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.
ANSWER: MNCs that are well-diversified across countries would have somewhat stable cash flows
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
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
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,
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.
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Multinational Cost of Capital and Capital Structure 2
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
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?
ANSWER: LaSalle Corporation can use mostly equity financing for its U.S. operations. When
8. Financing Decision. Drexel Co. is a U.S.-based company that is establishing a project in a politically
unstable country. It is considering two possible sources of financing. Either the parent could provide
most of the financing, or the subsidiary could be supported by local loans from banks in that country.
Which financing alternative is more appropriate to protect the subsidiary?
ANSWER: Drexel should let local banks support the subsidiary since it would be in the interest of
9. Financing Decision. Veer Co. is a U.S.-based MNC that has most of its operations in Japan. Since
the Japanese companies with which it competes use more financial leverage, it has decided to adjust
its financial leverage to be in line with theirs. With this heavy emphasis on debt, Veer should reap
more tax advantages. It believes that the market’s perception of its risk will remain unchanged, since
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Multinational Cost of Capital and Capital Structure 3
its financial leverage will still be no higher than that of its Japanese competitors. Comment on this
strategy.
ANSWER: Japanese corporations can use a higher degree of financial leverage because of their
relationships with creditors and the government. The Japanese government may be willing to bail out
10. Financing Tradeoffs. Pullman, Inc., a U.S. firm, has been highly profitable, but prefers not to pay out
higher dividends because its shareholders want the funds to be reinvested. It plans for large growth in
several less developed countries. Pullman would like to finance the growth with local debt in the host
countries of concern to reduce its exposure to country risk. Explain the dilemma faced by Pullman,
and offer possible solutions.
ANSWER: Pullman Inc. has retained earnings that it must reinvest. Yet, if it uses the retained
earnings to finance the growth, it will be more exposed to country risk. Pullman may consider using
11. Costs of Capital Across Countries. Explain why the cost of capital for a U.S.-based MNC with a
large subsidiary in Brazil is higher than for a U.S.-based MNC in the same industry with a large
subsidiary in Japan. Assume that the subsidiary operations for each MNC are financed with local
debt in the host country.
ANSWER: The risk-free interest rate is much higher in Brazil than in Japan. In addition, the risk
12. Cost of Capital. An MNC has total assets of $100 million and debt of $20 million. The firm’s
before-tax cost of debt is 12 percent, and its cost of financing with equity is 15 percent. The MNC has
a corporate tax rate of 40 percent. What is this firm’s cost of capital?
ANSWER:
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13. Cost of Equity. Wiley, Inc., an MNC, has a beta of 1.3. The U.S. stock market is expected to generate
an annual return of 11 percent. Currently, Treasury bills yield 2 percent. Based on this information,
what is Wiley’s estimated cost of equity?
Multinational Cost of Capital and Capital Structure 5
Advanced Questions
17. Interaction Between Financing and Investment. Charleston Corp. is considering establishing a
subsidiary in either Germany or the United Kingdom. The subsidiary will be mostly financed with
loans from the local banks in the host country chosen. Charleston has determined that the revenue
generated from the British subsidiary will be slightly more favorable than the revenue generated by
the German subsidiary, even after considering tax and exchange rate effects. The initial outlay will be
the same, and both countries appear to be politically stable. Charleston decides to establish the
subsidiary in the United Kingdom because of the revenue advantage. Do you agree with its
decision? Explain.
ANSWER: Charleston neglected the cost of financing the subsidiary. It may be more costly to
finance a subsidiary in the United Kingdom than a subsidiary in Germany when using the local debt
18. Financing Decision. In recent years, several U.S. firms have penetrated Mexico’s market. One of the
biggest challenges is the cost of capital to finance businesses in Mexico. Mexican interest rates tend
to be much higher than U.S. interest rates. In some periods, the Mexican government does not attempt
to lower the interest rates because higher rates may attract foreign investment in Mexican securities.
a. How might U.S.-based MNCs expand in Mexico without incurring the high Mexican interest
expenses when financing the expansion? Are any disadvantages associated with this strategy?
ANSWER: The parents of the MNCs could provide funding for the subsidiaries by investing their
own capital. This involves converting dollars to pesos for use in Mexico. In this case, the parent has
b. Are there any additional alternatives for the Mexican subsidiary to finance its business itself after
it has been well established? How might this strategy affect the subsidiary’s capital structure?
ANSWER: Once the subsidiary has generated earnings, it can retain the earnings and reinvest them
19. Financing Decision. The subsidiaries of Forest Company produce goods in the U.S., Germany, and
Australia, and sells the goods in the areas where they are produced. Foreign earnings are periodically
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Multinational Cost of Capital and Capital Structure 6
remitted to the U.S. parent. As the euro’s interest rates have declined to a very low level, Forest
Company has decided to finance its German operations with borrowed funds in place of the parent’s
equity investment. Forest will transfer its equity investment in the German subsidiary over to its
Australian subsidiary. These funds will be used to pay off a floating rate loan, as Australian interest
rates have been high and are rising. Explain the expected effects of these actions on the consolidated
capital structure and cost of capital of Forest Company.
Given the strategy to be used by Forest, explain how its exposure to exchange rate risk may have
changed.
ANSWER: While the capital structure is now more equity-intensive in Australia and more
The exposure of Forest resulting from German operations may have decreased, because the euro
inflows are now more offset by the euro outflows on the German debt. Thus, a smaller amount of
20. Financing in a High Interest Rate Country. Fairfield Corp., a U.S. firm, recently established a
subsidiary in a less developed country that consistently experiences an annual inflation rate of 80
percent or more. The country does not have an established stock market, but loans by local banks are
available with a 90 percent interest rate. Fairfield has decided to use a strategy in which the subsid–
iary is financed entirely with funds from the parent. It believes that in this way it can avoid the
excessive interest rate in the host country. What is a key disadvantage of using this strategy that may
cause Fairfield to be no better off than if it paid the 90 percent interest rate?
ANSWER: The local currency of the host company will likely depreciate consistently and
substantially against the dollar because of the pressure caused by high inflation. Consequently, the
21. Cost of Foreign Debt Versus Equity. Carazona Inc. is a U.S. firm that has a large subsidiary in
Indonesia. It wants to finance the subsidiary’s operations in Indonesia. However, the cost of debt is
presently about 30 percent there for firms like Carazona or government agencies that have a very
strong credit rating. A consultant suggests to Carazona that it should use equity financing there to
avoid the high interest expense. He suggests that since Carazona’s cost of equity in the U.S. is about
14 percent, so the Indonesian investors should be satisfied with a return of about 14 percent as well.
Clearly explain why the consultant’s advice is not logical. That is, explain why Carazona’s cost of
equity in Indonesia would not be less than Carazona’s cost of debt in Indonesia.
ANSWER: The cost of equity is based on a risk-free interest rate plus a risk premium. The risk-free
22. Integrating Cost of Capital and Capital Budgeting. Zylon Co. is a U.S. firm that provides
technology software for the government of Singapore. It will be paid S$7,000,000 at the end of each
of the next five years. The entire amount of the payment represents earnings since Zylon created the
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Multinational Cost of Capital and Capital Structure 7
technology software years ago. Zylon is subject to a 30 percent corporate income tax rate in the
United States. Its other cash inflows (such as revenue) are expected to be offset by its other cash
outflows (due to operating expenses) each year, so its profits on the Singapore contract represent its
expected annual net cash flows. Its financing costs are not considered within its estimate of cash
flows. The Singapore dollar (S$) is presently worth $.60, and Zylon uses that spot exchange rate as a
forecast of future exchange rates.
The risk-free interest rate in the United States is 6 percent while the risk-free interest rate in
Singapore is 14 percent. Zylon’s capital structure is 60 percent debt and 40 percent equity. Zylon is
charged an interest rate of 12 percent on its debt. Zylon’s cost of equity is based on the CAPM. It
expects that the U.S. annual market return will be 12 percent per year. Its beta is 1.5.
Quiso Co., a U.S. firm, wants to acquire Zylon and offers Zylon a price of $10,000,000.
Zylon’s owner must decide whether to sell the business at this price and hires you to make a
recommendation. Estimate the NPV to Zylon as a result of selling the business, and make a
recommendation about whether Zylon’s owner should sell the business at the price offered.
ANSWER:
Zylon’s cost of debt = 12% (1 – .3) = 8.4%
PV of forgone cash flows = $2,940,000 × 3.6959 = $10,865,946. This is more than Zylon would
receive from selling the business, so it should not sell the business.
23. Financing with Foreign Equity. Orlando Co. has its U.S. business funded in dollars with a capital
structure of 60% debt and 40% equity. It has its Thailand business funded in Thai baht with a capital
structure of 50% debt and 50% equity. The corporate tax rate on U.S. earnings and on Thailand
earnings is 30%. The annualized 10-year risk-free interest rate is 6% in the U.S. and 21% in Thailand.
The annual real rate of interest is about 2% in the U.S. and in Thailand. Interest rate parity exists.
Orlando pays 3 percentage points above the risk-free rates when it borrows, so its before-tax cost of
debt is 9% in the U.S. and 24% in Thailand. Orlando expects that the U.S. annual stock market return
will be 10% per year, and the Thailand annual stock market return will be 28% per year. Its business
in the U.S. has a beta of .8 relative to the U.S. market, while its business in Thailand has a beta of 1.1
relative to the Thai market. The equity used to support Orlando’s Thai business was created from
retained earnings by the Thailand subsidiary in previous years. However, Orlando Co. is considering a
stock offering in Thailand that is denominated in Thai baht and targeted at Thai investors. Estimate
Orlando’s cost of equity in Thailand that would result from issuing stock in Thailand.
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Multinational Cost of Capital and Capital Structure 8
ANSWER:
Estimate cost of equity in Thailand
R(f) 0.21
24. Assessing Foreign Project Funded With Debt and Equity. Nebraska Co. plans to pursue a
project in Argentina that will generate revenue of 10 million Argentine pesos (AP) at the end of each
of the next 4 years. It will have to pay operating expenses of AP3 million per year. The Argentine
government will charge a 30% tax rate on profits. All after-tax profits each year will be remitted to
the U.S. parent and no additional taxes are owed. The spot rate of the AP is presently $.20. The AP is
expected to depreciate by 10% each year for the next 4 years. The salvage value of the assets will be
worth AP40 million in 4 years after capital gains taxes are paid. The initial investment will require
$12 million, half of which will be in the form of equity from the U.S. parent, and half of which will
come from borrowed funds. Nebraska will borrow the funds in Argentine pesos. The annual interest
rate on the funds borrowed is 14%. Annual interest (and zero principal) is paid on the debt at the end
of each year, and the interest payments can be deducted before determining the tax owed to the
Argentine government. The entire principal of the loan will be paid at the end of year 4. Nebraska
requires a rate of return of at least 20% on its invested equity for this project to be worthwhile.
Determine the NPV of this project. Should Nebraska pursue the project?
ANSWER:
Initial investment of $12 million is supported by one-half debt, or $6 million. Debt financing requires
AP30 million. The annual interest payment is 14% of AP30 million = AP4,000,000.
Year 0 Year 1 Year 2 Year 3 Year 4
Revenue AP10,000,000 AP10,000,000 AP10,000,000 AP10,000,000
Operating
Repay loan AP 30,000,000
Salvage value AP 40,000,000
Exchange Rate $0.20 $0.18 $0.16 $0.15
Cash flow in $ to
parent $392,000 $352,800 $317,520 $1,743,768
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Multinational Cost of Capital and Capital Structure 9
The NPV for the project is -$4,403,646. Nebraska should not pursue the project.
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