Chapter 14
Financial Structure and International Debt
( Questions

1. Objective. What, in simple wording, is the objective sought by finding an optimal capital structure? When taxes and bankruptcy costs are considered, a firm has an optimal financial structure determined by that particular mix of debt and equity that minimizes the firm’s cost of capital for a given level of business risk. If the business risk of new projects differs from the risk of existing projects, the optimal mix of debt and equity would change to recognize trade-offs between business and financial risks.

2. Varying Debt Proportions. As debt in a firm’s capital structure is increased from no debt to a significant proportion of debt (say, 60%),
Discuss.

Main advantages of localization. The main advantages of a finance structure for foreign subsidiaries that conforms to local debt norms are as follows: ( A localized financial structure reduces criticism of foreign subsidiaries that have been operating with too high a proportion of debt (judged by local standards), often resulting in the accusation that they are not contributing a fair share of risk capital to the host country. At the other end of the spectrum, a localized financial structure would improve the image of foreign subsidiaries that have been operating with too little debt and thus appear to be insensitive to local monetary policy. ( A localized financial structure helps management evaluate return on equity investment relative to local competitors in the same industry. In economies where interest rates are relatively high as an offset to inflation, the penalty paid reminds management of the need to consider price level changes when evaluating investment performance. ( In economies where interest rates are relatively high because of a scarcity of capital, and real resources are fully utilized (full employment), the penalty paid for borrowing local funds reminds management that unless return on assets is greater than the local price of capital—that is, negative leverage—they are probably misallocating scarce domestic real resources such as land and labor. This factor may not appear