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Optimal Capital Structure

in Multinational Corporations

by

Prof. Dr. Dr. Joachim Häcker


Content

1. Financial issues of multinational companies

2. Theoretical analysis on optimal capital structure

2.1. The leverage effect

2.2. The Modigliani Miller proposition

2.3. The traditional approach

3. Practical analysis on optimal capital structure

Optimal Capital Structure by Prof. Dr. Dr. Joachim Häcker


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1. Financial issues of multinational companies

Financial Management Three core elements:


Definition „ Capital structure: Determination of debt and equity properties
necessary to maximize firm’s financial health and long-term
competitiveness.
„ Capital budgeting: Analysis of investment opportunities
considered by the firm.
„ Cash management: Management of the levels and composition
of the current assets of the firm (cash, receivables, inventories)
and their proper funding.

„ International: Goods produced in the domestic market and then


Multinational Corporation exported to foreign buyers.
(MNC)
„ Multinational: Parent company in home country and numerous
subsidiaries or joint ventures in foreign countries.

Optimal Capital Structure by Prof. Dr. Dr. Joachim Häcker


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2. Theoretical analysis on optimal capital structure
2.1 The leverage effect

Definition: Leverage effect „ The “financial leverage effect“ describes the


impact of the level of debt on return on
equity.

„ NI = ROE * E

Note: „ ROE * E = ROC * (E + D) – i * D

NI ….. Net income


E ..... Equity „ ROE * E = ROC * E + ROC * D – i * D
D ..... Debt
ROE ..... Return on equity „ ROE * E = ROC * E + (ROC –i) * D
ROC ..... Return on total capital
i ..... Interest rate
D/E ..... Debt to equity ratio ROE = ROC + (ROC - i) * D / E

Optimal Capital Structure by Prof. Dr. Dr. Joachim Häcker


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„ (ROC > i): If return on total capital is larger than the
ROC versus interest rate
interest rate on debt, return on equity increases in
proportion to the debt-equity ratio. The rate of
ROE (ROC > i) increase is determined by the spread between the
return on total capital and the interest rate on debt.

„ (ROC = i): If return on total capital equals the


(ROC = i) interest rate on debt, return on equity remains
constant with an increasing debt-equity ratio.
(ROC < i)
„ (ROC < i): If return on total capital is lower than the
D/E interest rate on debt, return on equity decreases with
a higher debt-equity ratio (magnitude depends on
spread).
ROE = ROC + (ROC - i) * D / E

Optimal Capital Structure by Prof. Dr. Dr. Joachim Häcker


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Example (1): Constant debt-equity ratio (D = E):

„ Deployed capital can, affected by an unfavourable (ROC = 2%), average (ROC = 6%), or favourable
(ROC = 14%) market development with equal probability, earn three different returns.

„ With a debt-equity ratio of 1 (D = E) and an interest rate on debt of i = 6%, the leverage equation gives
the following returns on equity:

3 Cases ROE ROC + (ROC - i) * D/E = ROE


Besides business risk and
ROC < i ROE (unfavourable) 2% + (2% - 6%) * 1 = -2%
investment risk, the company
ROC = i ROE (average) 6% + (6% - 6%) * 1 = 6% incurs a financial or capital
ROC > i ROE (favourable) 14% + (14% - 6%) * 1 = 22% structure risk with the use of debt.

„ The spread of percentage returns on equity is amplified.

„ With a higher debt-equity ratio, both the opportunity for a high return on equity and the risk of a low
(negative) return on equity increases simultaneously.

Optimal Capital Structure by Prof. Dr. Dr. Joachim Häcker


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Example (2): Different debt levels:

Shareholders:
Return on equity depends on the
debt level „ Risk but also potential reward increase with growing
level of debt.
3 Cases D/E 0/100 25/75 50/50 75/25
Lenders:
ROC < i Unfavourable 2% 0.67% -2% -10%

ROC = i Average 6% 6% 6% 6% „ Although interest payments are relatively safe at a low


ROC > i Favourable 14% 16.67% 22% 38% level of debt, negative returns on equity may occur
with an increasing level of debt, potentially leading to
a total consumption of equity.

„ With increasing debt levels, interest and principal


payments are increasingly at risk.

Optimal Capital Structure by Prof. Dr. Dr. Joachim Häcker


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„ What is the effect of the capital structure on return on
Question:
equity?

„ With increasing leverage, the potential reward (risk) of


Answer
increasing (decreasing) return on equity is amplified.

„ The outcome is a financial or capital structure risk:

If: ROC > i ROE (ROC-i; D/E)

If: ROC = i ROE (ROC-i; D/E)

If: ROC < i ROE (ROC-i; D/E)

Optimal Capital Structure by Prof. Dr. Dr. Joachim Häcker


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2.2 The Modigliani Miller proposition
„ The Modigliani / Miller proposition states that the market value of
Market value
any firm is independent of its capital structure. I.e., changes in
capital structure do not affect the stockholders’ welfare.

„ 2 companies that generate the same stream of operating income and


differ only in capital structure will have the same valuation.

„ Assuming perfect markets, the arbitrage argument ensures this


Arbitrage equilibrium. If levered firms were priced too high, rational
investors would simply borrow on personal account to buy shares in
unlevered firms, thus duplicating the effects of corporate leverage.

„ The arbitrage process would decrease the value of the levered firm
and increase the value of the unlevered firm, until both valuations
are again in equilibrium. Once again, investors are indifferent
between investment choices.

„ Since the equilibrium price is derived on markets, market values


and not book values are relevant.

Optimal Capital Structure by Prof. Dr. Dr. Joachim Häcker


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2.2 The Modigliani Miller proposition (cont’d)

The Modigliani Miller proposition is based on the following


Assumptions
assumptions (perfect capital markets):

(1) Every investor maximizes his financial utility

(2) Corporations and individuals can borrow at the same


interest rate

(3) The borrowing interest rate equals the lending interest rate

(4) No transaction costs

(5) No bankruptcy costs

(6) Debt instruments can be divided at the discretion of


market participants

(7) Taxation of all investment and debt instruments for all


market participants is equal

Optimal Capital Structure by Prof. Dr. Dr. Joachim Häcker


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2.3 The traditional approach

„ Shows the dependence of


ROE
the required return on
WACC ROE equity on the level of
i debt.

WACC „ Minimizing WACC


equals maximizing
i overall firm value.

Optimal level of debt Debt ratio

Optimal Capital Structure by Prof. Dr. Dr. Joachim Häcker


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Conclusion:

„ The value of the company is derived by discounting future cash flows with the weighted average cost
of capital (WACC).

„ With increasing levels of debt, expensive equity is replaced by cheap debt.

„ If a company gradually increases its debt level, risk increases. This fact will either be neglected by
equity holders, or it seems to them to be negligible.

„ Future cash flows will be discounted with the same WACC. Thus, company value increases.

„ Only with a significant increase of the debt level – the exact threshold is unknown – equity holders
act on the increase of risk. Consequently, they require a higher return on equity, and future cash flows
are discounted with a higher WACC.

„ Debt holders act similarly but temporally delayed.

„ Maximum company value is derived at the minimum WACC.

Optimal Capital Structure by Prof. Dr. Dr. Joachim Häcker


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Comparison of theories

The question regarding the existence of an optimal capital structure is not unequivocally answered in
theory.

Leverage Effect Modigliani Miller Traditional Approach

„ With increasing debt „ The capital structure is „ There is an optimal


levels the return on irrelevant for the market capital structure
equity changes, value of a company
„ This is the case at the
depending on ROC
„ I.e., there is no optimal minimum WACC (or
and i
capital structure the maximum overall
„ If ROC > i, the firm value)
optimal capital
structure implies a
fully levered firm
„ If ROC < i, a fully
unlevered firm is
optimal

Optimal Capital Structure by Prof. Dr. Dr. Joachim Häcker


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3. Practical analysis on optimal capital structure
Marktwerte (Mio. Euro) vom 17.9.99 Gearing I (Buchwert) Gearing II (Marktwert)
Name Sector Jahr Marktwert Equity ratio excl./ incl. Pens.rkst. excl./ incl. Pens.rkst.
DEUTSCHE TELEKOM Other Telecommunications 12/1998 120.229 32% 57% 59% 22%
DAIMLERCHRYSLER AG Motor Vehicles 12/1998 68.619 23% 41%
„ Since theory
55% 24%
does not 23%
offer a
36%
MANNESMANN AG Diversified Manufacture 12/1998 54.462 37% 2% 28%
clear answer,0% let us analyse
4%
SIEMENS AG Diversified Electronic Products 09/1998 47.672 27% 23% 49% 9% 23%
BAYER AG Major Chemicals 12/1998 28.739 44% 18% 37%
the question9%of an optimal
21%
VEBA AG Multi-Sector Companies 12/1998 28.106 31% 18% 36% 9% 21%
BASF AG Major Chemicals 12/1998 28.479 50% -1% capital structure
23% -1% empirically.
12%
HOECHST AG Major Pharmaceuticals 12/1998 24.400 34% 39% 48% 19% 26%
RWE AG Multi-Sector Companies 06/1997 19.701 18% n.m. -21% -47% -6%
BAYER MOTOREN WERK Motor Vehicles 12/1998 18.045 21% 58%
„ As an example,
63% 33%
the DAX
38%
100
SAP AG Computer Software 12/1998 17.753 60%60% -40% -38%
companies -3%are analysed-3%
VOLKSWAGEN AG Motor Vehicles 12/1998 16.999 16% 43% 62% 29% 47%
METRO AG Other Specialty Stores 12/1998 15.979 22% 39% 45% 14% 17%
VIAG AG Multi-Sector Companies 12/1998 13.909 16% 25% 48% 10% 24%
THYSSEN KRUPP AG Multi-Sector Companies 09/1998 10.856 26% 33% 58% 21% 43%
PREUSSAG AG Multi-Sector Companies 09/1998 8.731 18% 25% 49% 5% 14%
SCHERING AG Major Pharmaceuticals 12/1998 6.881 45% -66% 13% -13% 4%
DEUTSCHE LUFTHANSA Airlines 12/1998 6.697 27% 18% 51% 10% 34%
WCM BETEIL&GRUNDBE Real Estate 12/1998 6.253 54% 3% 4% 0% 0%
DEGUSSA-HULS AG Major Chemicals 09/1998 5.886 26% 29% 48% 9% 17%
BEIERSDORF AG Package Goods/Cosmetics 12/1998 5.704 46% -61% -4% -7% -1%
HEIDELBERGER DRUCK Industrial Machinery/Components 03/1997 5.163 59% -12% 6% -4% 2%
FRESENIUS MEDICAL Medical Specialties 12/1998 4.970 59% 27% 28% 17% 18%
LINDE AG Multi-Sector Companies 12/1998 4.795 52% -16% 10% -7% 5%
HENKEL KGAA Package Goods/Cosmetics 12/1998 3.949 31% 35% 54% 27% 44%
HEIDELBERGER ZEMEN Building Materials 12/1998 4.019 40% 27% 35% 15% 21%

Source: Extel, FactSet, year 2000 values

Optimal Capital Structure by Prof. Dr. Dr. Joachim Häcker


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Marktwerte (Mio. Euro) vom 17.9.99 Gearing I (Buchwert) Gearing II (Marktwert)
Name Sector Jahr Marktwert Equity ratio excl./ incl. Pens.rkst. excl./ incl. Pens.rkst.
ADIDAS-SALOMON AG Shoe Manufacturing 12/1998 3.753 16%
16% 77% 77% 31% 31%
KARSTADT AG Department Stores 12/1998 3.654 25% 42% „ 63%
Definition: 21% 39%
MAN AG Diversified Manufacture 06/1997 3.551 29% -75% 13% -32% 8%
HOCHTIEF AG Engineering & Construction 12/1998 2.975 32% n.m. Equity
-138% ratio-66%
= -34%
METALLGESELLSCHAFT Multi-Sector Companies 09/1998 2.771 14%
14% n.m. 18%
Equity incl.
-17%
minority
4%
stakes /
GEHE AG Medical/Dental Distributors 12/1998 2.770 28% 48% 49% 28% 29%
CONTINENTAL AG Auto Parts: O.E.M. 12/1998 2.745 23% 54% 64% 38% 48%
ALTANA AG Other Pharmaceuticals 12/1998 2.576 55% n.m.
total
-40%
assets. -21% -10%
BEWAG AG Non-U.S. Utilities 06/1997 2.215 35% 13% 21% 11% 17%
PORSCHE AG Motor Vehicles 07/1998 2.249 28% n.m. „ -31% -18%
Analysis of 77 DAX 100 -5%
FRESENIUS AG Medical Specialties 12/1998 1.670 38% 42% 44% 38% 40%
IVG HOLDING AG Multi-Sector Companies 12/1998 1.595 38% 53% companies.
54% 20% 21%
MERCK KGAA Other Pharmaceuticals 12/1998 1.571 31% 48% 59% 50% 61%
DOUGLAS HLDG AG Other Specialty Stores 12/1998 1.500 45% 16% 19% 5% 6%
SGL CARBON AG Industrial Specialties 12/1998 1.494 27% 39%
„ Excluded
53%
were
11%
financial
18%
service
SKW TROSTBERG AG Specialty Chemicals 12/1998 1.342 21% 61% 66%
providers 36% insurance
(incl. 42%
AVA ALLG HANDELS V Department Stores 12/1998 1.145 33% 33% 34% 14% 15%
BUDERUS AG Building Products 09/1998 1.102 32% -82% 18%
companies -17% asset
and 7%
HOLZMANN(PHILIPP) Engineering & Construction 12/1998 913 12%12% 66% 71% 52% 58%
SCHWARZ PHARMA AG Other Pharmaceuticals 12/1998 827 49% 29% management
32% companies)
14% 16% as well
BILFINGER & BERGER Engineering & Construction 12/1998 857 22% n.m. n.m. n.m. n.m.
PROSIEBEN MEDIA AG Broadcasting 12/1998 756 49% 28% as28%
real estate20%
companies. 20%
AGIV AG Industrial Machinery/Components 12/1998 718 28% n.m. -51% -61% -25%
JENOPTIK AG Diversified Manufacture 12/1998 710 35% 28% 36% 17% 23%
K & S AG Environmental Services 12/1998 723 34% n.m. -62% -89% -31%
KLOECKNER WERKE Specialty Chemicals 09/1998 688 15% 65% 72% 37% 44%
15%

Source: Extel, FactSet

Optimal Capital Structure by Prof. Dr. Dr. Joachim Häcker


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Marktwerte (Mio. Euro) vom 17.9.99 Gearing I (Buchwert) Gearing II (Marktwert)
Name Sector Jahr Marktwert Equity ratio excl./ incl. Pens.rkst. excl./ incl. Pens.rkst.
WELLA AG Package Goods/Cosmetics 12/1998 658 28% 44% 56% 35% 47%
SIXT AG Rental/Leasing Companies 12/1998 652
28%
21% 70% 70% 47% 47%
GEA AG Industrial Machinery/Components 12/1998 637 32% -1% 17% -1% 13%
FAG KUGELFISCHER Metal Fabrications 12/1998 588 26% 49% 65% 42% 58%
DYCKERHOFF AG Building Materials 12/1998 463 39% 27% 39% 34% 47%
SCHMALBACH LUBECA Containers/Packaging 12/1998 450 22% 52% 62% 52% 62%
DEUTZ AG Industrial Machinery/Components 12/1998 418 16% 6% 67% 3% 44%
BOSS (HUGO) AG Apparel 12/1998 413 n.a. n.a. n.a. 0% 0%
IWKA AG Industrial Machinery/Components 12/1998 396 28% -5% 23% -4% 17%
SUDZUCKER AG Specialty Foods/Candy 02/1999 364 n.a. n.a. n.a. 0% 0%
GROHE(FRIEDRICH)AG Building Products 12/1998 361 51% -46% 2% -34% 2%
GERRESHEIMER GLAS Containers/Packaging 12/1998 361 n.a. n.a. n.a. 0% 0%
RHON-KLINIKUM AG Medical/Nursing Services 12/1998 343 21% 54% 55% 34% 34%
KIEKERT AG Auto Parts: O.E.M. 12/1998 340 44% 32% 35% 16% 18%
DUERR AG Industrial Machinery/Components 12/1998 319 n.a. n.a. n.a. 0% 0%
PUMA AG Shoe Manufacturing 12/1998 311 44% -5% 7% -2% 2%
FIELMANN AG Other Specialty Stores 12/1998 304 61%61% 14% 14% 9% 9%
VOSSLOH AG Diversified Electronic Products 12/1998 300 42% 29% 33% 21% 25%
TARKETT SOMMER AG Building Products 12/1998 282 18% 72% 73% 64% 66%
BRAU UND BRUNNEN Alcoholic Beverages 12/1998 269 15% 61% 78% 40% 60%
RHEINMETALL AG Diversified Manufacture 12/1998 269 23% 27% 54% 30% 58%
BABCOCK BORSIG AG Industrial Machinery/Components 09/1998 261 5% 5% 81% 87% 52% 64%
JUNGHEINRICH Construction/Ag Equipment/Trucks 12/1998 221 34% 11% 29% 13% 34%
PHOENIX AG Auto Parts: O.E.M. 12/1998 211 35% 39% 44% 34% 39%
KRONES AG Industrial Machinery/Components 12/1998 122 56% -48% -29% n.m. -149%
SPAR HANDELS AG Food Chains 12/1998 124 18% 21% 29% 41% 51%
ESCADA AG Apparel 10/1998 98 29% 57% 57% 65% 65%
KSB KL SCHANZ BECK Fluid Controls 12/1998 99 32% -19% 28% -29% 36%

Source: Extel, FactSet

Optimal Capital Structure by Prof. Dr. Dr. Joachim Häcker


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„ The German equity ratio (for DAX
Equity ratio of DAX 100 companies
100 companies) averages 31%.

Cummulative number of companies (right axis)


„ The European equity ratio (based on
14 90
13 13 Number of companies (left axis) EuroStoxx) averages 38%.
80
12
11
70
„ The unlisted „German Mittelstand“
10
9 60
equity ratio averages around 10%
8 50 „ Business practice supports the
6 6
6 40 traditional approach.
5 5
30
4 „ Empirically, a large spread of optimal
3 3
20
2 equity ratios can be shown depending
2
1 10 on numerous factors such as sectors,
0 0 profitability and liquidity.
Up to Up to Up to Up to Up to Up to Up to Up to Up to Up to Up to Up to Up to
10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70%

Source: Extel, FactSet, based on year 2000 numbers

Optimal Capital Structure by Prof. Dr. Dr. Joachim Häcker


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International outlook

Country Auto- Food Paper Debt Ratio


motive Country „ Empirical study compares
Mean debt ratios for 677 listed
Singapore 0.22 0.28 n.a. 34%
0.34
n.a. firms in 9 industries in 23
Argentina 0.42 0.35 0.38
Australia 0.50 0.45 0.48 0.46 countries.
Brazil 0.66 0.57 0.37 0.54 „ Capital structure standards
UK 0.73 0.55 0.56 0.55
vary considerably from
US 0.58 0.56 0.58 0.55
Benelux 0.62 0.64 0.65 0.56 country to country,but are
Canada n.a. n.a. 0.68 0.58 similar for firms within a
Switzerland n.a. 0.54 n.a. 0.60 country.
Germany 0.57 0.49 0.70 62%
0.62
„ Neither industry nor size is
Denmark n.a. 0.69 0.74 0.63
-1% of
an important determinant
Spain 0.59 0.66 03/1997
0.85 5.163 0.64 -12% 6% -4% 2%
France 0.67 0.78 12/1998 0.74 4.970 0.71 27% debt ratios.17%
28% 18%
12/1998 4.795 -16% 10% -7% 5%
Italy 0.49 0.85 12/1998 0.77 3.949 0.76
76% 35% 54% 27% 44%
12/1998 4.019 27% 35% 15% 21%
Industry Mean 0.58 0.62 0.63

Source: Sekely/Collins (1988)

Optimal Capital Structure by Prof. Dr. Dr. Joachim Häcker


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Capital structure decision for MNC

„ Maintenance of desired debt ratio is facilitated by access to


How does international
availability of capital affect international capital markets, even when significant amounts
the optimal debt ratio of a of new funds must be raised.
MNC?
„ International availability of capital to a MNC may allow for
lower cost of capital than what is available to a domestic
firm.

„ Therefore, the value of MNCs can exceed the value of its


national peers

Optimal Capital Structure by Prof. Dr. Dr. Joachim Häcker


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Capital structure decision for MNC

„ MNCs should choose a capital structure that minimizes


Pro centralisation
consolidated cost of capital.

„ The individual subsidiary does not have an independent


cost of capital. Thus, the subsidiary’s cost of capital is
relevant only to the degree that it has an effect on the
overall goal.

„ Localized capital structure for foreign subsidiary helps


Contra centralisation
management to evaluate ROE relative to local competitors.

„ Better public relations with host country monetary


authorities might result.

Capital structure should be an issue of centralised management style.


MNCs should borrow at lowest cost, after adjusting for foreign exchange risk, anywhere in the
world without considering the impact on a particular subsidiary’s capital structure.

Optimal Capital Structure by Prof. Dr. Dr. Joachim Häcker


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