Chapter 17
Multinational Cost of Capital and Capital Structure
Lecture Outline
Components of Capital
External 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
Multinational Cost of Capital
MNC’s Cost of Debt
MNC’s Cost of Equity
Estimating an MNC’s Cost of Capital
Comparing Costs of Debt and Equity
Costs of Capital for MNCs Vs. Domestic Firms
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
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.
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.
Multinational Cost of Capital and Capital Structure ❖ 3
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
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?
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.
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 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 ❖ 6
ANSWER:
14. Cost of Capital. Blues, Inc. is an MNC located in the U.S. Blues would like to estimate its weighted
average cost of capital. 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 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
=
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 attack on the U.S., it decided that long-term debt was
a cheaper source of capital. Explain how the terrorist attack could have altered 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.
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
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?
ANSWER: The parents of the MNCs could provide funding for the subsidiaries by investing their
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?
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
Multinational Cost of Capital and Capital Structure ❖ 8
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 debt-
intensive in Germany, its consolidated capital structure is not necessarily affected. The MNC’s cost
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. 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.
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$7,000,000 at the end of each
of the next five years. The entire amount of the payment represents earnings since Zylon created the
Multinational Cost of Capital and Capital Structure ❖ 9
technology software years ago. Zylon is subject to a 30 percent corporate income tax rate in the
United States. Its other cash inflows (such as revenue) are expected to be offset by its other cash
outflows (due to operating expenses) each year, so its profits on the Singapore contract represent its
expected annual net cash flows. Its financing costs are not considered within its estimate of cash
flows. The Singapore dollar (S$) 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%
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.
Multinational Cost of Capital and Capital Structure ❖ 10
ANSWER:
Estimate cost of equity in Thailand
R(f)
0.21
Beta
R(m)
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 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
Year 0
Year 1
Year 2
Year 3
Year 4
Revenue
AP10,000,000
AP10,000,000
AP10,000,000
AP10,000,000
Expenses
Interest payments
Pre-tax profit
After tax (30%)
profit
Repay loan
Salvage value
Cash flow
in AP
Exchange Rate
parent
Operating
Multinational Cost of Capital and Capital Structure ❖ 11
25. Sensitivity of Foreign Project Risk to Capital Structure. Texas Co. produces drugs and plans to
acquire a subsidiary in Poland. This subsidiary is a lab that would perform biotech research. Texas Co. is
attracted to the lab because of the cheap wages of scientists in Poland. The parent of Texas Co. would
review the lab research findings of the subsidiary in Poland when deciding which drugs to produce, and
would then produce 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, and all transactions are 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. Nevada Co. is subject to a 25% corporate tax
rate.
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
Multinational Cost of Capital and Capital Structure ❖ 12
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. Messan Co. is subject to a 30% corporate tax rate. Estimate the cost of
capital to Messan Co.
ANSWER:
28. MNC’s Cost of Capital. Newark Co. is based in the U.S. About 30% of its sales are from exports to
Portugal. Newark Co. has no other international business. It finances its operations with 40% equity and
the remainder of funds with dollar-denominated debt. It 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. 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:
29. MNC’s Cost of Capital. Slater Co. is a U.S.-based MNC that finances all operations with debt and
Multinational Cost of Capital and Capital Structure ❖ 13
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. Estimate the cost of capital to Slater Co.
ANSWER:
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 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 risk-free interest rate in the U.S. 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, and it expects that the subsidiary will generate large earnings in zin (the currency).
However, it is the Zinland government’s policy to block all funds 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.
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 blade manufacturers operating solely in the United States? Substantiate your
answer by outlining how Blades’ characteristics distinguish it from domestic roller blade
manufacturers.
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:
Multinational Cost of Capital and Capital Structure ❖ 15
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
Multinational Cost of Capital and Capital Structure ❖ 16
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
b. While the Mexican venture will have higher financing costs, the Mexican subsidiary will not
d. The Hungarian subsidiary may have to pay a higher interest rate, because it would not have the
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?
Multinational Cost of Capital and Capital Structure ❖ 17
3. How can the equity proportion of this firm’s capital structure increase over time after it is more
established?