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.
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.
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.
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Multinational Cost of Capital and Capital Structure 2
4. Local Versus Global Capital Structure. Why might a firm use a “local” capital structure at a particu–
lar 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
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:
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.
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?
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Multinational Cost of Capital and Capital Structure 3
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?
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 its
financial leverage will still be no higher than that of its Japanese competitors. Comment on this
strategy.
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
as well. In this way, retained earnings are used while tying some local institutions into the project for
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.
Multinational Cost of Capital and Capital Structure 5
16. Nike’s Cost of Capital. If Nike decides to expand further in South America, why might its capital
structure be affected? Why will its overall cost of capital be affected?
ANSWER: If Nike expands further in South America, it must decide how to finance those operations.
It may consider using a large proportion of debt financing so that there will be less funds that
ultimately have to be converted into dollars as funds are remitted to the parent. This could reduce
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.
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?
b. Are there any additional alternatives for the Mexican subsidiary to finance its business itself after it
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Multinational Cost of Capital and Capital Structure 6
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
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.
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 subsidiary
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?
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.
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Multinational Cost of Capital and Capital Structure 7
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$7,000,000 at the end of each of
the next five years. The entire amount of the payment represents earnings since Zylon created the
technology software years ago. Zylon is subject to a 30 percent corporate income tax rate in the United
States. Its other cash inflows (such as revenue) are expected to be offset by its other cash outflows (due
to operating expenses) each year, so its profits on the Singapore contract represent its expected annual
net cash flows. Its financing costs are not considered within its estimate of cash flows. The Singapore
dollar (S$) 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.
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