Financial Structure

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Chapter 13 Financial Structure International
Debt
To Accompany
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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

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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

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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 firms 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

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Optimal Financial Structure
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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

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Optimal Financial Structure The MNE

• 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

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Optimal Financial Structure The MNE

• 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 firms 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

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Optimal Financial Structure The MNE

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

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

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Optimal Financial Structure The MNE

• 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
  currencys value

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
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Optimal Financial Structure The MNE

• 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

• The total cost is then

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Optimal Financial Structure The MNE

• 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

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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

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Financial Structure ofForeign Subsidiaries

• 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 doesnt conform
  with any one countrys norm the debt ratio would
  simply be a weighted average of all outstanding
  debt
• Typically, any subsidiarys debt is guaranteed by
  the parent, and the parent wont allow a default
  on the part of the subsidiary thus making the
  debt ratio more cosmetic for the foreign
  subsidiary

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Financial Structure ofForeign Subsidiaries

• 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

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Internal Financing ofthe Foreign Subsidiary
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External Financing ofthe Foreign Subsidiary
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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

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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

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International Debt Markets

• 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)

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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

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International Debt Markets

• 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

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International Debt Markets

• 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

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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

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International Debt Markets
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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
• Moodys, Fitch and Standard Poors rate bonds
  just as in US market

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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

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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

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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 MNEs 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

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Summary of Learning Objectives

• When a firm issues foreign currency-denominated
  debt, its effective cost of equals the after-tax
  cost of repayment in terms of the firms 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

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Summary of Learning Objectives

• 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

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Summary of Learning Objectives

• 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

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Summary of Learning Objectives

• 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

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Summary of Learning Objectives

• 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