Question

In today's economic environment, is the cost of capital for an MNE likely to be more or less expensive than the cost of capital for a domestic firm? Explain.

Answer 1

Solution:-

The cost of capital of a firm has various components including cost of debt, cost of preferred stock and cost of equity. When we speak of differences in cost of capital for a domestic enterprise and an MNE, the primary factor behind the difference is the diversification of sources of capital and diversification of geographical risk for an MNE as compared to a domestic firm. This diversification results in a lower cost of capital for MNE as compared to a domestic firm. Let's understand this in detail below:-

A domestic firm generally issues debt in the home country and therefore is more exposed to changes in interest rates in the country. On the other hand, an MNE could issue debt through many of its subsidiaries which means that its interest rate risk is far more diversified to adverse movements in a particular geography. This results in a lower cost of debt for an MNE as compared to a domestic firm

Similarly, the cost of equity is essentially the expected returns on equity investments by shareholders. The shareholders require a certain return on their investments based on the underlying risk in the investment.

A domestic firm has its entire business in one country and is more exposed to adverse economic and market siutuations in that country. Further, it has higher business risk due to potentially losing market share in its only market.

The multi-national companies on the other hand trade globally and therefore their business is well diversified across multiple geographies. An economic slowdown or losing market shares in one country will only impact a small part of their business whereas it would severly impact the business of domestic firms of that country.

Thus, business risk is more diversified for MNEs and therefore, the shareholders have a lower cost of equity for MNEs than for domestic firms.

Based on above explanations, we can conclude that the cost of capital for a MNE is likely to be more expensive as compared to that of a domestic firm.