Tutorial 10 Answers
- What are the main differences between debt and equity? What are hybrids?
ANSWER:
a. The main difference between debt and equity are:
- Debt has a maturity date (i.e. need to be repaid) whereas equity has no maturity.
- Debt involves payment of interest to lenders whereas no fixed returns are guaranteed to equity providers.
- Equity providers are the owners of the firm and all profits (after claims of other parties) belong to them.
- Equity providers bear higher risk than the debt providers.
- From the firm’s perspective, higher the debt component, more the financial risk.
- Interest payments (cost of debt) are tax deductible, but dividend payments (cost of equity) are not tax deductible.
- Equity is more costly than the debt.
- In the case of insolvency, debt providers come ahead of shareholders.
b. ‘Hybrids’ represent financial instruments (or sources of funds) which have features of both debt and equity. Convertible bonds and preference shares are two popular types of hybrid securities.
2. a. Present an argument in support of an MNC’s favoring a debtintensive capital structure.
b.Present an argument in support of an MNC’s favoring an equityintensive capital structure.
ANSWER:
a. MNCs that are welldiversified across countries would have somewhat stable cash flows and may therefore be able to handle a high level of debt. They may use substantial foreign debt financing to reduce their subsidiary exposure to exchange rate risk and country risk.
b. MNCs that are highly exposed to exchange rate movements or have subsidiaries located in politically unstable countries may experience very volatile cash flows. These MNCs could not handle high periodic debt payments and may be better off with an equity-intensive capital structure.
[Note: basically it all comes down to how stable are your cashflows. If more stable, you can afford to issue more debt, which means you get to enjoy the lower (after-tax) cost of debt. If less stable, then you are forced to rely more on equity, which has a higher (after-tax) cost. Keep this basic rule in mind when looking at the next question.
What about hybrids? Typically they are used by companies to get a cheaper cost of capital. For example, convertible bonds allow a lower cost of debt, because they ‘sweeten’ the deal for the bond investor by offering an embedded call option on the stock. Preference shares on the other hand reduce the cost of equity by offering a higher and more stable dividend than ordinary (or common) shares. In return, preference shareholders usually give up additional claim on profits and/or other ownership rights such as voting rights.]
3.Explain how following characteristics of MNCs can affect the cost of capital.
- Size
- Access to international capital markets
- International diversification
- Exchange rate risk.
- Country risk.
ANSWER:
Size.Larger and better known MNCs may receive preferential treatment by creditors.
Access to international capital markets. MNCs have access to more sources of funds than domestic firms. To the extent that financial markets are segmented, MNCs may be able to obtain financing from various sources at a lower cost.
International diversification.If MNCs can achieve more stable cash flows through their international diversification, their probability of bankruptcy is reduced. Creditors and shareholders may therefore accept a lower rate of return when providing funds to the MNCs, which reflects a lower cost of capital for MNCs.
Exchange rate risk. MNCs that are highly exposed to exchange rate movements may be more likely to experience financial problems (if they do not hedge the risk). Thus, they may incur a higher cost of capital.
Country risk. MNCs with subsidiaries in politically unstable countries may experience volatile cash flows over time and be more susceptible to financial problems. Thus, they may incur a higher cost of capital.
[Note: Basically, these factors all relate to how stable are the company’s cashflows. The only exception is the second item (access to international capital markets.]
4.Explain why managers of a whollyowned subsidiary may be more likely to satisfy the shareholders of the MNC.
ANSWER: Managers of a whollyowned subsidiary can more easily focus on the objective of satisfying the MNCs shareholders. If the subsidiary is partlyowned, this implies that there are minority shareholders who have an interest in the subsidiary (Usually the parent firm will hold majority interest). In this case, the managers may attempt to satisfy both the majority and minority shareholders. However, they cannot satisfy both groups simultaneously. Some decisions made to satisfy minority shareholders may have adverse effect on majority shareholders.
5.LaSalle Corp. is a U.S.based MNC with subsidiaries in various less developed countries where stock markets are not well established. How can LaSalle still achieve its “global” target capital structureof 50 percent debt and 50 percent equity, if it plans to use only debt financing for the subsidiaries in these countries?
ANSWER: LaSalle Corporation can use mostly equity financing for its U.S. operations. When consolidated with the debt financing of its subsidiaries, its “global” target capital structure is balanced. The heavy emphasis on equity financing in the U.S. offsets the heavy emphasis on debt financing in the foreign countries.
6.Explain why the cost of capital for a U.S.-based MNC with a large subsidiary in Brazil may be higher than for a U.S.-based MNC in the same industry with a large subsidiary in Japan. Assume that the subsidiary operations for each MNC are financed with local debt in the host country.
ANSWER: The risk-free interest rate is much higher in Brazil than in Japan. In addition, the risk premium on the business in Brazil may be higher than the risk premium on the business in Japan.
[Note: the cost of debt capital (kd) is usually thought to consist of two components – the risk-free rate for that maturity, plus the risk premium for that company, reflecting the creditworthiness of the company.]
7.A US based MNC, Charleston Corp. is considering establishing a subsidiary in either Germany or the United Kingdom. The subsidiary will be mostly financed with loans from the local banks in the host country chosen.Charleston has determined that the revenue generated from the British subsidiary will be slightly more favorable than the revenue generated by the German subsidiary, even after considering tax and exchange rate effects. The initial outlay will be the same, and both countries appear to be politically stable.Charleston decides to establish the subsidiary in the United Kingdom because of the revenue advantage. Do you agree with its decision? Explain.
ANSWER: Charleston neglected the cost of financing the subsidiary. It may be more costly to finance a subsidiary in the United Kingdom than a subsidiary in Germany when using the local debt of the host country as the primary source of funds. When considering the cost of financing, a subsidiary in the United Kingdom could be less favorable than a subsidiary in Germany, based on the information provided in this question.
[Note: if you think back to last week’s capital budgeting question, basically this question is saying that Charleston is only considering the cashflow elements (revenue, expenses, exchange rates and initial investment, but is neglecting to consider the cost of capital (discount rate), which will also affect the NPV of the investment.]
8.Recently, Wal-Mart established two retail outlets in the city of Shanzen, China, which has a population of 3.7 million. These outlets are massive and contain products purchased locally as well as imports. As Wal-Mart generates earnings beyond what it needs in Shanzen, it may remit those earnings back to the United States. Wal-Mart is likely to build additional outlets in Shanzen or in other Chinese cities in the future.
- Explain how the Wal-Mart outlets in China would use the spot market in foreign exchange.
ANSWER: The Wal-Mart stores in Chinaneed other currencies to buy products from other countries, and must convert the Chinese currency (yuan) into the other currencies in the spot market to purchase these products. They also could use the spot market to convert excess earnings denominated in yuan into dollars, which would be remitted to the U.S. parent.
b. Explain how Wal-Mart could use the international bond market to finance the establishment of new outlets in foreign markets.
ANSWER: Wal-Mart could issue bonds in the Eurobond market to generate funds needed to establish new outlets. The bonds may be denominated in the currency that is needed; then, once the stores are established, some of the cash flows generated by those stores could be used to pay interest on the bonds.
9. Bloomington Co. is a large U.S.-based MNC with large subsidiaries in Germany. It has issued stock in Germany in order to establish its business. It could have issued stock in the U.S. and then used the proceeds in order to support the growth in Europe. What is a possible advantage of issuing the stock in Germany to finance German operations? Also, why might the German investors prefer to purchase the stock that was issued in Germany rather than purchase the stock of Bloomington on a U.S. stock exchange?
ANSWER: By issuing stock in Germany, Bloomington can use the euro proceeds to support its growth in Germany. It can establish a secondary market in Germany by listing the stock on an exchange there, and this will make it easier for it to engage in a secondary stock offering there in the future. If German investors can purchase the stock and sell the stock on a German stock exchange, they will not have to worry about exchange rate risk.
Problems
1. An MNC has total assets of $100 million and debt of $20 million. The firm’s before-tax cost of debt is 12 percent, and its cost of financing with equity is 15 percent. The MNC has a corporate tax rate of 40 percent. What is this firm’s weighted average cost of capital?
ANSWER:
2. Wiley, Inc., an MNC, has a beta of 1.3. The U.S. stock market is expected to generate an annual return of 11 percent. Currently, Treasury bills yield 2 percent. Based on this information, what is Wiley’s estimated cost of equity?
ANSWER:
[Note: The market expected rate of return (Rm) is the expected return on the overall stock market. This is usually represented by a broad stock index. In the US, this may be the S&P500 stock index, for large companies, or an even broader index like the Wilshire 5000 stock index, which includes many more smaller companies as well in the index (see next question). The risk-free rate (Rf) is the interest rate for an investment that is free of credit risk, forex risk, interest rate risk and all other forms of risk. In the US this is usually represented by US Government T-Bills, which are short-maturity debt issued by the US government.
Sometimes a question may give you the ‘equity risk premium’ rather than the market expected rate of return. The equity risk premium is simply = Rm – Rf. If that is the case, then you do not need to subtract the risk-free rate again. Be very very careful whether the question is giving you the market expected rate of return or the equity risk premium!]
3.Blues, Inc. is an MNC located in the U.S. Blues would like to estimate its weighted average cost of capital. On average, bonds issued by Blues yield 9 percent. Currently, T-bill rates are 3 percent. Furthermore, Blues’ stock has a beta of 1.5, and the return on the Wilshire 5000 stock index is expected to be 10 percent. Blues’ target capital structure is 30 percent debt and 70 percent equity. If Blues is in the 35 percent tax bracket, what is its weighted average cost of capital?
ANSWER:
First, estimate the cost of equity using the CAPM:
Next, estimate the weighted average cost of capital:
4. Integrating Cost of Capital and Capital Budgeting. Zylon Co. is a U.S. firm that provides technology software for the government of Singapore. It will be paid S$7,000,000 at the end of each of the next five years. The entire amount of the payment represents earnings since Zylon created the technology software years ago. Zylon is subject to a 30 percent corporate income tax rate in the United States. Its other cash inflows (such as revenue) are expected to be offset by its other cash outflows (due to operating expenses) each year, so its profits on the Singapore contract represent its expected annual net cash flows. Its financing costs are not considered within its estimate of cash flows. The Singapore dollar (S$) is presently worth $.60, and Zylon uses that spot exchange rate as a forecast of future exchange rates.
The risk-free interest rate in the United States is 6 percent while the risk-free interest rate in Singapore is 14 percent. Zylon’s capital structure is 60 percent debt and 40 percent equity. Zylon is charged an interest rate of 12 percent on its debt. Zylon’s cost of equity is based on the CAPM. It expects that the U.S. annual market return will be 12 percent per year. Its beta is 1.5.
Quiso Co., a U.S. firm, wants to acquire Zylon and offers Zylon a price of $10,000,000.
Zylon’s owner must decide whether to sell the business at this price and hires you to make a recommendation. Estimate the NPV to Zylon as a result of selling the business, and make a recommendation about whether Zylon’s owner should sell the business at the price offered.
ANSWER:
Zylon’s cost of debt = 12% (1 – .3) = 8.4%
Zylon’s cost of equity = 6% + (12% – 6%) × 1.5 = 15%
Zylon’s cost of capital = 60% (8.4%) + 40% (15%) = .0504 + .06
= .1104 or about 11%
Zylon’s annual expected before-tax $ CF are S$7,000,000 × $.60 or $4,200,000 (year 1-5)
Zylon is taxed on these earnings, so its after-tax cash flows = $4,200,000 × (1 – .3) = $2,940,000
If Zylon divests, it gives up a five-year annuity of $2,940,000.
Its cost of capital = 11%, and the present value interest factor of annuity (PVIFA) for 5 yrs at this rate is 3.6959.
PV of forgone cash flows = $2,940,000 × 3.6959 = $10,865,946. This is more than Zylon would receive from selling the business, so it should not sell the business.
[Note: This is like last week’s capital budgeting questions, except that instead of calculating NPV, instead you calculate the PV of the future cashflows, and compare that to the offer price by the potential buyer. Also be careful that this question assumes the Singapore government does not charge corporate tax or any withholding tax on the Singaporean subsidiary’s earnings. Therefore, the only tax paid is at the parent company level, on the USD earnings.Also note that we use the US risk-free rate and US market expected return, not the Singapore one. This investment is seen from the US parent company’s perspective.]
5. Pricing ADRs. Today, the stock price of Genevo Company (based in Switzerland) is priced at SF80 per share. The spot rate of the Swiss franc (SF) is $.70. During the next year, you expect that the stock price of Genevo Company will decline by 3%. You also expect that the Swiss franc will depreciate against the U.S. dollar by 8% during the next year. You own American depository receipts (ADRs) that represent Genevo stock. Each ADR that you own represents two shares of the stock traded on the Swiss stock exchange. What is the estimated value of the ADR per share in one year?
ANSWER:
Expected value of Swiss stock in 1 year = SF80 x (1 - .03) = SF77.6.
Expected value of Swiss franc in 1 year = $.70 (1 - .08) = $0.644
Expected value of ADR in 1 year = 2 x SF77.6 x ($0.644 per franc) = $99.95.
[note: the quotation for the spot rate is SFr as base currency, so it is OK to use the equation:
(F-S)/S = x%
Where x% is the percentage appreciation/depreciation of the base currency (SFr).
]
Note: A higher cost of debt capital is represented by a higher coupon (interest) rate and/or a lower price paid by investors to buy the bond. A higher cost of equity capital is represented by a lower price paid by investors for the share. Hence there is an inverse relationship between the required rate of return versus the price paid by investors for the security (bond or share).