Capital Structure

Optimal Capital Structurein Multinational Corporations

by

Prof. Dr. Dr. Joachim Häcker

Page 2Optimal Capital Structure by Prof. Dr. Dr. Joachim Häcker

Content

1. Financial issues of multinational companies

2. Theoretical analysis on optimal capital structure

2.1. The leverage effect

2.2. The Modigliani Miller proposition

2.3. The traditional approach

3. Practical analysis on optimal capital structure


Three core elements:

Capital structure: Determination of debt and equity properties necessary to maximize firm’s financial health and long-term competitiveness.

Capital budgeting: Analysis of investment opportunities considered by the firm.

Cash management: Management of the levels and composition of the current assets of the firm (cash, receivables, inventories) and their proper funding.

International: Goods produced in the domestic market and then exported to foreign buyers.

Multinational: Parent company in home country and numerous subsidiaries or joint ventures in foreign countries.

Financial Management Definition

Multinational Corporation(MNC)

1. Financial issues of multinational companies


2. Theoretical analysis on optimal capital structure

The “financial leverage effect“ describes the impact of the level of debt on return on equity.

NI = ROE * E

ROE * E = ROC * (E + D) – i * D

ROE * E = ROC * E + ROC * D – i * D

ROE * E = ROC * E + (ROC –i) * D

ROE = ROC + (ROC - i) * D / E

Definition: Leverage effect

Note:

NI …..E .....D .....ROE .....ROC .....i .....D/E .....

Net incomeEquityDebtReturn on equityReturn on total capitalInterest rateDebt to equity ratio

2.1 The leverage effect


(ROC > i): If return on total capital is larger than the interest rate on debt, return on equity increases in proportion to the debt-equity ratio. The rate of increase is determined by the spread between the return on total capital and the interest rate on debt.

(ROC = i): If return on total capital equals the interest rate on debt, return on equity remains constant with an increasing debt-equity ratio.

(ROC < i): If return on total capital is lower than the interest rate on debt, return on equity decreases with a higher debt-equity ratio (magnitude depends on spread).

ROC versus interest rate

D / E

ROE (ROC > i)

(ROC = i)

(ROC < i)

ROE = ROC + (ROC - i) * D / E


Deployed capital can, affected by an unfavourable (ROC = 2%), average (ROC = 6%), or favourable (ROC = 14%) market development with equal probability, earn three different returns.

With a debt-equity ratio of 1 (D = E) and an interest rate on debt of i = 6%, the leverage equation gives the following returns on equity:

Example (1): Constant debt-equity ratio (D = E):

The spread of percentage returns on equity is amplified.

With a higher debt-equity ratio, both the opportunity for a high return on equity and the risk of a low (negative) return on equity increases simultaneously.

Besides business risk and investment risk, the company incurs a financial or capital structure risk with the use of debt.

3 Cases ROE ROC + (ROC - i ) * D / E = ROE

ROC < i ROE (unfavourable) 2% + (2% - 6%) * 1 = -2%

ROC = i ROE (average) 6% + (6% - 6%) * 1 = 6%

ROC > i ROE (favourable) 14% + (14% - 6%) * 1 = 22%


Shareholders:

Risk but also potential reward increase with growing level of debt.

Lenders:

Although interest payments are relatively safe at a low level of debt, negative returns on equity may occur with an increasing level of debt, potentially leading to a total consumption of equity.

With increasing debt levels, interest and principal payments are increasingly at risk.

Return on equity depends on thedebt level

Example (2): Different debt levels:

3 Cases D / E 0/100 25/75 50/50 75/25

ROC < i Unfavourable 2% 0.67% -2% -10%

ROC = i Average 6% 6% 6% 6%

ROC > i Favourable 14% 16.67% 22% 38%


What is the effect of the capital structure on return on equity?

With increasing leverage, the potential reward (risk) of increasing (decreasing) return on equity is amplified.

The outcome is a financial or capital structure risk:

If: ROC > i ROE (ROC-i; D/E)

If: ROC = i ROE (ROC-i; D/E)

If: ROC < i ROE (ROC-i; D/E)

Question:

Answer


The Modigliani / Miller proposition states that the market value of any firm is independent of its capital structure. I.e., changes in capital structure do not affect the stockholders’ welfare.

2 companies that generate the same stream of operating income and differ only in capital structure will have the same valuation.

Assuming perfect markets, the arbitrage argument ensures this equilibrium. If levered firms were priced too high, rational investors would simply borrow on personal account to buy shares in unlevered firms, thus duplicating the effects of corporate leverage.

The arbitrage process would decrease the value of the levered firm and increase the value of the unlevered firm, until both valuations are again in equilibrium. Once again, investors are indifferentbetween investment choices.

Since the equilibrium price is derived on markets, market valuesand not book values are relevant.

2.2 The Modigliani Miller proposition

Market value

Arbitrage


The Modigliani Miller proposition is based on the following assumptions (perfect capital markets):

(1) Every investor maximizes his financial utility

(2) Corporations and individuals can borrow at the same interest rate

(3) The borrowing interest rate equals the lending interest rate

(4) No transaction costs

(5) No bankruptcy costs

(6) Debt instruments can be divided at the discretion of market participants

(7) Taxation of all investment and debt instruments for all market participants is equal

2.2 The Modigliani Miller proposition (cont’d)

Assumptions


Debt ratio

ROE

WACC

i

ROE

WACC

i

Optimal level of debt

Shows the dependence of the required return on equity on the level of debt.

Minimizing WACC equals maximizing overall firm value.

2.3 The traditional approach


The value of the company is derived by discounting future cash flows with the weighted average cost of capital (WACC).

With increasing levels of debt, expensive equity is replaced by cheap debt.

If a company gradually increases its debt level, risk increases. This fact will either be neglected by equity holders, or it seems to them to be negligible.

Future cash flows will be discounted with the same WACC. Thus, company value increases.

Only with a significant increase of the debt level – the exact threshold is unknown – equity holders act on the increase of risk. Consequently, they require a higher return on equity, and future cash flows are discounted with a higher WACC.

Debt holders act similarly but temporally delayed.

Maximum company value is derived at the minimum WACC.

Conclusion:


The question regarding the existence of an optimal capital structure is not unequivocally answered in theory.

Leverage Effect

With increasing debt levels the return on equity changes, depending on ROC and i

If ROC > i, the optimal capital structure implies a fully levered firm

If ROC < i, a fully unlevered firm is optimal

Modigliani Miller

The capital structure is irrelevant for the market value of a company

I.e., there is no optimal capital structure

Traditional Approach

There is an optimal capital structure

This is the case at the minimum WACC (or the maximum overall firm value)

Comparison of theories


Source: Extel, FactSet, year 2000 values

Marktwerte (Mio. Euro) vom 17.9.99 Gearing I (Buchwert) Gearing II (Marktwert)Name Sector Jahr Marktwert Equity ratio excl./ incl. Pens.rkst. excl./ incl. Pens.rkst.DEUTSCHE TELEKOM Other Telecommunications 12/1998 120.229 32% 57% 59% 22% 23%DAIMLERCHRYSLER AG Motor Vehicles 12/1998 68.619 23% 41% 55% 24% 36%MANNESMANN AG Diversified Manufacture 12/1998 54.462 37% 2% 28% 0% 4%SIEMENS AG Diversified Electronic Products 09/1998 47.672 27% 23% 49% 9% 23%BAYER AG Major Chemicals 12/1998 28.739 44% 18% 37% 9% 21%VEBA AG Multi-Sector Companies 12/1998 28.106 31% 18% 36% 9% 21%BASF AG Major Chemicals 12/1998 28.479 50% -1% 23% -1% 12%HOECHST AG Major Pharmaceuticals 12/1998 24.400 34% 39% 48% 19% 26%RWE AG Multi-Sector Companies 06/1997 19.701 18% n.m. -21% -47% -6%BAYER MOTOREN WERK Motor Vehicles 12/1998 18.045 21% 58% 63% 33% 38%SAP AG Computer Software 12/1998 17.753 60% -40% -38% -3% -3%VOLKSWAGEN AG Motor Vehicles 12/1998 16.999 16% 43% 62% 29% 47%METRO AG Other Specialty Stores 12/1998 15.979 22% 39% 45% 14% 17%VIAG AG Multi-Sector Companies 12/1998 13.909 16% 25% 48% 10% 24%THYSSEN KRUPP AG Multi-Sector Companies 09/1998 10.856 26% 33% 58% 21% 43%PREUSSAG AG Multi-Sector Companies 09/1998 8.731 18% 25% 49% 5% 14%SCHERING AG Major Pharmaceuticals 12/1998 6.881 45% -66% 13% -13% 4%DEUTSCHE LUFTHANSA Airlines 12/1998 6.697 27% 18% 51% 10% 34%WCM BETEIL&GRUNDBE Real Estate 12/1998 6.253 54% 3% 4% 0% 0%DEGUSSA-HULS AG Major Chemicals 09/1998 5.886 26% 29% 48% 9% 17%BEIERSDORF AG Package Goods/Cosmetics 12/1998 5.704 46% -61% -4% -7% -1%HEIDELBERGER DRUCK Industrial Machinery/Components 03/1997 5.163 59% -12% 6% -4% 2%FRESENIUS MEDICAL Medical Specialties 12/1998 4.970 59% 27% 28% 17% 18%LINDE AG Multi-Sector Companies 12/1998 4.795 52% -16% 10% -7% 5%HENKEL KGAA Package Goods/Cosmetics 12/1998 3.949 31% 35% 54% 27% 44%HEIDELBERGER ZEMEN Building Materials 12/1998 4.019 40% 27% 35% 15% 21%

60%

3. Practical analysis on optimal capital structure

Since theory does not offer a clear answer, let us analysethe question of an optimal capital structure empirically.

As an example, the DAX 100 companies are analysed


Source: Extel, FactSet

Marktwerte (Mio. Euro) vom 17.9.99 Gearing I (Buchwert) Gearing II (Marktwert)Name Sector Jahr Marktwert Equity ratio excl./ incl. Pens.rkst. excl./ incl. Pens.rkst.ADIDAS-SALOMON AG Shoe Manufacturing 12/1998 3.753 16% 77% 77% 31% 31%KARSTADT AG Department Stores 12/1998 3.654 25% 42% 63% 21% 39%MAN AG Diversified Manufacture 06/1997 3.551 29% -75% 13% -32% 8%HOCHTIEF AG Engineering & Construction 12/1998 2.975 32% n.m. -138% -66% -34%METALLGESELLSCHAFT Multi-Sector Companies 09/1998 2.771 14% n.m. 18% -17% 4%GEHE AG Medical/Dental Distributors 12/1998 2.770 28% 48% 49% 28% 29%CONTINENTAL AG Auto Parts: O.E.M. 12/1998 2.745 23% 54% 64% 38% 48%ALTANA AG Other Pharmaceuticals 12/1998 2.576 55% n.m. -40% -21% -10%BEWAG AG Non-U.S. Utilities 06/1997 2.215 35% 13% 21% 11% 17%PORSCHE AG Motor Vehicles 07/1998 2.249 28% n.m. -31% -18% -5%FRESENIUS AG Medical Specialties 12/1998 1.670 38% 42% 44% 38% 40%IVG HOLDING AG Multi-Sector Companies 12/1998 1.595 38% 53% 54% 20% 21%MERCK KGAA Other Pharmaceuticals 12/1998 1.571 31% 48% 59% 50% 61%DOUGLAS HLDG AG Other Specialty Stores 12/1998 1.500 45% 16% 19% 5% 6%SGL CARBON AG Industrial Specialties 12/1998 1.494 27% 39% 53% 11% 18%SKW TROSTBERG AG Specialty Chemicals 12/1998 1.342 21% 61% 66% 36% 42%AVA ALLG HANDELS V Department Stores 12/1998 1.145 33% 33% 34% 14% 15%BUDERUS AG Building Products 09/1998 1.102 32% -82% 18% -17% 7%HOLZMANN(PHILIPP) Engineering & Construction 12/1998 913 12% 66% 71% 52% 58%SCHWARZ PHARMA AG Other Pharmaceuticals 12/1998 827 49% 29% 32% 14% 16%BILFINGER & BERGER Engineering & Construction 12/1998 857 22% n.m. n.m. n.m. n.m.PROSIEBEN MEDIA AG Broadcasting 12/1998 756 49% 28% 28% 20% 20%AGIV AG Industrial Machinery/Components 12/1998 718 28% n.m. -51% -61% -25%JENOPTIK AG Diversified Manufacture 12/1998 710 35% 28% 36% 17% 23%K & S AG Environmental Services 12/1998 723 34% n.m. -62% -89% -31%KLOECKNER WERKE Specialty Chemicals 09/1998 688 15% 65% 72% 37% 44%

12%

15%

Definition:Equity ratio = Equity incl. minority stakes /total assets.

Analysis of 77 DAX 100 companies.

Excluded were financial service providers (incl. insurance companies and asset management companies) as well as real estate companies.

16%

14%


Source: Extel, FactSet

Marktwerte (Mio. Euro) vom 17.9.99 Gearing I (Buchwert) Gearing II (Marktwert)Name Sector Jahr Marktwert Equity ratio excl./ incl. Pens.rkst. excl./ incl. Pens.rkst.WELLA AG Package Goods/Cosmetics 12/1998 658 28% 44% 56% 35% 47%SIXT AG Rental/Leasing Companies 12/1998 652 21% 70% 70% 47% 47%GEA AG Industrial Machinery/Components 12/1998 637 32% -1% 17% -1% 13%FAG KUGELFISCHER Metal Fabrications 12/1998 588 26% 49% 65% 42% 58%DYCKERHOFF AG Building Materials 12/1998 463 39% 27% 39% 34% 47%SCHMALBACH LUBECA Containers/Packaging 12/1998 450 22% 52% 62% 52% 62%DEUTZ AG Industrial Machinery/Components 12/1998 418 16% 6% 67% 3% 44%BOSS (HUGO) AG Apparel 12/1998 413 n.a. n.a. n.a. 0% 0%IWKA AG Industrial Machinery/Components 12/1998 396 28% -5% 23% -4% 17%SUDZUCKER AG Specialty Foods/Candy 02/1999 364 n.a. n.a. n.a. 0% 0%GROHE(FRIEDRICH)AG Building Products 12/1998 361 51% -46% 2% -34% 2%GERRESHEIMER GLAS Containers/Packaging 12/1998 361 n.a. n.a. n.a. 0% 0%RHON-KLINIKUM AG Medical/Nursing Services 12/1998 343 21% 54% 55% 34% 34%KIEKERT AG Auto Parts: O.E.M. 12/1998 340 44% 32% 35% 16% 18%DUERR AG Industrial Machinery/Components 12/1998 319 n.a. n.a. n.a. 0% 0%PUMA AG Shoe Manufacturing 12/1998 311 44% -5% 7% -2% 2%FIELMANN AG Other Specialty Stores 12/1998 304 61% 14% 14% 9% 9%VOSSLOH AG Diversified Electronic Products 12/1998 300 42% 29% 33% 21% 25%TARKETT SOMMER AG Building Products 12/1998 282 18% 72% 73% 64% 66%BRAU UND BRUNNEN Alcoholic Beverages 12/1998 269 15% 61% 78% 40% 60%RHEINMETALL AG Diversified Manufacture 12/1998 269 23% 27% 54% 30% 58%BABCOCK BORSIG AG Industrial Machinery/Components 09/1998 261 5% 81% 87% 52% 64%JUNGHEINRICH Construction/Ag Equipment/Trucks 12/1998 221 34% 11% 29% 13% 34%PHOENIX AG Auto Parts: O.E.M. 12/1998 211 35% 39% 44% 34% 39%KRONES AG Industrial Machinery/Components 12/1998 122 56% -48% -29% n.m. -149%SPAR HANDELS AG Food Chains 12/1998 124 18% 21% 29% 41% 51%ESCADA AG Apparel 10/1998 98 29% 57% 57% 65% 65%KSB KL SCHANZ BECK Fluid Controls 12/1998 99 32% -19% 28% -29% 36%

61%

5%

28%


Equity ratio of DAX 100 companies

3

9

11

13

21

5

3

566

13

0

2

4

6

8

10

12

14

Up to10%

Up to15%

Up to20%

Up to25%

Up to30%

Up to35%

Up to40%

Up to45%

Up to50%

Up to55%

Up to60%

Up to65%

Up to70%

0

10

20

30

40

50

60

70

80

90Cummulative number of companies (right axis)Number of companies (left axis)

Source: Extel, FactSet, based on year 2000 numbers

The German equity ratio (for DAX 100 companies) averages 31%.

The European equity ratio (based on EuroStoxx) averages 38%.

The unlisted „German Mittelstand“equity ratio averages around 10%

Business practice supports the traditional approach.

Empirically, a large spread of optimal equity ratios can be shown depending on numerous factors such as sectors, profitability and liquidity.


Source: Sekely/Collins (1988)

-1%03/1997 5.163 -12% 6% -4% 2%12/1998 4.970 27% 28% 17% 18%12/1998 4.795 -16% 10% -7% 5%12/1998 3.949 35% 54% 27% 44%12/1998 4.019 27% 35% 15% 21%

Empirical study compares debt ratios for 677 listed firms in 9 industries in 23countries.

Capital structure standards vary considerably from country to country,but are similar for firms within a country.

Neither industry nor size is an important determinant of debt ratios.

Country Auto-motive

Food Paper Debt Ratio Country

MeanSingapore 0.22 0.28 0.34Argentina 0.42 0.35 0.38Australia 0.50 0.45 0.48 0.46Brazil 0.66 0.57 0.37 0.54UK 0.73 0.55 0.56 0.55US 0.58 0.56 0.58 0.55Benelux 0.62 0.64 0.65 0.56Canada 0.68 0.58Switzerland 0.54 0.60Germany 0.57 0.49 0.70 0.62Denmark 0.69 0.74 0.63Spain 0.59 0.66 0.85 0.64France 0.67 0.78 0.74 0.71Italy 0.49 0.85 0.77 0.76

Industry Mean 0.58 0.62 0.63

62%

76%

34%

International outlook

n.a.n.a.

n.a.n.a.n.a.

n.a.

n.a.


How does international availability of capital affect the optimal debt ratio of a

MNC?

Capital structure decision for MNC

Maintenance of desired debt ratio is facilitated by access to international capital markets, even when significant amounts of new funds must be raised.

International availability of capital to a MNC may allow for lower cost of capital than what is available to a domestic firm.

Therefore, the value of MNCs can exceed the value of its national peers


MNCs should choose a capital structure that minimizes consolidated cost of capital.

The individual subsidiary does not have an independent cost of capital. Thus, the subsidiary’s cost of capital is relevant only to the degree that it has an effect on the overall goal.

Localized capital structure for foreign subsidiary helps management to evaluate ROE relative to local competitors.

Better public relations with host country monetary authorities might result.

Pro centralisation

Capital structure should be an issue of centralised management style.

MNCs should borrow at lowest cost, after adjusting for foreign exchange risk, anywhere in the world without considering the impact on a particular subsidiary’s capital structure.

Contra centralisation

Capital structure decision for MNC

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Capital Structure