Financial Structure and International Debt

8/3/2019 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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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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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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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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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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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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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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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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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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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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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

Financial Structure and International Debt

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