Multinational Cost of Capital - Essay Example

Multinational Cost of Capital Literature Review Introduction Evaluating the multinational investment requirements require the use of various financing sources. It is, therefore, a characteristic if a multinational firm to raise both equity and debt in capital markets with locations in different countries (James & Tsong-Yue, 1992). Cost of capital for a multinational firm consists of both equity, which is also referred to as retained earnings, and debt, which is also referred to as borrowed funds. Cost of retained earnings of a firm always reflects an opportunity cost. The opportunity cost represents what the shareholders could have earned if they took it upon themselves to invest the funds and receive the earnings as dividends. The cost of new common equity for the firm in the issuance of stock is another opportunity cost. Here, the opportunity cost represents what the shareholders could have earned somewhere else could they have invested their funds elsewhere rather than on the stock. Such a cost is bound to exceed that of retained earnings since it includes the expenses that are associated with selling the new stock, also referred to as the flotation cost. It is easier for the firm to measure its cost of debt since it incurs interest expense due to borrowing of funds. To minimize the multinational cost of capital, firms have the tendency of using a specific capital structure or a mixture of capital structures. The firms cost of capital should be low so that its required rate of return on a particular project can also become low (Anderson, et al., 2000). It is wise for firms to estimate their multinational cost of capital before making any capital budgeting decision as it affects the net present value of any project. This literature review will discuss the characteristics of multinational cost of capital as well as its theories. The first part will look into the characteristics while the second part is looking at the theories associated with multinational cost of capital. Characteristics of Multinational Cost of Capital Multinational cost of capital may differ from the domestic cost of capital for firms due to various characteristics that are particularly unique for multinational cost of capital. The first one is on the size of the firm. Multinational cost of capital is normally associated with large firms that extend their operations to various countries in the world (Eckert & Engelhard, 1999). They are always known as multinational corporations. They are known for borrowing substantial amounts of capital, which make them receive preferential kind of treatment from the creditors. Their costs of capital are, therefore, reduced due to this reason. Multinational cost of capital is also associated with the issuance of relatively large stocks and bonds, which make them receive reduced floatation costs, which comes as a percentage of the financing amount. However, it is important to note that such benefits come as a result of the size of a multinational corporation, but not because of its internationalized business. Similar treatment in terms of cost of capital may apply to domestic firms that prove that they are large enough. The growth of domestic firms is however restricted because they are not willing to stretch their arms internationally. They, therefore, fail to reap the advantages of receiving cost of capital that are associated with large multinational firms (Johnston & Menguc, 2007). It is because the multinational corporations are capable of achieving growth faster, that they are therefore able to reach the necessary size that favors them to receive preferential treatment from creditors when looking for capital to finance their businesses. The second point here is the ability to access the international capital market. There are advantages associated with finding financing through the international capital market. This makes the international cost of capital lower as such markets operate at high-efficiency levels, therefore, offering financing or capital to corporations at a very cheap cost. Cost of capital does vary among markets globally. However, the possible access of multinational corporations to the international capital market allows them to be the beneficiaries of the low cost of funds that are offered by these markets (Burgman, 1996). The subsidiary branches of the multinational companies are also capable of receiving cheaper costs of capital in their host countries than the parent company given the prevailing interest rates in these countries are relatively low. It is also important noting that the use of foreign currency will not necessarily increase the multinational corporations exposure to the risk of exchange rate because the revenues that are generated by the subsidiary companies are always dominated in the same currency. In such cases, the subsidiary do not rely on the parent for the provision of capital. However, there remains some centralized managerial support that the subsidiary still depends on the parent for. Multinational cost of capital is also characterized by factors of international diversification. The firms cost of capital is always affected by the possibility or probability that it will go bankrupt. It is, therefore, advantageous for a firms sources of cash inflow to come from various sources all over the world than if it only comes from a single source (Phelps & Waley, 2004). Such cash inflows are considered to be more stable as the total sales of a firm is considered not to be influenced only by a single economy. It is also expected that net cash flows should exhibit minimal variability as long as individual economies are independent of each other. In such cases, the probability of bankruptcy is reduced, thereby reducing the cost of capital. We, therefore, say that multinational cost of capital is influenced a great deal by the ability of a firm to diversify internationally. When one economy where the firm has put its subsidiary branch undergoes a bad economic time, other economies may be fairly stable or doing better. This way, the subsidiaries stand high survival chances that then lead to a reduction in the probability of bankruptcy. With reduced bankruptcy level, creditors are able and willing to provide capital to the multinational corporation at reduced costs. Exposure to exchange rate risk is another factor that characterizes the multinational cost of capital. The cash flow of a multinational corporation could be more volatile than that of a domestic firm operating in a similar industry if it has high exposure to exchange rate risk. For example, if foreign earnings are remitted to a multinational corporation with the parent branch in the U.S., they might not be strong as much provided the U.S dollar remains stronger than most major currencies (Raihan, 2013). The capability of making interest payment on behalf of the outstanding debts, thereby, becomes reduced. Such a phenomenon raises the probability of bankruptcy of a firm. The creditors and the shareholders may, in return, require a higher return, which will increase the cost of capital for the multinational corporation. As we know, all firms like it when the cost of capital is low, therefore, this might not be favorable to the multinational corporation, who is the capital borrower. On the overall view, a firm that is exposed more to exchange rate fluctuations usually has a wider distribution of possible cash flows in the coming periods. As the cost of capital is expected to reflect that possibility, and that the possibility of bankruptcy is also expected to be higher when the expectations of cash flows are more uncertain, exchange rate fluctuation exposure is therefore expected to lead to higher cost of capital. Multinational cost of capital are also characterized by exposure to country risks (Tong & Reuer, 2007). There exist a possibility and the risk of the host country seizing the assets of a subsidiary when a multinational corporation establishes foreign subsidiaries. Such an occurrence is usually influenced by many factors some of which may include the attitudes of the government of the country where the firm is based and the concerned industry. There will be, again, an increased probability of the subsidiary going bankrupt when the assets are seized, and no proper compensation is provided. The probability of bankruptcy will even increase if the percentage of investment of the multinational corporation in the said country is high which also increases the probability of risk of operation in the country. This obviously will raise the cost of capital that the creditors will have to lend to the firm. There are other sources of country risk, which may include the changes in the host countrys tax laws. Such also affect the cash inflow of the multinational corporation, hence raising its probability of bankruptcy. Companies, therefore, require to carry out a separate assessment to determine whether the net effects on its operations internationally on the cost of capital are favorable. Comparison of Multinational Cost of Capital Using CAPM The capital asset pricing model can be applied when assessing the required rate of return of the multinational corporations. The CAPM model requires that the required rate of return on the stock of a firm should be a positive function of the risk-free rate of interest, the market rate of return and the beta of that particular firms stock (Nagel, et al., 2007). By increasing the amount of foreign sales by a multinational corporation, there is a possibility of reducing the beta of the stock of the firm, which will, therefore, reduce the required return by the investor. The implication is, therefore, drawn that the cost of capital of the firm will, therefore, reduce. The required rate of return on the multinational corporations are normally lower due to these firms exhibiting lower betas. Because of this, the cost of capital for such corporations are always low. However, its worth to note that some multinational corporations consider unsystematic risks to be relevant in their businesses. It is necessary to know the reason cost of capital can vary across countries for three reasons. The first reason being, the reason can be used to explain why some multinational corporations have the comparative advantage over the others (Kurach, 2013). The cost of capital also changes across countries in the same way countries differ in technologies and resources. When the cost of capital is lower in some countries, a multinational corporation based in those countries will have larger sets of feasible projects that yield positive net present value. It is, therefore, very easy for such multinational corporations to increase their world market share. On the other hand, those multinational corporations based on countries where cost of capital is very high will have to decline many projects whose net present value are considered to be negative. However, such projects might be feasible in other countries with low cost of capital. The understanding of the disparity of the cost of capital among countries is also necessary in informing the Multinational Corporations when adjusting their international operations and sources of funds so that they can capitalize on the differences on the cost of capital among these countries. The third reason here is that, the differences in each capital component can be used in explaining why Multinational Corporation in some countries uses more debt intensive capital structure than others based in different countries. Conclusion In a nutshell, multinational cost of capital is the cost of capital required by Multinational Corporations to set up their structures or investments in various countries. The cost of capital depends on various reasons and circumstances in the host countries. Factors including the size of the firm, the ability to access the international capital market, international diversification, exposure to exchange rate risk and the exposure to the risks of the country, affect the multinational cost of capital for various firms. The capital asset pricing model is used to assess the required rate of return for the Multinational Corporation. This results in a given value of beta for the firms stock. Multinational Corporations always have low values of bets, which indicate lower required rates of return, hence lower costs of capital. It, therefore, sums up the fact that, multinational cost of capital is regarded to be relatively cheaper than the domestic cost of capital. However, to be in a position to warrant financing of a firm in the category of a multinational financing, the size of the firm must be determined as large. It is only easy for firms that internationalize their operations to receive such financing, which leaves them the only possible beneficiaries if the relatively cheaper multinational cost of finance. Bibliography Anderson, R., Byers, S. & Groth, J., 2000. The cost of capital for prjects: conceptual and practical issues. Management Decision, 38(6), pp. 384-393. Burgman, T., 1996. An emperical examination of multinational corporate capital structure. Journal of International Business Studies, 27(3), pp. 553-570. Eckert, S. & Engelhard, J., 1999. Towards a Capital Structure Theory for the Multinational Company. Management International Review, Volume 39, pp. 105-136. James, A. S. & Tsong-Yue, L., 1992. The Cost of Capital for Multinational Corporation. International Review of Economic and Finance, 1(4), pp. 305-314. Johnston, S. & Menguc, B., 2007. Subsidiary size and the level and subsidiary autonomy in multinational corporations: a quadratic model investigation of Australian subsidiaries. Journal of International Business Studies, 38(5), p. 789. Kurach, R., 2013. Does Beta Explain Global Equity Market Volatility. Journal of Contemporary Economics, 7(2), p. 55. Nagel, G., Perterson, D. & Prati, R., 2007. The effect of Risk Factors on Cost of Equity Estimation. Quarterly Journal of Business and Economics , 46(1), pp. 61-87. Phelps, N. & Waley, P., 2004. Capital Versus the Districts: A Tale of One Multinational Companys Attempt to Disembed Itself. Economic Geography, 80(2), pp. 191-215. Raihan, M., 2013. Exchange Rate Risk Pricing by U.S. Industrial Portfolios. International Journal of Economics and Finance, 5(11), pp. 13-21. Tong, T. & Reuer, J., 2007. Real options in multinational corporations: organizational challanges and risk implications. Journal of International Business Studies, 38(2), pp. 215-230. Read More