Financial structure and international debt

Chapter 13 Financial Structure and International Debt Optimal Financial Structure • The domestic theory of optimal financial structure must be  modified considerably to encompass the multinational firm • Most finance theorists are now in agreement about whether an  optimal financial structure exists for a firm, and if so, how it can be  determined • When taxes and bankruptcy costs are considered, a firm has an  optimal financial structure determined by that particular mix of  debtandequitythatminimizesthefirmscostofcapitalforagiven levelofbusinessrisk ã Asthebusinessriskofnewprojectsdiffersfromtheriskof existingprojects,theoptimalmixofdebtandequitywouldchange torecognizetradeoffsbetweenbusinessandfinancialrisks Copyright â 2004 Pearson Addison-Wesley All rights reserved 13-2 Optimal Financial Structure • The following exhibit illustrates how the  costofcapitalvarieswiththeamountof debtemployed ã Asthedebtratioincreases,theoverall costofcapital(kWACC)decreasesbecause oftheheavierweightoflowưcost(dueto taxưdeductability)debt([kd(1ưt)] comparedtohighcostequity(ke) Copyright â 2004 Pearson Addison-Wesley All rights reserved 13-3 Exhibit 13.1 The Cost of Capital and Financial Structure ke = cost of equity Cost of Capital (%) 30 28 26 24 22 20 18 16 14 12 10 Minimum cost of capital range kWACC = weighted average after-tax cost of capital kd (1-tx) = after-tax cost of debt 20 40 Debt Ratio (%) = Copyright © 2004 Pearson Addison-Wesley All rights reserved 60 80 100 Total Debt (D) Total Assets (V) 13-4 Optimal Financial Structure and the MNE • The domestic theory of optimal financial  structures needs to be modified by four more  variables in order to accommodate the case of  the MNE • These variables include: – Availability of capital – Diversification of cash flows – Foreign exchange risk – Expectations of international portfolio investors Copyright © 2004 Pearson Addison-Wesley All rights reserved 13-5 Optimal Financial Structure and the MNE • Availability of capital: – A multinational firm’s marginal cost of capital is  constant for considerable ranges of its capital  budget – This statement is not true for most small domestic  firms (as they do not have equal access to capital  markets), nor for MNEs located in countries that  have illiquid capital markets (unless they have  gained a global cost and availability of capital) Copyright © 2004 Pearson Addison-Wesley All rights reserved 13-6 Optimal Financial Structure and the MNE • Diversification of cash flows: – The theoretical possibility exists that multinational  firms are in a better position than domestic firms to  support higher debt ratios because their cash flows  are diversified internationally – As returns are not perfectly correlated between  countries, an MNE might be able to achieve a  reduction in cash flow variability (much in the same  way as portfolio investors who diversify their  security holdings globally) Copyright © 2004 Pearson Addison-Wesley All rights reserved 13-7 Optimal Financial Structure and the MNE • Foreign exchange risk: – When a firm issues foreign currency  denominated debt, its effective cost equals  the after­tax cost of repaying the principal  and interest in terms of the firm’s own  currency – This amount includes the nominal cost of  principal and interest in foreign currency  terms, adjusted for any foreign exchange  gains or losses Copyright © 2004 Pearson Addison-Wesley All rights reserved 13-8 Optimal Financial Structure and the MNE • Expectations of International Portfolio  Investors: – The key to gaining a global cost and availability  of capital is attracting and retaining  international portfolio investors – If a firm wants to raise capital in global  markets, it must adopt global norms that are  close to the US and UK norms as these markets  represent the most liquid and unsegmented  markets Copyright © 2004 Pearson Addison-Wesley All rights reserved 13-9 Financial Structure of Foreign Subsidiaries • If the theory that minimizing the cost of capital for  a given level of business risk and capital budget is  an objective that should be implemented from the  perspective of the consolidated MNE, then the  financial structure of each subsidiary is relevant  only to the extent that it affects this overall goal • In other words, an individual subsidiary does not  really have an independent cost of capital;  therefore its financial structure should not be based  on an objective of minimizing it Copyright © 2004 Pearson Addison-Wesley All rights reserved 13-10 Financial Structure of Foreign Subsidiaries • Advantages to implementing a financing  structure that conforms to local norms: – Reduction in criticisms – Improvement in the ability of management  to evaluate ROE relative to local competitors – Determination as to whether or not resources  are being misallocated (cost of local debt  financing versus returns generated by the  assets financed) Copyright © 2004 Pearson Addison-Wesley All rights reserved 13-11 Financial Structure of Foreign Subsidiaries • Disadvantages to localization: – MNEs are expected to have a competitive advantage  over local firms in overcoming imperfections in national  capital markets; there would then be no need to dispose  of this competitive advantage and conform – Consolidated balance sheet structure may not conform t  any country’s norm (increasing perceived financial risk  and cost of capital to the parent) – Local debt ratios are really only cosmetic as lenders will  ultimately look to the parent, and its consolidated  worldwide cash flow as the source of debt repayment Copyright © 2004 Pearson Addison-Wesley All rights reserved 13-12 Financial Structure of Foreign Subsidiaries • In addition to choosing an appropriate financial structure for  foreign subsidiaries, financial managers of MNEs must choose  among alternative sources of funds to finance the foreign  subsidiary • These funds can be either internal to the MNE or external to the  MNE • Ideally the choice should minimize the cost of external funds  (after adjusting for foreign exchange risk) and should choose  internal sources in order to minimize worldwide taxes and  political risk • Simultaneously, the firm should ensure that managerial  motivation in the foreign subsidiaries is geared toward  minimizing the firm’s worldwide cost of capital Copyright © 2004 Pearson Addison-Wesley All rights reserved 13-13 Exhibit 13.3 Internal Financing of the Foreign Subsidiary Cash Equity Real goods Funds From Within the Multinational Enterprise (MNE) Funds from parent company Debt cash loans Leads & lags on intra-firm payables Debt cash loans Funds from sister subsidiaries Leads & lags on intra-firm payables Subsidiary borrowing with parent guarantee Funds Generated Internally by the Foreign Subsidiary Copyright © 2004 Pearson Addison-Wesley All rights reserved Depreciation & non-cash charges Retained earnings 13-14 Exhibit 13.4 External Financing of the Foreign Subsidiary Borrowing from sources in parent country Funds External to the Multinational Enterprise (MNE) Banks & other financial institutions Security or money markets Local currency debt Borrowing from sources outside of parent country Third-country currency debt Eurocurrency debt Individual local shareholders Local equity Joint venture partners Copyright © 2004 Pearson Addison-Wesley All rights reserved 13-15 The Eurocurrency Markets • The Eurocurrency markets are one of the truly significant innovations in  international finance of the past 50 years • These markets have provided a foundation for a series of innovations in both  the structure of and choices in financing the MNE • Eurocurrencies are domestic currencies of one country on deposit in a second  country • Any convertible currency can exist in “Euro” form (not to be confused with the  European currency called the euro) • These markets serve two valuable purposes: – Eurocurrency deposits are an efficient and convenient money market device  for holding excess corporate liquidity – The Eurocurrency market is a major source of short­term bank loans to  finance corporate working capital needs (including imports and exports) Copyright © 2004 Pearson Addison-Wesley All rights reserved 13-16 International Debt Markets • The international debt market offers the borrower  a wide variety of different maturities, repayment  structures, and currencies of denomination • The markets and their many different instruments  vary by source of funding, pricing structure,  maturity, and subordination or linkage to other  debtandequityinstruments ã Thethreemajorsourcesofdebtfundingonthe internationalmarketsaredepictedinthe followingexhibit Copyright â 2004 Pearson Addison-Wesley All rights reserved 13-17 Exhibit 13.5 International Debt Markets & Instruments Bank Loans & Syndications (floating-rate, short-to-medium term) Euronote Market (floating-rate, short-to-medium term) International Bond Market (fixed & floating-rate, medium-to-long term) Copyright © 2004 Pearson Addison-Wesley All rights reserved International Bank Loans Eurocredits Syndicated Credits Euronotes & Euronote Facilities Eurocommercial Paper (ECP) Euro Medium Term Notes (EMTNs) Eurobond * straight fixed-rate issue * floating-rate note (FRN) * equity-related issue Foreign Bond 13-18 International Debt Markets • Bank loans and syndications: – International bank loans have traditionally been sourced in the  Eurocurrency markets, there is a narrow interest rate spread  between deposit and loan rates of less than 1% – Eurocredits are bank loans to MNEs, sovereign governments,  international institutions, and banks denominated in  Eurocurrencies and extended by banks in countries other than  the country in whose currency the loan is denominated – The syndication of loans has enabled banks to spread the risk  of very large loans among a number of banks (this is  significant for MNEs as they usually need credit in an amount  larger than a single bank’s loan limit) Copyright © 2004 Pearson Addison-Wesley All rights reserved 13-19 Exhibit 13.7 Comparative Spreads Between Lending and Deposit Rates in the Eurodollar Market Interest Rate Domestic Loan Rate 7.000 % 4.625 % Eurodollar Loan Rate Domestic Spread of 4.000% Eurodollar Spread of 0.500% 4.125 % Eurodollar Deposit Rate Domestic 3.000 % Deposit Rate Copyright © 2004 Pearson Addison-Wesley All rights reserved 13-20 International Debt Markets • The Euronote market: – Euronotes and Euronote facilities are short to  medium in term and are either underwritten and  non­underwritten – Euro­commercial paper is a short­term debt  obligation of a corporation or bank (usually  denominated in US dollars) – Euro medium­term notes is a new entrant to the  world’s debt markets, which bridges the gap  between Euro­commercial paper and a longer­term  and less flexible international bond Copyright © 2004 Pearson Addison-Wesley All rights reserved 13-21 International Debt Markets • The International Bond Market: – A Eurobond is underwritten by an international syndicate of  banks and other securities firms and is sold exclusively in  countries other than the country in whose currency the issue is  denominated – A foreign bond is underwritten by a syndicate composed of  members from a single country, sold principally within that  country, and denominated in the currency of that country – The Eurobond markets differ from the Eurodollar markets in  that there is an absence of regulatory interference, less  stringent disclosure rules and favorable tax treatments for these  bonds Copyright © 2004 Pearson Addison-Wesley All rights reserved 13-22 Project Financing • Project finance is the arrangement of financing for long­term  capital projects, large in scale, long in life, and generally high in  risk • Project finance is used widely today by MNEs in the development  of large­scale infrastructure projects in China, India, and many  other emerging markets • Most of these transactions are highly leveraged, with debt making  up more than 60% of the total financing • Equity is a small component of project financing for two reasons;  first, the scale of investment projects is often too large for an  investor or group of investors to fund and second, many projects  involve subjects traditionally funded by governments Copyright © 2004 Pearson Addison-Wesley All rights reserved 13-23 Project Financing • Since project financing usually utilizes a  substantial amount of debt financing,  additional levels of risk reduction are needed in  order to create an environment whereby lenders  feel comfortable lending: – Separability of the project from its investors – Long­lived and capital­intensive singular projects – Cash flow predictability from third­party  commitments – Finite projects with finite lives Copyright © 2004 Pearson Addison-Wesley All rights reserved 13-24 ... a wide variety of different maturities, repayment  structures,? ?and? ?currencies of denomination • Themarketsandtheirmanydifferentinstruments varybysourceoffunding,pricingstructure, maturity,andsubordinationorlinkagetoother debtandequityinstruments... existing projects, the optimal mix of? ?debt? ?and? ?equity would change  to recognize tradeoffs between business? ?and? ?financial? ?risks Copyright © 2004 Pearson Addison-Wesley All rights reserved 13-2 Optimal Financial Structure. .. after-tax cost of debt 20 40 Debt Ratio (%) = Copyright © 2004 Pearson Addison-Wesley All rights reserved 60 80 100 Total Debt (D) Total Assets (V) 13-4 Optimal Financial Structure and the MNE •