January 2024

International Business Finance

Chapter 5:
Financing Decision in MNCs

By
Dr.Takele Fufa

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 International Cost of Capital and
Capital structures

Cost of Capital:-
 A firm’s capital consists of equity (retained
earnings and funds obtained by issuing stock)
and debt (borrowed funds).
 The cost of equity reflects an opportunity
cost, while the cost of debt is reflected in
interest expenses.
 Firms want a c a pita l s t r u c t u r e that will
minimize their cost of capital, and hence the
required rate of return on projects.
Cost of Capital ...

A firm’s weighted average cost of capital

kc = ( D ) kd ( 1 _ t ) + ( E ) ke
D+E D+E
Where, D is the amount of debt of the firm
E is the equity of the firm
kd is the before-tax cost of its debt
t is the corporate tax rate
ke is the cost of financing with equity
 Cost of Capital...

 The interest payments on debt are tax

deductible. However, as interest expenses
increase, the probability of bankruptcy will
increase too.
 It is favorable to increase the use of debt
f i n a n c i n g u n t i l the p o i n t at w h i c h the
bankruptcy probability becomes large
enough to offset the tax advantage of using
debt.
Cost of Capital

Debt’s Tradeoff
Cost of Capital

Debt Ratio
 Cost of Capital for MNCs

 The cost of capital for MNCs may differ

from that for domestic firms because of the
following differences.
 Size of Firm. Because of their size, MNCs
are often given preferential treatment by
creditors. They can usually achieve smaller
per unit flotation costs too.
Cost of Capital for MNCs

 Access to International Capital Markets.

MNCs are normally able to obtain funds
through international capital markets, where
the cost of funds may be lower.
 International Diversification. MNCs may
h a v e m o r e s t a b l e c a s h i n f l o w s d u e to
international diversification, such that their
probability of bankruptcy may be lower.
 Cost of Capital for MNCs

 Exposure to Exchange Rate Risk. MNCs

may be more exposed to exchange rate
fluctuations, such that their cash flows may
be more uncertain and their probability of
bankruptcy higher.
 Exposure to Country Risk. MNCs that have
a higher percentage of assets invested in
foreign countries are more exposed to
country risk.
Cost of Capital for MNCs

Larger size Preferential

treatment from
Greater access to creditors
international
capital markets Possible access to
low-cost foreign Cost of
International financing capital
diversification
Exposure to
Probability of
exchange rate
bankruptcy
risk
Exposure to
country risk
Cost of Capital for MNCs

 The capital asset pricing model (CAPM) can

be used to assess how the required rates of
return of MNCs differ from those of purely
domestic firms.
 According to CAPM, ke = Rf + b (Rm – Rf )
where ke = the required return on a stock
Rf = risk-free rate of return
Rm = market return
b = the beta of the stock
Cost of Capital for MNCs

 A stock’s beta represents the sensitivity of

the stock’s returns to market returns, just
as a project’s beta represents the
sensitivity of the project’s cash flows to
market conditions.
 The lower a project’s beta, the lower its
systematic risk, and the lower its required
rate of return, if its unsystematic risk can
be diversified away.
Cost of Capital for MNCs

 An MNC that increases its foreign sales may

be able to reduce its stock’s beta, and hence
the return required by investors. This
translates into a lower overall cost of
capital.
 However, MNCs may consider unsystematic
risk as an important factor when
determining a foreign project’s required
rate of return.
Costs of Capital Across Countries

 T h e c o s t of c a p i t a l m a y v a r y a c r o s s
countries, such that:
 MNCs based in some countries may have
a competitive advantage over others;
 MNCs may be able to adjust their international
operations and sources of funds to capitalize on
the differences; and
 MNCs based in some countries may have a more
debt-intensive capital structure.
Costs of Capital Across Countries

 The cost of debt to a firm is prim a rily

determined by:
 the prevailing risk-free interest rate of the
borrowed currency and
 the risk premium required by creditors.
 The risk-free rate is determined by the
interaction of the supply and demand for
funds. It may vary due to different tax laws,
d e m o g r a p h i c s , m o n e t a r y p o l i c i e s , and
Costs of Capital Across Countries

 The risk premium compensates creditors

for the risk that the borr o w e r may be
unable to meet its payment obligations.
 The risk premium may vary due to different
economic conditions, relationships between
corporations and creditors, government
i n t e r v e n t i o n , and de gre e s of f i n a n c i a l
leverage.
Weighted Average Cost of Capital

 The weighted average cost of capital

(WACC) is the average return required by
all of the firm’s investors.
 It is determined by the firm ’s capital
structure (the firm ’s relative amounts of
debt and equity), interest rates, the firm’s
risk, and the market’s attitude toward risk.
 WACC = wdkd(1-T) + wpkp + wcks
 WACC_Example:
Component cost of debt

Example: A 15-year bond pays an annual coupon

rate of 10%, bond sells for $1,153.72. What
is the cost of debt (kd)?
 Interest is tax deductible, so
A-T kd = B-T kd (1-T)
= 10% (1 - 0.40) = 6%
 Use nominal rate.
 Flotation costs are small, so ignore them.
What is the cost of preferred
stock?

 Example: A preferred stock price $111.10

and dividend of $10 per share. what would
be the cost of preferred stocks. The cost
of preferred stock can be solved by using
this formula:
kp = Dp / Pp
= $10 / $111.10
= 9%
Three ways to determine the cost
of common equity, ks

 CAPM: ks = kRF + (kM – kRF) β

Capital Asset Pricing Model(CAPM)
 DCF: ks = (D1 / P0)+ g
Discounted Cash Flow Method(DCF)
 Own-Bond-Yield-Plus-Risk Premium:
ks = kd + RP
Example-1: If the kRF = 7%, RPM = 6%, and
the firm’s beta is 1.2, what’s the cost of
common equity based upon the CAPM?

Using CAPM the cost of common equity is:

ks = kRF + (kM – kRF) β
= 7.0% + (6.0%)1.2 = 14.2%

kRF= Risk free rate, RPM = Risk Premium = (kM – kRF ), kM =

Market rate
Example-2: If D0 = $4.19, P0 = $50, and
g = 5%, what’s the cost of common equity
based upon the DCF approach?

D1 = D0 (1+g)
D1 = $4.19 (1 + .05)
D1 = $4.3995
Using DCF the cost of common equity,
ks = (D1 / P0 )+ g
= ($4.3995 / $50) + 0.05
= 13.8%
 Example-3: If kd = 10% and RP = 4%,
what is ks using the own-bond-yield-
plus-risk-premium method?

 This RP is not the same as the CAPM RPM.

 This method produces a ballpark estimate of
ks, and can serve as a useful check.
 Using own-bond-yield-plus-risk-premium
method:
ks = kd + RP
ks = 10.0% + 4.0% = 14.0%
What is a reasonable final
estimate of ks?

Method Estimate
CAPM 14.2%
DCF 13.8%
kd + RP 14.0%
Average 14.0%
 Sum up three and divide it by 3.
WACC illustration Summary

 WACC =? Tax=40%, kd =10% kdT =?

 Wd =0.3 [weight of debt]
 kdT=kd(1-T) = 10%(1-40%)= 6%
 wp =0.1 [weight of preferred stock]
 kp =9%
 wc =0.6 [weight of common stock]
 ks =14% use Red WACC= wdkd(1-T) + wpkp + wcks
Ignoring floatation costs, what
is the firm’s WACC?

WACC = wdkd(1-T) + wpkp + wcks

= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4%
= 11.1%
Using the Cost of Capital
for Assessing Foreign Projects

 Foreign projects may have risk levels

different from that of the MNC, such that
the MNC’s weighted average cost of capital
(WACC) may not be the appropriate required
rate of return.
 There are various ways to account for this
risk differential in the capital budgeting
process.
Using the Cost of Capital
for Assessing Foreign Projects

 Derive NPVs based on the WACC.

– The probability distribution of NPVs can be
computed to determine the probability that the
foreign project will generate a return that is at
least equal to the firm’s WACC.
 Adjust the WACC for the risk differential.
– The MNC may estimate the cost of equity and
the after-tax cost of debt of the funds needed
to finance the project.
The MNC’s Capital Structure Decision

 The overall capital structure of an MNC is

essentially a combination of the capital
s t r u c t u r e s of the p a r e n t body and its
subsidiaries.
 The capital structure decision involves the
choice of debt versus equity financing, and is
influenced by both corporate and country
characteristics.
The MNC’s Capital Structure Decision

Corporate Characteristics
 Stability of cash flows. MNCs with more
stable cash flows can handle more debt.
 Credit risk. MNCs that have lower credit
risk have more access to credit.
 Access to retained earnings. Profitable
MNCs and MNCs with less growth may be
able to finance most of their investment
with retained earnings.
The MNC’s Capital Structure Decision

Corporate Characteristics
• Guarantees on debt. If the parent backs
the subsidiary’s debt, the subsidiary may be
able to borrow more.
 Agency problems. Host country
shareholders may monitor a subsidiary,
though not from the parent’s perspective.
The MNC’s Capital Structure Decision

Country Characteristics
 Stock restrictions. MNCs in countries
where investors have less investment
opportunities may be able to raise equity at
a lower cost.
 Interest rates. MNCs may be able to obtain
loanable funds (debt) at a lower cost in some
countries.
 The MNC’s Capital Structure Decision

Country Characteristics
• Strength of currencies. MNCs tend to
borrow the host country currency if they
expect it to weaken, so as to reduce their
exposure to exchange rate risk.
 Country risk. If the host government is
likely to block funds or confiscate assets,
the subsidiary may prefer debt financing.
The MNC’s Capital Structure Decision

Country Characteristics
 Tax laws. MNCs may use more local debt
financing if the local tax rates (corporate
tax rate, withholding tax rate, etc.) are
higher.
 International tax Policies

 The worldwide or residential method of

declaring a national tax jurisdiction is to tax
national residents of the country on their
worldwide income no matter in which country
it is earned.
 The national tax authority, according to this
method, is declaring its tax jurisdiction over
people and businesses.

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 International tax Policies

 A MNC firm with many foreign affiliates

would be taxed in its home country on its
income earned at home and abroad.
 Obviously, if the host countries of the
foreign affiliates of a MNC also tax the
income earned within their t e r r i t o r i a l
borders, the possibility of double taxation
exists, unless a mechanism is established to
prevent it.
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 International tax Policies

 The territorial or source method of declaring

a tax jurisdiction is to tax all income earned
within the country by any taxpayer, domestic
or foreign.
 Hence, regardless of the nationality of a
taxpayer, if the income is earned within the
territorial boundary of a country, it is taxed
by that country.

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 International tax Policies

 The national tax authority, according to this

method, is declaring its tax jurisdiction over
transactions conducted within its borders.
Consequently, local firms and affiliates of
fore ign MNCs are taxed on the inc om e
earned in the source country. Obviously, if
the parent country of the foreign affiliate
also levies a tax on worldwide income, the
possibility of double taxation exists, unless a
37 mechanism is established to prevent it.
Country Risk Analysis

 Country risk can be used:

– to monitor countries where the MNC is
presently doing business;
– as a screening device to avoid conducting
business in countries with excessive risk;
and
– to improve the analysis used in making
long-term investment or financing
decisions.
Political Risk Factors

 Attitude of Consumers in the Host Country

– Some consumers may be very loyal to homemade
products.
 Attitude of Host Government
– The host government may impose special
requirements or taxes, restrict fund transfers,
subsidize local firms, or fail to enforce copyright
laws.
Political Risk Factors

 Blockage of Fund Transfers

– Funds that are blocked may not be optimally
used.
 Currency Inconvertibility
– The MNC parent may need to exchange earnings
for goods.
Political Risk Factors

 War
– Internal and external battles, or even the threat
of war, can have devastating effects.
 Bureaucracy
– Bureaucracy can complicate businesses.
 Corruption
– Corruption can increase the cost of conducting
business or reduce revenue.
 Improving investment Climate

 Fiscal incentives
 are specific tax measures designed to attract the
foreign investor, including special depreciation allowances,
tax credits or rebates, special deductions for capital
expenditures, tax holidays, and reduction of tax burdens.
 Financial incentives
 offer special funding for the investor by providing land
or building, loans, and loan guarantees.
 Nonfinancial incentives
 can consist of guaranteed government purchases, special
protection from competition, and investments in
infrastructure facilities.
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 Investment climate

 Government attitude toward foreign

investment (e.g. incentives)
 Political stability
 Limitations on ownership
 Currency exchange regulations
 Stability of foreign exchange
 Tax structure

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 End of the chapter

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