Chapter 17—Multinational Cost of Capital and Capital Structure

1. An argument for MNCs to have a debt-intensive capital structure is:

a. they are well diversified.
b. foreign government tax rules may
change over time.
c. exposure to exchange rate fluctu-
ations.
d. exposure to fund blockage.

ANS: A PTS: 1

MNCs can benefit from a debt-intensive capital structure because they are
well diversified. This diversification reduces risk, allows access to lower bor-
rowing costs, provides tax advantages through interest deductibility, and of-
fers greater financial flexibility to invest in growth opportunities.

3. According to the text, the cost of capital for an international project will:
a. always be greater than the firm's
cost of capital.
b. always be less than the firm's
cost of capital.
c. always be the same as the firm's
cost of capital.
d. none of the above

ANS: D PTS: 1

The cost of capital for an international project can vary significantly based on
various factors, such as risk, financing conditions, and the specific circum-
stances of the project. It does not always follow a fixed relationship with the
firm's overall cost of capital.

4. Which of the following factors is not expected to generally have a favorable

impact on the firm's cost of capital according to the text?
a. easy access to international capi-
tal markets.
b. high degree of international di-
versification.
c. volatile exchange rate fluctua-
tions.
 d. all of the above

ANS: C PTS: 1

Volatile exchange rate fluctuations generally increase a firm's cost of capital

by introducing uncertainty and risk. This unpredictability affects cash flow
forecasts, leading investors to demand higher returns to compensate for the
increased risk. As a result, both the cost of equity and debt rise, making fi-
nancing more expensive. Additionally, such volatility can deter investment in
foreign markets, further complicating capital planning and raising overall
capital costs.

5. The capital asset pricing theory is based on the premise that:

a. only unsystematic variability in
cash flows is relevant.
b. only systematic variability in cash
flows is relevant.
c. both systematic and unsystem-
atic variability in cash flows are
relevant.
d. neither systematic nor unsystem-
atic variability in cash flows is rel-
evant.

ANS: B PTS: 1

The capital asset pricing model (CAPM) is based on the premise that only
systematic risk—risk that cannot be diversified away—affects an asset's ex-
pected return. This means that investors are primarily concerned with mar-
ket risk, as it reflects the asset's sensitivity to overall market movements

6. According to the text, MNCs:

a. use only debt financing in foreign
countries to support foreign sub-
sidiaries.
b. use only equity financing in for-
eign countries to support foreign
subsidiaries.
c. use only parent financing in for-
eign countries to support foreign
subsidiaries.
d. none of the above
 ANS: D PTS: 1

MNCs typically use a mix of debt, equity, and parent financing to support
their foreign subsidiaries, depending on various factors such as local market
conditions, tax implications, and the specific financial needs of the sub-
sidiaries.

7. The term "global" target capital structure for an MNC represents the MNC's
capital structure:
a. in the U.S.
b. relative to competitors across all
countries.
c. where it has its largest subsidiary.
d. when consolidating all of its sub-
sidiaries.

ANS: D PTS: 1

8. According to the text, an MNC's "global" target capital structure is:

a. always debt-intensive.
b. always equity-intensive.
c. sometimes different from an
MNC's "local" capital structures
(at subsidiaries).
d. none of the above

ANS: C PTS: 1

9. One argument for why subsidiaries should be wholly-owned by the parent is

that the potential conflict of interests between the MNC's ____ is avoided.
a. managers and shareholders
b. majority shareholders and minor-
ity shareholders
c. existing creditors
d. managers and creditors

ANS: B PTS: 1

One argument for MNCs to have wholly-owned subsidiaries is to avoid poten-

 tial conflicts of interest between majority and minority shareholders. When a
subsidiary is wholly owned, the parent company maintains complete control
over decision-making, ensuring that the interests of the parent and its share-
holders align without the complications that can arise from having minority
shareholders involved. This structure helps streamline operations and deci-
sion-making processes, reducing the risk of disputes and enhancing strategic
coherence.

10. One argument for why subsidiaries should be only partly-owned by the par-
ent is:
a. that the potential conflict of inter-
ests between the MNC's man-
agers and shareholders is
avoided.
b. that the potential conflict of inter-
ests between the MNC's majority
shareholders and minority share-
holders is avoided.
c. that the potential conflict of inter-
ests between the MNC's existing
creditors is avoided.
d. to motivate subsidiary managers
by allowing them partial owner-
ship.

ANS: D PTS: 1

One argument for MNCs to have partly-owned subsidiaries is to motivate

subsidiary managers by providing them with partial ownership. This structure
aligns the interests of managers with the performance of the subsidiary, as
they have a direct financial stake in its success. By sharing ownership, man-
agers are incentivized to work towards increasing profitability and enhancing
the subsidiary’s value, which can lead to improved performance and greater
commitment to the company’s goals.

12. Other things being equal, countries with relatively ____ populations and ____
inflation are more likely to have a low cost of capital.
a. young; high
b. old; high
c. old; low
d. young; low

ANS: C PTS: 1
13. Other things being equal, the financial leverage of MNCs will be higher if the
governments of their home countries are ____ likely to rescue them (in the
event of failure), and if their home countries are ____ likely to experience a
recession.
a. more; more
b. less; more
c. less; less
d. more; less

ANS: D PTS: 1

15. According to the text, the cost of debt:

a. for each country is somewhat sta-
ble over time.
b. among countries changes over
time, and these changes are neg-
atively correlated.
c. among countries changes over
time, and these changes are posi-
tively correlated.
d. among countries changes over
time, and are not correlated.

ANS: C PTS: 1

16. The term "local target capital structure" is used in the text to represent the:
a. average capital structure of local
firms where the MNC's subsidiary
is based.
b. average capital structure of local
firms where the MNC's parent is
based.
c. desired capital structure of a sub-
sidiary of a particular MNC.
d. desired capital structure of a par-
ticular MNC overall (including all
subsidiaries).

ANS: C PTS: 1
17. The term "global capital structure" is used in the text to represent the:
a. average capital structure of all
MNCs across countries.
b. average capital structure of all
domestic firms across countries.
c. capital structure of a subsidiary
of a particular MNC.
d. capital structure of a particular
MNC overall (including all sub-
sidiaries).

ANS: D PTS: 1

18. An MNC may deviate from its target capital structure in each country where
financing is obtained, yet still achieve its target capital structure on a consol-
idated basis.
a. True
b. False

ANS: T PTS: 1

19. Assume that the risk-free interest rate in the U.S. is the same as that in
Country M. Assume that the government of Country M is more likely to res-
cue local firms that experience financial problems. Other things being equal,
Country M's firms are likely to use a ____ degree of financial leverage than
U.S. firms. If a firm based in Country M had the same degree of financial
leverage and the same operating characteristics as a U.S. firm, its cost of
capital would be ____ than that of the U.S. firm.
a. higher; higher
b. higher; lower
c. lower; lower
d. lower; higher

ANS: B PTS: 1

20. When an MNC's firm's cost of capital rises, it would be ____ likely to divest an
existing project, other things held constant.
a. more
b. less
c. neither; there is no effect
 d. neither; MNCs do not ever divest
projects

ANS: A PTS: 1

When an MNC's cost of capital rises, it indicates that the required return on
investments has increased, making existing projects less attractive if they do
not meet the new return thresholds. As a result, the MNC may be more likely
to divest (sell off) an existing project that no longer aligns with its financial
goals or offers adequate returns, especially if the project is underperforming
or has become too costly to maintain. This decision helps the MNC reallocate
resources to more profitable opportunities.

21. Which of the following is not a factor that favorably affects an MNC's cost of
capital, according to your text?
a. exchange rate risk.
b. size.
c. access to international capital
markets.
d. international diversification.

ANS: A PTS: 1

Exchange rate risk is not a factor that favorably affects an MNC's cost of cap-
ital. In fact, exchange rate risk typically increases uncertainty and can raise
the cost of capital, as it affects cash flows and investment returns in foreign
markets. Other factors, such as stable political environments or favorable tax
conditions, may positively influence the cost of capital, but exchange rate
risk generally has the opposite effect.

22. According to your text, which of the following is not a factor that affects an
MNC's cost of capital unfavorably?
a. exchange rate risk.
b. country risk.
c. an increase in the risk-free inter-
est rate.
d. size.

ANS: D PTS: 1

Size is generally not a factor that affects an MNC's cost of capital unfavor-
 ably. In many cases, larger MNCs may benefit from economies of scale, bet-
ter access to capital markets, and a stronger credit rating, which can lead to
a lower cost of capital. Factors like exchange rate risk, political instability,
and economic volatility are more commonly associated with unfavorable im-
pacts on an MNC's cost of capital.

23. The ____ an MNC, the ____ its cost of capital is likely to be.
a. larger; higher
b. larger; lower
c. smaller; lower
d. A and C

ANS: B PTS: 1

Larger multinational corporations (MNCs) tend to have a lower cost of capital

because they benefit from economies of scale, better access to capital mar-
kets, stronger credit ratings, and greater diversification. These factors re-
duce perceived risk, allowing them to secure funding at lower interest rates
compared to smaller firms.

24. Zoro Corporation has a beta of 2.0. The risk-free rate of interest is 5%, and
the return on the stock market overall is expected to be 13%. What is the re-
quired rate of return on Zoro stock?
a. 21%.
b. 41%.
c. 16%.
d. 13%.
e. none of the above

ANS: A
SOLUTION: 5% + 2 (13% − 5%) = 21%.

PTS: 1

25. Which of the following is not a reason provided in the text regarding why the
cost of debt can vary across countries?
a. differences in the risk-free rate.
b. a high price-earnings multiple.
c. differences in the risk premium.
 d. differences in demographics.

ANS: B PTS: 1

26. In general, MNCs probably prefer to use ____ foreign debt when their foreign
subsidiaries are subject to ____ local interest rates.
a. more; low
b. more; high
c. less; low
d. B and C
e. none of the above

ANS: A PTS: 1

MNCs generally prefer to use more foreign debt when their subsidiaries are
subject to low local interest rates. Low interest rates reduce the cost of bor-
rowing, making it more attractive for MNCs to finance operations in those
countries. Additionally, borrowing in local currency can help hedge against
exchange rate risk and align cash flows with debt obligations, further en-
hancing financial stability for the subsidiaries.

27. In general, MNCs probably prefer to use ____ foreign debt when their foreign
subsidiaries are subject to potentially ____ local currencies.
a. more; strong
b. more; weak
c. less; strong
d. less; weak
e. B and D

ANS: B PTS: 1

In general, MNCs are less likely to prefer using more foreign debt when their
subsidiaries are subject to potentially weak local currencies. Weak local cur-
rencies can increase the risk of currency depreciation, making it more expen-
sive to repay foreign-denominated debt. Instead, MNCs may opt for local fi-
nancing to mitigate this risk, as it aligns debt obligations with local cash
flows and reduces exposure to currency fluctuations.

28. A firm's cost of ____ reflects an opportunity cost: what the existing sharehold-
ers could have earned if they had received the earnings as dividends and in-
 vested the funds themselves.
a. debt
b. retained earnings
c. new common equity
d. none of the above

ANS: B PTS: 1

29. The ____ the cost of capital, the ____ will be a project's net present value for a
project with a given set of expected cash flows.
a. lower; higher
b. higher; higher
c. lower; lower
d. none of the above

ANS: A PTS: 1

This is because NPV is calculated by discounting future cash flows at the cost
of capital. When the cost of capital is lower, the discounting effect is re-
duced, resulting in a higher present value of those cash flows and, conse-
quently, a higher NPV. This makes the project more attractive and potentially
more viable for investment.

30. To the extent that individual economies are ____ each other, net cash flows
from a portfolio of subsidiaries should exhibit ____ variability, which may re-
duce the probability of bankruptcy.
a. dependent on; less
b. dependent on; more
c. independent of; less
d. independent of; more

ANS: C PTS: 1

31. In general, a firm ____ exposed to exchange rate fluctuations will usually
have a ____ distribution of possible cash flows in future periods.
a. more; narrower
b. less; wider
c. more; wider
 d. none of the above

ANS: C PTS: 1

32. According to the CAPM, the required rate of return on stock is a positive func-
tion of all of the following, except:
a. the risk-free rate of interest.
b. the market rate of return.
c. the stock's beta.
d. the company's earnings.

ANS: D PTS: 1

33. The lower a project's beta, the ____ is the project's ____ risk.
a. lower; systematic
b. lower; unsystematic
c. higher; systematic
d. higher; unsystematic

ANS: A PTS: 1

34. Capital asset pricing theory suggests that ____ risk of projects can be ignored
and that ____ is relevant.
a. unsystematic; unsystematic
b. unsystematic; systematic
c. systematic; unsystematic
d. systematic; systematic

ANS: B PTS: 1

Capital asset pricing theory (CAPM) suggests that unsystematic risk, which is
specific to individual projects or companies, can be diversified away and is
therefore irrelevant when assessing expected returns. In contrast, system-
atic risk (market risk), which affects all investments, is considered relevant
because it cannot be eliminated through diversification. CAPM emphasizes
that the required return on an asset is primarily determined by its exposure
to systematic risk, as measured by beta.
35. Capital asset pricing theory would most likely suggest that the cost of capital
is generally ____ for ____.
a. higher; MNCs
b. lower; domestic firms
c. lower; MNCs
d. none of the above

ANS: C PTS: 1

39. When an MNC is considering financing a portion of a foreign project within

the foreign country, the best method to account for a foreign project's risk is
to:
a. derive net present values based
on the WACC.
b. adjust the weighted average cost
of capital for the risk differential.
c. derive the net present value of
the equity investment.
d. none of the above

ANS: C PTS: 1

This approach allows the MNC to evaluate the expected cash flows from the
project, discounted at an appropriate rate that reflects the specific risks as-
sociated with the foreign market, including currency risk, political risk, and
local economic conditions. By focusing on the equity investment, the MNC
can better assess the potential returns and risks associated with the project.

40. Normally, an MNC will issue stock in all of the countries where it does busi-
ness.
a. True
b. False

ANS: F PTS: 1

Normally, an MNC will not issue stock in all the countries where it does busi-
ness. Instead, MNCs often choose to issue stock in specific markets based on
factors such as regulatory environments, market conditions, and the strate-
gic importance of those markets. They may opt to raise capital through other
means, such as debt or internal financing, in countries where issuing stock
may not be practical or beneficial.

41. Generally speaking, an MNC's size, its access to international capital mar-
 kets, and international diversification are unfavorable to an MNC's cost of
capital.
a. True
b. False

ANS: F PTS: 1

Size often leads to economies of scale and stronger credit ratings, which can
reduce borrowing costs.
Access to international capital markets allows MNCs to secure financing un-
der more favorable conditions.
International diversification reduces overall risk, making the company more
attractive to investors and potentially lowering the cost of equity and debt.

42. Country differences, such as differences in the risk-free interest rate and dif-
ferences in risk premiums across countries, can cause the cost of capital to
vary across countries.
a. True
b. False

ANS: T PTS: 1

43. Because their economies have lower growth, the cost of debt in industrial-
ized countries is much higher than the cost of debt in many less developed
countries.
a. True
b. False

ANS: F PTS: 1

45. Although an MNC can adjust either the discount rate or the cash flows to ac-
count for a project's risk, there is no perfect formula to adjust for a project's
unique risk.
a. True
b. False

ANS: T PTS: 1

46. Assume a subsidiary is forced to borrow in excess of the MNC's optimal capi-
tal structure. Also assume that the parent company reduces its debt financ-
ing by an offsetting amount. Under this scenario, the cost of capital for the
MNC overall could not have changed.
a. True
b. False

ANS: F PTS: 1
47. Because increased external financing by a foreign subsidiary reduces the ex-
ternal financing needed by the parent, such an action will not affect the over-
all MNC's cost of capital.
a. True
b. False

ANS: F PTS: 1

48. Since the cost of funds can vary among markets, the MNC's access to the in-
ternational capital markets may allow it to attract funds at a lower cost than
that paid by domestic firms.
a. True
b. False

ANS: T PTS: 1

49. Capital asset pricing theory would most likely suggest that the MNC's cost of
capital is lower than that of domestic firms.
a. True
b. False

ANS: T PTS: 1

50. If an MNC's cash flows are more stable, it can probably handle more debt
than an MNC with erratic cash flows.
a. True
b. False

ANS: T PTS: 1

51. When MNCs pursue international projects that have a high potential for re-
turn, but also increase their risk, this increases the return to the bondholders
that provided credit to the MNCs.
a. True
b. False

ANS: F PTS: 1

52. There is an advantage to using equity rather than debt financing because
dividend payments are tax deductible.
a. True
b. False

ANS: F PTS: 1

53. An MNC's cost of capital may differ from that of domestic firms because of
their access to international capital markets, their exposure to exchange rate
risk, and other characteristics.
 a. True
b. False

ANS: T PTS: 1

54. Generally speaking, an MNC's size, its access to international capital mar-
kets, and international diversification are unfavorable to an MNC's cost of
capital.
a. True
b. False

ANS: F PTS: 1

55. The capital asset pricing model (CAPM) suggests that the required return on
a firm's stock is a positive function of the risk-free rate of interest and the
market rate of return and a negative function of the stock's beta.
a. True
b. False

ANS: F PTS: 1

56. Country differences, such as differences in the risk-free interest rate and dif-
ferences in risk premiums across countries, can cause the cost of capital to
vary across countries.
a. True
b. False

ANS: T PTS: 1

57. It is always advantageous to use foreign debt to finance a foreign project,

particularly in developing countries.
a. True
b. False

ANS: F PTS: 1

58. It is probably easier to estimate the cost of equity than it is to estimate the
cost of debt.
a. True
b. False

ANS: F PTS: 1

59. An MNC may deviate from its target capital structure in each country where
financing is obtained, yet still achieve its target capital structure on a consol-
idated basis.
a. True
b. False
 ANS: T PTS: 1

60. If a parent company backs the debt of a foreign subsidiary, the borrowing ca-
pacity of the parent might be reduced as creditors are not willing to provide
as many funds to the parent if those funds may possibly be needed to rescue
a parent's subsidiary.
a. True
b. False

ANS: T PTS: 1

61. In general, the ____ the cost of capital, the ____ the NPV of a project that is
evaluated with this cost of capital.
a. higher; higher
b. lower; lower
c. higher; lower
d. A and B
e. none of the above

ANS: C PTS: 1

In general, the higher the cost of capital, the lower the net present value
(NPV) of a project will be when evaluated using that cost of capital. This is
because NPV is calculated by discounting future cash flows at the cost of
capital. When the cost of capital is higher, the discount rate increases, which
reduces the present value of future cash flows, leading to a lower NPV. Con-
sequently, projects may appear less attractive as the cost of capital rises.

62. The capital asset pricing model suggests that the required return on a firm's
stock is a positive function of:
a. the risk-free rate of interest.
b. the market rate of return.
c. the stock's beta.
d. all of the above

ANS: D PTS: 1

63. The capital asset pricing model suggests that the required return on a firm's
stock is a negative function of:
a. the risk-free rate of interest.
 b. the market rate of return.
c. the stock's beta.
d. none of the above

ANS: D PTS: 1

64. The cost of capital can vary among countries because:

a. MNCs based in some countries do
not have a competitive advan-
tage over others.
b. MNCs may be able to adjust their
international operations and
sources of funds to capitalize on
differences in the cost of capital
among countries.
c. of country differences in tax laws
or monetary supply.
d. none of the above.

ANS: C PTS: 1

65. Werner Corporation has a target capital structure that consists of 40% debt
and 60% equity. Werner can borrow at an interest rate of 10%. Also, Werner
has determined its cost of equity to be 14%. Werner's tax rate is 40%. What
is Werner's weighted average cost of capital?
a. 10.80%
b. 12.40%
c. 9.20%
d. None of the above

ANS: A PTS: 1

67. Which of the following is least likely to influence an MNC's capital structure?
a. The stability of MNC's cash flows
b. The MNC's credit risk
c. The MNC's access to earnings
d. The MNC's decision to invest ex-
cess cash in a Treasury bill rather
than in a bank
 e. None of the above

ANS: D PTS: 1

Capital structure primarily concerns the mix of debt and equity financing
used by a company to fund its operations and growth. While investment de-
cisions regarding excess cash can affect liquidity and short-term cash man-
agement, they do not directly impact the overall capital structure, which is
more influenced by long-term financing decisions, market conditions, and fi-
nancial policy.

68. Which of the following is not a host country characteristic than can affect an
MNC's capital structure decision?
a. The strength of host country cur-
rencies
b. The country risk in host countries
c. Political decisions to increase
penalties for criminals
d. Tax laws in host countries

ANS: C PTS: 1

69. If the parent ____ the debt of the subsidiary, the subsidiary's borrowing ca-
pacity might be ____.
a. does not back; increased
b. backs; decreased
c. does not back; decreased
d. backs; increased
e. C and D

ANS: E PTS: 1

If the parent does not back the debt of the subsidiary (C): The subsidiary is
seen as a higher-risk borrower, which can lead to reduced borrowing capac-
ity, stricter lending terms, and higher interest rates.

If the parent backs the debt of the subsidiary (D): This backing reduces per-
ceived risk for lenders, allowing the subsidiary to secure loans more easily
and at better terms, thereby increasing its borrowing capacity.