Cost of Capital-MNCs

The basic principle of cost of capital remains the same The company tries to reduce its capital cost so that it can increase its rate of return The cost of capital is the rate that must be earned in order to satisfy the required rate of return of the firms investor There are two sources of capital
Equity Debt

Debt is inherently cheaper source than equity as the interest payment is tax deductible

Cost of capital-debt
Debt is good up to a level, as with increasing interest cost the probability of it defaulting on interest payments increases. Hence a company has to find an optimum balance between debt and equity Cost of debt Kd =Interest Charges/Market value of the debt After tax cost of debt=Kd=(1-t)

Cost of Capital-Equity
Cost of Preferred shares Kp=Dp/Po Cost of Equity shares:
Dp= Cash dividends paid to preference shareholders Po= Market price of the preferred shares
Dividend Growth Model Ke=D1/Po+G Capital Asset Pricing Model (CAPM) Rj=Rf+(Rm-Rf) Rj= Rate of return on asset Rf= Rate of return on the risk free asset Rm=Rate of return on a market index = beta of the share j

Cost of Capital for MNCs

The cost of capital for MNCs may differ from that of domestic rms because of the following characteristics that differentiate MNCs from domestic rms: Size of rm: An MNC that often borrows substantial amounts may receive preferential treatment from creditors, thereby reducing its cost of capital. Furthermore, its relatively large issues of stocks or bonds allow for reduced otation costs Access to international capital markets. MNCs are normally able to obtain funds through the international capital markets. Since the cost of funds can vary among markets, the MNCs access to the international capital markets may allow it to obtain funds at a lower cost than that paid by domestic rms. Subsidiaries may be able to obtain funds locally at a lower cost than that available to the parent if the prevailing interest rates in the host country are relatively low.

MNCs
The use of foreign funds will not necessarily increase the MNCs exposure to exchange rate risk since the revenues generated by the subsidiary will most likely be denominated in the same currency. In this case, the subsidiary is not relying on the parent for nancing, although some centralized managerial support from the parent will most likely still exist. International diversication. If a rms cash inows come from sources all over the world, those cash inows may be more stable because the rms total sales will not be highly inuenced by a single economy.

MNCs -contd
Exposure to exchange rate risk: An MNCs cash ows could be more volatile than those of a domestic rm in the same industry if it is highly exposed to exchange rate risk. A rm more exposed to exchange rate uctuations will usually have a wider (more dispersed) distribution of possible cash ows in future periods. Since the cost of capital should reect that possibility, exposure to exchange rate uctuations could lead to a higher cost of capital. Exposure to country risk: An MNC that establishes foreign subsidiaries is subject to the possibility of changes in the regulations and regimes of the host country government.

 Of the 5 factors listed above in general, the rst three factors listed (size, access to international capital markets, and international Diversication) have a favourable effect on an MNCs cost of capital. While exchange rate risk and country risk have an unfavourable effect. It is impossible to generalize as to whether MNCs have an overall cost-of-capital advantage over domestic rms. Each MNC should be assessed separately to determine whether the net effects of its international operations on the cost of capital are favourable.

Capital Structure
Stability of cash flows Risk faced by the MNC Country Characteristics and its influence Tax laws in host country

Weighted Average cost of capital

WACC is used to calculate the total cost of capital of the company WACC is defined as the weighted average of the after-tax costs of all the components of capital used by a company to finance its projects WACC= Kd x (Proportion of debt)+ Kp x (Proportion of preferred capital)+ Ke x (Proportion of equity capital) WACC is used as the hurdle rate If the projects rate of return exceeds the hurdle rate, then the project will be profitable