Question 1
Analyze the relationship between the marginal cost of capital and foreign investment analysis.
Marginal cost of capital is the cost connected to raising an additional unit of capital. The marginal cost of capital depends on the type of capital that will be used and the associated risks. Marginal cost of capital is important in foreign investment analysis because it is used to determine foreign projects that are to be undertaken and those that are to be rejected. A foreign project can only be accepted if its rate of return is greater than the marginal cost of capital. It is therefore used as the discounting rate for foreign projects. A project with a rate of return lower than the marginal cost of capital will have a negative net present value and should be rejected.
Marginal cost of capital is the major link between a company’s foreign investment decisions and the owners’ wealth as determined by global investors in the market place. It therefore used to evaluate whether a foreign investment will decrease or increase the stock price of a company. Only foreign investments that are expected to increase a company’s share price will be accepted.
Multinational companies can tap into foreign capital markets to raise funds when the local markets became saturated or when they can source the funds more cheaply than in the domestic capital markets. Multinational companies are also able to raise capital in foreign capital markets at lower cost than domestic firms since the have a lower risk due to international diversification. Lower risk and international availability of capital enables multinational companies to lower their overall cost of capital while maintaining their marginal cost of capital constant for a wide range of the firm’s capital budget.
Question 2
Given the added political and economic risks that exist overseas, are multinational companies more or less risky than purely domestic companies in the same industry?
Multinational companies are companies that operate in more than one country while domestic companies are companies that are based in a single country. Multinational corporations are less risky than domestic corporations in the same industry despite the added economic and political risks a multinational corporation faces. This is because multinational corporations can use international diversification to minimize their overall risks unlike purely domestic firms.
International diversification reduces systemic risk facing a company. Most of the systemic risk that faces a company relates to cyclical patterns of a country’s domestic economy. Operating in different countries whose economic cycles may not be in phase reduces the variability of a multinational company compared to a domestic company operating in one country. Therefore, even though the risk of operating in multiple countries in higher than operating in one country, most of the risk is reduced by international diversification.
Multinational companies also reduce operational risk by operating in different countries unlike domestic firms. Operational risks refer to risk specific risks that arise when executing business operations. A multinational company may reduce this risk since operational risks facing it in one country may not be available in another country. For example if a workers strike that impedes operations in one country resulting in stock out maybe overcome by importing from its firms abroad. Lastly, operating in foreign countries also enables multinational companies to react against competitive intrusions by foreign firms in their domestic markets. This is because multinational companies can easily monitor their foreign competitors in case they operate in the same market abroad therefore reducing the overall risk of being caught off guard by new developments unlike purely domestic firms.
Question 3
A foreign project has a beta of 0.50, a risk-free interest rate of 8 percent, and the expected rate of return on the market portfolio is 15 percent. What is the cost of capital for the project?
Kc = Rf + beta x (Km - Rf)
Where;
Kc is the Cost of Capital of the project.
Rf is the rate of a "risk-free" interest rate which is 8%
Km is the expected return rate of a market portfolio which is 15%
Kc = 8% + 0.5(15% - 8%) = 11.5%
Question 4
What is double taxation? How can its effect be lessened?
Double taxation refers to subjecting a single source of income to income taxes twice. It occurs because companies are separate legal entities from the owners who are the shareholders. Companies therefore pay income tax on their profits like any other person. Shareholders are again subjected to income tax on the cash dividends received. The same source of income has been subjected to income tax twice because it was first taxed at the corporate level and it is taxed again at the individual shareholders level. There several ways in which the impacts of double taxation can be lessened, they include; low dividend payout, bonus issue and payment of salaries.
A company may opt to reduce its dividends payout ratio to shareholders to lessen the impact of double taxation. By reducing the dividend payout ratio, the company increases its retained earning earnings which can be invested in projects with positive net present value. This will in turn increase the value of the firm and the share price of shares of that firm. The shareholder will therefore benefit from capital gains which are not taxable under certain jurisdictions. The second alternative would be a bonus issue. Bonus issue is an offer of fully paid additional shares to the current shareholders on a pro rata basis. Instead of paying cash dividends, the company can issue fully paid shares to current shareholders to reduce the impact of double taxation. A bonus issue is not subject to income since it is not considered income per se. lastly, in the case of a family owned business or a company owned by few individual who are also employees of the company, they can increase their salaries. This will reduce the corporate income that is subject to tax hence reducing the impact of double taxation.
References
Kim, K. A. (2011). Global Corporate Finance: A Focused Approach. New Jersey: World Scientific.
Kim, S. H., & Kim, S. H. (2006). Global corporate finance: text and cases (6, illustrated ed.). New York: John Wiley & Sons.
