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Chapter 17
Multinational Cost of Capital and Capital Structure
Lecture Outline
Background on Cost of Capital
Comparing the Costs of Equity and Debt
Cost of Capital for MNCs
Cost of Capital Comparison Using the CAPM
Implications of the CAPM for an MNC’s Risk
Costs of Capital Across Countries
Country Differences in the Cost of Debt
Country Differences in the Cost of Equity
Estimating the Cost of Debt and Equity
Combining the Costs of Debt and Equity
Using the Cost of Capital for Assessing Foreign Projects
Derive Net Present Values Based on the Weighted Average Cost of Capital
Adjust the Weighted Average Cost of Capital for the Risk Differential
Derive the Net Present Value of the Equity Investment
The MNC’s Capital Structure Decision
Influence of Corporate Characteristics
Influence of Country Characteristics
Revising the Capital Structure in Response to Changing Conditions
Interaction Between Subsidiary and Parent Financing Decisions
Impact of Increased Debt Financing by the Subsidiary
Impact of Reduced Debt Financing by the Subsidiary
Summary of Interaction Between Subsidiary and Parent Financing Decisions
Local Versus Global Target Capital Structure
Offsetting a Subsidiary’s High Degree of Financial Leverage
Offsetting a Subsidiary’s Low Degree of Financial Leverage
Limitations in Offsetting a Subsidiary’s Abnormal Degree of Financial Leverage
Impact of an MNC’s Capital Structure Decisions on Its Value
Chapter 17: Multinational Cost of Capital and Capital Structure 299
Chapter Theme
This chapter explains why the capital structure and the cost of capital of MNCs may vary with those of
domestic firms. It also explains why the cost of capital varies across countries. The disparity in the
cost of capital across countries is important because it can influence the MNC’s decisions on where to
establish subsidiaries and where to obtain funds.
Topics to Stimulate Class Discussion
1. Why don’t all MNCs attempt to obtain funds in countries where the cost of capital is very low?
2. The cost of capital is very high in Latin American countries. Yet, many MNCs continue to
establish subsidiaries there. What underlying factor that causes a high cost of capital can also
enhance the revenues of subsidiaries over time?
3. Explain why a firm’s capital structure may be dependent on the countries in which it operates.
POINT/COUNTER-POINT:
Should the Reduced Tax Rate on Dividends Affect an MNC’s Capital
Structure?
POINT: No. The change in the tax law reduces the taxes that investors pay on dividends. It does not
change the taxes paid by the MNC. Thus, it should not affect the capital structure of the MNC.
COUNTER-POINT: A dividend income tax reduction may encourage a U.S.-based MNC to offer
dividends to its shareholders, or to increase the dividend payment. This strategy reflects an increase in
the cash outflows of the MNC. To offset these outflows, the MNC may have to adjust its capital
structure. For example, the next time that it raises funds, it may prefer to use equity rather than debt so
that it could free up some cash outflows (the outflows to cover dividend would be less than outflows
associated with debt).
WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you
support? Offer your own opinion on this issue.
ANSWER: The MNC may consider shifting its capital structure, but would have to consider how the
shift in its capital structure would affect its own tax rates. A shift to more equity would reduce the
corporate tax advantage from using debt.
Answers to End of Chapter Questions
1. Capital Structure of MNCs. Present an argument in support of an MNC’s favoring a
debt-intensive capital structure.
Present an argument in support of an MNC’s favoring an equity-intensive capital structure.
300 International Financial Management
ANSWER: MNCs that are well-diversified across countries would have somewhat stable cash
flows and may therefore be able to handle a high level of debt. They may use substantial foreign
debt financing to reduce their subsidiary exposure to exchange rate risk and country risk.
MNCs that are highly exposed to exchange rate movements or have subsidiaries located in
politically unstable countries may experience very volatile cash flows. These MNCs could not
handle high periodic debt payments and may be better off with an equity-intensive capital
structure.
2. Optimal Financing. Wizard, Inc. has a subsidiary in a country where the government allows only
a small amount of earnings to be remitted to the U.S. each year. Should Wizard finance the
subsidiary with debt financing by the parent, equity financing by the parent, or financing by local
banks in the foreign country?
ANSWER: Wizard should use financing by local banks in the foreign country, so that the
subsidiary can make use of its funds by paying off local debt.
3. Country Differences. Describe general differences between the capital structures of firms based
in the United States and those of firms based in Japan. Offer an explanation for these differences.
ANSWER: Japanese firms tend to have a higher degree of financial leverage. This may be because
the government of Japan is more likely to rescue a troubled firm. Also, creditors may be more
patient there, allowing a firm more time to recover.
4. Local Versus Global Capital Structure. Why might a firm use a “local” capital structure at a
particular subsidiary that differs substantially from its “global” capital structure?
ANSWER: A particular country’s characteristics can cause the MNC’s subsidiary to use mostly
debt or mostly equity, even if the MNC’s “global” target capital structure is more balanced. For
example, if the country’s stock market is not well developed, the MNC may prefer not to issue
stock there, as an inactive secondary market may make it difficult to place stock in that country. In
this case, the subsidiary may be financed mostly with debt (such as loans from local banks).
5. Cost of Capital. Explain how characteristics of MNCs can affect the cost of capital.
ANSWER: The following characteristics of MNCs can influence the cost of capital:
• Size. MNCs have more opportunities to grow, and larger, better known firms may receive
preferential treatment by creditors.
• Access to international capital markets. MNCs have access to more sources of funds than
domestic firms. To the extent that financial markets are segmented, MNCs may be able to
obtain financing from various sources at a lower cost.
• International diversification. If MNCs can achieve more stable cash flows through their
international diversification, their probability of bankruptcy is reduced. Creditors and
shareholders may therefore accept a lower rate of return when providing funds to the
MNCs, which reflects a lower cost of capital for MNCs.
Chapter 17: Multinational Cost of Capital and Capital Structure 301
• Exchange rate risk. MNCs that are highly exposed to exchange rate movements may be
more likely to experience financial problems (if they do not hedge the risk). Thus, they
may incur a higher cost of capital.
• Country risk. MNCs with subsidiaries in politically unstable countries may experience
volatile cash flows over time and be more susceptible to financial problems. Thus, they
may incur a higher cost of capital.
6. Capital Structure and Agency Issues. Explain why managers of a wholly-owned subsidiary may
be more likely to satisfy the shareholders of the MNC.
ANSWER: Managers of a wholly-owned subsidiary can more easily focus on the objective of
satisfying the MNCs shareholders. If the subsidiary is partly-owned, this implies that these are
minority shareholders who have an interest in the subsidiary. In this case, the managers may
attempt to satisfy both the majority and minority shareholders. However, they cannot satisfy both
groups simultaneously. Some decisions made to satisfy minority shareholders will adversely effect
majority shareholders.
7. Target Capital Structure. LaSalle Corp. is a U.S.-based MNC with subsidiaries in various less
developed countries where stock markets are not well established. How can LaSalle still achieve
its “global” target capital structure of 50 percent debt and 50 percent equity, if it plans to use only
debt financing for the subsidiaries in these countries?
