1 International Capital Structure (or part I of chapter 13)

2 Agenda  Theories of capital structure.  Why MNE has special financial structure?  Cost of debt & Forex risk  Financial mix of foreign subsidiaries (talk by C. Fritz Foley).  How to finance a foreign subsidiary?

3 Theory of Capital Structure  Modigliani-Miller: capital structure is irrelevant!  Trade-off theory: firm does have optimal financial structure. Idea: minimize WACC. Why? B/c of taxes & bankruptcy costs. If new projects business risk differs from risk of existing projects, optimal mix would change (tradeoff between business and financial risks)  Market-timing: manager takes advantage of investor sentiment.  Managerial Entrenchment & Free Cash-flow: cash-rich firms’ managers dislike debt since it means more monitoring by banks!

4 Optimal financial mix? Debt Ratio (%) = Total Debt (D) Total Assets (V) Cost of Capital (%) k e = cost of equity Min cost of capital k d* (1-t) = after-tax cost of debt k WACC = weighted average after-tax cost of capital

5 Why financial mix for MNE is special?  A few facts: MNE has access to more capital in global markets. can achieve diversification of cash flows. subject to foreign exchange risk. has to cater for international portfolio investors.

6 Optimal Financial Structure  Availability of capital Allows MNE to lower cost of capital. Permits MNE 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.  Diversification of cash flows Reduces risk as in portfolio theory. Lowers volatility of cash flows among differing subsidiaries & forex rates.  Expectations of International Portfolio Investors Most international investors for US and the UK follow the norms of a 60% debt-assets ratio.

7 Forex Risk & Cost of Debt  Effective cost of debt example Idea: have to account for forex changes. US firm borrows SF 1,500,000 for 1 5% p.a. SF appreciates SF1.50/$ --> SF 1.44/$ –Initial $ amount borrowed –At the end of the year, the US firm repays the interest plus principal –Actual $ cost of loan:

8 Forex Risk & Cost of Debt: a shortcut Rationale: total home currency cost higher b/c of SF appreciation Can compute as: Total cost is Where k d $ = Cost of borrowing (US firm in US$) k d SF = Cost of borrowing (US firm in SF) s = Percentage change in spot rate

9 Shall MNE localize financial mix?  Pros: Reduces criticism of subs operating with too much debt. Helps management evaluate return on equity investment relative to local competitors.  Cons: MNE has comparative advantage over local firms through better availability of capital If each subsidiary localizes its financial structure, resulting consolidated balance sheet might show a structure that doesn’t conform with any one country’s norm Usually subs’ debt is guaranteed by parent => parent won’t allow a default … so subs’ debt ratio is set by parent.

10 Financing the Foreign Subsidiary  Internal vs. External Markets In addition to choosing appropriate financial structure, managers need to choose alternative sources of funds for financing. Sources of funds can be classified as internal & external to MNE

11 Subs’ Internal Financing Non-cash charges Retained earnings Internally generated funds Debt (cash loans) Leads & lags on intra-firm A/P Sister subsidiaries Borrows w/ parent’s collateral MNE Funds Debt (cash loans) Leads & lags on intra-firm A/P Equity Cash Goods Parent

12 Subs’ External Financing Banks Money markets External Funds Borrow in parent country Local currency debt Third-country currency debt Eurocurrency debt Borrow outside of parent country Joint venture partners Local shareholders Local equity

13 Tax concerns (Guest Talk 11/6)

14 Things to remember…  Theories of capital structure  Why MNE has special financial structure?  Cost of debt & Forex risk  Financial mix of foreign subsidiaries (talk by Professor C. Fritz Foley)  How to finance a foreign subsidiary?