Financial Structure and International Debt
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Transcript of Financial Structure and International Debt
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Chapter 13
Financial Structureand International
Debt
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Copyright 2004 Pearson Addison-Wesley. All rights reserved. 13-2
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 whether an
optimal financial structure exists for a firm, and if so, how it canbe determined.
When taxes and bankruptcy costs are considered, a firm has anoptimal financial structure determined by that particular mix ofdebt and equity that minimizes the firms cost of capital 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 and financialrisks.
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Optimal Financial Structure
The following exhibit illustrates how the
cost of capital varies with the amount of
debt employed.
As the debt ratio increases, the overall
cost of capital (kWACC) decreases because
of the heavier weight of low-cost (due totax-deductability) debt ([kd(1-t)]
compared to high cost equity (ke).
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Exhibit 13.1 The Cost of Capitaland Financial Structure
Debt Ratio (%) =Total Debt (D)
Total Assets (V)
30
28
26
24
22
20
18
16
14
12
10
8
6
4
2
0
Cost of Capital (%)
20 40 60 80 100
kWACC = weighted averageafter-tax cost of capital
kd (1-tx)= after-tax cost of debt
ke = cost of equity
Minimum cost
of capital range
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Optimal Financial Structureand the MNE
The domestic theory of optimal financial
structures needs to be modified by four more
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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Optimal Financial Structureand the MNE
Availability of capital:
A multinational firms marginal cost of capital is
constant for considerable ranges of its capital
budget
This statement is not true for most small domestic
firms (as they do not have equal access to capital
markets), nor for MNEs located in countries that
have illiquid capital markets (unless they havegained a global cost and availability of capital)
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Optimal Financial Structureand the MNE
Diversification of cash flows:
The theoretical possibility exists that multinational
firms are in a better position than domestic firms to
support higher debt ratios because their cash flowsare diversified internationally
As returns are not perfectly correlated between
countries, an MNE might be able to achieve a
reduction in cash flow variability (much in the sameway as portfolio investors who diversify their
security holdings globally)
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Optimal Financial Structureand the MNE
Foreign exchange risk:
When a firm issues foreign currencydenominated debt, its effective cost equals
the after-tax cost of repaying the principaland interest in terms of the firms owncurrency
This amount includes the nominal cost ofprincipal and interest in foreign currencyterms, adjusted for any foreign exchangegains or losses
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Optimal Financial Structureand 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 areclose to the US and UK norms as these markets
represent the most liquid and unsegmented
markets
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Financial Structureof Foreign Subsidiaries
If the theory that minimizing the cost of capital fora given level of business risk and capital budget isan objective that should be implemented from the
perspective of the consolidated MNE, then the
financial structure of each subsidiary is relevantonly to the extent that it affects this overall goal.
In other words, an individual subsidiary does notreally have an independent cost of capital;
therefore its financial structure should not be basedon an objective of minimizing it.
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Financial Structureof Foreign Subsidiaries
Advantages to implementing a financingstructure that conforms to local norms:
Reduction in criticisms
Improvement in the ability of managementto evaluate ROE relative to localcompetitors
Determination as to whether or notresources are being misallocated (cost oflocal debt financing versus returns generated
by the assets financed)
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Financial Structureof Foreign Subsidiaries
Disadvantages to localization:
MNEs are expected to have a competitive advantage
over local firms in overcoming imperfections in national
capital markets; there would then be no need to disposeof this competitive advantage and conform
Consolidated balance sheet structure may not conform t
any countrys norm (increasing perceived financial risk
and cost of capital to the parent)
Local debt ratios are really only cosmetic as lenders will
ultimately look to the parent, and its consolidated
worldwide cash flow as the source of debt repayment
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Financial Structureof Foreign Subsidiaries
In addition to choosing an appropriate financial structure forforeign subsidiaries, financial managers of MNEs must chooseamong alternative sources of funds to finance the foreignsubsidiary.
These funds can be eitherinternalto the MNE orexternalto theMNE.
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 andpolitical risk.
Simultaneously, the firm should ensure that managerial motivationin the foreign subsidiaries is geared toward minimizing the firmsworldwide cost of capital
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Exhibit 13.3 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
Funds from
parent company
Depreciation & non-cash charges
Retained earnings
Equity
Cash
Real goods
Debt -- cash loans
Leads & lags on intra-firm payables
Debt -- cash loans
Leads & lags on intra-firm payables
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Exhibit 13.4 External Financing of the Foreign Subsidiary
Funds
Externalto
the
Multinational
Enterprise
(MNE)
Borrowing from sources
outside of parent country
Borrowing from sources
in parent country
Local equity
Joint venture partners
Individual local shareholders
Banks & other financial institutions
Security or money markets
Local currency debt
Third-country currency debt
Eurocurrency debt
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The Eurocurrency Markets
The Eurocurrency markets are one of the truly significant innovationsin international finance of the past 50 years.
These markets have provided a foundation for a series of innovationsin both the structure of and choices in financing the MNE.
Eurocurrencies are domestic currencies of one country on deposit in asecond country.
Any convertible currency can exist in Euro form (not to be confusedwith the European currency called the euro).
These markets serve two valuable purposes:
Eurocurrency deposits are an efficient and convenient moneymarket device for holding excess corporate liquidity
The Eurocurrency market is a major source of short-term bankloans to finance corporate working capital needs (includingimports and exports)
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International Debt Markets
The international debt market offers theborrower a wide variety of different maturities,repayment structures, and currencies of
denomination. The markets and their many different
instruments vary by source of funding, pricingstructure, maturity, and subordination or
linkage to other debt and equity instruments. The three major sources of debt funding on the
international markets are depicted in thefollowing exhibit.
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Exhibit 13.5 International Debt Markets & Instruments
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 Facilities
Foreign Bond
Eurobond* straight fixed-rate issue
* floating-rate note (FRN)
* equity-related issue
Euronote
Market
(floating-rate,
short-to-medium term)
International
Bond Market
(fixed & floating-rate,
medium-to-long term)
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International Debt Markets
Bank loans and syndications:
International bank loans have traditionally been sourced inthe Eurocurrency markets, there is a narrow interest ratespread between deposit and loan rates of less than 1%.
Eurocredits are bank loans to MNEs, sovereigngovernments, international institutions, and banksdenominated in Eurocurrencies and extended by banks incountries other than the country in whose currency the loanis denominated.
The syndication of loans has enabled banks to spread the riskof very large loans among a number of banks (this issignificant for MNEs as they usually need credit in anamount larger than a single banks loan limit).
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Exhibit 13.7 Comparative Spreads Between Lendingand Deposit Rates in the Eurodollar Market
3.000 %
7.000 %Domestic
Loan Rate
DomesticDeposit Rate
Domestic Spread
of 4.000%
Eurodollar Loan Rate
Eurodollar Deposit Rate
Eurodollar Spread of 0.500%
Interest Rate
4.625 %
4.125 %
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International Debt Markets
The Euronote market:
Euronotes and Euronote facilities are short tomedium in term and are eitherunderwritten andnon-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 theworlds debt markets, which bridges the gap
between Euro-commercial paper and a longer-termand less flexible international bond
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International Debt Markets
The International Bond Market:
AEurobondis underwritten by an international syndicate ofbanks and other securities firms and is sold exclusively incountries other than the country in whose currency the issueis denominated
Aforeign bondis underwritten by a syndicate composed ofmembers from a single country, sold principally within thatcountry, and denominated in the currency of that country
The Eurobond markets differ from the Eurodollar markets inthat there is an absence of regulatory interference, lessstringent disclosure rules and favorable tax treatments forthese bonds
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Project Financing
Project finance is the arrangement of financing for long-termcapital projects, large in scale, long in life, and generally high inrisk.
Project finance is used widely today by MNEs in the developmentof large-scale infrastructure projects in China, India, and manyother emerging markets.
Most of these transactions are highly leveraged, with debt makingup more than 60% of the total financing.
Equity is a small component of project financing for two reasons;
first, the scale of investment projects is often too large for aninvestor or group of investors to fund and second, many projectsinvolve subjects traditionally funded by governments
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Project Financing
Since project financing usually utilizes asubstantial amount of debt financing, additionallevels of risk reduction are needed in order tocreate an environment whereby lenders feelcomfortable lending:
Separability of the project from its investors
Long-lived and capital-intensive singular projects
Cash flow predictability from third-partycommitments
Finite projects with finite lives