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Chapter 13 Financial Structure and International Debt
Copyright © 2004 Pearson Addison-Wesley. All rights reserved 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 debt and equity that minimizes the firm’s cost of capital for a given level of business risk. As 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.
Copyright © 2004 Pearson Addison-Wesley. All rights reserved Optimal Financial Structure The following exhibit illustrates how the cost of capital varies with the amount of debt employed. As the debt ratio increases, the overall cost of capital (k WACC ) decreases because of the heavier weight of low-cost (due to tax-deductability) debt ([k d (1-t)] compared to high cost equity (k e ).
Copyright © 2004 Pearson Addison-Wesley. All rights reserved Exhibit 13.1 The Cost of Capital and Financial Structure Debt Ratio (%) = Total Debt (D) Total Assets (V) Cost of Capital (%) k WACC = weighted average after-tax cost of capital k d (1-tx) = after-tax cost of debt k e = cost of equity Minimum cost of capital range
Copyright © 2004 Pearson Addison-Wesley. All rights reserved 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 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 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 Optimal Financial Structure and the MNE Foreign exchange risk: –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
Copyright © 2004 Pearson Addison-Wesley. All rights reserved 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 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 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 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 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 Exhibit 13.3 Internal Financing of the Foreign Subsidiary Funds From Within the Multinational Enterprise (MNE) Funds Generated Internally by the Foreign Subsidiary Subsidiary borrowing with parent guarantee Funds from sister subsidiaries Funds from parent company Depreciation & non-cash charges Retained earnings Equity Cash Real goods Debt -- cash loans Leads & lags on intra-firm payables Debt -- cash loans Leads & lags on intra-firm payables
Copyright © 2004 Pearson Addison-Wesley. All rights reserved Exhibit 13.4 External Financing of the Foreign Subsidiary Funds External to the Multinational Enterprise (MNE) Borrowing from sources outside of parent country Borrowing from sources in parent country Local equity Joint venture partners Individual local shareholders Banks & other financial institutions Security or money markets Local currency debt Third-country currency debt Eurocurrency debt
Copyright © 2004 Pearson Addison-Wesley. All rights reserved 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 short-term bank loans to finance corporate working capital needs (including imports and exports)
Copyright © 2004 Pearson Addison-Wesley. All rights reserved 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 debt and equity instruments. The three major sources of debt funding on the international markets are depicted in the following exhibit.
Copyright © 2004 Pearson Addison-Wesley. All rights reserved Exhibit 13.5 International Debt Markets & Instruments Bank Loans & Syndications (floating-rate, short-to-medium term) Eurocredits Syndicated Credits International Bank Loans Eurocommercial Paper (ECP) Euro Medium Term Notes (EMTNs) Euronotes & Euronote Facilities Foreign Bond Eurobond * straight fixed-rate issue * floating-rate note (FRN) * equity-related issue 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 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 Exhibit 13.7 Comparative Spreads Between Lending and Deposit Rates in the Eurodollar Market % % Domestic Loan Rate Domestic Deposit Rate Domestic Spread of 4.000% Eurodollar Loan Rate Eurodollar Deposit Rate Eurodollar Spread of 0.500% Interest Rate % %
Copyright © 2004 Pearson Addison-Wesley. All rights reserved International Debt Markets The Euronote market: –Euronotes and Euronote facilities are short to medium in term and are either underwritten and non-underwritten –Euro-commercial paper is a short-term debt obligation of a corporation or bank (usually denominated in US dollars) –Euro medium-term notes is a new entrant to the world’s debt markets, which bridges the gap between Euro-commercial paper and a longer-term and less flexible international bond
Copyright © 2004 Pearson Addison-Wesley. All rights reserved 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 Project Financing Project finance is the arrangement of financing for long-term 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 large-scale 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 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 –Long-lived and capital-intensive singular projects –Cash flow predictability from third-party commitments –Finite projects with finite lives
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