Multinational Capital Structure Decision at the Sports Exports Company
Response to the following problem:
The Sports Exports Company has considered a va- riety of projects, but all of its business is still in the United Kingdom. Since most of its business comes from exporting footballs (denominated in pounds), it remains exposed to exchange rate risk. On the favor- able side, the British demand for its footballs has risen consistently every month. Jim Logan, the owner of the Sports Exports Company, has retained more than
$100,000 (after the pounds were converted into dol- lars) in earnings since he began his business. At this point in time, his capital structure is mostly his own equity, with very little debt. Jim has periodically con- sidered establishing a very small subsidiary in the United Kingdom to produce the footballs there (so that he would not have to export them from the United States). If he does establish this subsidiary, he has several options for the capital structure that would be used to support it: (1) use all of his equity to invest in the ?rm, (2) use pound-denominated long-term debt, or (3) use dollar-denominated long-term debt. The in- terest rate on British long-term debt is slightly higher than the interest rate on U.S. long-term debt.
1. What is an advantage of using equity to support the subsidiary? What is a disadvantage?
2. If Jim decides to use long-term debt as the primary form of capital to support this subsidiary, should he use dollar-denominated debt or pound- denominated debt?
3. How can the equity proportion of this ?rm's capital structure increase over time after it is established?