1. Long-Term Financing 18 Chapter South-Western/Thomson Learning © 2003

2. A18 - 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.

3. A18 - 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.

4. A18 - 4 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

5. A18 - 5 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

6. A18 - 6 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

7. A18 - 7 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

8. A18 - 8 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  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)

9. A18 - 9 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.

10. A18 - 10 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

11. A18 - 11 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

12. A18 - 12 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.

13. A18 - 13 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

14. A18 - 14 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

15. A18 - 15 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