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INTRODUCTION The cost of capital for a domestic firm is the rate that must be earned in order to satisfy the required rate of return of the firm’s investors. The cost of capital has a major impact on the firm’s value.


DETERMINING CAPITAL STRUCTURE COMPONENTS As company raise a major part of their capital in the form of long-term debt, preferred stock, and equity, the cost of these companies must reflect the weighted average cost of capital (WACC) for each of these sources of finance. The three major components of capital: Debt Preferred stock Common stock

Cost of debt:

Cost of debt Company calculate the cost of debt for their capital structure components The basis for estimating cost of debt for a company is interest rates. Cost of debt Kd = interest charges market value of debt As interest charges are tax deductible, companies need to adjust the before – tax cost of the debt by applying the tax factor to calculate the after-tax cost of debt After tax cost of debt = Kd (1-t)

Cost of preferred stock:

Cost of preferred stock A company pay dividend on its preferred stock So these dividend are not tax deductible Cost of preferred stock Kp = Dp Po Where Dp = cash dividends paid on the preferred stock Po = current market price of the preferred stock

Cost of common stock:

Cost of common stock Is the return that the equity investors of the company require on their investment. Define as the minimum acceptable rate of return that a company must earn on equity- financed portion of its investment By two methods cost on common equity can be estimated :- DIVIDEND GROWTH MODEL CAPITAL ASSET PRICING MODEL


CAPITAL STRUCTURE OF MULTINATIONAL FIRMS Capital structure for the multinational firm involves a choice between debt and equity financing across all its subsidiaries. A MNC can tap both the source available at home and also the sources in the foreign currencies where it operates. A MNC can have more debt in its capital structure if its cash flows are more stable and it has a low credit risk. In fact the overall capital structure of a parent company is a combination of the capital structures of all its subsidiaries………

Important factors need to study:

Important factors need to study Some important factors that help in its choice of capital structure decision are discussed below Stability of cash flow Risk facing a MNC Extent of profitability Country characteristics and its influence Tax law in host country

Determinates of subsidiary’s capital structure:

Determinates of subsidiary’s capital structure Capital structure decision of these affiliates cannot be considered separately from the capital structure decision of their parents. The affiliates take advantage of opportunities to minimize the cost of capital. Capital structure of the affiliates vary according to the relative prices of distinct financing instruments in different location Thus a subsidiary with a capital structure similar ton its parent may miss out on profitable opportunities to lower its cost of funds.

Various characteristics to arrive at the optimal capital structure decision:

Various characteristics to arrive at the optimal capital structure decision Target capital structure Tax advantages to debt financing Country risk in foreign operations Impact of corporate characteristics such as stable cash flow, low credit risk etc…..

Four main capital structure theories:

Four main capital structure theories Net income approach Net operating income approach Traditional approach Modigliani and miller approach

Net income approach:

Net income approach The cost of debt is lower than the cost of equity The risk perception of investors is not changed by the use of debt. There are no corporate or personal income taxes.

Net operating income approach:

Net operating income approach The cost of debt is lower than the cost of equity Risk perception of lenders of debt do not change with the change in financial leverage and consequently the cost of debt remain constant at all levels of financial leverage The market capitalizes the value of the firm as a whole. Thus, the split between debt and equity is not important. These are no corporate or personal income taxes

Traditional approach:

Traditional approach First stage :- increase in financial leverage: the use of increased debt in the capital structure results in decrease in the overall cost of capital Second stage :- increase in leverage does not affect the overall cost of capital and the value of the firm Third stage :- further increase in debt will lead to increase in overall cost of capital and will reduce the value of the firm.

Modigliani- miller approach:

Modigliani- miller approach Feature Capital markets are perfect Homogeneous risk classes of firm Expectations about the net operating income 100% payout ratio No corporate taxes The rate of investment


Thanxxx ….

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