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AJA4604.12

Multinational Capital Budgeting, Cost of Capital

and Capital StructureAn Outline:

(a) Inputs into a Capital Budgeting Decision

(b) Additional Factors in Multinational Capital Budgeting.(c) Adjusted Present Value Method

(d) Cost of Capital

(e) Capital Structure

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Definition: Capital budgeting is the decision-making

process with respect to investment in fixed assets.Inputs into the Capital Budgeting Decision

Initial investment

Consumer demand

Price

Variable cost

Fixed cost

Project lifetime Salvage value

Tax-laws

Required rate of return

A. Basics of Capital Budgeting

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Other Factors in Multinational Capital Budgeting

Exchange rate fluctuations

Relative inflation

Financing arrangementssubsidies /penalties

Blocked funds

Remittance provisions

Uncertain salvage values

Impact of project on prevailing cash flows Government incentives

Social costs / Externalities

Political risk /Country risk.

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Transfer prices

Treatment of fees, royalties, etc.

Aggregating the cash flows and assigning

applicable discount rate to each component.

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Basics of Capital Budgeting

Popular Techniques

1. Payback Period: Is the length of time needed to recoup theinitial investment. This equals the length of time it takes forcumulative nominal cash inflows to equal the initial outlay.

Discounted Payback Period is a modified form of the StandardPayback Period which incorporates time value.

2. Net Present Value: Is the expected value, in today's dollars, afterconsidering all costs, of cash flows from a project.

k = required rate of return on "project."

Cost of capital is the cost of long-term funds for the firm.

NPV I

CF

k

t

t

t

n

0 1 1

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Decision Rule: When NPV > 0, accept the project.

When NPV < 0, reject the project.

When each of two mutually exclusive projects has

positive NPV, the project with the higher NPV

should be selected.

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3.Prof itabil ity I ndex (PI ): Considers the ratio of presentvalue of a project's cash flows to its initial outlay.

CFt= cash flow at time t

I0= initial outlay

k = required rate of return (cost of capital)

Decision Rule: When PI > 1, accept the project.

When PI < 1, reject the project.

PI

CF

k

I

t

tt

n

( )11

0

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4. I nternal Rate of Return (I RR): Is the rate of return

that the firm expects to earn on the project.

Mathematically, it is the "discount rate" that equates

the present value of cash flows to the initial outlay, so

that

Decision Rule:When IRR > required rate of return, accept project.

When IRR < required rate of return, reject project.

CFIRR

It tt

n

( )110

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5.Modif ied I nternal Rate of Return (M IRR):

This is given by:

PV Cost = PV of Terminal Value (TV)

I0 I1 I2 Ij CFt CFt+1 CFt+2 CFn-t

|--------|--------|----------|----------------|-------|--------|-----------------|

0 1 2 j t t+1 t+2 n

where: It= cash outflows, COF; CFt= cash inflows

nMIRR

TVPVCost

)1(

j

t

n

tn

tn

t

t

t

MIRR

KCIF

k

COF

0 1 )1(

)1(

)1(

n

t

n

tn

t

nMIRR

kCIF

MIRR

TVPVCost

1 )1(

)1(

)1(

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Shareholders wealth maximization is the primary

objective.

Shareholders are interested in how many additionaldollars they will receive in the future for the dollars

invested today.

Hence, incremental, not total cash flow, is whatmatters.

Incremental Cash Flows and Factors

Affecting Cash Flows

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Effects of sales from the (new) investment onexisting divisions:

Cannibalization: New product taking away sales

from the firm's existing products, e.g., substitutingforeign production for parent company exports.

Sales Creation: New investment creates

additional sales for existing products.The benefits of additional sales (or lost sales) andassociated incremental (decreased) cash flowsshould be attributed to the project.

Differences Between Incremental and

Total Cash Flows

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Transfer Pricing: Prices at which goods and

services are traded internally can significantly

distort the profitability of a proposed investment.

As far as possible prices of a project's inputs and

outputs should be market prices.

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Opportunity Costs: Project costs must include

the true economic cost of any resource required

for the project - already owned or just acquired.

Sunk Costs: Cash outlay already incurred, andwhich cannot be recovered regardless of whether

project is accepted or rejected, e.g., site analysis,

feasibility studies, etc.

Exclude sunk costs from cost considerations.

Other Factors:

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Fees and Royalties: These are costs to theproject but are benefits to the parent, e.g., legalcounsel, power, lighting, heat, rent, R&D, H.Q.

cost, and management costs, etc.

A project should be charged only for additionalexpenditures that are attributable to the project.

In general, incremental cash flows associatedwith an investment can be found by subtracting

worldwide corporate cash flows without thenew investment from "with" the new investmentcash flows.

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Capital budgeting analysis for a foreign project is

considerably more complex than domestic case for

a number of reasons including:

Parent Cash Flows Vs. Project Cash Flows:Parent cash flows often depend on the form of

financing - so that cash flows cannot be clearly

separated from financing decisions as is practicable

in a purely domestic capital budgeting exercise.

Foreign Complexities and Opportunities

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Remittance of funds to parent is compounded by

differences in tax systems and financial markets and

institutions as well as legal and political constraintson funds movement.

Cash flows from affiliate to parent can be generated

by an array of operational, financial or non-financialpayments, e.g., fees, royalties, transfer pricing, etc.

Different rates of national inflation introduce changes

in competitive position.

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Unanticipated changes in foreign exchange rates

have direct and indirect effects on costs, prices, and

sales volume.

Transaction across segmented national markets may

create opportunities for financial gains or lead to

additional costs.

Benefits of enhanced global service network.

Diversification of production facilities. Market diversification.

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Availability of host government subsidized loans

may complicate capital structure decisions and the

appropriate WACC.Political risks must be evaluated, and costs may

be involved in the management of political risks.

Terminal value is more difficult to estimate, i.e.,

uncertain salvage value.

Foreign complexities must be quantified asmodifications to either expected cash flows or

the rate of discount.

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International Capital Budgeting Decision Model

Multinational capital budgeting problems can be

solved by appealing to the principle of valueadditivity.

This states that the whole value of a project is equal

to the sum of its parts. The Adjusted Present Value (APV) rule divides up

the present value terms and focuses on each

component to maximize the development and useof information.

Each present value term employs an appropriate

discount rate for its level of systematic risk.

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Lessard (1981) extends this approach to deal

with foreign investment projects as follows:

APV= -PV of capital outlays+PV of remittable after tax operating cash flows

+PV of tax savings from depreciation

+PV of financial subsidies

+PV of other tax savings

+PV of extra (indirect) remittances

+PV of projects contribution to corporate debt

capacity+PV of residual plant and equipment (salvage)

Multinational Capital Budgeting Examples.(See sample problem set III, part B)

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Multinational Cost of Capital & Capital Structure

A firms capitalconsists of:

Retained Earnings

Equity (existing or newly issued)

Preferred Stock

Debt (borrowed funds)

The firms cost of retained earningsreflects the

opportunity cost - what existing shareholderscould

have earned if they invested the funds themselves.

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The firms cost ofnew equityalso reflects an

opportunity cost - what the new shareholderscould

have earned if they had invested their funds

elsewhere.

The cost of new equity exceeds the cost of retained

earnings by the floatation costs.

The firms cost of debtincreases with the level of

debt.

Increases in the level of debt also increases theprobability of default.

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Tax deductibility of interest payments on debts

enhances the attractiveness of debt financing.

A firm must maintain a proper balance between

the tax advantage of debt and its disadvantage

(greater probability of bankruptcy).

The firms weighted average cost of capital

(WACC) can be computed as:

(Total Capital = Debt + Equity + Pref. Stock)

WACC = WdKd(1-t) + WpKp + WeKe

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Assuming that the firms capital is made up of

debt and equity, then:

where:D = Proportion of capital (D+E) made up of debt,

E = The proportion of equity,

Kd = Cost of debt,Ke = Cost of Equity and

t = tax rate.

ed

KED

EtK

ED

DWACC

1

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Factors in Multinational Cost of Capital

Size of the Firm: The larger the size of the firm, the

larger the amount that is borrowed. In addition, largerissues of stocks or bonds allow for reduced

percentage flotation costs.

Access to International Capital Markets: Access tointernational capital markets allows MNCs to attract

funds at lower costs than purely domestic firms.

International Diversification: Diversified cash flowsources result in more stable cash inflows for MNCs

which may reduce the probability of bankruptcy and

therefore reduce the cost of capital.

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Exposure to Exchange Rate Risk: Firms that are

highly exposed to exchange rate risk may experience

greater cash inflow volatility.

However, exposure to a basket of currencieswill

mitigate or eliminate such a problem.

Exposure to Country Risks: To the extent to which

country risks are not diversifiable, increased cash

inflow volatility may result with attendant higher

cost of capital.

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Cost of Capital Across Countries:

Variations in the cost of capital across countries may help

to explain why MNCs are able to adjust their international

operations and sources of funds.

Differences in the cost of each capital component across

countries may explain why MNCs based in some

countries use more debt-intensive capital structure thanMNCs based elsewhere.

Differences in the Risk-Free Interest Rate:

The risk-free rate is frequently proxied by the yield on

3-month T-bills.

The rate is determined by supply and demand conditions

in each country, tax laws, monetary policies,

demographics, and economic conditions.

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Differences in the Risk Premium:

The risk premium is affected by the relationship betweenborrowers and creditors (e.g.. Japans Keiretsu), and the

propensity of governments to intervene and rescue ailingor failing firms (compare US. to UK).

Also firms in some countries have greater borrowingcapacity because creditors are tolerant of higher degrees

of financial leverage (e.g. Japanese and German firmshave higher degrees of financial leverage than US. firms).

Country Differences in the Cost of Equity:

The cost of equity is related to investment opportunitiesin each country.

In a country with many investment opportunities,potential returns may be relatively high resulting in a

relatively high opportunity cost of funds.

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International Differences in Cost of Equity Capital

Effectiveness of a Countrys Legal Institutions:

Well-functioning legal systems protect investors,reduce monitoring and enforcement costs to investors,reduces a firms cost of capital by leveling the playingfield among investors.

Differences in Securities Regulation:

Requirement of, and enforcement of, certain financial

disclosures help to reduce asymmetric informationbetween the firm and its investors and amonginvestors.

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Some of the firm specific characteristics that affect

MNCs capital structure include:

Stability of MNCs cash flows.

MNC credit risk - a MNC with assets acceptableas collateral has greater access to loans.

Level of retained earnings.

Multinational Capital Structure:

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Entry and cross-border barriers to investing.

Interest rates in host countries are affected by capitalcontrols, tax rates & country risks.

A MNCs preference for debt or equity may dependon relative costs in a particular country.

Host country currency innovations.

Country risks.

Relative tax laws.

Influence of Country Characteristics

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MNCs may deviate from their target capital structurein host countries but still able to achieve their target

capital structure on a consolidated basis.

i.e., MNCs may ignore local target capital structure

in favor of a global target capital structure.

Multinational Target Capital Structure

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When MNCs allow (or are forced to allow) foreign

subsidiaries to issue stocks to local investors, such asubsidiary becomes partially owned by the parent.

This can affect MNCs capital structure.

In some countries, a MNC will be allowed to establish

a subsidiary only if it meets the minimum percentage

of ownership by local investors.

A minority interest in a subsidiary by local investors

may, however, offer some protection against threats

of any adverse action by the host government.

Partially Owned Subsidiaries:

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Firms in Japan and Germany tend to use a higher

degree of financial leverage than U.S or U.K firms.

The system of interlocking ownership in Japan may

encourage a greater use of leverage.

Other International Factors

Stock restrictions in host countries

Interests rates in host countries Strength of host country currencies

Country risk in host countries

Tax laws in host countries

Capital Structure Across Countries

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Qu. 1: The following are major factors in multinational

cost of capital except:

Size of the firm

Access to international capital markets

International diversification of firm

Exposure to exchange risk

Exposure to country risk

Qu. 2: Which of the following is not a factor accounting

for variations in the cost of capital across countries:

Differences in risk free interest rate

Differences in risk premium

Differences in cost of equity35