Multinational Finance - Coursework Example

Introduction Whenever a multinational company plans to invest in a long-term project, it needs to assess the benefits that can be reaped out from that particular long-term investment and come to a conclusion whether that particular investment is profitable for the business or not. The entire process of assessing a proposed long-term investment and coming to a conclusion whether it is worth investing or not is termed as "Capital Budgeting." The ultimate goal of any individual or a MNC is nothing but maximization of profits or rate of returns - in other words market value of one's investments. Cost of Capital The cost of capital is the expected return that is required on investments to compensate you for the required risk. However, the cost of capital of a company is affected by various factors. All these factors are discussed in detailed in the forthcoming paragraphs. Importance of the Cost of Capital and capital Structure Decisions Capital Structure decisions are a significant managerial decision which influences the risk and return of the investors. Basically, the main goal of any company would be none other than maximization of present shareholder value. In order to achieve this goal, the capital structure decisions that are taken by a company should result in positive net present value which means that the "present value of the expected cash inflow less the present value of the required capital expenditures (NetMBA.com, 2002)." The company will have to plan its capital structure at the time of promotion itself and also subsequently whenever it has to raise additional funds for various new projects (Blackwell publishing, 2003). Wherever the company needs to raise finance, it involves a capital structure decision because it has to decide the amount o finance to be raised as well as the source from which it is to be raised. The advent of globalization has also got its influence on the cost of equity capital of a company. Let us suppose that a firm is planning to raise equity in order to finance a particular investment. In order for this to happen, the shareholder of the company should believe that their earnings or cash flow will not hamper because of such a decision. The company's ability to finance investments by way of raising equity mainly depends on the cash flow that the shareholders of the company expect from the investment. In order to succeed in this process, the managers initially need to convince the shareholders that the investment is worthwhile and it would yield cash flows that are expected but in reality, managers face a plethora of difficulties in convincing the shareholders. This is because due to the advent of globalization, the knowledge levels of managers of modern organizations have grown drastically and they have the information about the investments of the firm which the shareholders lack (Stulz, 1999). There are very many global risk factors which affect the cost of capital of a company. In order to investigate the effect of such factors over the cost of capital, alternative asset pricing models like international Capital asset pricing model etc, need to be assessed (Koedijk, et al., 2004)(Nagel, 2007). Exchange rates also have an impact on the cost of capital. Studies reveal that exchange rate flucutation have an impact on the relative wealth position of different countries of the world and hence they inturn effect the Foreign Direct Investment (FDI) (Munisamy Gopinath, 1998). The wealth position of international investors/firms is increased in contrast with that of domestic investors when the dollar depreciates. This is becasue they hold their investments in non-dollar denominated currencies. However, this aspect reduces the relative cost of capital of international firms (Munisamy Gopinath, 1998). Net present value is the most important criteria on which most of the firms rely when planning to invest or undertake a new project. Some firms alternatively rely upon rules like the Internal Rate of Return (IRR), Payback period and Profitability index etc. for the same (NetMBA.com, 2002). The cost of capital of a company is affected indirectly by various other factors like the country's economic condition, the company's business risk, financial risk and finally the size of the financing (Basic Aollege Accounting.Com, 2008). Each of the above mentioned factors are discussed in detail. Economic Conditions - When there is an increase in the inflation rate, then obviously the business costs also increase. This will in turn lead to the investors and lenders demanding higher rate of return ultimately resulting in a higher cost of capital. When the company is performing extremely well and as a result if demand for the funds increase and the supply for the same is limited, then there is a possibility that the financiers and lenders of the company increase their rate of lending. This in turn would result in a higher cost of capital (Basic Aollege Accounting.Com, 2008). Business risk of the firm - In case the business risk of a company is very high, then the required rate of return for the investors' will also be high and this also would result in a higher cost of capital. Financial risk of the firm - If the gearing of the company is high, then financiers' and lenders would consider the financial risk of the company also to be high. In such cases, they would expect a higher rate of return from the firm which would lead to a higher cost of capital. Financing Size - For example, if a company cannot match its size i.e. the assets or sales turnover with the financing needs, financiers would become more cautious in lending to such firms. In such cases, they would impose a higher cost of fund which would ultimately increase the cost of capital of the firm (Basic Aollege Accounting.Com, 2008). Apart from all the above mentioned various factors, there are also certain factors that would affect the cost of capital of the company. However, the company would have control over such factors. They are the Capital Structure policy, Dividend Policy and the Investment Policy. Capital Structure Policy: Every organization has control over its capital structure and also every organization would target to have an Optimal Capital Structure. The objective of any multinational company is to mix the permanent sources of funds used by it in a manner that will maximize the company's market price. In other words companies seek to minimize their cost of capital. This proper mix of funds is referred to as the Optimal Capital Structure (Nejadmalayeri, 2003). Leverage: The use of fixed charges sources of funds such as preference shares, debentures and term loans along with equity capital in the capital structure is described as financial leverage or trading on equity. The term trading on equity is used because it is the equity that is used as a basis for raising debt. Financial Institutions while sanctioning long-term loans insist that companies should generally have a debt-equity ratio of 2:1 for medium and large-scale industries and 3:1 for small-scale industries. A debt-equity ratio of 2:1 indicates that for every 1 unit of equity the company has, it can raise 2 units of debt. The ratio is calculated using the formula . Increased use of leverage increases the fixed commitments of the company in the form of interest and repayments and thus increases the risk of the equity shareholders as their returns are affected. The other factors that should be considered whenever a capital structure decision is taken are: Cash flow projections of the company Size of the company Dilution of control Floatation costs Dividend Policy: There are basically two options which a firm has while utilizing its profits after tax. Firms can either plough back the earnings by retaining them or distribute the same to the shareholders (Hanke, 2006). The first option suits those firms which need funds to finance their long-term projects. However, such projects should have enough growth potential and sufficient profitability. On the other hand, the second option of declaring cash dividends from the profits after tax will lead to maximization of the shareholders wealth. The returns to the shareholders either by way of the dividend receipts or capital gains are affected by the dividend policies of the firms. This is mainly due to the fact that the dividend policy decides the retention ratio and pay - out ratio i.e. dividend paid as a percent of profits. In addition to this, the dividend policy of the firm gains importance especially due to unambiguous relationship that exists between the dividend policy and the equity returns. Thus, it can be hence said that a firm's decision should meet the investors' expectation. As the dividend pay-out ratio of the firm increases, the breakeven point between the newly generated equity and the internally generated equity comes down. Investment Policy: Whenever a company is making an investment decision, then it is clearly understood that there is certain amount of risk involved depending on the size of the investment. If the company tends to change its investment decision to keep it in tune with the risk involved, then this would result in a change in both the cost of equity and cost of capital ultimately (Investopedia, 2008) (Robinson, 1997). However, there are yet certain other factors which affect a company's cost of capital and on which the company would not have any control (Investopedia, 2008). They are the level of interest rates and the rate of tax. The level of interest rates will certainly influence the cost of debt which would potentially affect the cost of equity also. In the same way, the higher the tax rates are, then ultimately the lower is the cost of debt of the company which in turn would result in a lower cost of capital (Agriculture and Consumer Protection , 1997). Optimal solution The long-term decisions of a firm involve setting up of the firm, expansion, diversification, modernization and other similar capital expenditure decisions ((ICMR), 2003). All these decisions involve huge investment, the benefits of which will be seen only in the long-term and these decisions are also irreversible in nature. Though there are various criteria or rule for capital budgeting options, Net present value has always been believed to be the one that maximizes the shareholder value. However, there are other criteria on which firms' base capital budgeting on IRR, profitability Index, Payback period and return on book value. Internal rate of return is and approach of discounted cash flows towards valuation and investing options. It is nothing but the discount rate which yields a zero net present value for a series of future cash flows (12MANAGE, 2006). Profitability index, otherwise known as the benefit cost ration is the rate of the present value of the cash flows of a particular project to its initial amount invested (Business Directory.com, 2007). Payback period is nothing but the duration of recovering the money invested on a particular project. Organizations use this to find out how profitable a particular project would be if invested in it. Despite the above options being available as criteria to assess capital budgeting decisions, Net Present value is the best choice of many organizations over others. Conclusion Financial data can provide insight into the future when analyzed properly in a strategic context. Regardless of the type of institution, the finance function must be examined in order to gain some insight into its health. It also reveals whether revenues have been increasing profitability. A thorough analysis of various factors identifies the financial sources of the firm and how well they have been and are being utilized. All this is important when considering the appropriateness and implementation of past, present and future strategies. Bibliography (ICMR) ICFAI Center for Management Research Financial Management for Managers [Book].- Hyderabad: ICFAI Center for Management Research , 2003. 12MANAGE IRR [Online]// 12MANAGE.- 12MANAGE, 2006.- December 2, 2008.- http://www.12manage.com/methods_irr.html. Agriculture and Consumer Protection Investment decisions - Capital budgeting [Online]// BAsic Finance for Marketers.- Agriculture and Consumer Protection, 1997.- November 11, 2008.- http://www.fao.org/docrep/w4343e/w4343e07.htm. al.. C. Horngren's et. Accounting 4th edition [Book].- New Jersey: Prentice Hall, 2000. Basic Aollege Accounting.Com Factors affecting a company's cost of capital [Online]// Basic Aollege Accounting.Com.- Basic Aollege Accounting.Com, October 26, 2008.- November 5, 2008.- http://basiccollegeaccounting.com/factors-affecting-a-company%E2%80%99s-cost-of-capital/. Blackwell publishing Financial Managment - An Insight [Journal]// Journal of International financial Management.- 2003.- pp. 23-26. Business Directory.com Profitability Index [Online]// Business Directory.com.- Business Directory.com, 2007.- December 2, 2008.- http://www.businessdictionary.com/definition/profitability-index.html. Ferson W., Harvey, C.R., The variation of economic risk premiums [Journal].- [s.l.]: Journal of Political Economy, 1991.- 2: Vol. 99. Foothill education Money in the Modern Economy [Online].- March 05, 2008.- www.foothill.edu/bss/people/moglen-david/chapte11.doc . Goodheart C.A.E Liquidity Risk Management [Report].- 1998. Hanke Steve H. Go For Dividends [Article]// Forbes.- April 17, 2006.- p. 212. Heston S.L., Rouwenhorst, K.G., Industry and country effects in international stock returns [Journal].- [s.l.]: Journal of Portfolio Management, 1995.- 12: Vol. 3. ICFAI Center for Management Research ICMR Financial Accounting & Financial Statement Analysis [Book].- Hyderabad: ICFAI Center for Management Research, 2004. Investopedia Corporate Finance [Online]// Investopedia.- Investopedia, October 3, 2008.- November 5, 2008.- http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/factors-affecting-cost-of-capital.asp. J. Francis Discussion on empirical research on accounting choice [Journal]// Journal of Accounting & Economics, 31.- 2001.- pp. pp. 309-319. Koedijk Kees G and Dijk Mathijs A van Global Risk Factors and the Cost of Capital [Journal].- [s.l.]: Financial Analysts Journal, 2004.- 60: Vol. 2. Lawrence Brian NEW FINANCIAL MANAGEMENT INFORMATION SYSTEM [Online]// JNCC SUPPORT CO..- March 23, 2006.- July 7, 2008.- http://www.jncc.gov.uk/pdf/board_06P03.pdf. MoneyInstructor.com Cost of Capital [Online]// MoneyInstructor.com.- MoneyInstructor.com, 2005.- November 11, 2008.- http://www.moneyinstructor.com/art/costcapital.asp. Munisamy Gopinath Daniel Pick, Utpal Vasavada Exchange rate effects on the relationship between FDI and trade in the U.S. food processing industry [Journal].- [s.l.]: American Journal of Agricultural Economics, 1998. Nagel Gregory L, Peterson, David R, Prati, Robert S The Effect of Risk Factors on Cost of Equity Estimation [Journal].- [s.l.]: Quarterly Journal of Finance and Accounting, 2007. Nejadmalayeri Manohar Singh & Ali Internationalization, capital structure, and cost of capital: evidence from French corporations [Journal].- Nevada, USA: Elseivier, 2003.- 2: Vol. 14. NetMBA.com Capital Budgeting [Online]// NetMBA.com.- Internet Center for Management and Business Administration, March 23, 2002.- November 11, 2008.- http://www.netmba.com/finance/capital/budgeting/. Norton Edgar Financial Review - Factors Affecting the cost of capital [Journal].- New Jersey: Eastern Finance Association, 2005.- 3: Vol. 28. Ormiston L. Fraser & A. Understanding Financial Statements [Book].- New Jersey: Pearson - Prentice Hall, 2004. Robinson Burke Making Investment Decisions [Online]// Blog: burke Robinson.- 1997.- november 11, 2008.- http://www.burkerobinson.com/investment%20decisions.htm. Stulz Ren M. Globalization of equity markets and the cost of capital [Online]// Ohio-state.edu.- SBF/NYSE Conference on Global Equity Markets, February 21, 1999.- November 22, 2008.- http://www.cob.ohio-state.edu/fin/journal/dice/papers/1999/99-1.pdf. The University of Arizona Capital Budgeting [Online]// Study Finance.com.- The University of Arizona, July 12, 1999.- November 11, 2008.- http://www.studyfinance.com/lessons/capbudget/index.mv. Read More