Posted at 12.12.2018
This article will consider the main element factors which have an impact on a company's cost of capital. The article will analyse first of all the key components which contribute towards a company's cost of capital prior to going to consider how these factors differ for a multinational company as opposed to those operating within a single national market.
In the first instance, the article will consider the issue of the cost of capital with specific reference to multinational organisations, consequently the research uses the definition of a multinational organisation as provided by Johnson et al (2008). Here this is given is a multinational company is merely one which manages in several varied geographic marketplaces which spans the edges of more than countrywide boundary.
Every business is subject to the price of capital, the cost of capital essentially represents the cost to a business of earning use of the resources for which investors in a variety of forms placed into the business to begin with. The cost of capital is incurred through a number of methods and includes interest payments and dividends, which an entrepreneur receives as a reward for investment in just a business. For pragmatic purposes the cost of capital is normal expressed as a share, the most common expression being that of the Weighted Average Cost of Capital (WACC).
WACC is a useful way of analysing a company's cost of capital. Essentially WACC considers the comparative costs of each of the component components of the business's capital framework and then can take an average of those costs, structured upon the comparative weights of every component (Tennent 2008). Whilst company's may have many resources of finance, each which have there own costs and nuances the expense of capital may be broken down into two major options, namely arrears and equity.
In a company's capital structure debts is usually one of the major components and includes permanent borrowings such as loans and other financial musical instruments such as bonds and debentures (Arnold 2007). The principal cost of capital with regards to the debt element of the capital structure is the payment of interest after the capital lent in the beginning. Regarding a bond, interest rates are fixed at the problem of point of the bond with the business getting a lump total investment on issue in return for regular repayments of a set interest rate. Alternatively long-term borrowing may have marginally more flexible approach to the price tag on capital. The principal cost of long-term borrowing continues to be an interest rate however, the borrower may opt to negotiate a fixed or floating rate of interest. Where a set rate of interest is decided, then the cost of capital is also fixed for the period and can operate like that of a relationship or debenture. However, where in fact the interest is a floating one, then your parties will make a deal a short rate but this will be amended to reflect changes in the underlying interest rates given by central lenders.
The question with regards to a multinational companies cost of capital which relates to debt is exactly what interest will be paid. The answer will be a combination of the ideas of risk and central loan provider interest rates.
A company's capital composition in itself also offers an impact upon the company's cost of capital. In general terms, whilst arrears funding is seen as a lesser cost source of capital than that of equity (Bringham and Ehrhardt 2005) the cost of credit debt however, in its home is not set. Bringham and Ehrhardt (2005) show that as a corporation takes on a greater level of debts within its capital framework, future borrowings become more expensive. That is because of the fact that buyers consider that as a firm increases its levels of leverage, the business becomes a more risky investment and so a higher rate of interest must secure future funding. In essence, you can consider that the price tag on capital for a corporation will increase, where in fact the company selects to increase its leverage by obtaining that capital through debt.
Equity signifies the component of the capital framework of any company which relates to those who have a direct ownership of a company, in other words stocks and shares and their derivatives (Arnold 2004). Shareholders are compensated through firstly the repayment of dividends which signifies a direct cost to an enterprise. Second of all shareholders will also be prepared to see capital profits in the share price representing a further non-financial cost of the price tag on capital.
As with your debt element of the capital structure, the cost of collateral varies from company to company and from industry to industry. Bringham and Ehrhardt (2005) signify that the relevant factors that will affect the expense of collateral are risk, the risk free rate of interest and the return obtainable from substitute investment with an identical risk profile.
In general terms, the cost of financing a company via equity is considered to be always a more costly option than financing a small business through debt. This is due to the fact that in effect equity presents a permanent source of capital, once issued shares stay in blood circulation in perpetuity unless a special action is taken up to buy again the shares. Alternatively all varieties of long term personal debt have a redemption particular date, even if that time frame is at a point far in to the future.
As has been determined one of the central contributing factors towards consider what affects a company's cost of capital is the concept of risk. At the overall level risk is merely defined as idea of uncertainty (Business Website link 2009), more specifically risk is usually from the concept of uncertainly manifesting itself in a poor format.
The basic romance between risk and reward for buyers and company's likewise is the account that in order to justify the taking of a higher level of risk, there should be the prospect of an increased level of compensation. This can be viewed as manifested on both the debt and collateral side of the expense of capital of the company's capital structure. On the debt side of the capital framework, those company's that contain high level of risk will be billed a higher rate of interest by banks or have to provide a higher rate appealing on bonds to be able to obtain funding. Therefore, this pushes up the business's overall cost of capital. Bonds for instance are often given a credit rating, these range from government bonds which are generally used as the chance free rate and the ones attract low interest rates through to low quality corporate bonds often referred to as "rubbish bonds" (Brealey et al 2006) and draw in a higher promotion rate for the chance taken.
Risk is in the same way incorporated into the expense of capital on the collateral part of a company's capital structure. Where a shareholder invests in what they understand to be always a riskier share then in exchange the shareholder will expect a greater level of come back by means of higher dividends and better capital growth. The concept of risk is often contained in the expense of equity by considering what experts make reference to as a risk beta. Betas are in place a manifestation of the recognized threat of a sector or specific company, 1 symbolizes a risk which is not any greater or lower than that of the average whilst a confident figure represents a business with a larger risk and a negative figure as you with a lower risk. So those establishments and companies which are associated with long-term profitability and stableness will have a minimal beta and thus a lesser cost of capital. Whilst those operating in a riskier sector, or with a shorter record of performance will have a higher beta and thus an increased cost of capital. This is demonstrated by looking at the relative betas of Coca-Cola, a long set up and profitable company with a beta of just 0. 6 (Reuters 2010 a) and Apple Inc a fashionable expansion centered company which thus has a beta of 1 1. 41 Reuters 2010 b).
As such one the essay has so far determined that risk is most likely the most important factor in determining the comparative cost of capital for a particular company. The question now for those working in the international business environment is exactly what constitutes risk and how do risk be were able to affect the price of capital.
One key awareness is that of diversification. Diversification is a strategic decision and may take on numerous forms from product diversification (Jobber 2007) through to market and geographic diversification (De Wit and Meyer 2004). Generally terms, shareholders usually consider that businesses which have a greater level of diversification have a lower level of risk than those people who have a smaller degree of diversification. The factor is that diversified firms are guarded against a land in any solo market or geographic region. The problem of the of course is that a firm deals of its capacity to make a huge profit in which a single market experiences a surge or expansion spurt. Empirical information would seem to aid this theory, well varied organizations such as Unilever and P&G having risk betas of 0. 73 and 0. 51 respectively (Digital Look 2010, Reuters 2010 d).
National ratings can also be seen as a key thought for risk where multinational businesses are concerned. Whilst overall geographic diversification may be observed as a way of lowering risk, this is not always the truth. Oftentimes companies have chosen to purchase emergent market segments such as China, Indian and SOUTH USA. Whilst these may be observed as regions of key development which make the possibility of high rates of return. National ratings would also claim that ventures in such countries also cause significant risks and thus raise the cost of capital. For instance those doing business in China face significant dangers over issues related to the security of intellectual property (Panitchpakdi and Clifford 2002), whilst on the other side other countries have problems with problems relating to political balance or other such areas of conflict.
Interest rates may be seen among the other important elements which affect the price tag on capital for those functioning in the multination business environment. At its most elementary level you can consider that the comparative cost of borrowing will reveal that of the base rate of central banking institutions throughout the world. Thus when interest rates are on the whole low as they are at present in the UK (BoE 2010) the cost of capital will also be lower due to lessen interest rates from permanent borrowings. On the other hand were interest rates rise, then the expense of capital will also risk as finance institutions and long term lenders starting to require a higher level appealing than recently.
The multinational corporation does indeed however, have a special consideration as it pertains to the issue of interest levels and the company's cost of capital. Whilst a domestic company is completely subject to interest fluctuations within their national market. There is the awareness that on a global scale interest rates are arranged locally to represent national and local interests. So for the multinational organization there is the consideration that the company can take advantage of such a divergence of interests by looking borrow or issue devices in the countries which can be exhibiting the cheapest interest on the behalf of central bankers. For instance at present, many companies may be seduced either to carry out their business within the united kingdom or to take out loans and concern financial instrument in the united kingdom due to the low interest rate at only 0. 5% which would have a positive impact upon the cost of capital.
The final factor which will impact the cost of capital for a multinational company is the consideration of the produce that investors can perform elsewhere. Generally terms investors will choose to invest in an investment which produces the highest come back for the given risk profile of the investment. As such a company's cost of capital will also fluctuate reliant on the performance of others within the sector, where the market all together has performed well one would expect that the price tag on capital on the equity area of the equation would increase. This is because of the fact that the stated company must be able to give a similar return to those working in the sector. Conversely where the performance of the marketplace all together or of the sector is poor, a company's cost of capital will reduce based upon falling expectations of buyers in equities.
Alternative investments must also be considered in the form of the chance free rate, the chance free rate being the pace you can obtain from investment in a high quality government bond. Generally risking without risk rates will dsicover risking costs of capital as buyers are able to gain increasing degrees of return at a lower risk elsewhere.
Having considered the study posed in this paper, you can conclude that we now have a wide range of issues which donate to the entire cost of capital for a business. Despite these things to consider, one conclusion is usually that the solo biggest factor which contributes towards the expense of capital is the account of the amount of risk for which a company is seen as exposing its traders capital too. Consequently the management of the price of capital may in effect be seen as an exercises in the willpower of risk management first of all.
In considering the cost of capital, you can also conclude that the multinational organisation has the ability to benefit from a lower level of the expense of capital through higher diversification and other risk minimizing factors, which allow a firm to lessen its hazards.