copyright © 2003 pearson education, inc.slide 13-1 prepared by shafiq jadallah to accompany...

Copyright © 2003 Pearson Education, Inc.

Slide 13-1

Prepared by Shafiq Jadallah

To Accompany

Fundamentals of Multinational FinanceFundamentals of Multinational FinanceMichael H. Moffett, Arthur I. Stonehill, David K. Eiteman

Chapter 13Chapter 13Financial Structure &Financial Structure &

International DebtInternational Debt


Slide 13-2

Chapter 13Financial Structure &

International Debt Learning Objectives

• Extend the theory of optimal financial structure to the MNE

• Analyze the factors which, in practice, determine the financial structure of foreign subsidiaries within the context of the MNE

• Evaluate the various internal & external sources of funds available for the financing of foreign subsidiaries


Slide 13-3

Chapter 13Financial Structure &

International Debt

Learning Objectives• Identify the relevant characteristics of different

international debt instruments in financing both the MNE itself, and its various foreign subsidiaries

• Apply the strategies of project financing to the funding of large global projects with unique characteristics


Slide 13-4

Optimal Financial Structure

When taxes and bankruptcy costs are considered, a firm has an optimal financial structure determined by an optimal mix of debt and equity that minimizes the firm’s cost of capital• If 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


Slide 13-5

Optimal Financial Structure

Debt Ratio (%) =Total Debt (D)

Total Assets (V)

3028262422201816141210 8 6 4 2

0

Cost of Capital (%)

20 40 60 80 100

ke = cost of equity

Minimum costof capital range

kd (1-tx) = after-tax cost of debt

kWACC = weighted average

after-tax cost of capital


Slide 13-6

Optimal Financial Structure& The MNE

The domestic theory of optimal capital structure is modified by four additional variables in order to accommodate the MNE• Availability of capital

• Diversification of cash flows

• Foreign exchange risk

• Expectation of international portfolio investors


Slide 13-7


Availability of capital• Allows MNEs to lower cost of capital • Permits MNEs 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 similar to portfolio theory of diversification

• Lowers volatility of cash flows among differing subsidiaries and foreign exchange rates


Slide 13-8


Foreign exchange risk & cost of debt• When a firm issues foreign currency denominated

debt, its effective cost equals the after-tax cost of repayment in terms of the firm’s own currency

• Example: US firm borrows Sfr1,500,000 for one year at 5.00% p.a.; the franc appreciates from Sfr1.500/$ to Sfr1.440/$

– Initial dollar amount borrowed

000,000,1$Sfr1.500/$

00Sfr1,500,0


Slide 13-9


• At the end of the year, the US firm repays the interest plus principal

750,093,1$Sfr1.440/$

1.05 x 00Sfr1,500,0

09375.1000,000,1

$1,093,750

• The actual dollar cost of the loan is not the nominal 5.00% paid in Swiss francs, but 9.375%


Slide 13-10


• This total home currency cost is higher than expected because of the appreciation of the Swiss franc

• This cost is the result of the combined cost of debt and the percentage change in the foreign currency’s value

1s1 x k1k Sfrd

$d

Where

kd$ = Cost of borrowing for US firm in home country

kdSfr = Cost of borrowing for US firm in Swiss francs

s = Percentage change in spot rate


Slide 13-11


The total cost of debt must include the change in the exchange rate The percentage change in the value of the Swiss franc is calculated as

09375.01041667.01 x 05.1k$d

4.1667% 100 x Sfr1.40/$

Sfr1.440/$ - Sfr1.500/$ 100 x

S

SS

2

21

The total cost is then


Slide 13-12


Expectations of International Portfolio Investors• If firms want to attract and maintain international

portfolio investors, they must follow the norms of financial structures

• Most international investors for US and the UK follow the norms of a 60% debt ratio


Slide 13-13

Financial Structure ofForeign Subsidiaries

Debt borrowed is from sources outside of the MNE (i.e. subsidiary borrows directly from markets)

Advantages of localization• Localized financial structure reduces criticism of foreign

subsidiaries that have been operating with too high (by local standards) proportion of debt

• Localized financial structure helps management evaluate return on equity investment relative to local competitors

• In economies where interest rates are high because of scarcity of capital and real resources are fully utilized, the penalty paid for borrowing local funds reminds management that unless ROA is greater than local price of capital, misallocation of real resources may occur


Slide 13-14


Disadvantages of localization• An MNE is expected to have comparative advantage over local

firms through better availability of capital and ability to diversify risk

• If each subsidiary localizes its financial structure, the resulting consolidated balance sheet might show a structure that doesn’t conform with any one country’s norm; the debt ratio would simply be a weighted average of all outstanding debt

• Typically, any subsidiary’s debt is guaranteed by the parent, and the parent won’t allow a default on the part of the subsidiary thus making the debt ratio more cosmetic for the foreign subsidiary


Slide 13-15


Financing the Foreign Subsidiary• In addition to choosing an appropriate financial

structure, financial managers need to choose among the alternative sources of funds for financing

• Sources of funds can be classified as internal and external to the MNE


Slide 13-16

Internal Financing ofthe Foreign Subsidiary

Depreciation & non-cash charges

Retained earnings

Funds Generated Internally by theForeign Subsidiary

Debt -- cash loans

Leads & lags on intra-firm payables

Funds fromsister subsidiaries

Subsidiary borrowing with parent guarantee

Funds From

Withinthe

MultinationalEnterprise

(MNE)

Debt -- cash loans

Leads & lags on intra-firm payables

EquityCash

Real goodsFunds fromparent company


Slide 13-17

External Financing ofthe Foreign Subsidiary

Banks & other financial institutions

Security or money markets

Funds External

tothe

MultinationalEnterprise

(MNE)

Borrowing from sourcesin parent country

Local currency debt

Third-country currency debt

Eurocurrency debt

Borrowing from sourcesoutside of parent country

Joint venture partners

Individual local shareholders

Local equity


Slide 13-18

International Debt Markets

These markets offer a variety of different maturities, repayment structures and currencies of denomination

They also vary by source of funding, pricing structure, maturity and subordination

Three major sources of funding are• International bank loans and syndicated credits

• Euronote market

• International bond market


Slide 13-19

International Debt Markets Bank loan and syndicated credits

• Traditionally sourced in eurocurrency markets• Also called eurodollar credits or eurocredits

– Eurocredits are bank loans denominated in eurocurrencies and extended by banks in countries other than in whose currency the loan is denominated

• Syndicated credits– Enables banks to risk lending large amounts– Arranged by a lead bank with participation of other

bank

• Narrow spread, usually less than 100 basis points


Slide 13-20


Euronote market• Collective term for medium and short term debt

instruments sourced in the Eurocurrency market

• Two major groups– Underwritten facilities and non-underwritten facilities

– Non-underwritten facilities are used for the sale and distribution of Euro-commercial paper (ECP) and Euro Medium-term notes (EMTNs)


Slide 13-21

International Debt Markets• Euronote facilities

– Established market for sale of short-term, negotiable promissory notes in eurocurrency market

– These include Revolving Underwriting Facilities, Note Issuance Facilities, and Standby Note Issuance Facilities

• Euro-commercial paper (ECP) – Similar to commercial paper issued in domestic markets

with maturities of 1,3, and 6 months

• Euro Medium-term notes (EMTNs)– Similar to domestic MTNs with maturities of 9 months to

10 years– Bridged the gap between short-term and long-term euro

debt instruments


Slide 13-22


International bond market• Fall within two broad categories

– Eurobonds

– Foreign bonds

• The distinction between categories is based on whether the borrower is a domestic or foreign resident and whether the issue is denominated in a local or foreign currency


Slide 13-23


Eurobonds• A Eurobond is underwritten by an international

syndicate of banks and sold exclusively in countries other than the country in whose currency the bond is denominated

• Issued by MNEs, large domestic corporations, governments, government enterprises and international institutions

• Offered simultaneously in a number of different capital markets


Slide 13-24

International Debt Markets Eurobonds

• Several different types of issues– Straight Fixed-rate issue

– Floating rate note (FRN)

– Equity related issue – convertible bond

Foreign bonds• Underwritten by a syndicate and sold principally within the

country of the denominated currency, however the issuer is from another country

• These include – Yankee bonds

– Samurai bonds

– Bulldogs


Slide 13-25


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 FacilitiesEuronoteMarket

(floating-rate,short-to-medium term)

Foreign Bond

Eurobond * straight fixed-rate issue * floating-rate note (FRN) * equity-related issue

InternationalBond Market

(fixed & floating-rate,medium-to-long term)


Slide 13-26

International Debt Markets Unique characteristics of Eurobond markets

• Absence of regulatory interference– National governments often impose controls on foreign

issuers of securities, however the euromarkets fall outside of governments’ control

• Less stringent disclosure• Favorable tax status

– Eurobonds offer tax anonymity and flexibility

Rating of Eurobonds & other international issues• Moody’s, Fitch and Standard & Poor’s rate bonds just

as in US market


Slide 13-27

Project Financing Project Finance is the arrangement of financing for

long-term capital projects, large in scale and generally high in risk

Widely used by MNEs in the development of infrastructure projects in emerging markets

Most projects are highly leveraged for two reasons• Scale of project often precludes a single equity

investor or collection of private equity investors• Many projects involve subjects funded by

governments This high level of debt requires additional levels of

risk reduction


Slide 13-28

Project Financing Four basic properties that are critical to the

success of project financing• Separation of the project from its investors

– Project is established as an individual entity, separated legally and financially from the investors

– Allows project to achieve its own credit rating and cash flows

• Long-lived and capital intensive singular projects• Cash flow predictability from third-party commitments

– Third party commitments are usually suppliers or customers of the project

• Finite projects with finite lives


Slide 13-29

Summary of Learning Objectives

The domestic theory of optimal capital structures needs to be modified by four variables in order to accommodate the case of the MNE. These four variables are (1) availability of capital, (2) diversification of risk, (3) foreign exchange risk and (4) expectations of international portfolio investors

An MNE’s marginal cost of capital is constant for considerable ranges of its capital budget

By diversifying cash flows internationally, the MNE may achieve lower cash flow volatility


Slide 13-30


When a firm issues foreign currency-denominated debt, its effective cost of equals the after-tax cost of repayment in terms of the firm’s own currency. This amount included the nominal cost of the loan adjusted for any foreign exchange gains or losses

Therefore, if a firm wants to raise capital in global markets, it must adopt global norms that are close to US and UK standards


Slide 13-31


A compromise position between minimizing the global cost of capital and conforming to local capital norms is possible when determining the financial structure of a foreign subsidiary. Both multinational and domestic firms should try to lower their overall WACC

The debt ratio of a foreign affiliate is in reality only cosmetic because lenders ultimately look at the parent and its consolidated cash flow


Slide 13-32


International debt markets offer the borrower a variety of maturities, repayment options, and currencies of denomination. These markets also vary by source of funding, pricing structure, subordination and linkage to other securities

Three major sources of debt funding are international bank loans and syndicated credits, euronote market and international bond market


Slide 13-33


Eurocurrency markets serve two valuable purposes (1) Eurocurrency deposits are an efficient and convenient money market device for excess corporate liquidity and (2) the market is a major source of short-term bank loans to finance working capital needs

Three original factors in the evolution of the Eurobond markets are the absence of regulatory interference, less stringent disclosure practices and favorable tax treatment


Slide 13-34


Project finance is used widely in the development of large-scale infrastructure projects in emerging markets. Most are highly leveraged transactions with debt making up more than 60% of the capital structure

copyright © 2003 pearson education, inc.slide 13-1 prepared by shafiq jadallah to accompany...

Documents

pearson education

aftertax cost of debt

optimal mix of debt

financial risks

effective cost

desired debt ratio

aftertax cost of repayment

various foreign subsidiaries