THE IMPACT OF CAPITAL STRUCTURE ON THE COST OF CAPITAL IN MULTINATIONAL ENTERPRISE

The Impact of Capital Structure on the Cost of Capital in Multinational Enterprise



The Impact of Capital Structure on the Cost of Capital in Multinational Enterprise

Introduction

An MNC finances its operations by using a capital structure (proportion of debt versus equity financing) that can minimize its cost of capital. By minimizing the cost of capital used to finance a given level of operations, financial managers minimize the required rate of return necessary to make the foreign operations feasible and therefore maximize the value of those operations (Bradley, 2000, 857).

The capital structure of a company comprises of debt and equity. Equity consists of the earnings retained by the firm and the funds generated through the issuance of stocks whereas debt is the borrowed funds. The firm's cost of retained earnings reflects an opportunity cost: what the existing shareholders could have earned if they had received the earnings as dividends and invested the funds themselves (Richard, 1999, 149).

The firm's cost of new common equity (issuing new stock) also reflects an opportunity cost: 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 associated with selling the new stock (flotation costs) (Van der, 1993, 58).

Literature Review

The firm's cost of debt is easier to measure because the firm incurs interest expenses as a result of borrowing funds. Firms attempt to use a specific capital structure, or mix of capital components, that will minimize their cost of capital (Richard, 1999, 149).

The lower a firm's cost of capital; the lower is its required rate of return on a given proposed project (Vilasuso, 2001, 55). Firms estimate their cost of capital before they conduct capital budgeting because the net present value of any project is partially dependent on the cost of capital. There is an advantage to using debt rather than equity as capital because the interest payments on debt are tax deductible (Van der, 1993, 58). The greater the use of debt is however the greater the interest expense and the higher the probability that the firm will be unable to meet its expenses. Consequently, the rate of return required by potential new shareholders or creditors will increase to reflect the higher probability of bankruptcy (Bradley, 2000, 857).

The trade-off between debt's advantage (tax deductibility of interest payments) and its disadvantage (increased probability of bankruptcy). The cost of capital for domestic firms differs from that of the MNCs due to the following characteristics that distinguish MNCs from domestic firms:

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). These advantages are due to the MNC's size and not to its internationalized business (Bradley, 2000, ...