© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. International Financial Management Abridged 10 th Edition by Jeff Madura 1

© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 18 Long-Term Financing Chapter Objectives This chapter will: A.Explain how exchange rate movements affect the cost of long-term financing in foreign currencies B.Explain how to reduce the exchange rate risk associated with debt financing in foreign currencies C. Explain the exposure and hedging of interest rate risk due to debt financing 2

© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Long-Term Financing Decision 1.Sources of Equity a.Domestic equity offering b.Global equity offering c.Private placement of equity in home country d.Private placement of equity in foreign country 2.Sources of Debt a.Public placement of debt in own country b.Global debt offering c.Private placement of debt in home country d.Private placement of debt in foreign country 3.Stockholder versus Creditor Conflict 3

© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Cost of Debt Financing To make long-term financing decision, the MNC must: 1.Determine the amount of funds needed 2.Forecast the price at which it can issue the bond 3.Forecast periodic exchange rate values for the currency denominating the bond 4

© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Measuring the Cost of Financing 1.Impact of a strong currency on financing costs: if the currency that was borrowed appreciates over time, an MNC will need more funds to cover the coupon or principal payments. 2.Impact of a weak currency on financing costs: a depreciating currency will reduce the issuer’s outflow payments and reduce financing costs. 5

© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Uncertainty of Financing Costs 1.Accounting for Uncertainty of Financing Costs by: a.Sensitivity Analysis: develop alternative forecasts for exchange rates each period and reestimate cost of financing. b.Simulation: develop a probability distribution for the exchange rate in each period and use a computer simulation program to iterate possible future scenarios. 2.Actual Financing Costs a.Determine how exchange rate movements affected the costs of bonds denominated in a foreign currency. 6

© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Reducing Exchange Rate Risk 1.Offsetting cash inflows a.Offsetting cash flows with high-yield debt 2.Forward contracts 3.Currency swaps 4.Parallel loans a.Using parallel loans to hedge risk 5.Diversifying among currencies 7

© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 18.7 Illustration of a Currency Swap 10

© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Interest Rate Risk from Debt Financing 1.The debt maturity decision: interest rates and the vary across maturities and across countries. Yield curve can be upward sloping, flat, or inverted in different countries. 2.The fixed versus floating decision: floating rate coupons can be tied to the London Interbank Offer Rate (LIBOR) 11

© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Hedging with Interest Rate Swaps 1.The plain vanilla swap: contract to exchange floating rate payments for fixed rate payments. 2.Determining swap payments: based on a notional principal but the principal itself is not exchanged. 3.Limitations of interest rate swaps: a.Time and resources associated with searching for suitable swap candidate and negotiating terms b.Risk that the counterparty could default on payments. 12

© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit Illustration of an Interest Rate Swap 13

© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Other Types of Interest Rate Swaps 1.Accretion swap 2.Amortizing swap 3.Basis (floating-for-floating) swap 4.Callable swap 5.Forward swap 6.Putable swap 7.Zero-coupon swap 8.Swaption 14

© 2011, 2010 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Standardization of Swap Market 1.International Swaps and Derivatives Association (ISDA): a global trade association representing leading participants in the privately negotiated derivatives industry. 2.ISDA Master Agreement: provides a general legal document to standardize the derivatives market. 15