Question

Do MNEs (Multinational Enterprises) have a lower or higher cost of capital than domestic firms? Discuss.

Answer 1

The term capital cost refers to the minimum return rate that a company will receive on its assets in order to keep the company's value in touch. This reflects the rate of return that the firm is expected to pay to the capital suppliers for using their funds. A firm's capital expense is mainly used for evaluating investment programs. It reflects an reasonable minimum rate of return on new investments. The fundamental considerations driving a company's cost of capital are the degree of risk associated with the company, the taxes it will pay, and the supply and demand of various forms of finance.

MNCs that are usually greater in size than domestic companies could be in a favored position to receive funds from both stocks and lower-cost bonds because their size gives them preferential treatment. Given better exposure to foreign capital markets, MNCs are in a position to get lower-cost funds than domestic firms pay. Furthermore, international availability helps MNCs to maintain the desired ratio, even if substantially large funds are required. In the case of domestic companies this is not valid. They have to either rely on internally raised funds or borrow from commercial banks for the short and medium term

In fact, when the prevailing interest rates in the developing country are relatively small, subsidiaries can be in a position to obtain capital locally at a lower cost than that available to the parent company. For example, due to its global reach and strong capital position, and thus having easy access to key financial markets, the Coca-Cola company could raise funds with lower effective cost.

MNC operations and their cash flows are exposed to higher swings in the exchange rate than domestic companies, which contribute to greater likelihood of bankruptcy. As a result, investors and stockholders are seeking a higher return, which raises capital costs for the MNC. A business with cash inflows from multiple sources worldwide enjoys comparatively greater stability due to the fact that a single economy does not significantly affect overall sales. Less volatility in cash flow allows the company to sustain a higher leverage ratio leading to lower capital costs; foreign diversification (by country and by product) will minimize the company's systemic risk, thereby lowering its beta coefficient and, ultimately, the equity costs.