Review of Multinational Cost of Capital - Essay Example

Finance and accounting Table of Contents Introduction 3 Literature Review 4 Conclusion 9 Reference List 10 Introduction The capital of a multinational company takes into account both equity and debt. The equity consists of retained earnings which are obtained from the stock investment by the investors. Moreover, the debt indicates towards the funds that are usually borrowed by the company to finance its working capital requirements (Durand, 1963). The cost of retained earnings of a multinational company actually depicts the opportunity cost, the amount which the existing stakeholders would earn when they receive the earnings in form of dividends and also invest the funds by themselves. The common equity highlights the opportunity cost that is obtained from the funds and invest the amounts in other stocks. The cost exceeds the retained earnings as it includes the expenses that are linked with the sale of new stocks (Durand, 1963; Heston and Rouwenhorst, 1994). The cost of debt of a multinational can be measured easily as it incurs the interest expense that results from the borrowing funds. The multinationals are observed to use specific mix of capital components and employ appropriate capital structure, which has the ability to reduce its cost of capital (Kraus and Litzenberger, 1973). When cost of capital of multinationals is low, the rate of return on projects is also observed to be low. The companies predict their cost of capital before conducting any capital budgeting technique as they have to calculate their net present value of the project. This net present value is dependent on cost of capital (Kraus and Litzenberger, 1973). The multinational companies encounter intricate cost of capital problems as compared to their domestic counterparts. This complexity offers higher opportunity to the firms to reduce their cost of capital. In the last 50 years, the application of financial management has changed to a great extent. This is reflected on the ownership structure and size of the company. This has also altered the functions of financial systems and the instruments that are used for depicting the financial structure of the company (Modigliani and Miller, 1958). This research paper aims at highlighting the different aspects of multinational cost of capital by emphasising on the opinions of different authors. Literature Review The multinational companies have the ability to raise capital for its operation from different capital markets around the world, despite its domestic opportunity. It is well identified that the multinational companies often encounter difficulty in the foreign country due to the difference in cost of capital between the countries. The studies pertaining to Japanese and US cost of capital revealed that during the year 1980, the cost of capital of the US companies was observed to be higher than that of Japan by 3.3% (Moyer, McGuigan and Kretlow, 2011). With the integration of the global capital market, there are reduced barriers to international flow of capital. The companies have the opportunity to employ the difference in cost of capital that is relevant in various countries; therefore, it also results in reduction of cost of capital of the companies. According to Scott Jr (1976) most of the multinationals raise their capital from the equity investments made by the investors in the home country. Moreover the companies are also seen to collect their capital from borrowed funds, which are obtained from the countries where they operate. In this way, the companies are successful in hedging some of the balance sheet risk that is linked with the modifications in value of assets (that occurs due to the exchange rate fluctuations). Reeb, Kwok and Baek (1998) had suggested that increased number of international activity can lower the risk of losing parts of investments. This is due to the advantages attached to diversification for the debt holders. However, the risk for the equity shareholders increase due to the risk associated with the fluctuations in exchange rates that exist due to international operations. For large multinational companies the use of greater debt financing is an appropriate strategy in order to reduce the cost of debt of the total cost of capital. The increase in leverage may also raise the cost of equity which may decrease the benefits related to higher leverage; which ultimately results in higher cost of capital. According to Bodnar and Wong (2000 cited in Burgman, 1996), the international diversification can also lead to change in different levels of volatility. It also modifies the value of equity call option as a result of which the cost of capital is expected to rise and simultaneously the cost of debt decreases (Reeb, Mansi and Allee, 2001; Nguyen and Ramachandra, 2006). This has huge impact on the total cost of capital and the cost is thus dependent on degree of international diversification and level of debt financing. Nevertheless, there are no such researches that deal with the affect of the international diversification in an overall context i.e. after taking in to consideration both equity and debt capital. Diversification of cost of capital Diversification in the international capital market takes into consideration all the imperfections that exist in the capital market. In order to safeguard their operation from these imperfections, the companies have to incur additional costs. Kindelberger (1969) had argued that the multinationals have the capability to internalize the transactions that occur in the capital markets. These transactions can overcome the barriers that occur in the imperfect market. The internal capital markets helps in providing opportunity to the multinational for avoiding the access to external market transactions and as a result the cost of capital is reduced. Lessard (1973) and Levy and Sarnat (1970) had depicted that advantages related to risk reduction are associated with diversification in multinational activities. Agmon and Lessard (1970) identified that the multinationals had gained greater stability against the volatile markets. The variability in the earnings is reduced and is perceived as the financial strength of the investors of the companies. Hence, it results in reduction of cost of capital. However, Fatemi (1984) had reported that the diversified companies had lowered their systematic risks, which had translated into the low cost of equity capital. Burgman (1996) had argued that the legal, institutional and socio-cultural differences across the globe had resulted in greater information asymmetry, which is encountered by the multinationals. Additionally, Lee and Kwok (1988) had suggested that the multinationals are difficult to monitor as they are operating globally as compared to domestic companies. The asymmetry in information has the ability to raise the total cost of capital of the companies. Moreover, as a result of lack of transparent international operation, there is higher monitoring cost that leads to conflict of interest between the shareholders and debt holders. Additionally, it also gives rise to conflict between the shareholders and managers. Lee and Kwok (1988) had depicted that the multinationals invest higher amount of money in the projects as compared to domestic companies. However, Meyer (1977) had indicated the existence of a number of underinvestment problems in the multinationals, which are not present in the domestic companies. This problems leads to increase in cost of debt as the lenders finds that the dent in the multinationals are less attractive. As a result of different risk-return policies, the shareholders and debt holders have the opportunity to raise the rate of return for adjusting the asset-substitution problem, which is related to the cost. This cost may become more severe in case of multinationals as it is difficult to monitor the international operations (Myers, 1977). Whenever, there is shareholder and management conflict, the managers of the multinationals encounters strict supervision on behalf of the shareholder; along with that information asymmetries acts as a severe problem that exists between the external and internal stakeholders. These events have the ability to increase the cost of equity as there is high monitoring and bonding cost (Myers, 1977). Aliber (1984) argued that the multinationals operating in the foreign countries is perceived to be risky by the investors with respect to finance and business. Additionally, the socio-political risks are also involved with the multinationals that are operating in a foreign economy. He and Ng (1998) had suggested that apart from the mentioned risk, the multinationals are also exposed to a number of other risks such as foreign exchange risk, which leads to increase in variation in domestic denominated currency. Lewellen (1971) had argued that product diversification had developed a sense of coinsurance, which had enhanced the capacity of corporate debt. A positive effect is expected on the debt in case of diversified companies (Gaud, et al., 2005). Fatemi (1984) and Agmon and Lessard (1977) had hypnotized that international diversification had reduced the predicted cost of bankruptcy and allowed the increase in the debt capacity. Singh and Nejadmalayeri (2003) had identified that the leverage position of a multinational “increases with the product and international diversification along with the strategy of combined product and international diversification, which leads to lower threat of bankruptcy risk” (Singh and Nejadmalayeri, 2003, p. 157). Nevertheless, Singh, Davidson and Suchard (2003) had provided evidence related to both and had signified that the companies which focus on product diversification possess higher degree of leverage and the multinationals are supported by lower debt financing. Cost of capital across the countries that affects the multinationals The cost of capital varies country-wise because of three basic reasons. Firstly, the competitive advantage of one country over another can be explained through the difference in cost of capital. This is due to the set of projects that are available in one country (Akhtar and Oliver, 2009). When net present value of a project is positive, cost of capital is low and the rate of return is high; in such a position the multinational have the ability to increase its market share globally. The multinationals, which are operating in other countries with higher cost of capital, are forced to decline their projects. These projects would have been feasible if the cost of capital is low. The multinationals may adjust the source of funds and international operations in order to capitalize the difference in cost of capital among the counties. The differences that occur in each of the cost components such as equity and debt are sufficient enough to explain why the multinationals prefer debt capital over equity capital (Akhtar and Oliver, 2009). The cost of debt of a multinational is ascertained with the help of risk free interest rate of the currency that is borrowed and the risk premium associated with the creditors. The cost of debt is higher in few countries as compared to others as the risk free rate is assumed to be higher at a certain period of time. Before financing a new project, the multinationals aims at estimating the cost of equity and debt from various sources. The estimations are made when they prepare the capital structure of the projects (Ethier and Horn, 1990). The after tax cost of debt is predicted with accuracy with the help of public information on present cost of debt, which is incurred by the companies. The cost of equity is defined as an opportunity cost for the investors. The multinationals attempts to gauge expected return on stocks and the risk associated with the projects. The expected returns serve as the cost of equity of the project. The return is also ascertained to be the weighted cost of capital of the project (Ethier, 1996). Conclusion Cost of capital in multinationals are observed to be different in countries worldwide. It varies due to strength of economy and potential of projects, which are undertaken by the companies. The cost of equity and debt differ according to the financial stability of the projects. Hence, it is worth mentioning that the multinationals encounters higher level of complexity with regard to determination of cost of equity and debt in a particular country. The multinationals with higher internationalization are comfortable with higher degree of debt financing. These reduce the overall cost of capital of the multinational despite the fact that risk level is higher in this case as compared to equity financing. The multinationals that uses higher foreign currency denomination as the hedging instrument employ higher proportion of debt financing, which helps in reducing the cost of capital. Reference List Agmon, T. and Lessard, D.R., 1977. Investor recognition of corporate international diversification. Journal of Finance ,32, pp.1049–1055. Akhtar, S. and Oliver, B., 2009. Determinants of capital structure for Japanese multinational and domestic corporations. International Review of Finance, 9(1-2), pp. 1-26. Aliber, R.Z., 1984. International banking: a survey. Journal of Money Credit and Banking, 16, pp. 661–684. Burgman, T. A., 1996. An empirical examination of multinational corporate capital structure. Journal of International Business Studies, 27, pp. 553–570. Durand, D., 1963. The Cost of Capital in an Imperfect Market: A Reply to M-M. American Economic Review, 53. Ethier, W.J. and Horn, H., 1990. Managerial control of international firms and patterns of direct investment. Journal of International Economics, 28, pp. 25–46. Ethier, W.J., 1996. The multinational firm. Quarterly Journal of Economics, 101, pp. 805–834. Fatemi, A.M., 1984. Shareholder benefits from corporate international diversification. Journal of Finance, 39, pp. 325–1344. Gaud, P., Jani, E., Hoesli, M. and Bender, A., 2005. The Capital Structure of Swiss Companies: an Empirical Analysis Using Dynamic Panel Data. European Financial Management, 11, pp. 51–69. He, J. and Ng, L.K., 1998. The foreign exchange exposure of Japanese multinational corporations. Journal of Finance, 53, pp. 733–753. Heston, S.L. and Rouwenhorst, K.G., 1994. Does industrial structure explain the benefits of international diversification? Journal of Financial Economics, 36, pp.3–27. Kindelberger, C. P., 1969. American business abroad: Six lectures on direct investment. Yale : University Press. Kraus, A. and Litzenberger, R. H., 1973. A State Preference Model of Optimal Financial Leverage. Journal of Finance, 28, pp. 911-22. Lee, W.S. and Kwok, C.C., 1988. Domestic and international practice of deposit insurance: a survey. Journal of Multinational Financial Management, 10, pp. 29–62. Lessard, D., 1973. International portfolio diversification. Journal of Finance, 28, pp. 619–632. Levy, H. and Sarnat, M., 1970. International diversification of investment portfolios. American Economic Review, 60, pp. 668–675. Lewellen, W.G., 1971. A pure financial rationale for the conglomerate merger. Journal of Finance, 26, pp. 521–537. Modigliani, F. and Miller, M. H., 1958. The Cost of Capital, Corporation Finance and the Theory of 36 Investments. American Economic Review, 48, pp. 261-97. Moyer, R., McGuigan, J. and Kretlow, W., 2011. Contemporary financial management. Connecticut: Cengage Learning. Myers, S., 1977. The determinants of corporate borrowing. Journal of Financial Economics, 5, pp. 147–175. Nguyen, T. D. K. and Ramachandra, N., 2006. Capital structure in small and medium-sized enterprises. ASEAN Economic Bulletin , 23(2), pp. 192-211. Reeb, D. M., Mansi, S. A. and Allee, J.M., 2001. Firm internationalization and the cost of debt financing: evidence from non-provisional publicly traded debt. Journal of Financial and Quantitative Analysis, 36, pp. 395–414. Reeb, D.M., Kwok, C.C. and Baek, H.Y., 1998. Systematic risk of the multinational corporation. Journal of International Business Studies, 29, pp. 263–279. Scott Jr., J, H., 1976. A Theory of Optimal Capital Structure. Bell Journal of Economics, pp.33-54. Singh, M., Davidson, W. N. and Suchard, J., 2003. Corporate diversification strategies and capital structure. Quarterly Review of Economics and Finance, 43, pp.147–167. Singh, M. and Nejadmalayeri, A., 2003. Internationalization, capital structure, and cost of capital: evidence from French corporations. Journal of Multinational Financial Management, 12, pp. 153-169. Read More