I.

Determining the Cost of Capital for Multinational Corporations

What is Cost Capital?

The cost of capital determines the minimal return required to support a capital budgeting
project, such as building a new factory. It is an assessment of whether a proposed choice can
be justified by its cost.

Many businesses utilize a combination of debt and equity to fund their development.
Companies calculate their total cost of capital by taking the weighted average of all capital
sources. This is called the weighted average cost of capital (WACC).

The cost of capital determines a project's hurdle rate. A firm beginning on a significant
project must determine how much money the project will need to earn in order to cover its
costs and continue to generate profits for the company.
The corporation may calculate the capital cost using debt—levered cost of capital.
Alternatively, they might analyze project expenses without debt (unlevered).

The cost of capital is an investor's appraisal of the projected return on stock or other
investments. This is an estimate, which may contain best- and worst-case scenarios.
Investors may assess the volatility (beta) of a company's financial results to see if the stock's
pricing aligns with its prospective return.

Weighted Average Cost of Capital (WACC)

A firm's cost of capital is commonly estimated using the weighted average cost of capital
formula, which takes into account the cost of both debt and equity capital.
Each category of the firm's capital is weighted proportionally to arrive at a blended rate, and
the calculation takes into account all types of debt and equity on the company's balance sheet,
including common and preferred stock, bonds, and other kinds of debt.

The Cost of Debt

The cost of capital becomes a factor in deciding which financing track to follow: debt,
equity, or a combination of the two.

Early-stage companies rarely have sizable assets to pledge as collateral for loans, so equity
financing becomes the default mode of funding. Less-established companies with limited
operating histories will pay a higher cost for capital than older companies with solid track
records.

The cost of debt is merely the interest rate paid by the company on its debt. However, since
interest expense is tax-deductible, the debt is calculated on an after-tax basis as follows:

Cost of Debt= Interest Expenses/Total Debt x (1-T)

Where:

Interest Expenses= Interest paid on the firm’s current

debt.
 T= The company’s marginal tax rate

Example:

A small business loan of $300,000 which has a 6% interest rate from the bank. Another one is a
$100,000 loan from a businessman with an interest rate of 4%.

Now, here is how the numbers, in this case, play out:

Total annual interest of both the debts

= [($300,000 x 6%) + (4% x $100,000)]

= $18,000 + $4,000

= $22,000

Total Debt amount = $400,000

So, Total Cost of Debt = $22,000 / $300,000

= 5.5%

The effective pre-tax interest rate the business pays to service all its debts is 5.5%.

The Cost of Equity

The cost of equity is more complicated since the rate of return demanded by equity investors
is not as clearly defined as it is by lenders. The cost of equity is approximated by the capital
asset pricing model as follows:

CAPM (Cost of Equity)= Rƒ + β (Rᵐ - Rƒ)

Where:

Rƒ = risk-free rate of return

Rᵐ = market rate of return

Beta is used in the CAPM formula to estimate risk, and the formula would require a public
company's own stock beta. For private companies, a beta is estimated based on the average
beta among a group of similar public companies. Analysts may refine this beta by
calculating it on an after-tax basis. The assumption is that a private firm's beta will become
the same as the industry average beta.

The measure of systematic risk (the volatility) of the asset relative to the market. Beta can be
found online or calculated by using regression: dividing the covariance of the asset and
market’s returns by the variance of the market.

βi < 1: Asset i is less volatile (relative to the market)

βi = 1: Asset i’s volatility is the same rate as the market

βi > 1: Asset i is more volatile (relative to the market)

For example, let’s consider a well-established retail corporation with a beta of 1.2. If the risk-
free rate is 3% and the market’s expected return is 8%, the equity risk premium would be 8%
– 3% = 5%. The company’s equity cost calculation will be 3% + (1.2 * 5%) = 9%.

Cost of Debt + Cost of Equity = Overall Cost of Capital

The firm’s overall cost of capital is based on the weighted average of these costs.

For example, consider an enterprise with a capital structure consisting of 70% equity and
30% debt; its cost of equity is 10% and the after-tax cost of debt is 7%.

Therefore, its WACC would be:

(0.7×10%)+(0.3×7%)=9.1%(0.7×10%)+(0.3×7%)=9.1%

This is the cost of capital that would be used to discount future cash flows from potential
projects and other opportunities to estimate their net present value (NPV) and ability to
generate value.

Debt financing is more tax-efficient than equity financing since interest expenses are tax-
deductible and dividends on common shares are paid with after-tax dollars. However, too
much debt can result in dangerously high leverage levels, forcing the company to pay higher
interest rates to offset the higher default risk.

How Do You Calculate the Weighted Average Cost of Capital?

The weighted average cost of capital represents the average cost of the company's capital,
weighted according to the type of capital and its share on the company balance sheet. This is
determined by multiplying the cost of each type of capital by the percentage of that type of
capital on the company's balance sheet and adding the products together.

Why Is Cost of Capital Important?

Most businesses strive to grow and expand. There may be many options: expand a factory,
buy out a rival, or build a new, bigger factory. Before the company decides on any of these
options, it determines the cost of capital for each proposed project. This indicates how long
it will take for the project to repay what it costs, and how much it will return in the future.
Such projections are always estimates, of course. However, the company must follow a
reasonable methodology to choose between its options.

The Bottom Line

The cost of capital measures the cost that a business incurs to finance its operations. It
measures the cost of borrowing money from creditors, or raising it from investors through
equity financing, compared to the expected returns on an investment. This metric is
important in determining if capital is being deployed effectively.
Multinational Cost Capital

An MNC’s capital represents its debt and its equity, its cost of capital is based on its cost of
debt and its cost of equity. An MNC’s cost of debt depends on the interest rate that it pays
when borrowing funds. The interest rate that it pays is equal to the risk-free rate at the time it
borrows funds along with a credit risk premium that compensates creditors for accepting
credit (default) risk when extending credit to the MNC. Interest expenses incurred by
corporations are deductible when determining a corporation’s taxable income, there is a tax
advantage associated with debt.
An MNC creates equity by retaining earnings or by issuing new stock. The firm’s cost of
retained earnings reflects an opportunity cost, which represents what the existing
shareholders could have earned if they had received the earnings as dividends and invested
the funds themselves. The MNC’s cost of new equity (from issuing new common stock) also
reflects an opportunity cost of what the new shareholders could have earned if they had
invested their funds elsewhere instead of in the stock. This cost exceeds that of retained
earnings because it also includes the expenses (known as “flotation costs”) associated with
selling the new stock. An MNC’s cost of equity contains a risk premium (above the risk-free
interest rate) that compensates the equity investors for their willingness to invest in the
equity. If investors thought the MNC would offer a future return on equity that was no higher
than the prevailing risk-free rate, then they would not invest in its equity because they would
rather earn that same return without any exposure to risk by investing in a risk-free Treasury
security. The equity risk premium that investors would expect in order to invest in an MNC’s
equity (instead of investing in a risk-free security or in other securities) depends on the risk of
the MNC. Those MNCs with higher levels of uncertainty surrounding their cash flows exhibit
a higher level of risk. Thus, to entice investors, the stock price of an MNC with high risk
must be low enough so that the investment can potentially offer a large enough return to
compensate for the risk involved.

Estimating an MNC’s Cost of Capital

Comparing Costs of Debt and Equity

There is an advantage to using debt rather than equity as capital because the interest
payments on debt are tax deductible. The greater the use of debt, however, the greater the
interest expense and the higher the probability that the firm will be unable to meet its
expenses. Consequently, as an MNC increases its proportion of debt, the rate of return
required by potential new shareholders or creditors will increase to reflect the greater
likelihood of bankruptcy.

The trade-off between debt’s advantage (tax deductibility of interest payments) and its
disadvantage (increased likelihood of bankruptcy) is illustrated. The graph shows the
relationship between the firm’s degree of financial leverage (as measured by the ratio of debt
to total capital on the horizontal axis) and the cost of capital (on the vertical axis).

When the ratio of debt to total capital is low, there is not much concern that the firm will go
bankrupt because the firm should be able to cover its debt payments easily. Under these
conditions, the tax advantage of debt. Overwhelms the disadvantage of debt (potential
concerns about bankruptcy). Yet at some point (labeled X in Graph), the debt ratio is high
enough to trigger concern by creditors and shareholders about the firm’s potential
bankruptcy.

The larger amount of debt would require the firm to make higher debt payments, which
would increase the probability of the firm going bankrupt. At such a higher level of debt, the
firm would incur a higher cost of additional debt to reflect the higher level of credit risk. In
addition, investors might require higher returns (which means a higher cost of equity from the
firm’s perspective) in order to invest because of the firm’s higher risk of bankruptcy.

Consequently, when the ratio of debt to total capital is beyond point X on the horizontal axis,
the cost of capital rises as the ratio of debt to total capital increases. The firm’s cost of capital
is minimized at point X, where it benefits from the tax advantage of debt but does not use so
much debt that its tax advantage is overwhelmed by concerns about the firm’s bankruptcy.
Cost of Capital for MNCs versus Domestic Firms

The cost of capital for MNCs may differ from that for domestic firms because of the
following characteristics that distinguish MNCs from domestic firms. Size of Firm, Access to
International Capital Markets, International Diversification, Exposure to Exchange Rate Risk,
Exposure to Country Risk

1. Size of Firm

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 flotation costs (as a percentage of the amount of financing). Note,
however, that these advantages are due to the MNC’s size and not to its internationalized
business. A domestic corporation may receive the same treatment if it is large enough.
Nevertheless, a firm’s growth is more restricted if it is not willing to operate internationally.
Because MNCs may more easily achieve growth, they may be more able than purely
domestic firms to become large enough to receive preferential treatment from creditors.

2. Access to International Market

Multinational corporations are normally able to obtain funds through the international capital
markets. Because the cost of funds can vary among markets, the MNC’s access to the
international capital markets may allow it to obtain funds at a lower cost than that paid by
domestic firms. In addition, 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.

Example:

The Coca-Cola Co.’s recent annual report stated: “Our global presence and strong capital
position afford us easy access to key financial markets around the world, enabling us to raise
funds with a low effective cost. This posture, coupled with the aggressive management of our
mix of short-term and long-term debt, results in a lower overall cost of borrowing.”

3. International Diversification

As explained earlier, a firm’s cost of capital is affected by the probability that it will go
bankrupt. If a firm’s cash inflows come from sources all over the world, those cash inflows
may be more stable because the firm’s total sales will not be strongly influenced by a single
economy. To the extent that individual economies are independent of each other, net cash
flows from a portfolio of subsidiaries should exhibit less variability, which may reduce the
probability of bankruptcy and therefore reduce the cost of capital.

4. Exposure to Exchange Rate Risk

An MNC’s cash flows could be more volatile than those of a domestic firm in the same
industry if it is highly exposed to exchange rate risk. If foreign earnings are remitted to the
U.S. parent, they will not be worth as much when the U.S. dollar is strong against major
currencies. This reduces the firm’s ability to make interest payments on its outstanding debt,
which increases the likelihood of bankruptcy. In addition, an MNC that is more exposed to
exchange rate fluctuations will usually have a wider (more dispersed) distribution of possible
cash flows in future periods. This could lead creditors and shareholders to require a higher
return, which would increase the MNC’s cost of capital.

5. Exposure to Country Risk

An MNC that establishes foreign subsidiaries is subject to the possibility that a host country
government may seize a subsidiary’s assets. The probability of such an occurrence is
influenced by many factors, including the industry in which the MNC operates and the
attitude of the host country government. If assets are seized and fair compensation is not
provided, the probability of the MNC’s going bankrupt increases. The higher the percentage
of an MNC’s assets invested in foreign countries and the higher the overall country risk of
operating in these countries, the higher will be the MNC’s probability of bankruptcy (and
therefore its cost of capital), other things being equal. Other more moderate forms of country
risk, such as changes in a host government’s tax laws, could also affect an MNC’s
subsidiary’s cash flows. Because it is possible that these events will occur, the capital
budgeting process should incorporate such risk.

Example:

ExxonMobil has much experience in assessing the feasibility of potential projects in foreign
countries. If it detects a radical change in government or tax policy, it adds a premium to the
required return of related projects. The adjustment also reflects a possible increase in its cost
of capital.

In general, the first three factors listed (size, access to international capital markets, and
international diversification) have a favorable effect on an MNC’s cost of capital; the next
two factors (exposure to exchange rate risk and country risk) have an unfavorable effect. It is
impossible to generalize about whether MNCs have an overall cost-of-capital advantage over
domestic firms. Each MNC should be assessed separately to determine whether the net
effects of its international operations on the cost of capital are favorable.

II. The impact of Global Capital Structure on financing Decision

The global capital structure impacts financing decisions in various way. Capital structure is
the particular combination of debt and equity used by a company to finance its overall
operations and growth. The global component complicates these decisions due to variances
in financial markets, legislation, and economic situations between countries.

1. Access to finance markets

Diversification of Sources: The topic of access to finance and financial inclusion has been of
growing interest throughout the world, particularly in emerging and developing economies.
Policymakers are increasingly concerned that the benefits produced by financial
intermediation and markets are not being spread widely enough throughout the population
and across economic sectors, with potential negative impacts on growth, income distribution
and poverty levels, among others.

Market Conditions: Market Conditions refers to economic and financial factors that affect
the construction industry. These can include fluctuations in the cost of materials, labor
availability, interest rates, and the overall economic climate

2. Cost of Capital

Interest Rates: Interest rate risk is the risk associated with interest rate fluctuations in assets.
Interest rates and bond prices are inversely related. Certain products and options, such as
forward and futures contracts, help investors hedge interest rate risks.

Currency Risk: Currency risk, or exchange rate risk, refers to the exposure faced by investors
or companies that operate across different countries, in regard to unpredictable gains or losses
due to changes in the value of one currency in relation to another currency.

3. Regulatory and Tax Considerations

Regulating Variations: A special or regulatory tax is imposed primarily for the regulation of useful
or non-useful occupation or enterprises and secondarily only for the purpose of raising public funds.

Tax Implications: Tax implications refer to the financial impact that a decision or action can have
on an organization's tax liability. This means that one activity or transaction can result in different
amounts of tax being paid depending on the methods used to carry out the transaction.

Example:

“Taxation is no longer a measure merely to raise revenue to support the existence of

government. Taxes may be levied with a regulatory purpose to provide means for the
rehabilitation and stabilization of a threatened industry which is affected with public interest
as to be within the police power of the State. The oil industry is greatly imbued with public
interest as it vitally affects the general welfare.”

-Caltex v. Commissioner, 208 SCRA 755

4. Economic and Political Risk

Economic Risk : Economic risk is the risk when we have major change in the economic
structure, that will bring changes in the expected return of investment. This risk can arise
from changes in fundamental economic policy goals or country's comparative advantage. It’s
connected with the political risk, since both deal with policy in the country.

Political Risk: Political risk comes from the changes in a country's political structure or its
policies, such as tax laws, tariffs, expropriation of assets, or restriction in repatriation of
profits. It can occur because of attitude of consumers in the host country where some
consumers are very loyal to locally manufactured products. The most common action is the
one from the host government, where they can impose special requirements or taxes, restrict
fund transfers, and subsidize local firms. Or the opposite, governments lack of restrictions.

Another actions that might lead to political risk is the blockage of fund transfers for the
MNCs or currency inconvertibility when the MNC parent may need to exchange earnings for
goods if the foreign currency cannot be changed into other currencies. War or even the threat
of war, can have devastating effects and represent political risk. Also bureaucracy and
corruption can complicate business, increase the its cost or reduce revenue.

Example:

We determined the values for economical and political risk, we used them to find the total
political and economical risk for Macedonia.

Following the FIRM (Foreign Investment Risk Matrix) we created a two dimensional
graphic. One dimension is economic risk and the other dimension is political risk, both of
them scaled from one to five. After that we used the values from Table 1 to find the position
of Macedonia. Like we can see in Figure 1, Macedonian position is in the lower left corner,
just for comparison with the countries that are acceptable for foreign direct investment and
are in the upper right corner.

After we had calculated the political risk dimension and economic risk dimension, we
positioned Macedonia in the Foreign Investment Risk Matrix. (Figure 1.) Its position in the
uncertain region tells us that Macedonia might represent a country for a direct foreign
investment only in a case when there are no other countries that are available for FDI or in a
case when the MNC wants to participate in this market at any cost. This position can be
easily changed by further analyzing of that country, that will help in the decision making for
investment. The closeness to the unacceptable region might represent a threat, but knowing
that the country is going trough massive economical and political changes, it can be expected
to see Macedonia’s risk position in FIRM to be closer to the acceptable region in the next
years.
Multinational corporations need to be able to determine the countries that offer the best
economic conditions and political stability that ensures production and sale for a long run.
Political risk usually can result from government actions and economic risk can result from
changes in the micro or macroeconomic stability. For both of them, MNCs desire less
instability. The Foreign Investment Risk Matrix used in this research represents a good
framework and any MNC can use it to analyze both, political and economic risk. Any MNC
can specify its own values, that are more likely connected to their specific investment in a
specific country. For this research, as a guidance we used values that are specific for initial
country research and previously
recommended by other researchers. Basing on those six independent variables used in this
paper, we can rate countries as acceptable for foreign direct investment, unacceptable, and
countries that provide uncertain environments and need further study before
accepting/rejecting them from our investment decision.

5. Strategic Flexibility

Mergers and acquisitions: Mergers and acquisitions (M&A) are the different ways
companies are combined. Entire companies or their major business assets are consolidated
through financial transactions between two or more companies. A company may:

 Purchase and absorb another company outright

 Merge with it to create a new company
 Acquire some or all of its major assets
 Make a tender offer for its stock
 Stage a hostile takeover

All of these ways of combining or consolidating assets are M&A activities. The term M&A
also is used to describe the divisions of financial institutions that facilitate or manage such
activities.

Growth Opportunities: A growth opportunity refers to any situation or initiative that allows a
business to expand its operations, increase revenue, enhance its market presence or improve
profitability.
6. Financial Reporting and Transparency

Complexity in Reporting: The growing complexity of business transactions, and greater

investor, regulatory and public scrutiny have all added to the demands on financial reporting.
Financial reporting aims to reflect economic and business reality, which ultimately shapes
how investors formulate their investment decisions. Obscuring that reality can have a chain of
negative consequences affecting investors themselves, lenders, customers, suppliers, and
employees. Although the consequences of inaccuracy in financial statements due to fraud are
often sensational, there is a widening concern that the increasing complexity in financial
reporting standards themselves also adversely affects confidence in the financial reporting
system.

Investor Perception: An investor perception study might even reach out to potential investors
and analysts who are involved with peer companies but not the issuer itself. However, given
the regulatory and staffing changes in the industry, less people are being asked to do more.
The appetite and willingness to participate in an investor survey is much less these days,
especially among those who do not have a direct relationship with the company.

III. Cross-border financing options and international debt financing

What is cross border financing?

Cross-border financing refers to the process of providing funding for business activities that
occur outside a country's borders. Companies that seek cross-border financing want to
compete globally and expand their business beyond their current domestic borders.

Understanding Cross-Border Financing

Cross border financing within corporations can become very complex, mostly because
almost every inter-company loan that crosses national borders has tax consequences. This
occurs even when the loans or credit are extended by a third party, such as a bank. Large,
international corporations have entire teams of accountants, lawyers, and tax experts that
evaluate the most tax-efficient ways of financing overseas operations.

While financial institutions retain the lion's share of business for many cross-border loan and
debt capital market financing, increasingly private credit borrowers have supported the
arrangement and provision of loans globally. U.S. debt and loan capital markets overall have
remained remarkably healthy after the 2008 financial crisis and they continue to offer
attractive returns for foreign borrowers.

What are the types of cross-border financing?

1. Debt Financing- Debt financing is the act of raising capital by borrowing money from a
lender or a bank, to be repaid at a future date. In return for a loan, creditors are then owed
interest on the money borrowed. Lenders typically require monthly payments, on both
short- and long-term schedules.

2. Equity Financing- Equity financing is the process of raising capital through the sale of
shares. Both private and public companies raise money for short-term needs to pay bills
or long-term projects by selling ownership of their company in return for
 cash. Equity financing can come from friends and family, professional investors, or
an initial public offering (IPO).

3. Trade Financing- Trade finance represents the financial instruments and products that
are used by companies to facilitate international trade and commerce. Trade finance
makes it possible and easier for importers and exporters to transact business through
trade. Trade finance is an umbrella term meaning it covers many financial products that
banks and companies utilize to make trade transactions feasible.

4. Project Financing- Project financing is a loan structure that relies primarily on the
project's cash flow for repayment, with the project's assets, rights, and interests held as
secondary collateral. Project finance is especially attractive to the private sector because
companies can fund major projects off-balance sheet (OBS).

Advantages and Disadvantages of Cross-Border Financing

Advantages
Many companies opt for cross-border financing services when they have global subsidiaries
(e.g., a Canadian-based company with one or more subsidiaries located in select countries in
Europe and Asia). Opting in for cross-border financing solutions can allow these
corporations to maximize their borrowing capacity and access the resources they need for
sustained global competition.

Cross-border factoring is a type of cross-border financing that provides businesses with

immediate cash flow that can be used to support growth and operations. In this type of
financing, businesses will sell their receivables to another company.

This third-party company—also known as the factoring company—collects payments from

customers and transfers the payments to the original business owner, minus fees charged for
providing the service. The advantage to the business owners is that they receive their money
upfront rather than waiting anywhere from 30 to 120 days for payment from their customers.

Disadvantages
In cross-border financing, currency risk and political risk are two potential disadvantages.
Currency risk refers to the possibility companies may lose money due to changes in currency
rates that occur from conducting international trade. When structuring terms of a loan across
nations and currencies, companies may find it challenging to obtain a favorable exchange
rate.

Political risk refers to the risk a company faces when doing business in a foreign country
that experiences political instability. Shifting political climates—including elections, social
unrest, or coups—could hinder a deal’s completion or turn a profitable investment into an
unprofitable one. For this reason, some providers of cross-border financing may restrict
doing business in certain regions of the world.

Example of Cross-Border Financing:

Computer World agrees to sell its $10 billion semiconductor unit to a consortium led by
Private Equity Partners LLC. The group of investors include large American tech
companies.
The acquisition requires the U.S.-headquartered companies within the consortium to obtain
Japanese yen to complete the deal. Private Equity Partners LLC also requires upwards of $2
billion from a few of the companies to close the negotiation. The advantage to these
American companies participating in a cross-border deal is that it helps ensure them
continued access to Computer World's prized semiconductor chips for their businesses.

Special Considerations

In recent years, many corporations, along with sponsors, have chosen loan financing over
debt financing. This has affected the structure of many cross-border loan financing deals,
particularly as covenant-lite (cov-lite) loans allow the borrower significantly more flexibility
than some traditional loan terms. Cov-lite loans require fewer restrictions on collateral,
repayment terms, and level of income on the part of the borrower.

What Are the Risks in Cross-Border Transactions?

The risk of cross-border transactions is the risk that an entity will not be able to receive
payments from its customers due to government measures that put restrictions on the
convertibility and transferability of foreign currencies. This risk arises from problems within
the foreign currency, such as political risk, as opposed to risks associated with a specific
customer.

Why Is Cross-Border Trade Important?

Cross-border trade is important because it allows individuals and companies access to the
best services and technologies. This allows for efficiency and a reduction in costs, which
benefit the economy overall. Cross-border trade also increases the market size in which
individuals and companies can conduct business, leading to higher revenues. The free flow
of data across borders lifts up everyone partaking in cross-border trade.

What Is a Cross-Border Product?

When a buyer purchases a good or service from a seller that is located in another country,
that good or service is considered to be a cross-border product.

Since cross-border financing provides access to capital funding sources and financial
solutions to support cross-border business activities and transactions, it plays vital role in
facilitating international trade, investment and economic development.
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