BD30603 - Capital Financing

8/3/2019 BD30603 - Capital Financing

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Sourcing

Equity and DebtGlobally


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Sourcing Equity Globally

To implement the goal of gaining access to global capitalmarkets a firm must begin by designing a strategy that willultimately attract international investors.

This would mean identifying and choosing alternative pathsto access global markets.

This would also require some restructuring of the firm,improving the quality and level of its disclosure, and makingits accounting and reporting standards more transparent topotential foreign investors.


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Designing a Strategyto Source Equity Globally

Designing a capital sourcing strategy requires thatmanagement agree upon a long-run financial objectiveand then choose among the various alternative paths toget there.

Often, this decision making process is aided by an earlyappointment of an investment bank as an official advisorto the firm.

Investment bankers are in touch with potential foreign

investors and know what they currently require, and canalso help navigate the numerous institutional andregulatory barriers in place.


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Designing a Strategyto Source Equity Globally

Most firms raise their initial capital in their owndomestic market.

However, most firms that have only raised capital

in their domestic market are not well knownenough to attract foreign investors.

Incremental steps to bridge this gap includeconducting an international bond offering and/or

cross-listing equity shares on more highly liquidforeign stock exchanges.


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Foreign Equity Listingand Issuance

A firm must choose one or more stockmarkets on which to cross-list its sharesand sell new equity.

Just where to go depends mainly on thefirms specific motives and the willingnessof the host stock market to accept the firm.


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Foreign Equity Listingand Issuance

Cross-listing attempts to accomplish one or more of manyobjectives:

Improve the liquidity of its existing shares and support aliquid secondary market for new equity issues in foreignmarkets

Increase its share price by overcoming mis-pricing in asegmented and illiquid home capital market

Increase the firms visibility

Establish a secondary market for shares used to acquireother firms

Create a secondary market for shares that can be used tocompensate local management and employees in foreignsubsidiaries


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Effect of Cross-Listing and EquityIssuance on Share Price

Cross-listing may have a favorable impact on share price ifthe new market values the firm or its industry more than thehome market does.

It is well known that the combined impact of a new equityissue undertaken simultaneously with a cross-listing has amore favorable impact on stock price than cross-listingalone.

Even US firms can benefit by issuing equity abroad asincreased investor recognition and participation in theprimary and secondary markets results.


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Barriers to Cross-Listingand Selling Equity Abroad

There are certainly barriers to cross-listing and/or sellingequity abroad.

The most serious of these includes the future commitment toproviding full and transparent disclosure of operating results

and balance sheets as well as a continuous program ofinvestor relations.

The US school of thought is that the worldwide trend towardrequiring fuller, more transparent, and more standardizedfinancial disclosure of operating results and balance sheet

positions may have the desirable effect of lowering the costof equity capital.


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Alternative Instruments to SourceEquity in Global Markets

Alternative instruments to source equity inglobal markets include the following:

Sale of a directed public share issue to investors in atarget market

Sale of a Euroequity public issue to investors inmore than one market (foreign and domesticmarkets)

Private placements under SEC Rule 144A

Sale of shares to private equity funds

Sale of shares to a foreign firm as part of a strategicalliance


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Alternative Instrumentsto Source Equity in Global Markets

A directed public share issue is defined as one thatis targeted at investors in a single country andunderwritten in whole or in part by investmentinstitutions from that country.

The issue might or might not be denominated inthe currency of the target market.

The shares might or might not be cross-listed on a

stock exchange in the target market.


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The gradual integration of the worlds capital markets andincreased international portfolio investment has spawned theemergence of a very viable Euroequitymarket.

A firm can now issue equity underwritten and distributed in

multiple foreign equity markets, sometimes simultaneouslywith distribution in the domestic market.

The Euro market (a generic term for internationalsecurities issues originating and being sold anywhere in theworld), was created by the same financial institutions that

had previously created an infrastructure for the Euronoteand Eurobond markets.


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One type of directed issue with a long history as asource of both equity and debt is theprivate

placementmarket.

A private placement is the sale of a security to a

small set of qualified institutional buyers underSEC Rule 144A.

Since the securities are not registered for sale tothe public, investors have typically followed a buyand hold policy.

Private placement markets now exist in mostcountries.


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Private equity funds are usually limited partnerships ofinstitutional and wealthy individual investors that raisetheir capital in the most liquid capital markets.

These investors then invest the private equity fund inmature, family-owned firms located in emerging markets.

The investment objective is to help these firms torestructure and modernize in order to face increasingcompetition and the growth of new technologies.

Private equity funds differ from traditional venture capitalfunds as private equity funds operate in many countries,

fund companies in many industry sectors and have oftenhave a longer time horizon for exiting.


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Strategic alliances are normally formed by firmsthat expect to gain synergies from one or more ofthe following joint efforts:

Sharing the cost of developing technology Gaining economies of scale or scope

Financial assistance (lowering of cost of capitalthrough attractively priced debt or equity

financing)


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Sourcing

Debt


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Optimal Financial Structure

The domestic theory of optimal financial structure must bemodified considerably to encompass the multinational firm.

Most finance theorists are now in agreement about whetheran optimal financial structure exists for a firm, and if so,

how it can be determined. When taxes and bankruptcy costs are considered, a firm has

an optimal financial structure determined by that particularmix of debt and equity that minimizes the firms cost ofcapital for a given level of business risk.

As the business risk of new projects differs from the risk ofexisting projects, the optimal mix of debt and equity wouldchange to recognize tradeoffs between business andfinancial risks.


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Optimal Financial Structure

The following exhibit illustrates how thecost of capital varies with the amount ofdebt employed.

As the debt ratio increases, the overall costof capital (kWACC) decreases because of theheavier weight of low-cost (due to tax-

deductibility) debt ([kd(1-t)] compared tohigh cost equity (ke).


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Exhibit 16.1 The Cost of Capitaland Financial Structure


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Optimal Financial Structureand the MNE

The domestic theory of optimal financialstructures needs to be modified by fourmore variables in order to accommodate

the case of the MNE. These variables include:

Availability of capital

Diversification of cash flows

Foreign exchange risk

Expectations of international portfolio investors


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Availability of capital:

A multinational firms marginal cost of capital isconstant for considerable ranges of its capitalbudget

This statement is not true for most smalldomestic firms (as they do not have equalaccess to capital markets), nor for MNEs locatedin countries that have illiquid capital markets

(unless they have gained a global cost andavailability of capital)


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Diversification of cash flows:

The theoretical possibility exists thatmultinational firms are in a better position than

domestic firms to support higher debt ratiosbecause their cash flows are diversifiedinternationally

As returns are not perfectly correlated between

countries, an MNE might be able to achieve areduction in cash flow variability (much in thesame way as portfolio investors who diversifytheir security holdings globally)


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Foreign exchange risk:

When a firm issues foreign currencydenominated debt, its effective cost equals the

after-tax cost of repaying the principal andinterest in terms of the firms own currency

This amount includes the nominal cost ofprincipal and interest in foreign currency terms,

adjusted for any foreign exchange gains orlosses


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Expectations of International PortfolioInvestors:

The key to gaining a global cost and

availability of capital is attracting andretaining international portfolio investors

If a firm wants to raise capital in globalmarkets, it must adopt global norms thatare close to the US and UK norms as thesemarkets represent the most liquid andunsegmented markets


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Financial Structureof Foreign Subsidiaries

If the theory that minimizing the cost of capital for agiven level of business risk and capital budget is anobjective that should be implemented from theperspective of the consolidated MNE, then the financialstructure 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 itsfinancial structure should not be based on an objectiveof minimizing it.


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Advantages to implementing a financing structurethat conforms to local norms:

Reduction in criticisms

Improvement in the ability of management toevaluate ROE relative to local competitors

Determination as to whether or not resourcesare being misallocated (cost of local debt

financing versus returns generated by theassets financed)


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Disadvantages to localization:

MNEs are expected to have a competitive advantageover local firms in overcoming imperfections innational capital markets; there would then be no

need to dispose of this competitive advantage andconform

Consolidated balance sheet structure may notconform t any countrys norm (increasing perceivedfinancial risk and cost of capital to the parent)

Local debt ratios are really only cosmetic as lenderswill ultimately look to the parent, and itsconsolidated worldwide cash flow as the source ofdebt repayment


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In addition to choosing an appropriate financial structure forforeign subsidiaries, financial managers of MNEs mustchoose among alternative sources of funds to finance theforeign subsidiary.

These funds can be either internalto the MNE or externaltothe MNE.

Ideally the choice should minimize the cost of external funds(after adjusting for foreign exchange risk) and should chooseinternal sources in order to minimize worldwide taxes and

political risk.

Simultaneously, the firm should ensure that managerialmotivation in the foreign subsidiaries is geared towardminimizing the firms worldwide cost of capital


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International Debt Markets

The international debt market offers the borrowera wide variety of different maturities, repaymentstructures, and currencies of denomination.

The markets and their many different instrumentsvary by source of funding, pricing structure,maturity, and subordination or linkage to otherdebt and equity instruments.

The three major sources of debt funding on theinternational markets are depicted in the followingexhibit.


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Bank loans and syndications:

International bank loans have traditionally been sourcedin the Eurocurrency markets, there is a narrow interestrate spread between deposit and loan rates of less than1%.

Eurocredits are bank loans to MNEs, sovereigngovernments, international institutions, and banksdenominated in Eurocurrencies and extended by banksin countries other than the country in whose currencythe loan is denominated.

The syndication of loans has enabled banks to spreadthe risk of very large loans among a number of banks(this is significant for MNEs as they usually need creditin an amount larger than a single banks loan limit).


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The Euronote market:

Euronotes and Euronote facilities are short tomedium in term and are either underwrittenand non-underwritten

Euro-commercial paper is a short-term debtobligation of a corporation or bank (usuallydenominated in US dollars)

Euro medium-term notes is a new entrant to

the worlds debt markets, which bridges the gapbetween Euro-commercial paper and a longer-term and less flexible international bond


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The International Bond Market: A Eurobondis underwritten by an international syndicate

of banks and other securities firms and is sold exclusivelyin countries other than the country in whose currency theissue is denominated

A foreign bondis underwritten by a syndicate composed ofmembers from a single country, sold principally withinthat country, and denominated in the currency of thatcountry

The Eurobond markets differ from the Eurodollar markets

in that there is an absence of regulatory interference, lessstringent disclosure rules and favorable tax treatments forthese bonds


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Unique Characteristics of Eurobond Markets:

Absence of regulatory interference

National governments often impose tight controls on foreignissuers of securities denominated in local currencies.However, governments in general have less stringentlimitations for securities denominated in foreign currenciesand sold within their markets

Less stringent disclosure

Disclosure requirements less stringent than those of the SEC

Favorable tax status

Eurobonds offer tax anonymity and flexibility. Interest paidon Eurobonds is generally not subject to an incomewithholding tax

BD30603 - Capital Financing

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