidated financial accounts—balance sheet and profit and

loss statement, it must first consolidate them with its home currency assets and liabilities. The

translation procedure might result in assets and liabilities having unfavorable comparable home

currency values. Moreover, multinational companies may face many risks in relation to the

currency that could increase the costs the firm originally wanted to spend on an investment or

business activity due to exchange rates and fluctuating laws and regulations for exports and

imports. However, for a domestic firm, if the raw materials were imported from outside, it could

affect their business activities negatively by pushing more costs onto their product or services by

increased taxes on imports or the differences of currencies. If a foreign rival selling to the same

client as the firm sees its exchange rate increase positively, future cash flows may be decreased

when converted for the local currency.

Higher degrees of market diversification tends to increase the cost of capital, but a strategy that

combines market diversification with more company diversification has the reverse impact. As a

result, it is completely logical to expect the firm's value to decline as it gets more market diverse,

but to sell at a premium if it can capitalize on the synergies that appear to result from efficiently

integrating market and business diversification. Unless market diversity can be successfully

paired with business diversification, investors prefer less market diversification to more. To put

it another way, investors are willing to pay a premium for a company with more business

possibilities that can be leveraged across more foreign markets, as measured by a lower

necessary rate of return. These findings are both compatible with the firm's resource-based

approach and intuitively attractive. Diversification that is not projected to provide a return on

invested capital over the firm's risk-adjusted cost of capital will lead the firm's share price to be

bid down, even if sales, profits, and cash flow improve. Diversification is undertaken at a

reasonable cost, where synergy is likely to result from combining market and business

diversification and the same effect cannot be achieved by investors acting independently, and

where the resulting return on invested capital is highly likely to exceed the market's required rate

of return, would result in an increase in the firm's market value. Otherwise, the firm's cost of

capital will likely rise, and unless this is offset by higher returns, a challenge that will be made

more difficult when diversification takes the firm away from core activities and markets where it

has a competitive advantage, the firm's underlying economic value will likely fall, with market
value following. All of this emphasizes how complicated the link between diversity, growth,

costs, investment, and financing is, yet investor expectations about the expected implications of

diversification are reflected swiftly and effectively through changes in the firm's cost of capital.

In a nutshell, factors that cause the cost of capital for MNCs to differ from domestic firms

include preferential treatment from creditors and smaller per unit flotation costs due to their large

size. Multinational companies can enjoy the benefits of economies of scale as an improved level

of output results in commensurate cost savings. Moreover, there is possible access to low-cost

foreign financing which translates to greater access to international capital markets and

international diversification. Additionally the probability of bankruptcy. The exposure to the

exchange rate is a risk as MNCs' operations and cash flows are subject to larger exchange rate

volatility than local enterprises, increasing the risk of insolvency. Creditors and investors want a

larger return as a result, raising the MNC's cost of capital. Furthermore the exposure to country

risk, because of the added cultural, political, and financial risks associated with international

investments, is higher than in identical domestic ventures. As a result, risks increase the

unpredictability of returns on foreign investment, which is typical of the MNC's harm. The size

of capital market segmentation and how extensively the firm's investments are locally or

internationally diversified will determine how much international diversification reduces the

effect of country-specific and currency-specific risks. Country-specific and currency-specific

hazards cannot be diversified and thus the firm's exposure to these risks cannot be minimized

when a firm's investment is concentrated in a local economy and markets are partially separated

from other capital markets. A corporation with internationally diverse investors, particularly in

integrated financial markets, may, on the other hand, remove these risks, and its cost of capital

will be low. It is commonly established that the cost of capital varies per industry to some extent.
The interaction between industry and diversity is less well understood, and further studies are

needed.

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