Q.1 What do you mean by optimum capital structure? What factors affect cost of capital across nations?
Answer : The objective of capital structure management is to mix the permanent sources of funds in manner that will maximise the company’s common stock price. This will also minimise the firm’s composite cost of capital. This proper mix of fund sources is referred to as the optimal capital structure. Thus, for each firm, there is a combination of debt, equity and other forms(preferred stock) which maximises the value of the firm while simultaneously minimising the cost of capital. The financial manager is continuously trying to achieve an optimal proportion of debt and equity that will achieve this objective.
Cost of Capital across Countries
Just like technological or resource differences, there exist differences in the cost of capital across countries. Such differences can be advantageous to MNCs in the following ways:
1. Increased competitive advantage results to the MNC as a result of using low cost capital obtained from international financial markets compared to domestic firms in the foreign country. This, in turn, results in lower costs that can then be translated into higher market shares.
2. MNCs have the ability to adjust international operations to capitalise on cost of capital differences among countries, something not possible for domestic firms.
3. Country differences in the use of debt or equity can be understood and capitalised on hymns.
We now examine how the costs of each individual source of finance can differ across countries.
Country differences in Cost of Debt
Before tax cost of debt (Kid) = Fro + Risk Premium
This is the prevailing risk free interest rate in the currency borrowed and the risk premium required by creditors. Thus the cost of debt in two countries may differ due to difference in the risk free rate or the risk premium.
(a) Differences in risk free rate:
Since the risk free rate is a function of supply and demand, any factors affecting the supply and demand will affect the risk free rate. These factors include:
–Tax laws:
Incentives to save may influence the supply of savings and thus the interest rates. The corporate tax laws may also affect interest rates through effect son corporate demand for funds.
– Demographics:
They affect the supply of savings available and the amount of loan able funds demanded depending on the culture and values of a given country. This may affect the interest rates in a country.
– Monetary policy:
It affects interest rates through the supply of loan able funds. Thus a loose monetary policy results in lower interest rates if a low rate of inflation is maintained in the country.
– Economic conditions:
A high expected rate of inflation results in the creditors expecting a high rate of interest which increases the risk free rate.
(b) Differences in risk premium:
The risk premium on the debt must be large enough to compensate the creditors for the risk of default by the borrowers. The risk varies with the following:
– Economic conditions:
Stable economic conditions result in a low risk of recession. Thus there is a lower probability of default.
– Relationships between creditors and corporations:
If the relationships are close and the creditors would support the firm in case of financial distress, the risk of illiquidity of the firm is very low. Thus a lower risk premium.
–Government intervention:
If the government is willing to intervene and rescue affirm, the risk of bankruptcy and thus, default is very low, resulting in a low risk premium.
– Degree of financial leverage:
All other factors being the same, highly leveraged firms would have to pay a higher risk premium.
Q.2 What is sub-prime lending? Explain the drivers of sub-prime lending? Explain briefly the different exchange rate regime that is prevalent today.
Q.3 What is covered interest rate arbitrage?
Assume spot rate of £ = $ 1.60
180 day forward rate £ = $ 1.56
180 day interest rate in U.K. = 4%
180 day U.S interest rate = 3%
Is covered interest arbitrage by U.S investor feasible?
Q.4 Explain double taxation avoidance agreement in detail
Q.5 Explain American depository receipt sponsored programme and unsponsored programme.
Q.6 Explain (a) Parallel Loans (b) Back — to- Back loans
