Question

How is the optimal capital structure for a MNC abroad compared to domestic firms in the target country? What are the considerations in making a comparison?

Answer 1

Every company plans its capital structure, i.e., the ratio of debt and equity to minimize the cost of capital and tries to maximize its value. MNCs in foreign country tries to do the same.

Weighted average cost of capital or WACC of a company is measured by the below formula

Where, E is the value of firm’s Equity, D is the amount of Debt, k_d is the before tax cost of debt, k_e is the cost of equity, t is the prevailing tax rate.

The main difference between the capital structure of an MNC and a domestic firm can arise due to different cost of capital because of the following important factors. Also, these factors should be taken into account while making the comparison:

Size of the firm – Typically MNCs size are larger and because they borrow substantial amount of debt, there cost of capital can be lower than that of the domestic firms. MNCs have higher growth because of their business expansion, so they are able to easily pay off their debts. Hence, they are capable of borrowing more and receive preferential treatment from the lenders as well.

Currency risk – However, MNCs are prone to exchange rate risk and hence their cash flows are more volatile because of exchange rate fluctuations. Apart from currency risk, MNCs are also more prone to country risk in terms of the country’s laws and regulations. All these factors increase the possibility of bankruptcy of a MNC in a foreign country and therefore they should carefully plan their capital structure i.e., the ratio of Debt and Equity to finance their business