International Finance Assignment to Discusses Capital Structure
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1. Capital Structure of MNCs: Present an argument in support of an MNC's favoring a debt intensive capital structure. Present an argument in support of an MNC's favoring an equity intensive capital structure.
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Solution Summary
This solution provides arguments that MNC's should favor an equity intensive capital structure and debt intensive structure.
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Issue of capital structure
A firm's optimal capital structure is that mixture of debt and equity than minimizes its weighted average cost of capital (WACC). Since the after-tax cost of debt is lower than equity for many corporations, why not use debt only or mostly? It turns out that, while debt reduces a company's tax liability because interest payments are deductible expenses, increasing amounts of debt raise both the cost of equity capital and the interest rate on debt because of the increasing probability of bankruptcy. In other words, higher amounts of debt raise the financial risk of a company, and this risk is reflected on the cost of all the types of capital the company uses.
Thus, the relationship between financial leverage and WACC is not a straight line, but more of a U-shaped curve, with a minimum WACC between the extremes of debt utilization. ...
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