Chapter 17
Multinational Cost of Capital and Capital Structure
Lecture Outline
Components of Capital
Retained Earnings
Sources of Debt
External Sources of Equity
The MNC‘s Capital Structure Decision
Influence of Corporate Characteristics
Influence of Host Country Characteristics
Response to Changing Country Characteristics
Subsidiary Versus Parent Capital Structure Decisions
Impact of Increased Subsidiary Debt Financing
Impact of Reduced Subsidiary Debt Financing
Limitations in Offsetting a Subsidiary’s Leverage
Multinational Cost of Capital
MNC’s Cost of Debt
MNC’s Cost of Equity
Estimating an MNC’s Cost of Capital
Cost of Capital Across Countries
Country Differences in the Cost of Debt
Country Differences in the Cost of Equity
Multinational Cost of Capital and Capital Structure ❖ 2
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
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.
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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?
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.
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?
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.
Multinational Cost of Capital and Capital Structure ❖ 5
in the host countries of concern to reduce its exposure to country risk. Explain the dilemma faced by
Pullman and offer possible solutions.
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.
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 20 percent. What is this firm’s cost of capital?
ANSWER:
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?
ANSWER:
%7.13
137.
%)2%11(3.1%2
)(
=
=
−+=
−+= fmfe RRBRk
14. Cost of Capital. Blues, Inc. is an MNC located in the U.S. The firm would like to estimate its
weighted average cost of capital (WACC). On average, bonds issued by Blues yield 9 percent.
Currently, Treasury security rates are 3 percent. Furthermore, Blues’ stock has a beta of 1.5, and the
return on the Wilshire 5000 stock index is expected to be 10 percent. Blues’ target capital structure is
Multinational Cost of Capital and Capital Structure ❖ 6
30 percent debt and 70 percent equity. If Blues is in the 35 percent tax bracket, what is its weighted
average cost of capital?
ANSWER: First, estimate the cost of equity using the CAPM:
%5.13
135.
%)3%10(5.1%3
)(
=
=
−+=
−+= fmfe RRBRk
Next, estimate the weighted average cost of capital:
15. Effects of September 11. Rose, Inc., of Dallas, Texas needed to infuse capital into its foreign
subsidiaries to support their expansion. As of August 2001, it planned to issue stock in the U.S.
However, after the September 11, 2001 terrorist attacks on the U.S., it decided that long-term debt
was a cheaper source of capital. Explain how the terrorist attacks could have altered the appeal of the
two forms of capital.
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
Multinational Cost of Capital and Capital Structure ❖ 7
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
stream generated from the British subsidiary will be slightly more favorable than the revenue stream
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 entered the market in Mexico. 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 become well established? How might this strategy affect the subsidiary’s capital structure?
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, which will replace 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.
Multinational Cost of Capital and Capital Structure ❖ 8
a. Explain the expected effects of these actions on the consolidated capital structure and cost of
capital of Forest Company.
b. 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 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?
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, but 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 in Indonesia
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.
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$7,000,000 at the end of each
of the next five years. The entire amount of the payment represents earnings since Zylon created the
technology software years ago. Zylon is subject to a 30 percent corporate income tax rate (federal and
state combined) in the United States. Its other cash inflows (such as revenue) are expected to be offset
by its other cash outflows (due to operating expenses) each year, so its profits on the Singapore
contract represent its expected annual net cash flows. Its financing costs are not considered within its
Multinational Cost of Capital and Capital Structure ❖ 9
estimate of cash flows. The Singapore dollar (S$) 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, whereas the risk-free interest rate in
Singapore is 14 percent. Zylon’s capital structure is 60 percent debt and 40 percent equity. The
company 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%
Zylon’s cost of equity = 6% + (12% – 6%) × 1.5 = 15%
23. Financing with Foreign Equity. The U.S. firm Orlando Co. is funded in dollars with a capital
structure of 60% debt and 40% equity. Its Thailand business is 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% (federal and state combined). 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, whereas 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. Now, 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.
ANSWER:
Estimate cost of equity in Thailand
Multinational Cost of Capital and Capital Structure ❖ 10
R(f)
0.21
Beta
1.1
R(m)
0.28
Cost of Equity = R(f) + Beta(R(m) – R(f))
=28.70%
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 Argentinean 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 on those funds. The spot rate of the AP is currently
$.20. The AP is expected to depreciate by 10% each year for the next 4 years. The salvage value of
the proposed project’s assets will be worth AP40 million in 4 years after Nebraska pays capital gains
taxes. 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 at an annual interest rate of 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 Argentinean government. The firm will pay the entire principal of the loan 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
Expenses
AP3,000,000
AP3,000,000
AP3,000,000
AP3,000,000
Interest
payments
AP4,200,000
AP4,200,000
AP 4,200,000
AP 4,200,000
Pre-tax profit
AP 2,800,000
AP 2,800,000
AP 2,800,000
AP 2,800,000
After tax (30%)
profit
AP,960,000
AP 1,960,000
AP 1,960,000
AP 1,960,000
Repay loan
AP 30,000,000
Salvage value
AP 40,000,000
Cash flow in
AP
AP 1,960,000
AP 1,960,000
AP 1,960,000
AP 11,960,000
Exchange Rate
$0.20
$0.18
$0.16
$0.15
Cash flow in
$ to parent
$392,000
$352,800
$317,520
$1,743,768
PV (20%
discount rate)
$326,666
$245,000
$183,750
$840,937
Initial outlay
in U.S. $
$6,000,000.00
Cumulative
NPV
-$5,673,333
-$5,428,333
-$5,244,583
-$4,403,645
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25. Sensitivity of Foreign Project Risk to Capital Structure. Texas Co. produces pharmaceutical drugs
and plans to acquire a subsidiary in Poland. This subsidiary, a laboratory, would perform
biotechnology research. Texas Co. is attracted to the lab because of the cheap wages paid to scientists
in Poland. The parent of Texas Co. would review the lab research findings of the subsidiary in Polish
subsidiary when deciding which drugs to produce, and would then manufacture the drugs in the U.S.
The expenses incurred in Poland will represent about half of the total expenses incurred by Texas Co.
All drugs produced by Texas Co. are sold in the U.S. and this situation would not change in the
future. Texas Co. has considered 3 ways to finance the acquisition of the Polish subsidiary if it buys
it. First, it could use 50% equity funding (in dollars) from the parent and 50% borrowed funds in
dollars. Second, it could use 50% equity funding (in dollars) from the parent and 50% borrowed funds
in Polish zloty. Third, it could use 50% equity funding by selling new stock to Polish investors
denominated in Polish zloty and 50% borrowed funds denominated in Polish zloty. Assuming that
Texas Co. decides to acquire the Polish subsidiary, which financing method for the Polish subsidiary
would minimize the exposure of Texas to exchange rate risk? Explain.
26. Cost of Capital and Risk of Foreign Financing. Nevada Co. is a U.S. firm that conducts major
importing and exporting business in Japan, with all these transactions invoiced in dollars. It obtained
debt in the U.S. at an interest rate of 10 percent per year. The long-term risk-free rate in the U.S. is 8
percent. The stock market return in the U.S. is expected to be 14 percent annually. Nevada’s beta is
1.2. Its target capital structure is 30 percent debt and 70 percent equity. The firm is subject to a 25%
corporate tax rate (federal and state combined).
a. Estimate the cost of capital to Nevada Co.
b. Nevada has no subsidiaries in foreign countries but plans to replace some of its dollar-
denominated debt with Japanese yen-denominated debt, since Japanese interest rates are low. It
will obtain yen-denominated debt at an interest rate of 5 percent. It can not effectively hedge the
exchange rate risk resulting from this debt because of parity conditions that makes the price of
derivatives contracts reflect the interest rate differential. How could Nevada Co. reduce its
exposure to the exchange rate risk resulting from the yen-denominated debt without moving its
operations?
ANSWER:
27. Measuring the Cost of Capital. Messan Co. (a U.S. firm) borrows U.S. funds at an interest rate of
10 percent per year. Its beta is 1.0. The long-term annualized risk-free rate in the U.S. is 6 percent.
The stock market return in the U.S. is expected to be 16 percent annually. Messan’s target capital
structure is 40 percent debt and 60 percent equity. The firm is subject to a 30% corporate tax rate
(federal and state combined). Estimate the cost of capital for Messan Co.
Multinational Cost of Capital and Capital Structure ❖ 12
ANSWER:
Cost of equity =
)( fmfe RRBRk −+=
28. MNC’s Cost of Capital. Newark Co. is based in the U.S. Approximately 30% of its sales are from
exports to Portugal, and the company has no other international business. It finances its operations
with 40% equity and the remainder of funds with dollar-denominated debt. Newark borrows its funds
from a U.S. bank at an interest rate of 9 percent per year. The long-term risk-free rate in the U.S. is 6
percent, whereas the long-term risk-free rate in Portugal is 11 percent. The stock market return in the
U.S. is expected to be 13 percent annually. Newark’s stock price typically moves in the same
direction and by the same degree as the U.S. stock market. Its earnings are subject to a 20% corporate
tax rate. Estimate the cost of capital to Newark Co.
ANSWER:
Cost of equity =
)( fmfe RRBRk −+=
29. MNC’s Cost of Capital. Slater Co. is a U.S.-based MNC that finances all of its operations with debt
and equity. It borrows U.S. funds at an interest rate of 11 percent per year. The long-term risk-free
rate in the U.S. is 7 percent. The stock market return in the U.S. is expected to be 15 percent annually.
Slater’s beta is 1.4. Its target capital structure is 20 percent debt and 80 percent equity. Slater Co. is
subject to a 30% corporate tax rate (federal and state combined). Estimate the cost of capital to Slater
Co.
ANSWER:
Cost of debt = 11%
30. Change in Cost of Capital. Assume that Naperville Co. will use equity to finance a project in
Switzerland, while Lombard Co. will rely on a dollar-denominated loan to finance a project in
Switzerland, and that Addison Co. will rely on a Swiss franc-denominated loan to finance a project in
Switzerland. The firms will arrange their financing in one month. This week, the U.S. risk-free long-
term interest rate declined, but interest rates in Switzerland did not change. Do you think the
Multinational Cost of Capital and Capital Structure ❖ 13
estimated cost of capital for the projects by each of these 3 U.S. firms increased, decreased, or
remained unchanged? Explain.
31. Cost of Equity. Illinois Co. is a U.S. firm that plans to expand its business overseas. It plans to use
all equity to be obtained in the U.S. to finance a new project. The project’s cash flows are not affected
by U.S. interest rates. Just before Illinois Co. obtains new equity, the U.S. risk-free interest rate rises.
Will the change in interest rates increase, decrease, or have no effect on the required rate of return on
the project? Briefly explain.
32. Debt Financing Decision. Marks Co. (a U.S. firm) considers a project in which it will establish a
subsidiary in Zinland, which it expects would generate large earnings in zin (the currency). However,
the Zinland government’s policy is to block all funds transfers so that earnings cannot be remitted to
the U.S. parent for at least 10 years; furthermore, the blocked funds cannot earn interest. The zin is
expected to weaken by 20% per year against the dollar over time. Marks Co. will borrow some funds
to finance the subsidiary. Should the company (a) obtain a dollar-denominated loan and convert the
loan into zin, or (b) obtain a zin-denominated loan, or (c) obtain half of the funds needed from each
possible source? [Assume that the interest rate from borrowing zin is the same as the interest rate
from borrowing dollars.] Briefly explain.
CRITICAL THINKING
Tradeoffs Involved in MNC’s Capital Structure Decisions In recent years, some U.S.-based MNCs
(such as Apple) have taken advantage of the very low interest rates in the U.S. by borrowing large amount
of dollars to finance their operations. Write a short essay that explains the advantages and possible
disadvantages (if any) due to this type of financing. Consider how it affects the cost of capital. Also,
consider how it affects the MNC’s capital structure, but keep in mind that the interest payments on debt
borrowed at an interest rate of 3% differs from interest rate payments on debt borrowed at 10%. Also,
consider how it affects the exposure to exchange rate risk if the funds borrowed are used to finance
foreign operations.
ANSWER
Multinational Cost of Capital and Capital Structure ❖ 14
Solution to Continuing Case Problem: Blades, Inc.
1. If Blades expands into Thailand, do you think its cost of capital will be higher or lower than the cost
of capital of roller blades manufacturers operating solely in the United States? Substantiate your
answer by outlining how Blades’ characteristics distinguish it from domestic roller blades
manufacturers.
ANSWER: Blades’ cost of capital will probably be higher than the cost of capital of roller blade
manufacturers operating solely in the U.S. as a result of Blades’ expansion into Thailand. Usually, an
2. According to the CAPM, how would Blades’ required rate of return be affected by an expansion into
Thailand? How do you reconcile this result with your answer to question 1? Do you think Blades
should use the required rate or return resulting from the CAPM to discount the cash flows of the Thai
subsidiary to determine its NPV?
ANSWER: Before Blades’ expansion into Thailand, its required rate of return according to the
CAPM was:
%19
=
Subsequent to Blades’ expansion into Thailand, its required rate of return according to the CAPM
will be:
%6.17
=
Thus, the required rate of return on equity would decrease by 1.4 percent as a result of Blades’
expansion into Thailand.
The answer to question 1 suggests that Blades’ cost of capital would increase as a result of its
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3. If Blades borrows funds in Thailand to support its Thai subsidiary, how would this affect its cost of
capital? Why?
4. Given the high level of interest rates in Thailand, the high level of exchange rate risk, and the high
(perceived) level of country risk, do you think Blades will be more or less likely to use debt in its
capital structure as a result of its expansion into Thailand? Why?
ANSWER: Given the high levels of interest rates, exchange rate risk, and (perceived) country risk in
Thailand, it is uncertain whether Blades will use more or less debt in its capital structure as a result of
Solution to Supplemental Case: Sabre Computer Corporation
a. The cost of financing is composed of a risk-free rate and a risk premium. The Mexican joint venture
would likely have a higher risk-free rate since its inflation rate is usually much higher than
Hungary’s. The risk premium should probably be higher on the Hungarian venture because there is
b. While the Mexican venture will have higher financing costs, the Mexican subsidiary will not
necessarily experience lower returns. The high inflation that causes a high risk-free rate also can
inflate periodic cash flows. Thus, there may be an offsetting effect. Recall that the price of
computers in Mexico is tied to the inflation rate.
c. If the debt is backed by the parent, the creditors may be less inclined to charge a high-risk premium.
d. The Hungarian subsidiary may have to pay a higher interest rate, because it would not have the
Multinational Cost of Capital and Capital Structure ❖ 16
e. The risk-free interest rate is likely to rise in response to an increase in inflation. Therefore, the cost of
Small Business Dilemma
Multinational Capital Structure Decision at the Sports Exports Company
1. What is an advantage of using equity to support the subsidiary? What is a disadvantage?
ANSWER: An advantage is that retained earnings may be a relatively low-cost method of financing.
The use of equity to support the subsidiary is especially effective if Jim did not have any other plan
for using the equity.
2. If Jim decided to use long-term debt as its primary form of capital to support this subsidiary, should
he use dollar-denominated debt or pound-denominated debt?
3. How can the equity proportion of this firm’s capital structure increase over time after it is more
established?