1. Sourcing Equity and Debt Globally
Chapter 13
Sourcing Equity and Debt Globally

2. Sourcing Equity and Debt Globally: Learning Objectives
Design a strategy to source equity and debt globally
Analyze the motivations and goals of a firm cross-listing its shares on foreign equity markets
Analyze the motivations and goals of a firm issuing new equity shares on foreign equity markets
Understand the many barriers to penetrate effectively foreign equity markets through cross-listing and selling equity abroad
Examine the various financial instruments which can be used to source equity in the global equity markets

3. Sourcing Equity and Debt Globally: Learning Objectives
Extend the theory of optimal financial structure to the multinational enterprise (MNE)
Analyze the factors that, in practice, determine the financial structure of foreign subsidiaries within the context of the MNE
Evaluate the various internal and external sources of funds available for the financing of foreign subsidiaries
Identify the relevant characteristics of different international debt instruments in financing both the MNE itself, and its various foreign affiliate components

4. Designing a Strategy to Source Equity Globally
This requires management to agree upon a long-run financial objective and then choose among various alternative paths to get there
Normally the choice of paths and implementation is aided by an early appointment of an investment bank as official advisor to the firm
Investment bankers are in touch with the potential foreign investors and what they require in terms of risk/reward
Investment bankers can also help navigate the various institutional requirements and barriers that must be satisfies to source equity globally

5. Designing a Strategy to Source Equity Globally
Most firms raise their initial capital in their own domestic market
While many can be tempted to skip the intermediate steps to complete an Euroequity issue in global markets, good financial advisors will offer a ‘reality check’ on this strategy
Most firms that have only raised capital in their domestic market are not well enough known to attract foreign investors
The following exhibit walks through a more probable chain of events in accessing global capital markets with the end goal being equity capital

6. Exhibit 13.1 Alternative Paths to Globalize the Cost & Availability of Capital

7. Optimal Financial 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 tradeoffs between business and financial risks

8. Exhibit 13.2 The Cost of Capital and Financial Structure

9. Optimal Financial Structure & The MNE
The domestic theory of optimal capital structure is modified by four additional variables in order to accommodate the MNE
Availability of capital
International diversification of cash flows
Foreign exchange risk
Expectation of international portfolio investors

10. Optimal Financial Structure & The MNE
Availability of capital
Allows MNEs to lower cost of capital
Permits MNEs to maintain a desired debt ratio even when new funds are raised
Allows MNEs to operate competitively even if their domestic market is illiquid and segmented
International diversification of cash flows
Reduces risk similar to portfolio theory of diversification
Lowers volatility of cash flows among differing subsidiaries and foreign exchange rates

11. Optimal Financial Structure & The MNE
Foreign exchange risk & cost of debt
When a firm issues foreign currency denominated debt, its effective cost equals the after-tax cost of repayment in terms of the firm’s own currency
Example: US firm borrows Sfr1,500,000 for one year at 5.00% p.a.; the franc appreciates from Sfr1.500/$ to Sfr1.440/$
Initial dollar amount borrowed

12. Optimal Financial Structure & The MNE
At the end of the year, the US firm repays the interest plus principal
The actual dollar cost of the loan is not the nominal 5.00% paid in Swiss francs, but 9.375%

13. Optimal Financial Structure & The MNE
This total home currency cost is higher than expected because of the appreciation of the Swiss franc
This cost is the result of the combined cost of debt and the percentage change in the foreign currency’s value
Where
kd$ = Cost of borrowing for US firm in home country
kdSfr = Cost of borrowing for US firm in Swiss francs
s = Percentage change in spot rate

14. Optimal Financial Structure & The MNE
The total cost of debt must include the change in the exchange rate
The percentage change in the value of the Swiss franc is calculated as
The total cost is then
= 9.375%

15. Optimal Financial Structure & The MNE
Expectations of International Portfolio Investors
If firms want to attract and maintain international portfolio investors, they must follow the norms of financial structures
Most international investors for US and the UK follow the norms of up to a 60% debt ratio

16. Financial Structure of Foreign Subsidiaries
Debt borrowed is from sources outside of the MNE (i.e. subsidiary borrows directly from markets)
Advantages of localization
Localized financial structure reduces criticism of foreign subsidiaries that have been operating with too high (by local standards) proportion of debt
Localized financial structure helps management evaluate return on equity investment relative to local competitors
In economies where interest rates are high because of scarcity of capital and real resources are fully utilized, the penalty paid for borrowing local funds reminds management that unless ROA is greater than local price of capital, misallocation of real resources may occur

17. Financial Structure of Foreign Subsidiaries
Disadvantages of localization
An MNE is expected to have comparative advantage over local firms through better availability of capital and ability to diversify risk
If each subsidiary localizes its financial structure, the resulting consolidated balance sheet might show a structure that doesn’t conform with any one country’s norm; the debt ratio would simply be a weighted average of all outstanding debt
Typically, any subsidiary’s debt is guaranteed by the parent, and the parent won’t allow a default on the part of the subsidiary thus making the debt ratio more cosmetic for the foreign subsidiary

18. Financial Structure of Foreign Subsidiaries
Financing the Foreign Subsidiary
In addition to choosing an appropriate financial structure, financial managers need to choose among the alternative sources of funds for financing
Sources of funds can be classified as internal and external to the MNE
Ideally the choice among the sources of funds should minimize the cost of external funds after adjusting for foreign exchange risk
The firm should choose internal sources in order to minimize worldwide taxes and political risk

19. Exhibit 13.3 Internal Financing of the Foreign Subsidiary

20. Exhibit 13.4 External Financing of the Foreign Subsidiary

21. Sourcing Equity Globally
Depositary Receipts
Depositary receipts are negotiable certificates issued by a bank to represent the underlying shares of stock, which are held in trust at a foreign custodian bank
Global Depositary Receipts (GDRs) – refers to certificates traded outside the US
American Depositary Receipts (ADRs) – are certificates traded in the US and denominated in US dollars
ADRs are sold, registered, and transferred in the US in the same manner as any share of stock with each ADR representing some multiple of the underlying foreign share

22. Sourcing Equity Globally
Depositary Receipts
This multiple allows the ADRs to possess a price per share conventional for the US market
ADRs are either sponsored or unsponsored
Sponsored ADRs are created at the request of a foreign firm wanting its shares traded in the US; the firm applies to the SEC and a US bank for registration and issuance

23. Exhibit 13.5 American Depositary Receipts (ADRs)

24. Exhibit 13.6 Characteristics of Depositary Receipt Programs

25. Foreign Equity Listing & Issuance
By cross-listing and selling its shares on a foreign stock exchange a firm typically tries to accomplish one or more of the following objectives:
Improve the liquidity of its existing shares and support a liquid secondary market
Increase its share price by overcoming mispricing in a segmented and illiquid home market
Increase the firm’s visibility and political acceptance to its customers, suppliers, creditors & host governments
Establish a secondary market for shares used for acquisitions
Create a secondary market for shares that can be used to compensate local management and employees in foreign subsidiaries

26. Size and Liquidity of Markets
Three key trends in the evolution of modern exchanges:
Demutualization or the end of market ownership by a small, privileged group of “seat owners”
Diversification by exchanges to trade a broader range of products
Globalization or effectively another form of diversification through several techniques

27. Foreign Equity Listing & Issuance
Cross-listing is a way to encourage investors to continue to hold and trade shares that may or may not be listed on an investors home market or in a preferred currency
Cross-listing is usually done through ADRs (in the United States, where they are traded and quoted in U.S. dollars)
Global Registered Shares (GRSs), on the other hand, are able to be traded on equity exchanges around the globe in a variety of currencies and are traded electronically

28. Effect of Cross-Listing and Equity Issuance on Share Price
The impact on price of cross-listing on a foreign stock market depends on the degree to which the markets are segmented
As was the situation experienced by Novo, a firm can benefit if a foreign market values a company more highly than a home market (in a highly-segmented situation)

29. Other Motives for Cross-Listing
Increasing visibility and political acceptance
MNEs list in markets where they have substantial physical operations
Political objectives might include the need to meet local ownership requirements for an MNE’s foreign joint venture
Increasing potential for share swaps with acquisitions
Compensating management and employees

30. Barriers to Cross-Listing and Selling Equity Abroad
Commitment to disclosure and investor relations
A decision to cross-list must be balanced against the implied increased commitment to full disclosure and a continuing investor relations program
Disclosure is a double-edged sword
Increased firm disclosure should have the effect of lowering the cost of equity capital
On the other hand, this increased disclosure is a costly burden to corporations

31. Alternative Instruments to Source Equity
Alternative instruments to source equity in global markets include the following:
Sale of a directed public share issue to investors in a target market
Sale of a Euro equity public issue to investors in more than one market, including both foreign and domestic markets
Private placements under SEC Rule 144A
Sale of shares to private equity funds
Sale of shares to a foreign firm as a part of a strategic alliance

32. Alternative Instruments to Source Equity
Directed Public Share Issues
Defined as one which is targeted at investors in a single country and underwritten in whole or in part by investment institutions from that country
Issue may or may not be denominated in the currency of the target market
The shares might or might not be cross-listed on a stock exchange in the target market
A foreign share issues, plus cross-listing can provide it with improved liquidity

33. Alternative Instruments to Source Equity
Euroequity Public Issue
Gradual integration of worlds’ capital markets has spawned the emergence of a Euroequity market
A firm can now issue equity underwirtten and distributed in multiple foreign equity markets; sometimes simultaneously with distribution in the domestic market
As we have reviewed, the term “Euro” does not imply that the issuers or investors are located in Europe, nor does it mean the shares are sold in the currency “euro”

34. Alternative Instruments to Source Equity
Private Placement Under SEC Rule 144A
A private placement is the sale of a security to a small set of qualified institutional buyers
Investors are traditionally insurance companies and investment companies
Because shares are not registered for sale, investors typically follow “buy and hold” strategy
Rule 144A allows qualified institutional buyers (QIB) to trade privately placed securities without previous holding period restrictions and without requiring SEC registration

35. Alternative Instruments to Source Equity
Private Equity Funds
Limited partnerships of institutional and wealthy individual investors that raise their capital in the most liquid capital markets
Then invest these funds in mature, family-owned firms located in emerging markets
Strategic Alliances
Normally followed by firms that expect to gain synergies from one or more joint efforts

36. International Debt Markets
These markets offer a variety of different maturities, repayment structures and currencies of denomination
They also vary by source of funding, pricing structure, maturity and subordination
Three major sources of funding are
International bank loans and syndicated credits
Euronote market
International bond market

37. Exhibit 13.7 International Debt Markets & Instruments

38. International Debt Markets
Bank loan and syndicated credits
Traditionally sourced in eurocurrency markets
Also called eurodollar credits or eurocredits
Eurocredits are bank loans denominated in eurocurrencies and extended by banks in countries other than in whose currency the loan is denominated
Syndicated credits
Enables banks to risk lending large amounts
Arranged by a lead bank with participation of other bank
Narrow spread, usually less than 100 basis points

39. International Debt Markets
Euronote market
Collective term for medium and short term debt instruments sourced in the Eurocurrency market
Two major groups
Underwritten facilities and non-underwritten facilities
Non-underwritten facilities are used for the sale and distribution of Euro-commercial paper (ECP) and Euro Medium-term notes (EMTNs)

40. International Debt Markets
Euronote facilities
Established market for sale of short-term, negotiable promissory notes in eurocurrency market
These include Revolving Underwriting Facilities, Note Issuance Facilities, and Standby Note Issuance Facilities
Euro-commercial paper (ECP)
Similar to commercial paper issued in domestic markets with maturities of 1,3, and 6 months
Euro Medium-term notes (EMTNs)
Similar to domestic MTNs with maturities of 9 months to 10 years
Bridged the gap between short-term and long-term euro debt instruments

41. International Debt Markets
International bond market
Fall within two broad categories
Eurobonds
Foreign bonds
The distinction between categories is based on whether the borrower is a domestic or foreign resident and whether the issue is denominated in a local or foreign currency

42. International Debt Markets
Eurobonds
A Eurobond is underwritten by an international syndicate of banks and sold exclusively in countries other than the country in whose currency the bond is denominated
Issued by MNEs, large domestic corporations, governments, government enterprises and international institutions
Offered simultaneously in a number of different capital markets

43. International Debt Markets
Eurobonds
Several different types of issues
Straight Fixed-rate issue
Floating rate note (FRN)
Equity related issue – convertible bond
Foreign bonds
Underwritten by a syndicate and sold principally within the country of the denominated currency, however the issuer is from another country
These include
Yankee bonds
Samurai bonds
Bulldogs

44. International Debt Markets
Unique characteristics of Eurobond markets
Absence of regulatory interference
National governments often impose controls on foreign issuers of securities, however the euromarkets fall outside of governments’ control
Less stringent disclosure
Favorable tax status
Eurobonds offer tax anonymity and flexibility
Rating of Eurobonds & other international issues
Moody’s, Fitch and Standard & Poor’s rate bonds just as in US market

45. Summary of Learning Objectives
Designing a capital sourcing strategy requires management to agree upon a long run financial objective
The firm must then choose among the various alternative paths to get there, including where to cross-list its shares and where to issue new equity and in what form

46. Summary of Learning Objectives
A firm cross-lists its shares on foreign stock exchanges for one or more of the following reasons
Improving liquidity of its existing shares through depositary receipts
Increase its share price by overcoming mispricing by a segmented, illiquid home market
Support a new equity issue sold in a foreign market
Establish a secondary market for shares used in acquisitions
Increase the firm’s visibility & political acceptance to its customers, suppliers, creditors and host governments
Create a secondary market for shares that will be used to compensate local management and employees in foreign subsidiary

47. Summary of Learning Objectives
If it is to support a new equity issue or to establish a market for share swaps, the target market should also be the listing market
If it is to increase the firm’s commercial and political visibility or to compensate local management and employees, it should be in markets in which the firm has significant operations
The major liquid stock markets are the NYSE, NASDAQ, LSE, Euronext, Tokyo, and Deutsche Bourse

48. Summary of Learning Objectives
The choice among these six markets depends on its size, and the sophistication of its market-making activities, including competitive transaction costs and competent crisis management
Increased commitment to full disclosure
A continuing investor relations program

49. Summary of Learning Objectives
A firm can lower its cost of capital and increase its liquidity by selling its shares to foreign investors in a variety of forms
Sale of a directed share issue to investors in one particular foreign equity market
Sale of a Euroequity share issue to foreign investors simultaneously in more than one market, including both foreign and domestic markets
Private placement under SEC rule 144A
Sale of shares to private equity funds
Sales of shares to a foreign firm as part of a strategic alliance

50. Summary of Learning Objectives
The domestic theory of optimal financial structures needs to be modified by four variables in order to accommodate the case of the MNE:
1) the availability of capital;
2) diversification of cash flows;
3) foreign exchange risk; and
4) the expectations of international portfolio investors.

51. Summary of Learning Objectives
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 because they do not have access to the national equity or debt markets
By diversifying cash flows internationally, the MNE may be able to achieve the same kind of reduction in cash flow variability as portfolio investors receive from diversifying their security holdings internationally

52. Summary of Learning Objectives
When a firm issues foreign currency-denominated debt, its effective cost equals the after-tax 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
Therefore, regardless of other factors, if a firm wants to raise capital in global markets, it must adopt global norms that are close to the U.S. and U.K. norms. Debt ratios up to 60% appear to be acceptable. Any higher debt ratio is more difficult to sell to international portfolio investors

53. Summary of Learning Objectives
A compromise position is possible between minimizing the global cost of capital and conforming to local capital norms (localization) when determining the financial structure of a foreign subsidiary. Both multinational and domestic firms should try to minimize their overall weighted average cost of capital for a given level of business risk and capital budget, as finance theory suggests
The debt ratio of a foreign affiliate is in reality only cosmetic, because lenders ultimately look to the parent and its consolidated worldwide cash flow as the source of repayment. In many cases, debt of subsidiaries must be guaranteed by the parent firm

54. Summary of Learning Objectives
The international debt markets offer the borrower a 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 debt and equity instruments
The three major sources of debt funding on the international markets are international bank loans and syndicated credits, the Euronote market, and the international bond market

55. Summary of Learning Objectives
Eurocurrency markets serve two valuable purposes:
1) Eurocurrency deposits are an efficient and convenient money market device for holding excess corporate liquidity, and
2) the Eurocurrency market is a major source of short-term bank loans to finance corporate working capital needs, including the financing of imports and exports
Three original factors in the evolution of the Eurobond markets are still of importance:
1) absence of regulatory interference,
2) less stringent disclosure practices, and
3) favorable tax treatment