1. 18
Chapter
Long-Term Financing
South-Western/Thomson Learning © 2003

2. Chapter Objectives
To explain why MNCs consider long-term financing in foreign currencies;
To explain how the feasibility of long-term financing in foreign currencies can be assessed; and
To explain how the assessment of long-term financing in foreign currencies can be adjusted for bonds with floating interest rates.

3. The Long-Term Financing Decision
Because bonds denominated in foreign currencies sometimes require lower yields, MNCs often consider long-term financing in foreign currencies.
The actual cost of such financing depends on the quoted interest rate, as well as the changes in the value of the borrowed currency over the life of the loan.

4. Annualized Bond Yields Across Countries
Ten-year maturity, as of June 1998
Annualized Bond Yield
US$
Swiss
franc
Thai
baht
Canadian dollar
Australian
dollar
Malaysian
ringgit
Indonesian
rupiah

5. Online Application
Long-term interest rates for major currencies for various maturities can be found at while currency forecasts are available at

6. The Long-Term Financing Decision
To make the long-term financing decision, the MNC must
determine the amount of funds needed,
forecast the price (interest rate) at which the bond may be issued, and
forecast the exchange rates of the borrowed currency for the times when it has to make payments (coupons and principal) to the bondholders.

7. The Long-Term Financing Decision
Then the probability distribution of the bond’s financing costs may be determined.
An MNC that denominates bonds in a foreign currency may achieve major cost reductions, but is subject to the possibility of incurring high costs if the borrowed currency appreciates over time.

8. Actual Costs of Financing
With Pound-Denominated Bonds from a U.S. Perspective
Exchange
Rate of £
US$ Needed to Cover Annual Coupon Payment of £1 million

9. Managing Exchange Rate Risk
Point-estimate exchange rate forecasts cannot adequately account for the potential impact of exchange rate fluctuations.
Instead, the probability distribution of the exchange rate should be developed, so as to determine the expected financing cost and its probability distribution.
Computer simulation may aid the process.

10. Managing Exchange Rate Risk
The exchange rate risk from financing with bonds in foreign currencies can be reduced by using:
offsetting cash inflows in the borrowed currency
forward contracts
currency swaps

11. Illustration of A Currency Swap
Euros Received From
Ongoing Operations
Miller Company
[known within the dollar-
denominated market]
Euro
Payments
Beck Company
[known within the euro-
Dollars Received From
Dollar
Euro
Payments
Dollar
Payments
Investors in Dollar-
denominated Bonds
Issued by Miller
Dollar
Payments
Investors in Euro-
denominated Bonds
Issued by Beck
Euro
Payments

12. Managing Exchange Rate Risk
The exchange rate risk from financing with bonds in foreign currencies can be reduced by using:
parallel (or back-to-back) loans

13. Illustration of A Parallel Loan
Subsidiary of
U.K.- based MNC
that is located
in the U.S.
Provision
of loans
U.S.- based MNC
in the U.K.
British Parent
U.S. Parent 
Repayment
of loans in
the currency
that was
borrowed 

14. Managing Exchange Rate Risk
The exchange rate risk from financing with bonds in foreign currencies can be reduced by using:
parallel (or back-to-back) loans
diversified portfolios of bonds that are denominated in several foreign currencies or currency cocktail bonds (which are bonds denominated in a multicurrency unit e.g. SDR)

15. Floating-Rate Bonds
Eurobonds are often issued with a floating coupon rate. For example, the rate may be tied to the London Interbank Offer Rate (LIBOR).
If the coupon rate is floating, forecasts are required for both exchange rates and interest rates.

16. Floating-Rate Bonds
When MNCs issue floating-rate bonds that expose them to interest rate risk, they may use interest rate swaps to hedge the risk.
Interest rate swaps enable a firm to exchange fixed rate payments for variable rate payments, and vice versa. They are used by bond issuers to reconfigure future bond payments to a more preferable structure.

17. Illustration of An Interest Rate Swap
Variable Rate
Payments at
LIBOR+.5%
Quality Company
Choice of 9% fixed
or LIBOR + .5%
Prefers variable
Risky Company
Choice of 10.5% fixed
or LIBOR + 1%
Prefers fixed
Fixed Rate
Payments at
9.5%
Investors in
Fixed Rate Bonds Issued by
Quality Company
Fixed Rate
Payments
at 9%
Investors in Variable Rate Bonds Issued by Risky Company
Variable Rate
Payments at
LIBOR+1%
Gains ½ %
Saves ½ %

18. Floating-Rate Bonds
Note that financial intermediaries are usually involved in swap agreements. They match up participants and also assume the default risk involved for a fee.

19. Use of Yield Curves to Make Debt Maturity Decisions
An MNC must decide on the maturity for any potential debt. To do this, the MNC may want to assess the yield curve in the country of the currency to be borrowed.
Since the slopes of the yield curves may vary across countries, the choice of short-term, medium-term, or long-term debt financing may vary across countries too.

20. Yield Curves Across Countries
As of February 2001
Canada
Japan
Italy
Germany
U.S.
U.K.
Years to Maturity
Annualized Yield (except Japan)
Annualized Yield (Japan only)

21. Impact of Long-Term Financing Decisions on an MNC’s Value
E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t
k = weighted average cost of capital of the parent
Parent’s Long-Term Financing Decisions

22. Chapter Review The Long-Term Financing Decision
Measuring the Cost of Financing
Actual Effects of Exchange Rate Movements on Financing Costs
Managing Exchange Rate Risk
Accounting for Exchange Rate Risk
Reducing Exchange Rate Risk

23. Chapter Review Floating-Rate Bonds Hedging Interest Rate Risk
Use of Yield Curves to Make Debt Maturity Decisions
Impact of Long-Term Financing Decisions on an MNC’s Value