Multinational Capital Structure and cost of Capital

Question 1

How can subsidiaries raise equity

Answer 1

A cash infusion in the subsidiary by the parent represents an equity investment . An alternative method by which the subsidiary can build more equity is to offer its own stock to the public
In general, an MNC can increase its capital internally by retaining earnings or externally by issuing debt or equity

Question 2

How is an MNCs global capital structure formed

Answer 2

When an MNC has foreign subsidiaries, its overall
(or “global”) capital structure is the combination of the capital structures of the parent and all subsidiaries

Question 3

Name some external sources of debt

Answer 3

Domestic bond offering
Global bond offering
Private placement of bonds
Loans from financial institutions

Question 4

Define domestic vs gloabl bond offerings

Answer 4

Domestic Bond Offering - MNCs commonly engage in a domestic bond offering in their home country in which the funds are denominated in their local currency.
Global Bond Offering - MNCs can engage in a global bond offering, in which they simultaneously sell bonds
denominated in the currencies of multiple countries

Question 5

Explain private placement of bonds

Answer 5

MNCs may offer a private placement of bonds to financial institutions in their home country or in the foreign country where they are expanding

Question 6

Name some external sources of equity

Answer 6

Domestic equity offering
Global equity offering
Private placement of equity

Question 7

Define domestic equity vs global equity

Answer 7

Domestic Equity Offering - MNCs can engage in a domestic equity offering in their home country in which the funds are denominated in their local currency.
Global Equity Offering - Some MNCs pursue a global equity offering in which they can simultaneously access equity from multiple countries

Question 8

Define private placement of equity

Answer 8

Offer a private placement of equity to financial institutions in their
home country or in the foreign country where they are expanding

Question 9

What are some corporate characteristics that influence an MNCs capital structure decisions between debt and equity

Answer 9

Cash flow stability
Credit risk
Access to retained earnings
Guarantees on debt
Agency problems

Question 10

Explain the influence over a MNCs capital structure decision of a firms cash flow stability

Answer 10

MNCs with more stable cash flows
can handle more debt because there is a constant stream of cash
inflows to cover periodic interest payments on debt.

Question 11

Explain the influence over a MNCs capital structure decision of a firms credit risk

Answer 11

MNCs that have lower credit risk have more access to credit – can more easily secure loans and so may prefer
to emphasize debt financing

Question 12

Explain the influence over a MNCs capital structure decision of a firms access to retained earnings

Answer 12

Highly profitable MNCs may be able to finance most of their investment with retained earnings and therefore use an equity-intensive capital structure.

Question 13

Explain the influence over a MNCs capital structure decision of a firms guarantees on debt

Answer 13

If the parent backs the debt of its
subsidiary, the subsidiary’s borrowing capacity might be increased. The subsidiary would need less equity financing

Question 14

Explain the influence over a MNCs capital structure decision of a firms agency problems

Answer 14

If a subsidiary in a foreign country
cannot easily be monitored by investors from the parent’s country,
agency costs are higher – inducement for debt financing

Question 15

Name some factors of the host countries that influence a MNC capital structure decisions

Answer 15

Interest rates of host
Strength of host country currency
Country risk in host countries
Tax laws in host countries

Question 16

Explain the influence over a MNCs capital structure decision of the host countries interest rates

Answer 16

The cost of loanable
funds may be lower in some countries.

Question 17

Explain the influence over a MNCs capital structure decision of the host countries currency

Answer 17

If an MNC expects weakness of the currencies in its subsidiaries’ host
countries, it may borrow in those currencies rather than rely
on parent financing. If the subsidiary’s local currency is
expected to appreciate, then the subsidiary may retain and
reinvest its earnings

Question 18

Explain the influence over a MNCs capital structure decision of the host countries country risk

Answer 18

If an MNC’s subsidiary
is exposed to the risk that the host government might
confiscate its assets, the subsidiary may use much debt
financing in that host country.

Question 19

Explain the influence over a MNCs capital structure decision of the host countries tax law

Answer 19

Foreign subsidiaries may be
subject to a withholding tax when they remit earnings – the parent’s taxes are reduced by using more local debt financing

Question 20

How should ideal capital structures respond to changing country characteristics?

Answer 20

May vary among countries
Could change within any particular country over time.

Question 21

What is the impact of increased subsidiary debt financing on both the subsidiary and parents capital structures

Answer 21

When a subsidiary relies heavily on debt financing, its need
for internal equity financing (retained earnings) is reduced.
Because these “extra” internal funds are remitted to the parent, the parent will itself have a larger amount of
internal funds.
Assuming that the parent’s operations absorb all internal
funds and require some debt financing, there are offsetting
effects on the capital structures of the subsidiary and the parent. The increased use of debt financing by the subsidiary is offset by the reduced debt financing of the
parent.

Question 22

What is the impact of reduced subsidiary debt financing on both the subsidiary and parents capital structures

Answer 22

When global conditions encourage the subsidiary to use less
debt financing, it will need to use more internal financing
and consequently will remit fewer funds to the parent
If the parent’s operations absorb all internal funds and require some debt financing, then there are offsetting
effects on the capital structures of the subsidiary and the
parent.
The subsidiary’s reduced use of debt financing is offset by the parent’s increased use.

Question 23

What are the limitations in offsetting a subsidiary’s leverage for an MNC

Answer 23

The strategy of offsetting a subsidiary’s shift in financial
leverage to achieve a global target capital structure is rational as long as it is acceptable to foreign creditors and investors.
However, foreign creditors may charge higher loan rates to a subsidiary that uses a highly leveraged local capital structure
If the parent plans to back the subsidiaries, it could guarantee debt repayment to the creditors in the foreign countries
Doing so might reduce their risk perception and lower the cost of debt

Question 24

Define an MNCs cost of Debt

Answer 24

An MNC’s cost of debt is
dependent on the interest rate that it pays when borrowing funds (risk free rate + credit risk premium) – there is a tax advantage associated with debt

Question 25

Define an MNCs cost of equity

Answer 25

An MNC creates equity
by retaining earnings or by issuing new stock. An MNC’s cost of equity contains a risk premium (above the risk-free interest rate) that
compensates the equity investors for their willingness to invest in the equity

Question 26

Formulae for estimating an MNCs cost of capital

Answer 26

K = (D/D+E)Kd(1-t)+(E/D+E)Ke

K= weighted average cost of capital
D= debt
E= equity
T= corporate tax rate
Kd= before tax cost of its debt
Ke = cost of financing with equity.

Question 27

Compare the costs advantages/disadvantages to using debt vs equity

Answer 27

There is an advantage to using debt rather than equity as capital because the interest payments on
debt are tax deductible. The greater the use of debt, however, the greater the interest expense and the higher the probability that
the firm will be unable to meet its expenses.
If MNC increases its proportion of debt, the rate of return required by potential new shareholders or creditors will increase to reflect the higher probability of bankruptcy

Question 28

Where is the appropriate capital structure?

Answer 28

Where the debt ratio minimizes the cost of capital

Question 29

Why might Cost of Capital for MNCs versus Domestic Firms differ

Answer 29

Size of firm - MNC borrow substanial amount and may receive preferential treatment from creditors to reduce cost of capital.
Access to international capital markets - MNCs may be able to obtain funds at lower cost
International diversification - Cash inflows coming from all over the world means these are more stable as the firms total sales will not be influenced by a single economy.
Exchange rate exposure - MNC cash flows are more volatile
Exposure to country risk - MNC establishing subsidaries is subject to possibility that a host country government may seize a subsidaries assets.

Question 30

What does CAPM suggest that required return is a positive
function of

Answer 30

▪ The risk-free rate of interest
▪ The market rate of return
▪ The stock’s beta

Question 31

Formula for required return on stock (ie cost of equity) as per CAPM

Answer 31

ke = Rf + B(Rm – Rf)

Question 32

Define risk free rate

Answer 32

The risk-free rate is the interest rate charged on loans to a country’s government that is perceived to have no risk of defaulting on the loans (affected by tax laws, demographics, monetary policies and economic conditions)

Question 33

What determines an MNC’s credit risk premium

Answer 33

The credit risk premium paid by an MNC must be large enough to compensate creditors for taking the risk that the MNC may not meet its payment obligations

Question 34

How can the risk free rate influence cost of equity

Answer 34

When the country’s risk-free interest rate is high, local investors would only invest in equity if the potential return is sufficiently higher than that they can earn at the risk-free rate