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FINC3240 International Finance

FINC3240 International Finance. Chapter 17 Multinational Cost of Capital and Capital Structure. Chapter Objectives. This chapter will: A. Explain how corporate and country characteristics influence an MNC’s cost of capital

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FINC3240 International Finance

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  1. FINC3240 International Finance Chapter 17 Multinational Cost of Capital and Capital Structure

  2. Chapter Objectives This chapter will: A. Explain how corporate and country characteristics influence an MNC’s cost of capital B. Explain why there are differences in the costs of capital among countries C. Explain how corporate and country characteristics are considered by an MNC when it establishes its capital structure

  3. Balance Sheet Assets Liabilities and Owners Equity Cash Marketable securities Accounts Receivable Inventories Total Current Assets Gross Fixed Assets (less Accum. Depreciation) Net Fixed Assets Total Assets Notes Payable Accounts Payable Accrued Expenses Current Portion of LTD Total Current Liabilities Long term (L.T.) Debt Total Liabilities Preferred Stock Common Stock Retained Earnings Total Liabilities and equity S.T. Funds Liquidity L.T. Capital Assets Claims on Assets

  4. Capital Components 4

  5. weighted average cost of capital (WACC) WACC = wdrd(1-T) + were The w’s refer to the firm’s capital structure weights. The r’s refer to the cost of each component. d: debt; e: equity T: tax rate

  6. Component cost of debt WACC = wdrd(1-T) + were rd is the cost of debt capital. why rd(1-T)?

  7. focus on after-tax capital costs Because interest is tax deductible.

  8. Income Statement Company Name For the time period ending date Net Sales - Cost of Goods Sold • Operating Expenses • Depreciation = Operating Profit - Interest Expense = Profit Before Taxes - Taxes = Net Income • Operating income • Earnings before interest & taxes (EBIT) • Earnings before taxes (EBT) • Earnings • Net profit 8

  9. Component cost of equity WACC = wdrd(1-T) + were re is the cost of common equity

  10. Example If weight of debt =40%, weight of equity =60%, cost of debt=10%, cost of equity=14%, tax rate=30%, WACC = wdrd(1-T) + were = 0.4(10%)(1-0.3) + 0.6(14%) = 0.028 + 0.084 = 0.112=11.2%

  11. Searching for the Appropriate Capital Structure 17.1

  12. Difference in WACC between MNC and Domestic firms • Firm size • Access to international financial markets • International diversification lowers the cost of capital • Exposure to exchange rate risk • Exposure to country risk

  13. Costs of Capital across Countries 1. Country Differences in the Cost of Debt a. Differences in the Risk-Free Rate b. Differences in the Risk Premium c. Comparative Costs of Debt across Countries 2. Country Differences in the Cost of Equity

  14. Exhibit 17.3 Cost of Debt across Countries Source: Federal Reserve

  15. Using the Cost of Capital for Assessing Foreign Projects 1. Derive Net Present Values Based on the Weighted Average Cost of Capital 2. Adjust the Weighted Average Cost of Capital for the Risk Differential

  16. Exhibit 17.4 Lexon’s Estimated Weighted Average Cost of Capital (WACC) for Financing a Project

  17. Foreign Project NPV and Capital Structure

  18. MNC’s Capital Structure Decision 1. Influence of Corporate Characteristics a. Stability of MNC’s Cash Flows b. MNC’s Credit Risk 2. Influence of Host Country Characteristics Stock Restrictions in Host Countries Interest Rates in Host Countries Strength of Host country Currencies Country Risk in Host Countries Tax Laws in Host Countries 3. Revising the Capital Structure in Response to Changing Conditions

  19. Example • In recent years, several U.S. firms have penetrated Mexico’s market. One of the biggest challenges is the cost of capital to finance business 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.

  20. Question 1 • How might U.S.-based MNCs expand in Mexico without incurring 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 more at stake. As the Mexican subsidiary remits funds back to the U.S. parent, the MNC is exposed to a higher level of exchange rate risk.

  21. Question 2 • 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? ANSWER: Once the subsidiary has generated earnings, it can retain the earnings and reinvest them to finance future operations. This strategy emphasizes equity financing and would result in an equity-intensive capital structure for the subsidiary.

  22. Homework 11 Chapter 17: 2,5,8,9,10,12,21

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