The cost of capital and the optimal financing mix for multinational enterprises


Term Paper, 2017

10 Pages


Excerpt

Table of contents

1 Introduction

2 Fundamentals of International Financing for Corporations

3 The Cost of capital and the optimal financing mix for MNEs

4 Conclusion

5 References

List of tables and figures

Figure 1: Financing Globa lOperations

Figure 2: CAPM and the required return on equity.

1 Introduction

In this paper, the question if Multinational Enterprises (MNEs) are able to accomplish a more favorable financing situation compared to their domestic counterparts will be examined. In order to prepare a sound discussion, there will be at first an overview of international financing possibilities for MNEs. After that, the different types of cost of capital and the relating consequences for the company’s capital structure in an international surrounding are connected to discuss the relevant views in the financial literature.

2 Fundamentals of International Financing for Corporations

Before handling the cost and availability of capital in the international financing decision more deeply, MNEs are defined and their ways to achieve finance is presented. A MNEs is operating globally and 20% of its sales has to be from each of three different continents (ft.com 2017). Furthermore, there exist the reliance on foreign tax rates as well as foreign assets, what is complementary useful because sales could be generated by a foreign subsidiary or just by selling abroad (Rasaei/Nguyen 2011). To obtain finance there are more and complex possibilities for a global corporation as (shown in figure 1) compared to a local operating enterprise. Intercompany financing relates to a reliance on ‘family’ funds, i.e. receiving finance from the parent company or from sister subsidiaries, both in the form of loans, trade credit, guarantees or equity. There is also the way of keeping higher levels of retained earnings. Both ways reduce the dependence on capital markets and are usually preferred if available (Shenkar/Lou/Chi 2015).

Beyond that, we have classic equity financing which occurs normally through two ways: There is the possibility to ‘cross-list’ shares on foreign stock exchanges - usually via depositary receipts - which improves liquidity and increases the firm’s visibility in the local market. Alternatively, firms can issue stocks via subsidiaries, which can be useful to broaden ownership and to give local administrations the opportunity to invest as required in some states (Ibid.).

On the debt side, there are often used international bank loans called ‘Eurocredits’, which are mostly syndicated between banks to share risks. For short- and medium-term debt capital needs the ‘Euronote market’ ensures relatively cheap financing for MNEs, because these instruments are publicly traded. An example are ‘Euro-Medium-Term-Notes’. The third usual debt vehicle are bonds, dividing into ‘Eurobonds’ and ‘foreign bonds’. The difference is, that Eurobonds are not sold in the specific country of the denominated currency, e.g. a Yen-Bond exclusively for European Investors. Foreign bonds are in contrast sold abroad and denominated in the foreign currency, e.g. a US company is operating in Germany and selling local bonds denominated in EUR (Ibid.)

Furthermore, we have local currency financing opportunities. Using local banks outside the US, a common instrument are overdrafts of local currency accounts. Beyond that, there are classical term loans and credit lines. By conducting ‘discounting’, the company’s trade bills can be discounted by the local bank. There are also local non-bank financing sources such as factoring or the usage of traded commercial papers (Ibid.).

illustration not visible in this excerpt

Figure 1: Financing Global Operations, source: Shenkar/Lou/Chi 2015, p. 472

3 The Cost of capital and the optimal financing mix for MNEs

In this chapter, the benefits and drawbacks of international financing will be examined in order to answer the main question. The mentioned better or desirable financing mix can be equated with the possibility to obtain cheaper funds. So how can a multinational expansion lead to perceptible cost reductions of enterprises? Basically, an easier access of funds abroad is assumed if a company finds an illiquid or segmented securities market in its domestic country. A market is segmented if there exist higher required returns on securities than in comparable markets around the world. That can be explained by imperfections like political risks, lacking transparency or corruption. In contrast, global markets normally provide a liquid environment combined with a fair pricing of securities, which in turn means that there can be issued greater volumes to more favorable prices (Eitemann et al. 2016).

Market liquidity is a crucial factor as it describes the possibility to issue new shares or bonds without impacting the actual market price. This is often the case if the domestic market is a small one. In that scenario, companies cannot fund their project sufficiently in the short run and are forced to expand their time horizon. If the financing is nevertheless needed and fully placed on the illiquid market, the result will be a lower price and higher funding costs. In international markets and the presence of large bond and stock markets, such liquidity issues should normally not matter. This aspect is enforced by the fact that domestic companies have to rely mostly on internally generated funds and on commercial banks to obtain capital, which leads to a rather fluctuating ability of funds, what is negative in the light of our main question (Ibid.).

On top of that, there is the effect of international diversification, which reduces risk for investors who are adding foreign securities to their portfolio. Every time there is an obvious value-creation, demand for these securities is rising which in turn leads to higher prices and lower issuing costs for the MNE. Because risk is such an important aspect in determining capital costs, it will be discussed in more detail in the following. Basically, the cost of capital is calculated using the weighted average cost of capital (WACC) which results from the cost of equity and debt of a firm in a relative weight dependent on its optimal long-term capital structure. The weighted cost of debt is determined easily by reducing the tax burden from the average interest expense. On the equity side, the capital asset pricing model (CAPM) is used. Here, the firms individual risk in relation to the general market is regarded and added to the risk-free rate in order to arrive at a company-specific required return on equity, as showed on figure 2 (Ibid.).

illustration not visible in this excerpt

Figure 2: CAPM and the required return on equity, source: Investopedia.com 2017.

The individual firm risk is described by the beta value, which determines the volatility of the individual firm compared to the market and is also called a measure of the firms’ systematic risk. Thus, we can conclude that if we achieve a lower beta on the company level, the risk will be obviously lower, which would then lead to a lower required return on equity and lower funding costs for the company. Beyond that, the risk for an investor can be further reduced if he is able to diversify his portfolio efficiently as implied above. That works in fact, if the portfolio contains a high grade of low correlating elements, because that way, the unsystematic risk can be diversified away and the investor achieves a more favorable risk-return-profile. This could be done by simply adding a foreign stock or choosing a MNE which ensures an international diversification by itself, because its revenues are collected around the world and its production can also be divided across different regions. On this way, the variability of cash flows is lowered and the coverage of fixed costs should be achieved more easily on the company level. It has to be further acknowledged, that international investments usually go in line with additional foreign exchange risks, which themselves can enforce the diversification effect or lead to higher volatility if they are wrongly combined (Ibid.).

The preceding argumentation concerning lower risk is mainly comprehensible, but one aspect could be regarded from a different perspective: The described company beta value has a domestic market portfolio as its foundation, which shows lower correlation with international stocks. But what if the market portfolio is a global one itself? Then we would not have such a huge diversification benefit, because the market as a reference could contain mostly of MNEs itself and correlation among securities is generally higher (Unit 7 2016). In view of our main question we can nevertheless say, that the global diversification effect is a relevant factor that ensures MNEs a better funding situation compared to their domestic counterparts.

Despite what has been found about the obvious diversification benefits of MNEs, reality shows that MNEs have often higher capital costs than their domestic counterparts. That is an effect of the second large cost element of capital, agency costs (Eitemann et al. 2016). First of all, there are generally higher agency costs for MNEs, because in an international surrounding there is a higher effort of monitoring for creditors and shareholders due to language, legal and tax differences (Kwok/Reeb 2000) as well as due higher information asymmetries (Doukas/Pantzalis 2003). Debt agency costs evolve in particular with rising debt levels, because managers get the moral hazard incentive to expropriate bondholders by high dividends while taking higher risks than committed (Hillier et al 2016). “The fear of wealth transfers from debtholders to equityholders lowers bond value.“ (Graham 2017, p. 12) These costs are generally paid by the issuing company, i.e. the shareholders, through demanded higher interest rates, leading to a capital structure with lower debt. In general, agency costs have a negative correlation to a company’s leverage, meaning that debt levels are decreasing with rising agency costs, what in turn makes funding more expensive (Rasaei/Nguyen 2011). On the other hand, empirical studies indicate that MNEs have a lower average cost of debt (Eitemann et al. 2016), what could be explained by better financing conditions in local currency abroad as described in chapter 2 combined with positive size effects of large MNEs. Thus, the lower and unfavorable leverage situation implicated by agency costs stands in contrast with the assumed lower costs of debt for MNEs. Regarding the agency costs of equity, one could argue that higher debt levels are favored, because they restrict free cash flows available for a possible management’s expropriation of shareholders, e.g. buying company jets etc. (Park et al. 2013).

The effect of rising agency costs on the MNE depends on the origin: If the company is located in a developed market and goes abroad to pursue a project in an emerging market country, i.e. it is going downstream, total risk after diversification advantages is expected to increase. Besides the mentioned agency costs, an explanation for that are higher political and foreign exchange risks in these countries (Rasaei/Nguyen 2011). On the other hand, if an emerging market firm expands its business to a developed country, i.e. it is going upstream, the agency costs aren’t overlapping the previously explained international portfolio benefits, that is because of the lower risks in the developed target market (Kwok/Reeb 2000).

On top of that, there are firm-specific factors like the size: Larger firms are less likely impacted by information asymmetries which leads to lower agency costs for them, independent of the relating country’s risk parameters. That goes in line with lower bankruptcy costs and lower transaction costs in international debt issues for larger firms. Additionally, a higher range of tangible assets leads to lower debt levels at better conditions, because loans can be collateralized. (Ramirez/Kwok 2010). Smaller MNEs are further impacted by the underinvestment problem: They avoid using large amounts of debt because they cannot be sure to find a usage for that funds in the future, when maybe less investment opportunities are present. Another aspect refers to natural hedging: If strong cash flows are created in a foreign country, it could be worthwhile to issue more local debt to hedge currency fluctuations. (Park et al. 2013). These findings are accompanied by country-level determinants: Studies show, that firms in countries with sophisticated legal systems and higher GDP levels are using more debt, leading to higher leverage and profitability through the usage of tax shields. If a strong capital market is present, the company has an incentive to issue stocks, which in turn results in lower debt levels. The same is true for countries with a common law system, which is known for protecting investor’s rights (Ibid.). It cannot be said in general, which of all these factors leads to a better funding environment, because the individual situation for the MNE concerning its own sector, balance sheet and operating countries has to be examined to judge its financing advantages.

[...]

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Details

Title
The cost of capital and the optimal financing mix for multinational enterprises
College
School of Oriental and African Studies, University of London  (CeFIMS)
Author
Year
2017
Pages
10
Catalog Number
V379754
ISBN (eBook)
9783668572645
ISBN (Book)
9783668572652
File size
500 KB
Language
English
Tags
multinational, enterprises
Quote paper
Arno Hetzel (Author), 2017, The cost of capital and the optimal financing mix for multinational enterprises, Munich, GRIN Verlag, https://www.grin.com/document/379754

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