Sourcing Debt Globally

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Chapter 16

• Sourcing Debt Globally

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The Goals of Chapter 16
0

• This chapter discusses the optimal capital
  structures for MNEs
• In addition to the traditional capital structure
  theory, the effects of the availability of
  capital, the diversification of cash flows, the
  foreign exchange risk, and the expectations of
  international investors should also be taken into
  account for MNEs
• Discuss how to determine the capital structure of
  foreign subsidiaries
• Introduce the international debt markets and some
  debt instruments

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Optimal capital structure

• The classic theory of optimal capital structure
  must be modified considerably to encompass the
  multinational firm
• In the classic theory, when taxes and bankruptcy
  costs are considered, a firm has an optimal
  capital structure determined by that particular
  mix of debt 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 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 capital structure

• Exhibit 16.1 illustrates how the cost of equity,
  cost of debt, and cost of capital vary with the
  debt ratio
• The cost of equity (ke) increases with the debt
  ratio, because equity investors perceive greater
  financial risk when the firm employs more debt
• As the debt ratio increases, the overall cost of
  capital (kWACC) decreases initially because of
  the heavier weight of lower-cost (partially due
  to tax-deductibility) debt (kd(1-t)) compared to
  the cost of equity (ke)
• The cost of capital (kWACC) declines until
  financial risk becomes so serious and dominates
  the benefit from employing lower-cost debt

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Exhibit 16.1 The Cost of Capital and capital
structure
? Most theorists believe that the minimum cost of
capital is a broad flat area, and the location of
this minimum cost of capital range is determined
by (1) the industry in which it competes, (2)
volatility of its sales and operating income, and
(3) collateral value of its assets
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Optimal capital structure and the MNE

• The classic theory of optimal capital structures
  focuses only on the tradeoff between the
  financial risk and the benefit of employing
  lower-cost debt
• This classic theory needs to be modified by
  considering four more factors in order to
  accommodate the case of the MNE, including
• Availability of capital
• Diversification of cash flows
• Foreign exchange risk
• Expectations of international portfolio investors

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Optimal capital structure and the MNE

• Availability of capital
• Chapter 11 has shown that the availability of
  capital can permit MNEs to maintain their optimal
  debt ratios (through the viewpoint of minimizing
  the cost of capital) with a constant marginal
  cost of capital, even when significant amounts of
  new funds must be raised
• This statement is not true for most small
  domestic firms (as they do not have access to
  international capital markets), nor for MNEs
  located in countries that have illiquid capital
  markets (unless they have gained a global
  availability of capital)
• They must either rely on internally generated
  funds or borrow for the short and medium term
  from commercial banks

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Optimal capital structure and the MNE

• If they need to raise significant amounts of new
  funds to finance growth opportunities, they may
  need to borrow more than would be optimal from
  the viewpoint of minimizing their cost of capital
• This is equivalent to the results in Ch11 that
  their marginal cost of capital is increasing at
  higher budget levels

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Optimal capital structure and the MNE

• Diversification of cash flows
• As returns are not perfectly correlated among
  countries, an MNE might be able to achieve a
  reduction in cash flow variability
• Because of the lower cash flow variability, the
  theoretical possibility exists that multinational
  firms are in a better position than domestic
  firms to support higher debt ratios
• It has be mentioned in Ch11 that some empirical
  researches find that MNEs in the U.S. actually
  have lower debt ratios than their domestic
  counterparts due to higher agency cost of debt,
  political risks, foreign exchange risks, and
  asymmetric information

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Optimal capital structure and the MNE

• Foreign exchange risk
• When a firm issues foreign currency denominated
  debt, its effective cost equals the after-tax
  cost of repaying the principal and interest in
  terms of the firms own currency
• In other words, this amount includes the nominal
  cost of principal and interest in foreign
  currency terms, adjusted for any foreign exchange
  gains or losses
• Consider a U.S.-based firm borrow SF at the
  interest rate , the effective cost of debt
  for this firm can be calculated by the following
  equation
• where s is the percentage change in the SF/
  exchange rate

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Optimal capital structure and 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 are
  close to the U.S. and U.K. norms as these markets
  represent the most liquid and unsegmented markets
• Debt ratios up to 60 appear to be acceptable,
  but any higher debt ratio is more difficult to
  sell to international portfolio investors

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Capital structure of Foreign Subsidiaries

• If the theory that minimizes the cost of capital
  for a given level of business risk and capital
  budget is an objective for MNE, then the capital
  structure 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 its capital structure should NOT be
  based on an objective of minimizing its cost of
  capital
• So, should an MNE take differing country debt
  ratio norms into consideration when determining
  its desired debt ratio for foreign subsidiaries?

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Capital structure of Foreign Subsidiaries

• Advantages of localization (conforming local debt
  norms)
• Reduction in criticisms from local countries
• Debt ratio is too high the foreign subsidiary
  does not have enough economic capital to avoid
  default
• Debt ratio is too low the foreign subsidiary
  tries to escape the effect of the local monetary
  policy
• Improvement in the ability of management to
  evaluate ROE relative to local competitors
• Maintaining similar debt ratio levels with local
  competitors provides a fair condition for
  comparison
• Reminding management not to misallocate resources
• The high cost of local capital could make the
  management to be more cautious about the
  efficiency of allocating resources

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Capital structure of Foreign Subsidiaries

• Disadvantages of localization
• MNEs are expected to have a competitive advantage
  over local firms in overcoming imperfections in
  national capital markets it is unreasonable to
  conform local norms to adopt a suboptimal capital
  structure
• If each foreign subsidiary localizes its capital
  structure, the MNEs financial risk and the cost
  of capital may increase provided two additional
  conditions are present
• The consolidated debt ratio is pushed out of the
  minimum cost of capital range for the MNE
• The international Fisher effect does not hold, so
  the high cost of debt in the foreign country
  cannot be offset by the depreciation of the
  foreign currency
• Local debt ratios are meaningless as lenders will
  ultimately look to the parent firm and its
  consolidated worldwide cash flow as the source of
  debt repayment

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Capital structure of Foreign Subsidiaries

• Compromise solution
• If the international Fisher effect holds, a MNE
  can replace the debt of a foreign subsidiary with
  the debt raised elsewhere at a equal cost after
  adjusting for foreign exchange risk
• Therefore, a compromise solution exists, i.e. the
  foreign subsidiaries minimize their WACC for a
  given level of business risk and capital budget,
  and then the parent firm decide its capital
  structure to minimize the global WACC for the
  whole MNE
• In this solution, foreign subsidiaries can enjoy
  the advantages of conforming local norms, and the
  MNE can maintain its desired consolidated capital
  structure and enjoy the lower global WACC

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Capital structure of Foreign Subsidiaries

• In addition to deciding an appropriate capital
  structure for foreign subsidiaries, financial
  managers of MNEs must choose among alternative
  sources of funds to finance the foreign
  subsidiary
• These funds can be either internal or external to
  the MNE
• Ideally the choice should minimize the cost of
  external funds (after adjusting for foreign
  exchange risk) and should choose internal sources
  in order to minimize worldwide taxes and
  political risk
• Simultaneously, the firm should ensure that
  managerial motivation in the foreign subsidiaries
  is geared toward minimizing the firms worldwide
  cost of capital

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Exhibit 16.3 Internal Financing of the Foreign
Subsidiary
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Exhibit 16.4 External Financing of the Foreign
Subsidiary
Funds External to the Multinational Enterprise (M
NE)
Borrowing from sources in parent country
Banks other financial institutions
Security or money markets
Borrowing from sources outside of parent country
Local currency debt
Third-country currency debt
Eurocurrency debt
Local equity
Individual local shareholders
Joint venture partners
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International Debt Markets

• The international debt market offers the borrower
  a wide variety of different maturities, repayment
  structures, and currencies of denomination
• The markets and their many different instruments
  vary by source of funding, pricing structure,
  maturity, and subordination or linkage to other
  debt and equity instruments
• Exhibit 13.5 provides an overview of the three
  major sources of debt funding on the
  international markets, see the next slide

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Exhibit 16.5 International Debt Markets
Instruments
Bank Loans Syndications (floating-rate, short-t
o-medium term)
International Bank Loans
Eurocredits
Syndicated Credits
Euronotes Euronote Facilities
Euronote Market (floating-rate, short-to-medium
term)
Eurocommercial Paper (ECP)
Euro Medium Term Notes (EMTNs)
Eurobond straight fixed-rate issue
floating-rate note (FRN)
equity-related issue
International Bond Market (fixed
floating-rate, medium-to-long term)
Foreign Bond
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International Debt Markets

• Bank loans and syndications
• International bank loans
• They have traditionally been sourced in the
  Eurocurrency markets
• The attractiveness is the narrow interest rate
  spread in the Eurocurrency load market, i.e.
  there is a narrow interest rate spread between
  deposit and loan rates of less than 1
• Eurocredits
• The line of credit is an arrangement between a
  bank and its customers that establishes a maximum
  loan balance that the bank will permit the
  borrower to maintain. The borrower can draw down
  on the line of credit at any time, as long as he
  or she does not exceed the maximum set in the
  agreement
• Eurocredits are a type of credit dominated in
  Eurocurrencies, i.e. the denominated currency is
  not the lending banks national currency

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International Debt Markets

• Syndicated credits
• The syndication of loans has enabled banks to
  spread the risk of very large loans among a
  number of banks
• Syndication is particularly important for MNEs as
  they usually need credit in an amount larger than
  a single banks loan limit
• The periodic expense of the syndicated credit are
  composed of two elements
• The actual interest expense of the loan normally
  states as a spread in basis points over a
  variable-rate base such as LIBOR
• The commitment fees paid on any unused portions
  of the credit

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International Debt Markets

• The Euronote market
• It is a collective term used to describe short-
  to medium-term debt instruments sourced in the
  Eurocurrency markets
• Euronotes and Euronote facilities
• A major development in international money
  markets was the establishment of facilities for
  sales of short-term, negotiable, promissory
  noteseuronotes
• The euronote is a cheaper source of short-term
  funds than international bank loans, because the
  notes are placed directly to the investing
  public, and the securitized and underwritten form
  help the establishment of liquid secondary
  markets (it is a kind of direct financing)
• However, it needs substantial fees initially for
  the underwriting services

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International Debt Markets

• Euro-commercial paper (ECP)
• ECP is a short-term debt obligation of a
  corporation or bank
• Its maturities are typically one, three, and six
  months, and it is sold normally at a discount
• Over 90 of issues outstanding are denominated in
  U.S. dollars
• Euro medium-term notes (EMTNs)
• EMTN is a new entrant to the worlds debt
  markets, which bridges the gap between
  Euro-commercial paper and a longer-term and less
  flexible international bond
• The EMTNs basic characteristics are similar to
  those of a bond, with principal, maturity, and
  coupon rates
• The unique characteristics for EMTN
• The EMTN allows continuous issuance over a period
  of time, whereas a bond issue is essentially sold
  all at once
• For EMTN, to ease the management of coupon
  payments for continuous issuance, the coupons are
  paid on set calendar dates regardless of the date
  of issuance
• EMTNs are in smaller denominations, from 2 to 5
  million, than the minimum amount needed for
  international bonds

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International Debt Markets

• The International Bond Market
• The international bond market rivals the
  international banking market in terms of the
  quantity and cost of funds provided to
  international borrowers
• International bonds can be classified as
  Eurobands and foreign bonds
• Eurobonds
• Which are underwritten by an international
  syndicate of banks and other securities firms and
  are sold exclusively in countries other than the
  country in whose currency the issue is
  denominated
• For example, a bond issued by a U.S.-based firm
  and denominated in U.S. dollars, but sold to
  investors in Europe and Japan, would be a
  Eurobond

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International Debt Markets

• Foreign bonds
• Which are underwritten by a syndicate composed of
  members from a single country, sold principally
  within that country, and denominated in the
  currency of that country
• For example, a bond issued by a firm resident in
  Sweden, denominated in dollars, and sold in the
  U.S. by U.S. investment bankers, would be a
  foreign bond
• The international bond has many innovative
  instruments created by investments bankers, who
  are free of controls and regulations in domestic
  capital markets
• Straight fixed-rate issues
• It is like most domestic bonds, with a fixed
  coupon, a set of payment date, and full principal
  repayment at maturity
• Coupons are normally paid annually, rather than
  semiannually

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International Debt Markets

• Floating-rate notes (FRNs)
• The FRN normally pays a semiannual coupon that is
  determined using a variable-rate base, e.g. LIBOR
  plus a spread
• It was the new and popular instrument on the
  international bonds in the early 1980s, since the
  interest rate is relatively high and
  unpredictable in that era
• Equity-related issues
• The most recent major addition to the
  international bond markets is the equity-related
  issue
• The equity-related international bond resembles a
  straight fixed-rate issue with an additional
  feature that it is convertible to stock prior to
  maturity at the specified price per share, e.g.
  Euro-convertible bond (ECB)
• The borrower is able to issue debt with lower
  coupon payments due to the added value of the
  equity conversion feature

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International Debt Markets

• Unique characteristics of Eurobond markets
• Absence of regulatory interference
• Governments in general have less rigorous
  limitations for securities sold within the county
  but denominated in foreign currencies
• Thus, Eurobond sales fall outside the regulatory
  domain of any single nation
• Less stringent disclosure
• Disclosure requirements in the Eurobond market
  are much less stringent than those of the SEC for
  sales within the U.S.
• Thus, non-U.S. firms often prefer Eurodollar
  bonds over bonds sold within the U.S., because
  they do not wish to undergo the costs and the
  disclosure needed to register with the SEC

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International Debt Markets

• Favorable tax status
• Interest paid on Eurobonds is generally not
  subject to an income withholding tax, i.e.
  Eurobonds offer tax avoidance
• This is because Eurobonds are usually issued in
  bearer form, under which the name of the owner is
  not on the certificate, and the bearer must cuts
  an interest coupon to exchange for interest
  receipt
• On the contrary, for a registered bond, it is
  necessary for bond owners to register with the
  bond's issuer. Since the issuer knows the owner
  of the bond, it is possible to withhold tax from
  the interest payment

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Project Financing

• One of the hottest topics in international
  finance today is project finance
• Project finance is the arrangement of financing
  for long-term capital projects, large in scale,
  long in life, and generally high in risk
• Project finance is used widely today by MNEs in
  the development of large-scale infrastructure
  projects in China, India, and many other emerging
  markets
• Most of these transactions are highly leveraged,
  with debt making up more than 60 of the total
  financing

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Project Financing

• Equity is a small component of project financing
  for two reasons
• First, the scale of investment project is often
  too large for a single investor or a group of
  investors to fund it
• Second, many projects involve subjects
  traditionally funded by governments, such as
  electrical power generation, dam building,
  highway construction, etc. So, the future cash
  flows are predictable and thus able to serve the
  high debt ratio
• Since project financing usually utilizes a
  substantial amount of debt financing, additional
  levels of risk reduction are needed in order to
  create an environment whereby lenders feel
  comfortable lending

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Project Financing

• Four basic properties are critical to the success
  of project financing
• Separability of the project from its investors
• The project is established as an individual legal
  entity, separate from the legal and financial
  responsibilities of its equity investors
• The separation not only protects equity investors
  but also enables creditors to evaluate clearly
  the risks associated with this project
• The cash flows generated by the project will
  automatically be allocated to serve debt payments
  first
• Long-lived, capital-intensive, and singular
  projects
• The business line of the project must be singular
  in its construction, operation, and size

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Project Financing

• Cash flow predictability from third-party
  commitments
• Thrid-party commitments to buy the product or to
  supply the material at a reasonable price enhance
  the predictability of future cash flows
• For example, an electric power plant project can
  contract for selling electricity and purchasing
  raw material, like coal, through long-term
  contracts with price adjustment based on
  inflation
• The predictability of net cash inflows eliminates
  much of the projects business risk, allowing the
  capital structure to be heavily debt-financed and
  still safe from financial distress
• Projects with finite lives
• Because the project is a standalone investment
  whose cash flow go directly to service its
  capital structure, and not to reinvestment for
  growth or other investment, investors of debt and
  equity need assurances about the ending point at
  which all debt and equity has bee repaid