Financial Structure and International Debt
Objective. What, in simple wording, is the objective sought by finding an optimal capital structure?
When taxes and bankruptcy costs are considered, a firm has an optimal financial structure determined by that particular mix of debt and equity that minimizes the firm’s cost of capital for a given level of business risk. If the business risk of new projects differs from the risk of existing projects, the optimal mix of debt and equity would change to recognize trade-offs between business and financial risks.
Varying Debt Proportions. As debt in a firm’s capital structure is increased from no debt to a significant proportion of debt (say, 60%), what tends to happen to the cost of debt, to the cost of equity, and to the overall weighted average cost of capital?
As the debt ratio, defined as total debt divided by total assets at market values, increases, the overall cost of capital (Kwacc) decreases because of the heavier weight of low-cost debt [Kd(1 − t)] compared to high-cost equity (Ke). The low cost of debt is, of course, due to the tax deductibility of interest shown by the term (1 − t).
Partly offsetting the favorable effect of more debt is an increase in the cost of equity (Ke), because investors perceive greater financial risk. Nevertheless, the overall weighted average after-tax cost of capital (Kwacc) continues to decline as the debt ratio increases, until financial risk becomes so serious that investors and management alike perceive a real danger of insolvency. This result causes a sharp increase in the cost of new debt and equity, thus increasing the weighted average cost of capital. The low point on the resulting U-shaped cost of capital curve defines the debt ratio range in which the cost of capital is minimized. Most theorists believe that the low point is actually a rather broad, flat area encompassing a wide range of debt ratios, 30% to 60%.
Availability of Capital. How does the availability of capital influence the theory of optimal capital structure for a multinational enterprise (MNE)?
Access to capital in global markets allows a MNE to lower its cost of equity and debt compared with most domestic firms. It also permits a MNE to maintain its desired debt ratio, even when significant amounts of new funds must be raised. In other words, a multinational firm’s marginal cost of capital is constant for considerable ranges of its capital budget. This statement is not true for most small domestic firms because they do not have access to the national equity or debt markets. They must either rely on internally generated funds or borrow for the short-and medium-term from commercial banks.
Multinational firms domiciled in countries that have illiquid capital markets are in almost the same situation as small domestic firms unless they have gained a global cost and availability of capital. They must rely on internally generated funds and bank borrowing. If they need to raise significant amounts of new funds to finance growth opportunities, they may need to borrow more than would be optimal from the viewpoint of minimizing their cost of capital. This is equivalent to saying that their marginal cost of capital is increasing at higher budget levels.
Diversified Cash Flows. If a multinational firm is able to diversify its sources of cash inflow so as to receive those flows from several countries and in several currencies, do you think that tends to increase or decrease its weighted average cost of capital?
The theoretical possibility exists that multinational firms are in a better position than domestic firms to support higher debt ratios because their cash flows are diversified internationally. The probability of a firm’s covering fixed charges under varying conditions in product, financial, and foreign exchange markets should increase if the variability of its cash flow is...
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