Exam Questions Ch14 Multinational Capital Structure And The

Chapter 14 Multinational Capital Structure and the Cost of Capital

Notes to instructors:

Answers to non-numeric multiple choice questions are arranged alphabetically, so that answers are randomly assigned to the five outcomes.

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1. If financial markets are perfect, then corporate financial policy is irrelevant.

This is Modigliani and Miller’s famous irrelevance proposition.

2. Capital structure refers to the relative proportion of monetary and real assets in the firm.

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 firm’s overall cost of capital, given the firm’s assets.

4. If financial policy is to increase firm value, then it must either increase the firm’s expected future cash flows or decrease the discount rate in a way that cannot be replicated by individual investors.

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.

6. In integrated financial markets, nominal rates of return on equivalent assets are equal across currencies.

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.

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.

9. On balance, market segmentation hurts the multinational corporation more than the domestic corporation.

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.

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.

12. Foreign political risks increase the variability of outcomes on foreign investment projects.

13. The total risk of a foreign investment is likely to be greater than similar domestic investments.

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.

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.

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.

17. In the real world, hedging can increase the firm’s expected cash flows by reducing expected taxes, bankruptcy costs, or agency costs.

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.

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.

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. The weighted average cost of capital cannot be calculated for a single segment in a multisegment firm when the segments have different systematic risks.

The WACC should reflect the after-tax required returns on the debt and equity supported by that division weighted by the division’s target debt- and equity-to-value ratios.

21. Discount rates on new investments should reflect the discount rates on the firm’s existing assets and the firm’s existing debt-equity mix.

The discount rate should reflect the systematic operating risk and debt capacity of the proposed investment.

22. 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.

23. 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.

24. The discount rate in project valuation should reflect the mix of debt and equity that is actually raised to finance a particular project.

The discount rate should reflect the target or optimal mix of debt and equity.

25. The target debt capacity of a foreign project should reflect the firm’s existing assets and debt-equity mix.

Debt capacity is asset-specific.

26. The market portfolio in an integrated financial market is the domestic market index.

The market portfolio in an integrated financial market is globally diversified.

27. For investments in developed economies, the security market line is still the most popular method for identifying equity required returns.

28. The value of a foreign investment depends on the way it is financed.

29. The systematic business risk of a project can be estimated using the beta of a similar asset that is financed with 100 percent equity.

30. In the capital asset pricing model, diversifiable risks do not affect the cost of capital.

31. Empirical studies find that the capital asset pricing model is the best model for estimating required returns in developed as well as emerging capital markets.

There is no consensus cost of capital model for emerging markets.

32. 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.

It depends on the total risk of foreign investment and on the correlation of foreign investment returns with investors’ relevant market portfolio.

33. Depository receipts are derivative securities backed by a pool of foreign shares held in trust by an investment banker.

34. In the context of multinational finance, a depository receipt is given by a commercial bank to a multinational corporation when the corporation makes a cash deposit at the bank

A depository receipt is a derivative security that is backed by a pool of foreign shares held in trust by an investment banker.

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.

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.

Emerging markets’ lower correlations with other markets tend to overcome their higher volatilities, resulting in lower betas than on similar assets in developed markets.

37. Empirical studies find that profitable firms tend to use less debt in emerging markets.

The text cites Booth et al., “Capital Structures in Developing Countries,” J. of Finance (2001).

Multiple Choice Select the BEST ANSWER

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

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

3. Foreign political risk includes each of the following EXCEPT unexpected changes in ____.

a. expropriation risk

b. foreign exchange rates

c. local ownership limitations

d. repatriation restrictions

e. taxes

4. 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 risk-free rate of interest on government bonds

e. the yield to maturity on existing corporate debt

5. 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 firm’s stock

c. equal the nominal required return for a similar U.S. investment

d. equal the parent’s weighted average cost of capital

e. equal the rate used by Spanish investors to capitalize corporate cash flows

6. Which of the following statements is ?

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.

d. Global investors are exposed to a multinational corporation’s total risk, measured by standard deviation of return in the investors’ functional currencies.

e. None of the above is

7. A firm’s debt sells for £10 million and equity for £30 million. The firm’s before-tax cost of debt is 9 percent. Its cost of equity is 18 percent. The corporate tax rate is 33 percent. The firm’s weighted average cost of capital is closest to which of the following?

a. 6%

b. 9%

c. 12%

d. 15%

e. 18%

8. 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.

9. When is it appropriate to use the firm’s existing WACC as a discount rate on a proposed investment?

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 optimal financial structure of the project is identical to that of the firm

d. Both a and b are appropriate.

e. Both b and c are appropriate.

10. The yield to maturity on a junk bond ____ investors’ required return.

a. equals

b. overstates

c. preempts

d. understates

e. none of the above

11. L’Occitane’s debt-to-value ratio is 80 percent at book value and 50 percent at market value. Existing debt has a coupon rate of 6 percent. The pretax borrowing cost on new debt is 8 percent. L’Occitane’s uses the CAPM security market line to estimate its cost of equity. L’Occitane’s equity beta is 1.4. The risk-free rate is 2 percent. The market risk premium over the risk-free rate is estimated to be 5 percent. The corporate income tax rate is 20 percent. What is L’Occitane’s weighted average cost of capital (WACC)?

a. less than 5%

b. between 5% and 5.99%

c. between 6% and 6.99%

d. between 7% and 7.99%

e. 8% or more

SOLUTION: WACC = (B/V)i_B(1 – T_C) + (S/V)i_S = (0.5)(8%)(1 – 0.2) + (0.5)(2% + 1.45%) = 7.7%

12. A firm has no depreciation. Cash flows arising from the calculation (EBIT)(1 – TC) should be discounted at _____.

a. the firm’s Black-Scholes option value

b. the firm’s weighted average cost of capital

c. the required return on new debt

d. the required return on new equity

e. none of the above

13. Erb, Harvey, and Viskanta [“Political Risk, Financial Risk and Economic Risk,” Financial Analysts Journal (1996)] found which of the following?

a. A decrease in the country risk of an emerging market tends to be followed by a fall in equity share prices.

b. Emerging markets with high country risk tend to have more volatile returns than markets with low country risk.

c. Emerging markets with high country risk tend to have higher betas than markets with low country risk.

d. Financial market liberalizations tend to increase local firms’ cost of capital.

e. Financial market liberalizations tend to decrease the correlation of emerging markets with the rest of the world.

14. Bekaert and Harvey [“Foreign Speculators and Emerging Equity Markets,” Journal of Finance, (2000)] found which of the following?

a. A decrease in the country risk of an emerging market tends to be followed by a fall in equity share prices.

b. Emerging markets with high country risk tend to have higher betas than markets with low country risk.

c. Emerging markets with high country risk tend to have less volatile returns than markets with low country risk.

d. Financial market liberalizations tend to increase local firms’ cost of capital.

e. Financial market liberalizations tend to increase the correlation of emerging markets with the rest of the world.

15. International sources of funding for foreign investment projects include each of (a) through (d) EXCEPT ____.

a. cash flow from other international divisions

b. international debt

c. international equity

d. project finance

e. All of the above are sources of funding for international investment projects.

16. 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

17. 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 purchases from key suppliers

c. interest payments on debt

d. lease payments on operating and financial lease agreements

e. royalties and management fees

18. 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

19. Most countries specify that transfer prices be set at ____.

a. an arm’s 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

20. Which of statements (a) through (d) concerning project finance is ?

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.

21. 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.

22. 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

23. Rajan and Zingales [ “What Do We Know about Capital Structure? Some Evidence from International Data,” J. of Finance (1995)] found that leverage increases with ____.

a. the tangibility of the firm’s 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.

24. Rajan and Zingales [“What Do We Know about Capital Structure? Some Evidence from International Data,” J. of Finance, (1995)] found that leverage decreases with ____.

a. the tangibility of the firm’s 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.

25. 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

26. 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

27. The ____ method is the most popular approach to project valuation.

a. adjusted value

b. Boston Consulting Group

c. marginal cost method

d. price elasticity of demand

e. weighted average cost of capital

Problems (Many of these can be converted into ‘Multiple Choice’ questions.)

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. Italy’s Olivetti has a beta of 1.0 when measured against the MSCI world stock market index and 0.8 against Milan’s 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. DanzWear’s debt-to-value ratio is 50 percent at book value and 20 percent at market value. Existing debt has a coupon rate of 1 percent. The pretax borrowing cost on new debt is 4 percent. DanzWear uses the security market line to estimate its cost of equity. DanzWear’s equity beta is 1.5. The risk-free rate is 2 percent. The expected return on the market portfolio is 8 percent. The corporate income tax rate is 35 percent. What is DanzWear’s weighted average cost of capital (WACC)?

4. Find Olivetti’s weighted average cost of capital under each of the following scenarios.

a. Olivetti has a market value debt-to-value ratio of 50 percent. Olivetti’s pretax borrowing cost on new long-term euro-denominated debt is 6 percent. Olivetti’s beta relative to MSCI’s 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 Olivetti’s 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 year’s after-tax operating cash flow, i is the weighted average cost of capital, and g is the growth rate of operating cash flow.

5. Find Fiat’s 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. Fiat’s 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 year’s cash flow, a weighted average cost of capital of i_WACC, and a growth rate of g. Find Fiat’s value using the weighted average costs of capital from (a) and (b). By how much can Fiat increase its value by appealing to international investors?

6. Advanced—this is not covered in the text but is covered in several introductory texts in finance

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 Miller’s world is

V_L = V_U + (1 – [(1 – T_C)(1 – T_S)/(1 – T_B)])B,

where V_L = the levered value of the firm (including the tax shields from debt)

V_U = the unlevered value of the firm

B = market value of the firm’s bonds

T_C = firm’s marginal tax rate

T_S = the personal tax rate on stock (dividend and capital gain) income

T_B = 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. Suppose 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 Miller’s 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. i_WACC = (B/V_L) i_B (1 – T_C) + (S/V_L) i_S = (£2b/£4b)(10%(1 – 0.4)) + (£2b/£4b)(16%) = 11%.

2. a. i_S = r_F + (E[r_W] – r_F) = 5% + (1.0)(4%) = 9%.

b. i_S = r_F + (E[r_M] – r_F) = 5% + (0.8)(5%) = 9%.

3. d. WACC = (B/V)i_B(1 – T_C) + (S/V)i_S = (0.2)(4%)(1 – 0.35) + (0.8)(11%) = 9.32 percent

where i_S = r_F + β(E[r_M] – r_F) = 2% + 1.5(8% – 2%) = 11%

4. a. i_S = r_F + (E[r_M] – r_F) = 5% + (0.8)(5%) = 9%.

i_WACC = (B/V_L)i_B(1 – T_C) + (S/V_L)i_S = (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.

5. a. i_S = r_F + (E[r_M] – r_F) = 5% + (1.5)(5%) = 12.5%

i_WACC = (B/V_L)i_B(1 – T_C) + (S/V_L)i_S = (0.25)(6%)(1 – 0.4) + (0.75)(12.5%) = 10.3%.

b. i_S = r_F + (E[r_M] – r_F) = 5% + (1.5)(4%) = 11%

i_WACC = (B/V_L)i_B(1 – T_C) + (S/V_L)i_S = (0.4)(5.5%)(1 – 0.4) + (0.6)(11%) = 7.9%.

c. In Italy, Fiat’s value is V₀ = (€20 million) / (0.125 – 0.01) = €215.6 million.

In London, Fiat’s 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.

6. Advanced

a. Miller’s equation states: V_L = V_U + (1 – [(1 – T_C)(1 – T_S)/(1 – T_B)])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 United Kingdom 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.