C18 - 2 Chapter Objectives To explain why MNCs consider long-term financing in foreign currencies; To explain how the feasibility of long-term financing in foreign currencies can be assessed; and To explain how the assessment of long- term financing in foreign currencies can be adjusted for bonds with floating interest rates.
C18 - 3 The Long-Term Financing Decision Because bonds denominated in foreign currencies sometimes require lower yields, MNCs often consider long-term financing in foreign currencies. The actual cost of such financing depends on the quoted interest rate, as well as the changes in the value of the borrowed currency over the life of the loan.
C18 - 4 Annualized Bond Yields Across Countries Ten-year maturity, as of June 1998 Annualized Bond Yield ¥£US$ Swiss franc Thai baht Canadian dollar Australian dollar Malaysian ringgit Indonesian rupiah
C18 - 5 Long-term interest rates for major currencies for various maturities can be found at http://www.bloomberg.com/, while currency forecasts are available at http://biz.yahoo.com/ifc/.http://www.bloomberg.com/ http://biz.yahoo.com/ifc/ Online Application
C18 - 6 To make the long-term financing decision, the MNC must determine the amount of funds needed, forecast the price (interest rate) at which the bond may be issued, and forecast the exchange rates of the borrowed currency for the times when it has to make payments (coupons and principal) to the bondholders. The Long-Term Financing Decision
C18 - 7 Then the probability distribution of the bond’s financing costs may be determined. An MNC that denominates bonds in a foreign currency may achieve major cost reductions, but is subject to the possibility of incurring high costs if the borrowed currency appreciates over time. The Long-Term Financing Decision
C18 - 8 Actual Costs of Financing With Pound-Denominated Bonds from a U.S. Perspective Exchange Rate of £ US$ Needed to Cover Annual Coupon Payment of £1 million
C18 - 9 Point-estimate exchange rate forecasts cannot adequately account for the potential impact of exchange rate fluctuations. Instead, the probability distribution of the exchange rate should be developed, so as to determine the expected financing cost and its probability distribution. Computer simulation may aid the process. Managing Exchange Rate Risk
C18 - 10 Managing Exchange Rate Risk The exchange rate risk from financing with bonds in foreign currencies can be reduced by using: offsetting cash inflows in the borrowed currency forward contracts currency swaps
C18 - 11 Euro Payment s Dollar Payment s Investors in Dollar- denominated Bonds Issued by Miller Dollar Payment s Euros Received From Ongoing Operations Miller Company [known within the dollar- denominated market] Euro Payment s Beck Company [known within the euro- denominated market] Dollars Received From Ongoing Operations Dollar Payment s Investors in Euro- denominated Bonds Issued by Beck Euro Payment s Illustration of A Currency Swap
C18 - 12 The exchange rate risk from financing with bonds in foreign currencies can be reduced by using: Managing Exchange Rate Risk parallel (or back-to-back) loans
C18 - 13 Subsidiary of U.K.- based MNC that is located in the U.S. Provision of loans Subsidiary of U.S.- based MNC that is located in the U.K. British ParentU.S. Parent Repayment of loans in the currency that was borrowed Illustration of A Parallel Loan
C18 - 14 The exchange rate risk from financing with bonds in foreign currencies can be reduced by using: parallel (or back-to-back) loans Managing Exchange Rate Risk diversified portfolios of bonds that are denominated in several foreign currencies or currency cocktail bonds (which are bonds denominated in a multicurrency unit e.g. SDR)
C18 - 15 Floating-Rate Bonds Eurobonds are often issued with a floating coupon rate. For example, the rate may be tied to the London Interbank Offer Rate (LIBOR). If the coupon rate is floating, forecasts are required for both exchange rates and interest rates.
C18 - 16 When MNCs issue floating-rate bonds that expose them to interest rate risk, they may use interest rate swaps to hedge the risk. Interest rate swaps enable a firm to exchange fixed rate payments for variable rate payments, and vice versa. They are used by bond issuers to reconfigure future bond payments to a more preferable structure. Floating-Rate Bonds
C18 - 17 Quality Company Choice of 9% fixed or LIBOR +.5% Prefers variable Risky Company Choice of 10.5% fixed or LIBOR + 1% Prefers fixed Investors in Variable Rate Bonds Issued by Risky Company Variable Rate Payments at LIBOR+1% Investors in Fixed Rate Bonds Issued by Quality Company Fixed Rate Payments at 9% Variable Rate Payments at LIBOR+.5% Fixed Rate Payments at 9.5% Illustration of An Interest Rate Swap Gains ½ %Saves ½ %
C18 - 18 Note that financial intermediaries are usually involved in swap agreements. They match up participants and also assume the default risk involved for a fee. Floating-Rate Bonds
C18 - 19 Use of Yield Curves to Make Debt Maturity Decisions An MNC must decide on the maturity for any potential debt. To do this, the MNC may want to assess the yield curve in the country of the currency to be borrowed. Since the slopes of the yield curves may vary across countries, the choice of short- term, medium-term, or long-term debt financing may vary across countries too.
C18 - 20 Yield Curves Across Countries As of February 2001 Canada Japan Italy Germany U.S. U.K. Years to Maturity Annualized Yield (except Japan) Annualized Yield (Japan only)
C18 - 21 Impact of Long-Term Financing Decisions on an MNC’s Value E (CF j,t )=expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ER j,t )=expected exchange rate at which currency j can be converted to dollars at the end of period t k=weighted average cost of capital of the parent Parent’s Long-Term Financing Decisions
C18 - 22 The Long-Term Financing Decision ¤ Measuring the Cost of Financing ¤ Actual Effects of Exchange Rate Movements on Financing Costs Managing Exchange Rate Risk ¤ Accounting for Exchange Rate Risk ¤ Reducing Exchange Rate Risk Chapter Review
C18 - 23 Chapter Review Floating-Rate Bonds ¤ Hedging Interest Rate Risk Use of Yield Curves to Make Debt Maturity Decisions Impact of Long-Term Financing Decisions on an MNC’s Value