C. Kirt Butler, Multinational Finance, 3rd edition
Chapter 16 Multinational Capital Structure and the Cost of Capital
True/False
1.
A firms cost of capital is independent of its financial structure.
ANS: False. Given the firms investments, financial structure determines the firms cost of
capital.
2.
Capital structure refers to the relative proportion of monetary and real assets in the firm.
ANS: False. Capital structure refers to the proportions and forms of long-term debt and
equity capital used to finance the assets of the firm.
3.
The goal of financial policy is to minimize the firms overall cost of capital, given the firms
assets.
ANS: True.
4.
If financial markets are perfect and there are no taxes, then corporate financial policy is
vitally important to the firms stakeholders.
ANS: False. If financial markets are perfect, then corporate financial policy is irrelevant.
5.
If financial markets are perfect, then the value of an asset is determined by the value of
expected future investment cash flows and not by the way that it is financed.
ANS: True.
6.
In integrated financial markets, nominal rates of return on equivalent assets are equal.
ANS: False. In integrated markets, real after-tax required returns on equivalent assets are
equal.
7.
If financial markets are integrated and systematic risk is to be measured against a market
portfolio, then the appropriate choice of a market portfolio is the domestic market index.
ANS: False. The world market index is the appropriate market portfolio.
8.
If goods and financial markets are segmented across national borders but are otherwise
efficient, then multinational corporations can reduce their cost of capital through foreign
direct investment or through financing from foreign sources or both.
ANS: True.
9.
On balance, market segmentation hurts the multinational corporation more than the
domestic corporation.
ANS: False. The multinational corporation may be able to gain access to new investments or
financing at more favorable rates than are available domestically.
10. If investors are restricted from some markets by capital flow barriers, then the multinational
corporation with access to these markets can provide indirect diversification benefits to
investors.
ANS: True.
11. A higher cost of capital on foreign investment could arise if a foreign government requires
that at least a part of the foreign investment be financed locally.
ANS: True.
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12. Foreign political risks increase the variability of outcomes on foreign investment projects.
ANS: True.
13. The total risk of a foreign investment is likely to be greater than similar domestic
investments.
ANS: True.
14. The total operating risk of a foreign investment could be greater than the risk of a similar
domestic investment, and yet the investment could have a lower required return than a
similar domestic investment.
ANS: True.
15. In perfect and integrated financial markets, multinational corporations are able to achieve
diversification benefits that cannot be replicated by individual investors or portfolio
managers.
ANS: False. Investors can already diversify for themselves in perfect, integrated financial
markets.
16. In a perfect and integrated financial market, investors can reduce or even eliminate the
currency risk exposures of their portfolios through their own portfolio hedging and
diversification strategies.
ANS: True.
17. In the real world, hedging can increase the firms expected cash flows by reducing expected
taxes, bankruptcy costs, and agency costs.
ANS: True.
18. When evaluating new investment alternatives, the multinational corporation should use a
discount rate that reflects the systematic risk of other assets in that country.
ANS: False. Use an asset-specific discount rate that reflects the risk of the proposed
investment.
19. According to the weighted average cost of capital approach to project valuation, operating
cash flows are discounted at the required return of levered equity capital.
ANS: False. After-tax operating cash flows to debt and equity are discounted at a weighted
average of after-tax required returns on debt and equity capital.
20. Discount rates on new investments should reflect the discount rates on the firms existing
assets and the firms existing debt-equity mix.
ANS: False. The discount rate should reflect the systematic operating risk and debt capacity
of the proposed investment.
21. Discounting after-tax cash flows to debt and equity at the weighted average cost of capital is
the most commonly used method for project valuation in market economies.
ANS: True.
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22. The target debt capacity of a foreign project is the amount of debt that the firm would
choose to borrow if the project were financed as a stand-alone entity.
ANS: True.
23. The discount rate in project valuation should reflect the mix of debt and equity that is
actually raised to finance a particular project.
ANS: False. The discount rate should reflect the target or optimal mix of debt and equity.
24. The target debt capacity of a foreign project should reflect the firms existing assets and
debt-equity mix.
ANS: False. Debt capacity is asset-specific.
25. The market portfolio in an integrated financial market is the domestic market index.
ANS: False. The market portfolio in an integrated financial market is globally diversified.
26. For investments in developed economies, the security market line is still the most popular
method for identifying equity required returns.
ANS: True.
27. The value of a foreign investment depends on the way it is financed.
ANS: True.
28. Adjusted present value is found by discounting cash flows to levered equity at a discount
rate that reflects the systematic risk of levered equity.
ANS: False. APV adds the value of financing side effects to the value of unlevered equity.
29. The systematic business risk of a project can be proxied by the beta of a similar asset that is
financed with one hundred percent equity.
ANS: True.
30. First-time issuers of American depository receipts tend to see a gain in share price.
ANS: True.
31. Agency costs arise from conflicts of interest between the various institutional owners of the
firms equity.
ANS: False. Agency costs arise from conflicts between managers and other stakeholders.
32. Studies find that international equity issues do not suffer the same degree of post-issuance
underperformance as domestic issues do.
ANS: True.
33. In the capital asset pricing model, diversifiable risks do not affect the cost of capital.
ANS: True.
34. Whether higher total operating risks on foreign investment translate into higher systematic
risks depends only on the severity of political risks in the host country.
ANS: False. Whether higher total operating risks on foreign investment translate into higher
systematic risk depends on the total risk of foreign investment and on the correlation of
foreign investment returns with investors relevant market portfolio.
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35. Most empirical studies that study the cost of capital of multinational corporations relative to
similar domestic corporations find that the risks of cross-border operations result in a higher
cost of capital for the multinational corporation.
ANS: False. It depends on the nature of the risks, especially on whether they are
diversifiable. Indeed, most studies find lower capital costs for multinational corporations.
36. Erb, Harvey, and Viskanta [Political Risk, Financial Risk and Economic Risk, Financial
Analysts Journal, 1996] found the higher volatilities of companies in emerging markets
resulted in higher betas than on comparable assets in developed markets.
ANS: False. Emerging markets lower correlations with other markets tend to overcome
their higher volatilities, resulting in lower betas than on similar assets in developed markets.
Multiple Choice
1.
In their famous articles on the cost of capital, corporation finance and the theory of
investment, Modigliani and Miller made each of the following assumptions except ____.
a. equal access to bid and ask prices
b. homogeneous investor expectations
c. homogeneous business risk classes
d. perpetual cash flows
e. rational investors
ANS: A
2.
Factors contributing to financial market segmentation include each of the following except
____.
a. different investor expectations
b. different legal, political, or tax systems
c. informational barriers
d. rational investors
e. transactions costs
ANS: D
3.
Foreign political risk includes each of the following except ____.
a. unexpected changes in expropriation risk
b. unexpected changes in foreign exchange rates
c. unexpected changes in local ownership limitations
d. unexpected changes in repatriation restrictions
e. unexpected changes in taxes
ANS: B
4.
Which of a) through d) is true?
a. A particular political risk is more likely to be diversifiable by local investors than by
international investors.
b. A political risk such as an election imposes higher costs of capital on MNCs held by
globally diversified investors.
c. From the perspective of managers in the multinational corporation, political risk is
not diversifiable.
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d. Global investors are exposed to a multinational corporations total risk, measured by
standard deviation of return in the investors functional currencies.
e. None of the above
ANS: C
5.
A firms debt sells for 10 million and equity for 30 million. The firms before-tax cost
of debt is 9%. Its cost of equity is 18%. The corporate tax rate is 33%. The firms
weighted average cost of capital is closest to which of the following?
a. 6%
b. 9%
c. 12%
d. 15%
e. 18%
ANS: D
6.
The cost of capital for a project in Spain should ____.
a. be a function of the riskiness of the project
b. equal the minimum rate of return necessary to induce investors to buy or hold the
firms stock
c. equal the nominal required return for a similar U.S. investment
d. equal the parents weighted average cost of capital
e. equal the rate used by Spanish investors to capitalize corporate cash flows
ANS: A
7.
Which of the following does not fit in a list of potential sources of capital for foreign direct
investment?
a. funds generated internally by the foreign affiliate
b. funds from elsewhere within the corporation
c. funds from sources external to the corporation but within the parent country
d. funds from sources external to the corporation but within the host country
e. each of the above can be a source of funds
ANS: E
8.
The firms existing WACC is appropriate as a discount rate on a proposed investment when
____.
A. the project is financed with debt from the host country
B. the project has the same systematic business risk as the rest of the firm
C. the project is not exposed to foreign political risk
D. the optimal financial structure of the project is identical to that of the firm
Select one of the following:
a. A and B
b. A and C
c. B and C
d. B and D
e. C and D
ANS: D
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9.
The corporate cost of debt can be approximated by ____.
a. regressing stock returns on market returns
b. the average historical rate of 8.2 percent on corporate debt
c. the coupon rate on existing corporate debt
d. the riskfree rate of interest on government bonds
e. the yield to maturity on existing corporate debt
ANS: E
10. The yield to maturity on a junk bond ____ investors required return.
a. overstates
c. equals
b. preempts
d. understates
e. none of the above
ANS: B
11. Erb, Harvey, and Viskanta [Political Risk, Financial Risk and Economic Risk, Financial
Analysts Journal, Nov./Dec. 1996] found which of a) through c)?
a. An increase in country risk tends to be followed by a rise in equity returns.
b. Emerging markets with high country risk tend to have less volatile returns than
markets with low country risk.
c. Emerging markets with high country risk tend to have lower betas than markets with
low country risk.
d. More than one of the above.
e. None of the above.
ANS: C
12. International sources of funding for foreign investment projects include each of a) through
d) except ____.
a. cash flow from other international divisions
b. interest rate and currency swaps
c. international debt and equity
d. project finance
e. all of the above are sources of funding for international investment projects
ANS: E
13. A targeted registered offering must satisfy which of requirements a) through d)?
a. Interest or dividends must be paid directly to individuals in foreign countries.
b. The issuer must certify that it has no knowledge that a U.S. taxpayer is the owner of
the security.
c. The registered owner must be a U.S. financial institution.
d. The securities must be issued in registered form.
e. More than one of the above
ANS: B
14. Each of a) through d) can be valued as a separate side effect except ____.
a. blocked funds
b. expropriation risk
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c. negative-NPV tie-in projects
d. subsidized financing
e. each of the above can be valued as a side effect
ANS: E
15. Vehicles for repatriating funds from a foreign affiliate to the parent include each of the
following except ____.
a. Dividend payments on equity
b. Higher prices on sales to key suppliers
c. Interest payments on debt
d. Lease payments on operating and financial lease agreements
e. Royalties and management fees
ANS: B
16. Stakeholders prefer internally generated funds to external funds because ____.
a. internal funds avoid the discipline of the financial markets
b. internal funds avoid the transactions costs of external issues
c. they indicate the corporation has free cash flow
d. more than one of the above
e. none of the above
ANS: D
17. Most countries specify that transfer prices be set at ____.
a. an arms length or market price
b. cost
c. cost plus a profit margin
d. the maximum price that the market will bear
e. none of the above
ANS: A
18. Which of statements a) through d) concerning project finance is false?
a. Debt in a project finance arrangement is contractually linked to the cash flow
generated by the project.
b. Governments participate in project finance in the form of infrastructure support,
guarantees, and assurances against political risk.
c. In project finance, claims are contractually tied to the cash flows of the project.
d. The cash flows of a project are commingled with other corporate cash flows.
e. The project is a separate legal entity and relies heavily on debt financing.
ANS: D
19. Which of a) through d) would not be a good candidate for project finance?
a. natural resource developments
b. power generation projects
c. telecommunication
d. toll roads and bridges
e. All of the above are good candidates for project finance
ANS: E
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20. Empirical studies of the capital structure of corporations in the United States have generally
agreed that leverage increases with each of the following except ____.
a. fixed assets
b. advertising and research/development expenditures
c. nondebt tax shields
d. growth opportunities
e. firm size
ANS: B
21. Rajan and Zingales [ What Do We Know about Capital Structure? Some Evidence from
International Data, 1995] found that leverage increases with ____.
a. the tangibility of the firms assets
b. the presence of growth options
c. the level of profitability
d. all of the above are associated with higher leverage
e. none of the above are associated with higher leverage
ANS: A
22. Rajan and Zingales [ What Do We Know about Capital Structure? Some Evidence from
International Data, 1995] found that leverage decreases with ____.
a. the tangibility of the firms assets
b. profitability
c. firm size
d. all of the above are associated with higher leverage
e. none of the above are associated with higher leverage
ANS: B
23. Empirical studies find that emerging market returns tend to have ____
a. lower volatilities than developed market returns
b. lower correlations with the world market portfolio than developed market returns
c. less political risk than developed market returns
d. more than one of the above
e. none of the above
ANS: B
24. Empirical studies find that financial market liberalizations tend to ____
a. increase local firms cost of capital
b. increase the correlation of emerging market returns with world market returns
c. increase the volatility of emerging market returns
d. more than one of the above
e. none of the above
ANS: B
25. The ____ method is the most popular approach to project valuation.
a. adjusted present value
b. Goldman Sachs
c. opportunity cost method
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d. price elasticity of demand
e. weighted average cost of capital
ANS: E
Problems
1.
Suppose the market value of debt is 2 billion, the market value of equity is 2 billion, the
before-tax cost of debt is 10 percent, the before-tax cost of equity is 16 percent, and the
corporate tax rate is 40 percent. Calculate the weighted average cost of capital.
2.
Italys Olivetti has a beta of 1.0 when measured against the MSCI world stock market index
and 0.8 against Milans Banca Commerziale index of 200 stocks. The euro risk-free rate is 5
percent.
a. If the market risk premium on the MSCI world index is 4 percent, what is the required
return on Olivetti stock?
b. If the market risk premium on the Banca Commerziale index is 5 percent, what is the
required return on Olivetti stock?
3.
Find Olivettis weighted average cost of capital under each of the following scenarios.
a. Olivetti has a market value debt-to-value ratio of 50 percent. Olivettis pretax borrowing
cost on new long-term euro-denominated debt is 6 percent. Olivettis beta relative to
MSCIs world stock market index is 1.0. The euro risk-free rate is 5 percent. The risk
premium on the MSCI world stock market is 4 percent. Interest is deductible in Italy at
the marginal corporate income tax rate of 40 percent. What is Olivettis weighted
average cost of capital in this setting?
b. Suppose Olivetti is expected to generate after-tax operating cash flow of one billion
euros in the coming year and that this cash flow is expected to grow at a 2 percent rate in
perpetuity. Value Olivetti with the equation V0 = CF1 / (i-g), where CF1 is the coming
years after-tax operating cash flow, i is the weighted average cost of capital, and g is the
growth rate of operating cash flow.
4.
Find Fiats weighted average cost of capital under each of the following scenarios.
a. Fiat has a market value debt-to-value ratio of 25 percent. The euro risk-free rate is 5
percent. The risk premium in the Italian stock market is 5 percent. Fiat has a beta is 1.5
when measured against the Italian market. Fiats pretax borrowing cost in Milan on new
long-term euro-denominated debt is 6 percent. Interest payments are tax deductible in
Italy at the marginal corporate income tax rate of 40 percent.
b. Suppose Fiat appeals to international investors by listing on the London stock exchange.
Fiat can borrow in the London market at a pretax cost of 5.5 percent. The euro risk-free
rate 5 percent. International investors are willing to tolerate a 40 percent debt-to-value
mix at this cost of debt. With a 40 percent debt-to-equity ratio, the beta of Fiat is 1.5
against the MSCI world index. The risk premium on the world market portfolio is 4
percent.
c. Suppose Fiat will generate after-tax operating cash flow of 20 million euros in the
coming year, and that this is expected to grow at a g = 1 percent rate in perpetuity. Use
the equation V0 = CF1/(i-g) to value Fiat, given CF1 is the coming years cash flow, a
weighted average cost of capital of iWACC, and a growth rate of g. Find Fiats value using
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the weighted average costs of capital from a) and b). By how much can Fiat increase its
value by appealing to international investors?
5.
Advanced - not covered in the text
Merton Miller [Debt and Taxes, Journal of Finance, 1977] extended the MM capital
structure model to include both corporate and personal taxes, but not costs of financial
distress. The value of the levered firm in Millers world is
VL = VU + (1-[(1-TC)(1-TS)/(1-TB)]) B,
where VL
VU
B
TC
TS
TB
=
=
=
=
=
=
the levered value of the firm (including the tax shields from debt),
the unlevered value of the firm,
market value of the firms bonds,
firms marginal tax rate,
the personal tax rate on stock (dividend and capital gain) income,
the personal tax rate on interest (bond) income.
The rightmost term captures the increment to unlevered firm value from the tax shields on
interest payments. Corporate income tax rates are 0 percent, 18 percent, and 33 percent in
Bermuda, Hong Kong, and the United Kingdom, respectively. Personal tax rates on interest
income are 0 percent, 25 percent, and 40 percent, respectively. Individuals from each of
these countries face effective tax rates on equity incomes of 0 percent, 0 percent, and 40
percent, respectively.
a. Use Millers equation to find how much value the tax shield on a 100 million bond
would add to the individuals in each of these three countries. Assume perpetual bonds
and ignore costs of financial distress.
b. If these tax rates are faced by a majority of the residents in each country, in which
country would you expect to find the most debt financing? In which country would you
expect to find the most equity financing?
Problem Solutions
1.
iWACC = (B/VL) iB (1-TC) + (S/VL) iS = (2b/4b)(10%(1-0.4)) + (2b/4b)(16%) = 11%.
2.
a. iS = rF + (E[rW] - rF) = 5% + (1.0)(4%) = 9%.
b. iS = rF + (E[rM] - rF) = 5% + (0.8)(5%) = 9%.
3.
a. iS = rF+(E[rM]-rF) = 5% + (0.8)(5%) = 9%.
iWACC = (B/VL)iB(1-TC)+(S/VL)iS = (0.5)(6%)(1-0.4)+(0.5)(9%) = 6.3%.
b. V0 = CF1 / (i-g) = (1 billion)/(0.063-0.020) = 23.25 billion.
4.
a. iS = rF + (E[rM]-rF) = 5%+(1.5)(5%) = 12.5%
iWACC = (B/VL)iB(1-TC)+(S/VL)iS = (0.25)(6%)(1-0.4) + (0.75)(12.5%) = 10.3%.
b. iS = rF + (E[rM]-rF) = 5%+(1.5)(4%) = 11%
iWACC = (B/VL)iB(1-TC)+(S/VL)iS = (0.4)(5.5%)(1-0.4) + (0.6)(11%) = 7.9%.
c. In Italy, Fiats value is V0 = (20 million) / (0.125-0.01) = 215.6 million.
In London, Fiats value is V0 = (20 million) / (0.079-0.01) = 289.0 million.
Fiat can increase its value by (289.0/215.6)-1 = 34% in international markets.
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5.
Advanced
a. Millers equation states: VL = VU + (1-[(1-TC)(1-TS)/(1-TB)])B. The rightmost term is the
after-tax value of the tax shield. Calculating this value in each country yields the
following tax shield values:
Bermuda: (1-(1-0)(1-0)/(1-0))(100,000,000) = 0.
H.K.: (1-(1-0.18)(1-0)/(1-0.25))(100,000,000) = -9,333,000.
U.K.: (1-(1-0.33)(1-0.40)/(1-0.40))(100,000,000) = +33,000,000.
b. Companies in Hong Kong should prefer equity financing.
Companies in the U.K. should prefer debt financing.
Based on tax considerations alone, companies and investors in Bermuda should be
indifferent to the use of debt or equity financing.
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