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# Multinational Cost of

Capital
Prepared by:
Background on Cost of
Capital
The cost of capital is a term used in the

## field of financial investment to refer to the

cost of a company's funds (proportion of
debt versus equity financing),or from an
investor's point of view "the shareholder's
required return on a portfolio of all the
company's existing securities". It is used
to evaluate new projects of a company as
it is the minimum return that investors
expect for providing capital to the
company, thus setting a benchmark that
a new project has to meet.
Fo r a n in ve stm e n t to b e w o rth w h ile , th e
exp e cte d return
on capital must be greater than the cost of
capital.

## WHY IS COST OF CAPITAL IMPORTANT?

If financing cost is reduced => NPV increases
=> more projects end up with NPV > 0 =>
more wealth created to shareholders .

## To determine a company's cost of capital, We

must calculate both the cost of debt and the
cost of equity .

## # cost of debt is the effective rate that a

company pays on its current debt. The debt
formula can be written as
( Rf + credit risk rate ) ( 1 - T ) , where T is the
# The cost of equity is more challenging to
investors.
Comparing the costs of Equity & Debt :
WACC = r D ( 1 - T c )*( D / V )+ r E *( E / V )
Where ...
r D = The required return of the firm's Debt financing
This should reflect the CURRENT MARKET rates the firm
pays for debt .
( 1 - T c ) = The Tax adjustment for interest expense
Interest paid on debt reduces Net Income , and therefore
reduces tax payments for the firm . This value of this
'interest tax shield' depends on the firm's tax rate .
( D / V ) = ( Debt / Total Value )
The % of the firm's value that is comprised of debt .
r E = the firm's cost of equity
The firm's cost of equity is best ( or , at least , most
easily ) calculated using the CAPM ( Capital Asset Pricing
Model ).
( E / V ) = ( Equity / Total Value )
The % of the firm's value that is comprised of Equity .
This is based on the firm's intra - day market cap ( stock
price x shares outstanding ).
An advantage to using debt rather than equity as
capital is that the interest payments on debt
are tax deductible, however, it increases the
interest expense & the probability that the
firm will be unable to meet its expenses.
Searching for the appropriate
capital structure
 cost of capital

x
D e b t R a tio
This shows that the firm’s cost of
capital initially decreases as the ratio of
debt t total capital increases. However,
after some point ( point x ), the cost f
capital rises as the ratio of debt to total
capital increases.
domestic firm due to the following characteristics
that differentiate MNCs from domestic firms:

## 1- Size of firm: An MNC that often borrows

treatment from creditors, thereby reducing its cost of
capital. Note, however , that this advantage is due to
the MNC’s size and not to its internationalized
business. MNCs may achieve growth more easily to
reach the necessary size to receive preferential
treatment from creditors.
MNCs are able to obtain funds through the
international capital markets. Since the cost of funds
can vary among markets, the MNCs may obtain
funds at a lower cost than that paid by domestic
firms. In addition, subsidiaries may be able to obtain
funds locally at a lower cost than that available to
inflows come from sources all over the world, those
cash inflows may be more stable because the firm’s
total sales will not be highly influenced by a single
economy . To the extent that individual economies are
independent of each other, net cash flows from a
portfolio of subsidiaries should exhibit less variability,
which may reduce the probability of bankruptcy and
therefore reduce the cost of capital.
4- Exposure to exchange rate risk: An MNC’s cash
flows could be more volatile than those of a domestic
firm in the same industry if it is highly exposed to
exchange rate risk. If foreign earnings are remitted to
the US parent of an MNC, they will not be worth as
much when the US dollar is strong against major
currencies. Thus the capacity of making interest
payments on outstanding debt is reduced, and the
probability of bankruptcy is higher. This could force
creditors and shareholders to require a higher return,
which increases the MNC’s cost of capital.
5 - E x p o su re to co u n try risk : A n M N C th a t
e sta b lish e s fo re ig n su b sid ia rie s is su b je ct to th e
p o ssib ility th a t a h o st co u n try g o ve rn m e n t m a y se ize
a su b sid ia ry ’ s a sse ts. T h e p ro b a b ility o f su ch a n
o ccu rre n ce is in flu e n ce d b y m a n y fa cto rs, in clu d in g
th e a ttitu d e o f th e h o st co u n try g o ve rn m e n t a n d th e
in d u stry o f co n ce rn . if a sse ts a re se ize d a n d fa ir
co m p e n sa tio n is n o t p ro vid e d , th e p ro b a b ility o f th e
M N C ’ s g o in g b a n kru p tcy in cre a se s. T h e h ig h e r th e
p e rce n ta g e o f a n M N C ’ s a sse ts in v e ste d in
fo re ig n co u n trie s a n d th e h ig h e r th e o v e ra ll
co u n try risk o f o p e ra tin g in th e se co u n trie s , th e
h ig h e r w ill b e th e M N C ’ s p ro b a b ility o f
b a n k ru p tcy .
O th e r fo rm s o f co u n try risk , su ch a s ch a n g e s in a h o st
g o ve rn m e n t’ s ta x la w s.
Summary of factors that cause the cost of capital
of MNCs to differ from that of domestic firms.

## ccess to int. capital markets

Cost of capital

national diversification
Reduced probability of bankruptcy

## ure to exchange rate risk

Increased probability of bankruptcy

## posure to country risk

Cost of Equity comparison using
the CAPM
To assess how required rates of return of
MNCs differ from those of purely domestic
firms, the capital asset pricing model
(CAPM) can be applied.
Cost of Equity r
E = rf + β( rM - rf)
where...

## r f = the 'Risk Free' rate of return

β = the firm's 'Beta'; the correlation
between the firm's returns and the
market
r M = the historical "Market" return
The CAPM suggests that the required
return on a
firm’s stock is a positive function of:

## (1) the risk free rate of interest,

(2) the market rate of return, and
(3) the stock’s beta.
The Beta represents the sensitivity of the
stock’s returns to market returns.
( a stock index is normally used as a proxy
for the market)
For a well-diversified firm with cash
flows generated by several projects,
each project contains two types of
risk:
(1) unsystematic variability in cash
flows unique to the firm, and
(2) systematic risk, also known as
undiversified risk.
S y ste m a tic risk refers to the risk common to all
se cu ritie s—i. e . m a rke t risk .
U n sy ste m a tic risk is th e risk a sso cia te d w ith
in d ivid u a l a sse ts. It ca n b e d ive rsifie d away to
sm a lle r le ve ls b y in clu d in g a g re a te r n u m b e r o f a sse ts
in th e p o rtfo lio ( sp e cific risks " a ve ra g e o u t" ). T h e
sa m e is n o t p o ssib le fo r syste m a tic risk w ith in o n e
m a rke t. D e p e n d in g o n th e m a rke t, a p o rtfo lio o f
a p p roxim a te ly 3 0 - 4 0 se cu ritie s in d e ve lo p e d m a rke ts
su ch a s U K o r U S w illre n d e r th e p o rtfo lio su fficie n tly
d ive rsifie d su ch th a t risk exp o su re is lim ite d to
syste m a tic risk o n ly. In d e ve lo p in g m a rke ts a la rg e r
n u m b e r is re q u ire d , d u e to th e h ig h e r a sse t
vo la tilitie s.
Asset pricing
Once the expected/required rate of return, E(Ri), is
calculated using CAPM, we can compare this required