Copyright © 2010 Pearson Prentice Hall. All rights reserved. Chapter 16 Sourcing Debt Globally

Copyright © 2010 Pearson Prentice Hall. All rights reserved Optimal Financial Structure The domestic theory of optimal financial structure must be modified 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 can be determined. When taxes and bankruptcy costs are considered, a firm has an optimal financial structure determined by that particular mix of debt and equity that minimizes the firm’s 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.

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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 (k WACC ) decreases because of the heavier weight of low-cost (due to tax- deductibility) debt ([k d (1-t)] compared to high cost equity (k e ).

Copyright © 2010 Pearson Prentice Hall. All rights reserved Exhibit 16.1 The Cost of Capital and Financial Structure

Copyright © 2010 Pearson Prentice Hall. All rights reserved Optimal Financial Structure and 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

Copyright © 2010 Pearson Prentice Hall. All rights reserved Optimal Financial Structure and the MNE Availability of capital: –A multinational firm’s 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 have gained a global cost and availability of capital)

Copyright © 2010 Pearson Prentice Hall. All rights reserved Optimal Financial Structure and 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 flows are 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 same way as portfolio investors who diversify their security holdings globally)

Copyright © 2010 Pearson Prentice Hall. All rights reserved Optimal Financial 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 firm’s own currency –This amount includes the nominal cost of principal and interest in foreign currency terms, adjusted for any foreign exchange gains or losses

Copyright © 2010 Pearson Prentice Hall. All rights reserved Optimal Financial 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 US and UK norms as these markets represent the most liquid and unsegmented markets

Copyright © 2010 Pearson Prentice Hall. All rights reserved Financial Structure of Foreign Subsidiaries If the theory that minimizing the cost of capital for a given level of business risk and capital budget is an objective that should be implemented from the perspective of the consolidated MNE, then the financial 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 financial structure should not be based on an objective of minimizing it.

Copyright © 2010 Pearson Prentice Hall. All rights reserved Financial Structure of Foreign Subsidiaries Advantages to implementing a financing structure that conforms to local norms: –Reduction in criticisms –Improvement in the ability of management to evaluate ROE relative to local competitors –Determination as to whether or not resources are being misallocated (cost of local debt financing versus returns generated by the assets financed)

Copyright © 2010 Pearson Prentice Hall. All rights reserved Financial Structure of 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 dispose of this competitive advantage and conform –Consolidated balance sheet structure may not conform t any country’s 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

Copyright © 2010 Pearson Prentice Hall. All rights reserved Financial Structure of Foreign Subsidiaries In addition to choosing an appropriate financial 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 to the MNE 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 firm’s worldwide cost of capital

Copyright © 2010 Pearson Prentice Hall. All rights reserved Exhibit 16.2 Internal Financing of the Foreign Subsidiary

Copyright © 2010 Pearson Prentice Hall. All rights reserved Exhibit 16.3 External Financing of the Foreign Subsidiary

Copyright © 2010 Pearson Prentice Hall. All rights reserved 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. The three major sources of debt funding on the international markets are depicted in the following exhibit.

Copyright © 2010 Pearson Prentice Hall. All rights reserved Exhibit 16.4 International Debt Markets and Instruments

Copyright © 2010 Pearson Prentice Hall. All rights reserved International Debt Markets Bank loans and syndications: –International bank loans have traditionally been sourced in the Eurocurrency markets, there is a narrow interest rate spread between deposit and loan rates of less than 1%. –Eurocredits are bank loans to MNEs, sovereign governments, international institutions, and banks denominated in Eurocurrencies and extended by banks in countries other than the country in whose currency the loan is denominated. –The syndication of loans has enabled banks to spread the risk of very large loans among a number of banks (this is significant for MNEs as they usually need credit in an amount larger than a single bank’s loan limit).

Copyright © 2010 Pearson Prentice Hall. All rights reserved International Debt Markets The Euronote market: –Euronotes and Euronote facilities are short to medium in term and are either underwritten and non-underwritten –Euro-commercial paper is a short-term debt obligation of a corporation or bank (usually denominated in US dollars) –Euro medium-term notes is a new entrant to the world’s debt markets, which bridges the gap between Euro-commercial paper and a longer- term and less flexible international bond

Copyright © 2010 Pearson Prentice Hall. All rights reserved International Debt Markets The International Bond Market: –A Eurobond is underwritten by an international syndicate of banks and other securities firms and is sold exclusively in countries other than the country in whose currency the issue is denominated –A foreign bond is underwritten by a syndicate composed of members from a single country, sold principally within that country, and denominated in the currency of that country –The Eurobond markets differ from the Eurodollar markets in that there is an absence of regulatory interference, less stringent disclosure rules and favorable tax treatments for these bonds

Copyright © 2010 Pearson Prentice Hall. All rights reserved International Debt Markets Unique Characteristics of Eurobond Markets: –Absence of regulatory interference National governments often impose tight controls on foreign issuers of securities denominated in local currencies. However, governments in general have less stringent limitations for securities denominated in foreign currencies and sold within their markets –Less stringent disclosure Disclosure requirements less stringent than those of the SEC –Favorable tax status Eurobonds offer tax anonymity and flexibility. Interest paid on Eurobonds is generally not subject to an income withholding tax

Copyright © 2010 Pearson Prentice Hall. All rights reserved Mini-Case Questions: Tirstrup Biomechanics (Denmark) Which of the many debt characteristics – currency, maturity, cost, fixed versus floating rate – do you believe are of the highest priority for Julie and Tirstrup? Does the currency of denomination depend on the currency of the parent or the currency of the business unit that will be responsible for servicing the debt? Exhibit 1 is Julie’s spreadsheet analysis of what she considers relevant choices. Using these, what would you recommend as a financing package?

Copyright © 2010 Pearson Prentice Hall. All rights reserved. Additional Chapter Exhibits Chapter 16

Copyright © 2010 Pearson Prentice Hall. All rights reserved Exhibit 1