chapter 17 multinational capital structure and cost of capital
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Chapter 17 Multinational Capital Structure and Cost of Capital. 17.1Capital Structure and the Cost of Capital 17.2Project Valuation and the Cost of Capital 17.3Sources of Funds for Multinational Operations 17.4The International Evidence on Capital Structure - PowerPoint PPT PresentationTRANSCRIPT
Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-1
Chapter 17Chapter 17Multinational Capital Structure Multinational Capital Structure
and Cost of Capitaland Cost of Capital
17.1 Capital Structure and the Cost of Capital
17.2 Project Valuation and the Cost of Capital
17.3 Sources of Funds for Multinational Operations
17.4 The International Evidence on Capital Structure
17.5 The Cost of Capital on Multinational Operations
17.6 Summary
Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-2
Capital structureCapital structure
Capital structure refers to the proportion of long-term debt and equity and the particular forms of capital chosen to finance the assets of the firm.
Management must choose – the proportions of debt and equity
– the currency of denomination
– fixed or floating rate interest payments
– indenture provisions
– conversion features
– callability
– seniority
– maturity
Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-3
Multinational financing opportunitiesMultinational financing opportunities
MNC’scost of capital
Investment opportunity set
Domestic firm’scost of capital
Domestic firm Capital budget
%
MNC
Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-4
The weighted average cost of capitalThe weighted average cost of capital
Weighted average cost of capital iWACC
After-tax cost ofdebt capital iB(1-TC)
Cost of equity capital iS
Range of optimal capital structure Debt/equity ratio
Cost of capital (%) iWACC = (B/V)iB(1TC)+(S/V)iS
Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-5
The multinational’s cost of capital The multinational’s cost of capital (given a particular set of investments)(given a particular set of investments)
Debt/equity ratio
Cost of capital (%)
Domestic iS
Multinational iS
Multinational iWACC
Multinational iB(1 TC)
Domestic iWACC
Domestic iB(1 TC)
Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-6
Optimal capital structureOptimal capital structure
Far better an approximate answer to the right question, which is often vague, than an exact
answer to a wrong question, which can always be made precise.
John W. Tukey
Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-7
The perfect market assumptionsThe perfect market assumptions
Perfect markets:
» Frictionless markets
» Equal access to market prices
» Rational investors
» Equal access to costless information
Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-8
Modigliani-Miller’s irrelevance propositionModigliani-Miller’s irrelevance proposition
Equal access to perfect financial markets means that individual investors can replicate any financial action that the firm can take.
This leads to MM’s irrelevance proposition:
» If financial markets are perfect, then corporate financial policy is irrelevant.
Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-9
The converse of The converse of MM’s irrelevance propositionMM’s irrelevance proposition
If financial policy is to increase value, then it must either
» increase the firm’s expected future cash flows
or
» decrease the discount rate
in a way that cannot be replicated by individual investors.
V =E[CF ]
(1 + i)
t
tt
Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-10
Financial market integration vs. segmentationFinancial market integration vs. segmentation
In integrated financial markets, real after-tax rates of return on equivalent assets are equal.
Factors contributing to segmentation include:» prohibitive transactions costs
» different legal and political systems
» regulatory interference (e.g., barriers to financial flows)
» differential taxes
» informational barriers
» home asset bias (a tendency to buy financial assets in the domestic market)
» differential investor expectations
Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-11
Project valuation and the cost of capitalProject valuation and the cost of capital
Alternative approaches to project valuation
» WACC: Weighted average cost of capital
» APV: Adjusted present value
Use an asset-specific discount rate that reflects the opportunity cost of capital.» Cash flows denominated in the domestic (foreign)
currency should be discounted at a domestic (foreign) discount rate.
» Nominal (real) cash flows should be discounted at nominal (real) discount rate.
Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-12
Weighted average cost of capitalWeighted average cost of capital(WACC)(WACC)
NPV = t [ E[CFt] / (1+iWACC)t ]
where iWACC = [(B/VL) iB (1-TC)] + [(S/VL)iS]
and B = the market value of corporate bonds
S = the market value of corporate stock
VL = B + S = the market value of the firm
iB = the required return on corporate bonds
iS = the required return on corporate stock
TC = the marginal corporate income tax rate
Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-13
Adjusted present valueAdjusted present value(APV)(APV)
APV = VU + PV(financing side effects)
- initial investment
where VU = the value of the unlevered
or all-equity project
PV(financing side effects)
= value of tax shields from the use of debt
net of costs of financial distress
Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-14
Sources of funds for multinational operationsSources of funds for multinational operations
The financial pecking order:
» Internally generated funds are the preferred source.
» External sources of funds are accessed only after internal sources are exhausted.
External debt is the preferred external funding source.
New external equity is used only as a last resort.
Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-15
Sources of funds for multinational operationsSources of funds for multinational operations
Internal sources External sources
Multinational Cash flow from the parent New debt or equity financingcorporation’s and from affiliates in the (perhaps issued or guaranteedhome country parent’s home country by the parent corporation)
Foreign project’s Cash flow from existing Local debt or equity fromhost country operations in the host institutions or markets in the
country host country
International Cash flow redistributed Eurobondsfinancing sources from other foreign Euroequity
affiliates Project finance
Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-16
Targeted registered offeringsTargeted registered offerings
Registered versus bearer securities» Securities in the United States are issued in registered
form. » The convention in Western European countries is to issue
securities in bearer form.
U.S. corporations can issue bearer securities to international investors as targeted registered offerings.
» The registered owner must be a financial institution in another country.
» Interest or dividends is paid to this registered financial institution.» The issuer must certify that it has no knowledge that a U.S.
taxpayer owns the security.» The issuer and the registered foreign institutions must follow the
certification procedures of the Securities and Exchange Commission.
Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-17
The U.S. evidence on capital structureThe U.S. evidence on capital structure
Leverage increases with» Fixed assets
» Firm size
» Nondebt tax shields
Leverage decreases with» Growth opportunities
» Profitability
» Uniqueness of the firm’s product(s)
» Earnings volatility
» Advertising and R&D expenditures
» Probability of bankruptcy or default
Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-18
Balance sheets for nonfinancial firmsBalance sheets for nonfinancial firms
$ ¥ DM Franc Lira £ C$
Current assets 48.0 57.7 59.4 58.3 56.5 54.7 33.2Fixed assets 54.2 40.3 39.9 41.2 41.0 44.9 63.6Assets - other 5.8 2.9 0.7 0.7 3.3 0.5 3.7Assets -- total 100.0 100.0 100.0 100.0 100.0 100.0 100.0
Current liabilities 33.4 42.2 30.0 43.4 43.2 40.0 23.1Long-term debt 23.3 18.9 9.8 15.7 12.1 12.4 28.1Other liabiliites 9.6 5.8 32.8 11.5 12.5 5.4 7.0Liabilities -- total 66.1 66.8 72.0 68.8 67.4 57.8 60.3
Shareholders equity 34.1 33.2 28.0 31.2 32.6 42.2 39.7Total liabilities & equity 100.0 100.0 100.0 100.0 100.0 100.0 100.0
Longterm debt to capitaladjusted for accountingdifferences
33% 37% 18% 34% 39% 16% 37%
Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-19
The international evidenceThe international evidenceon capital structureon capital structure
Leverage increases with
» The proportion of fixed to total assets» Firm size
Leverage decreases with
» Asset market-to-book ratios (~ growth opportunities)
» Profitability
Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-20
Diversifiable versus nondiversifiable risksDiversifiable versus nondiversifiable risksand the multinational’s cost of capitaland the multinational’s cost of capital
If operating risks are diversifiable, then they are not priced by investors and should not be reflected in capital costs.
If operating risks are nondiversifiable (systematic), then they should be reflected in capital costs.
» The multinational corporation’s capital costs are increased if these risks are positively related to the market portfolio
» The multinational corporation’s capital costs are decreased if these risks are negatively related to the market portfolio
Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-21
The multinational corporation’s cost of capitalThe multinational corporation’s cost of capital
Mixed empirical evidence
» MNCs have lower betas despite higher financial leverageMichel and Shaked, “Multinational Corporations vs. Domestic Corporations: Financial Performance and Characteristics,” Journal of International Business Studies, Fall 1986.
» MNCs have higher betas after controlling for leverage, size and growth
Reeb, Kwok and Baek, “Systematic Risk of the Multinational Corporation,” Journal of International Business Studies, No. 2, 1998.
Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 17-22
The effect of financial market The effect of financial market liberalizations on the cost of capitalliberalizations on the cost of capital
Bekaert and Harvey (1998) find that financial market liberalizations tend to:
» Increase the correlation of emerging market returns with world market returns.
» Have little impact on emerging market volatility.
» Decrease local firms’ capital costs by up to 1 percent.
Source: Geert Bekaert and Campbell Harvey, “Foreign Speculators
and Emerging Equity Markets,” Fuqua School of Business
Working Paper, June 1998.