1. Sourcing Debt Globally
Chapter 16
Sourcing Debt Globally

2. The Goals of Chapter 16
This chapter discusses the optimal capital structures for MNEs
In addition to the traditional capital structure theory, the effects of the availability of capital, the diversification of cash flows, the foreign exchange risk, and the expectations of international investors should also be taken into account for MNEs
Discuss how to determine the capital structure of foreign subsidiaries
Introduce the international debt markets and some debt instruments

3. Optimal capital structure
The classic theory of optimal capital structure must be modified considerably to encompass the multinational firm
In the classic theory, when taxes and bankruptcy costs are considered, a firm has an optimal capital 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

4. Optimal capital structure
Exhibit 16.1 illustrates how the cost of equity, cost of debt, and cost of capital vary with the debt ratio
The cost of equity (ke) increases with the debt ratio, because equity investors perceive greater financial risk when the firm employs more debt
As the debt ratio increases, the overall cost of capital (kWACC) decreases initially because of the heavier weight of lower-cost (partially due to tax- deductibility) debt (kd(1-t)) compared to the cost of equity (ke)
The cost of capital (kWACC) declines until financial risk becomes so serious and dominates the benefit from employing lower-cost debt

5. Exhibit 16.1 The Cost of Capital and capital structure
Debt Ratio (%) 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2
Cost of Capital (%) 40 60 80
100
ke = cost of equity
Minimum cost
of capital range
kWACC = weighted average
after-tax cost of capital
kd (1-t) = after-tax cost of debt
Exhibit The Cost of Capital and capital structure
※ Most theorists believe that the minimum cost of capital is a broad flat area, and the location of this minimum cost of capital range is determined by (1) the industry in which it competes, (2) volatility of its sales and operating income, and (3) collateral value of its assets

6. Optimal capital structure and the MNE
The classic theory of optimal capital structures focuses only on the tradeoff between the financial risk and the benefit of employing lower-cost debt
This classic theory needs to be modified by considering four more factors in order to accommodate the case of the MNE, including
Availability of capital
Diversification of cash flows
Foreign exchange risk
Expectations of international portfolio investors

7. Optimal capital structure and the MNE
Availability of capital:
Chapter 11 has shown that the availability of capital can permit MNEs to maintain their optimal debt ratios (through the viewpoint of minimizing the cost of capital) with a constant marginal cost of capital, even when significant amounts of new funds must be raised
This statement is not true for most small domestic firms (as they do not have access to international capital markets), nor for MNEs located in countries that have illiquid capital markets (unless they have gained a global availability of capital)
They must either rely on internally generated funds or borrow for the short and medium term from commercial banks

8. Optimal capital structure and the MNE
If they need to raise significant amounts of new funds to finance growth opportunities, they may need to borrow more than would be optimal from the viewpoint of minimizing their cost of capital
This is equivalent to the results in Ch11 that their marginal cost of capital is increasing at higher budget levels

9. Optimal capital structure and the MNE
Diversification of cash flows:
As returns are not perfectly correlated among countries, an MNE might be able to achieve a reduction in cash flow variability
Because of the lower cash flow variability, the theoretical possibility exists that multinational firms are in a better position than domestic firms to support higher debt ratios
It has be mentioned in Ch11 that some empirical researches find that MNEs in the U.S. actually have lower debt ratios than their domestic counterparts due to higher agency cost of debt, political risks, foreign exchange risks, and asymmetric information

10. Optimal capital 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
In other words, this amount includes the nominal cost of principal and interest in foreign currency terms, adjusted for any foreign exchange gains or losses
Consider a U.S.-based firm borrow SF at the interest rate , the effective cost of debt for this firm can be calculated by the following equation
where s is the percentage change in the SF/$ exchange rate

11. Optimal capital 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 U.S. and U.K. norms as these markets represent the most liquid and unsegmented markets
Debt ratios up to 60% appear to be acceptable, but any higher debt ratio is more difficult to sell to international portfolio investors

12. Capital structure of Foreign Subsidiaries
If the theory that minimizes the cost of capital for a given level of business risk and capital budget is an objective for MNE, then the capital 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 capital structure should NOT be based on an objective of minimizing its cost of capital
So, should an MNE take differing country debt ratio norms into consideration when determining its desired debt ratio for foreign subsidiaries?

13. Capital structure of Foreign Subsidiaries
Advantages of localization (conforming local debt norms):
Reduction in criticisms from local countries
Debt ratio is too high: the foreign subsidiary does not have enough economic capital to avoid default
Debt ratio is too low: the foreign subsidiary tries to escape the effect of the local monetary policy
Improvement in the ability of management to evaluate ROE relative to local competitors
Maintaining similar debt ratio levels with local competitors provides a fair condition for comparison
Reminding management not to misallocate resources
The high cost of local capital could make the management to be more cautious about the efficiency of allocating resources

14. Capital structure of Foreign Subsidiaries
Disadvantages of localization:
MNEs are expected to have a competitive advantage over local firms in overcoming imperfections in national capital markets; it is unreasonable to conform local norms to adopt a suboptimal capital structure
If each foreign subsidiary localizes its capital structure, the MNE’s financial risk and the cost of capital may increase provided two additional conditions are present:
The consolidated debt ratio is pushed out of the minimum cost of capital range for the MNE
The international Fisher effect does not hold, so the high cost of debt in the foreign country cannot be offset by the depreciation of the foreign currency
Local debt ratios are meaningless as lenders will ultimately look to the parent firm and its consolidated worldwide cash flow as the source of debt repayment

15. Capital structure of Foreign Subsidiaries
Compromise solution:
If the international Fisher effect holds, a MNE can replace the debt of a foreign subsidiary with the debt raised elsewhere at a equal cost after adjusting for foreign exchange risk
Therefore, a compromise solution exists, i.e. the foreign subsidiaries minimize their WACC for a given level of business risk and capital budget, and then the parent firm decide its capital structure to minimize the global WACC for the whole MNE
In this solution, foreign subsidiaries can enjoy the advantages of conforming local norms, and the MNE can maintain its desired consolidated capital structure and enjoy the lower global WACC

16. Capital structure of Foreign Subsidiaries
In addition to deciding an appropriate capital 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 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

17. Exhibit 16.3 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
parent company
Depreciation & non-cash expenses
Retained earnings
Equity
Cash
Real goods
Debt -- cash loans
Leads & lags on intra-firm payables

18. Exhibit 16.4 External Financing of the Foreign Subsidiary
Funds
External to
the
Multinational
Enterprise
(MNE)
Borrowing from sources
in parent country
Banks & other financial institutions
Security or money markets
Borrowing from sources
outside of parent country
Local currency debt
Third-country currency debt
Eurocurrency debt
Local equity
Individual local shareholders
Joint venture partners

19. 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
Exhibit 13.5 provides an overview of the three major sources of debt funding on the international markets, see the next slide

20. Exhibit 16.5 International Debt Markets & Instruments
Bank Loans &
Syndications
(floating-rate,
short-to-medium term)
International Bank Loans
Eurocredits
Syndicated Credits
Euronote
Market
(floating-rate,
short-to-medium term)
Euronotes & Euronote Facilities
Eurocommercial Paper (ECP)
Euro Medium Term Notes (EMTNs)
International
Bond Market
(fixed & floating-rate,
medium-to-long term)
Eurobond
* straight fixed-rate issue
* floating-rate note (FRN)
* equity-related issue
Foreign Bond

21. International Debt Markets
Bank loans and syndications:
International bank loans
They have traditionally been sourced in the Eurocurrency markets
The attractiveness is the narrow interest rate spread in the Eurocurrency load market, i.e. there is a narrow interest rate spread between deposit and loan rates of less than 1%
Eurocredits
The line of credit is an arrangement between a bank and its customers that establishes a maximum loan balance that the bank will permit the borrower to maintain. The borrower can draw down on the line of credit at any time, as long as he or she does not exceed the maximum set in the agreement
Eurocredits are a type of credit dominated in Eurocurrencies, i.e. the denominated currency is not the lending bank‘s national currency

22. International Debt Markets
Syndicated credits
The syndication of loans has enabled banks to spread the risk of very large loans among a number of banks
Syndication is particularly important for MNEs as they usually need credit in an amount larger than a single bank’s loan limit
The periodic expense of the syndicated credit are composed of two elements
The actual interest expense of the loan: normally states as a spread in basis points over a variable-rate base such as LIBOR
The commitment fees paid on any unused portions of the credit

23. International Debt Markets
The Euronote market:
It is a collective term used to describe short- to medium- term debt instruments sourced in the Eurocurrency markets
Euronotes and Euronote facilities
A major development in international money markets was the establishment of facilities for sales of short-term, negotiable, promissory notes–euronotes
The euronote is a cheaper source of short-term funds than international bank loans, because the notes are placed directly to the investing public, and the securitized and underwritten form help the establishment of liquid secondary markets (it is a kind of direct financing)
However, it needs substantial fees initially for the underwriting services

24. International Debt Markets
Euro-commercial paper (ECP)
ECP is a short-term debt obligation of a corporation or bank
Its maturities are typically one, three, and six months, and it is sold normally at a discount
Over 90% of issues outstanding are denominated in U.S. dollars
Euro medium-term notes (EMTNs)
EMTN 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
The EMTN’s basic characteristics are similar to those of a bond, with principal, maturity, and coupon rates
The unique characteristics for EMTN
The EMTN allows continuous issuance over a period of time, whereas a bond issue is essentially sold all at once
For EMTN, to ease the management of coupon payments for continuous issuance, the coupons are paid on set calendar dates regardless of the date of issuance
EMTNs are in smaller denominations, from $2 to $5 million, than the minimum amount needed for international bonds

25. International Debt Markets
The International Bond Market:
The international bond market rivals the international banking market in terms of the quantity and cost of funds provided to international borrowers
International bonds can be classified as Eurobands and foreign bonds
Eurobonds
Which are underwritten by an international syndicate of banks and other securities firms and are sold exclusively in countries other than the country in whose currency the issue is denominated
For example, a bond issued by a U.S.-based firm and denominated in U.S. dollars, but sold to investors in Europe and Japan, would be a Eurobond

26. International Debt Markets
Foreign bonds
Which are underwritten by a syndicate composed of members from a single country, sold principally within that country, and denominated in the currency of that country
For example, a bond issued by a firm resident in Sweden, denominated in dollars, and sold in the U.S. by U.S. investment bankers, would be a foreign bond
The international bond has many innovative instruments created by investments bankers, who are free of controls and regulations in domestic capital markets
Straight fixed-rate issues:
It is like most domestic bonds, with a fixed coupon, a set of payment date, and full principal repayment at maturity
Coupons are normally paid annually, rather than semiannually

27. International Debt Markets
Floating-rate notes (FRNs)
The FRN normally pays a semiannual coupon that is determined using a variable-rate base, e.g. LIBOR plus a spread
It was the new and popular instrument on the international bonds in the early 1980s, since the interest rate is relatively high and unpredictable in that era
Equity-related issues
The most recent major addition to the international bond markets is the equity-related issue
The equity-related international bond resembles a straight fixed-rate issue with an additional feature that it is convertible to stock prior to maturity at the specified price per share, e.g. Euro-convertible bond (ECB)
The borrower is able to issue debt with lower coupon payments due to the added value of the equity conversion feature

28. International Debt Markets
Unique characteristics of Eurobond markets
Absence of regulatory interference
Governments in general have less rigorous limitations for securities sold within the county but denominated in foreign currencies
Thus, Eurobond sales fall outside the regulatory domain of any single nation
Less stringent disclosure
Disclosure requirements in the Eurobond market are much less stringent than those of the SEC for sales within the U.S.
Thus, non-U.S. firms often prefer Eurodollar bonds over bonds sold within the U.S., because they do not wish to undergo the costs and the disclosure needed to register with the SEC

29. International Debt Markets
Favorable tax status
Interest paid on Eurobonds is generally not subject to an income withholding tax, i.e. Eurobonds offer tax avoidance
This is because Eurobonds are usually issued in bearer form, under which the name of the owner is not on the certificate, and the bearer must cuts an interest coupon to exchange for interest receipt
On the contrary, for a registered bond, it is necessary for bond owners to register with the bond's issuer. Since the issuer knows the owner of the bond, it is possible to withhold tax from the interest payment

30. Project Financing
One of the hottest topics in international finance today is project finance
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

31. Project Financing
Equity is a small component of project financing for two reasons:
First, the scale of investment project is often too large for a single investor or a group of investors to fund it
Second, many projects involve subjects traditionally funded by governments, such as electrical power generation, dam building, highway construction, etc. So, the future cash flows are predictable and thus able to serve the high debt ratio
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

32. Project Financing
Four basic properties are critical to the success of project financing
Separability of the project from its investors
The project is established as an individual legal entity, separate from the legal and financial responsibilities of its equity investors
The separation not only protects equity investors but also enables creditors to evaluate clearly the risks associated with this project
The cash flows generated by the project will automatically be allocated to serve debt payments first
Long-lived, capital-intensive, and singular projects
The business line of the project must be singular in its construction, operation, and size

33. Project Financing
Cash flow predictability from third-party commitments
Thrid-party commitments to buy the product or to supply the material at a reasonable price enhance the predictability of future cash flows
For example, an electric power plant project can contract for selling electricity and purchasing raw material, like coal, through long-term contracts with price adjustment based on inflation
The predictability of net cash inflows eliminates much of the project’s business risk, allowing the capital structure to be heavily debt-financed and still safe from financial distress
Projects with finite lives
Because the project is a standalone investment whose cash flow go directly to service its capital structure, and not to reinvestment for growth or other investment, investors of debt and equity need assurances about the ending point at which all debt and equity has bee repaid