International Finance

International Finance
FIN456 ♦ Spring 2013 Michael Dimond

Financial Globalization and Strategy
Global integration of capital markets has given many firms access to new and cheaper sources of funds beyond those available in their home market A firm that must source its long-term debt and equity in a highly illiquid domestic securities market will probably have a relatively high cost of capital and will face limited availability of such capital This in turn will limit the firm’s ability to compete both internationally and vis-à-vis foreign firms entering its market

Firms resident in small capital markets often source their long-term debt and equity at home in these partially-liquid domestic markets The costs of funds is slightly better than that of illiquid markets, however, if these firms can tap the highly liquid international capital markets, their competitiveness can be strengthened Firms resident in segmented capital markets must devise a strategy to escape dependence on that market for their long-term debt and equity needs

A national capital market is segmented if the required rate of return on securities differs from the required rate of return on securities of comparable expected return and risk traded on other securities markets Capital markets become segmented because of such factors as excessive regulatory control, perceived political risk, anticipated FOREX risk, lack of transparency, asymmetric information, cronyism, insider trading and other market imperfections

Firms constrained by any of these above conditions must develop a strategy to escape their own limited capital markets and source some of their long-term capital needs abroad

Cost and Availability of Capital

Cost of Capital Where kWACC = weighted average cost of capital
ke = risk adjusted cost of equity kd = before tax cost of debt t = tax rate E = market value of equity D = market value of debt V = market value of firm (D+E)

Cost of Equity and Debt Cost of equity is calculated using the Capital Asset Pricing Model (CAPM) Where ke = expected rate of return on equity krf = risk free rate on bonds km = expected rate of return on the market β = coefficient of firm’s systematic risk The normal calculation for cost of debt is analyzing the various proportions of debt and their associated interest rates for the firm and calculating a before and after tax weighted average cost of debt

The Cost of Capital The key component of CAPM is beta, the measure of systematic risk. Systematic risk is a measure of how the firm’s returns vary with those of the market in which it trades Beta will have a value of less than 1.0 if the firm’s returns are less volatile than the market, 1.0 if the same as the market, or greater than 1.0 if more volatile—or risky—than the market CAPM’s biggest challenge is that the beta used needs to be for the future and not the past International CAPM (ICAPM) assumes that there is a global market in which the firm’s equity trades, and estimates of the firm’s beta ke global = krfg + βjg (kmg – krfg)

Nestlé: An Application of the International CAPM
The process of calculating an international WACC differs from a domestic WACC in the selection of the appropriate market portfolio and beta Stulz (1995) suggests using a global portfolio of securities available to investors rather than the world portfolio of all securities (some of which may not be available to investors) when calculating a firm’s international cost of equity The next slide shows the domestic and international risk-free rates, market portfolios, and betas for Nestlé used to calculate required rates of return for equity In this example the domestic required return for Nestlé of % differs slightly from Nestlé’s global required return of %

The Cost of Equity for Nestlé of Switzerland

Calculating Equity Risk Premia in Practice
Using CAPM, there is rising debate over what numerical values should be used in its application, especially the equity risk premium The equity risk premium is the expected average annual return on the market above riskless debt Typically, the market’s return is calculated on a historical basis yet others feel that the number should be forward looking since it is being used to calculate expected returns

Calculating Equity Risk Premia in Practice
The field of finance does agree that a cost of equity calculation should be forward-looking, meaning that the inputs to the equation should represent what is expected to happen over the relevant future time horizon As is typically the case, however, practitioners use historical evidence as the basis for their forward-looking projections

Geometric Average vs Arithmetic Average
Arithmetic Average only shows the “typical” result Geo Avg = [(1+20%)*( %)* (1+20%)*( %)]^(1/4) -1 = 8.78% CAGR also shows the result of compounding (14/10)^(1/4) – 1 = = 8.78% The price didn’t increase 8.78% each year, but we end up with the same final value if we compound it by 8.78% every year. 5 years means 4 periods of compounding, so we find the 4th root ( ^1/4 power)

Alternative Ke Estimates for Hypothetical U.S Firm
Assuming β = 1 and krf = 4%

The Demand for Foreign Securities
International portfolio investment and cross-listing of equity shares on foreign markets have become commonplace As both domestic and international portfolio managers are asset allocators, their objective is to maximize a portfolio’s rate of return for a given level of risk, or to minimize risk for a given rate of return International portfolio managers can choose from a larger bundle of assets than portfolio managers limited to domestic-only asset allocations Some important diversification dimensions include diversification by country, geographic region and/or stage of development

Link between Cost & Availability of Capital
Although no consensus exists on the definition of market liquidity, market liquidity can be observed by noting the degree to which a firm can issue new securities without depressing existing market prices In a domestic case, the underlying assumption is that total availability of capital at anytime for a firm is determined by supply and demand within its domestic the market In the multinational case, a firm is able to improve market liquidity by raising funds in the Euromarkets, by selling securities abroad, and by tapping local capital markets

Market Segmentation Capital market segmentation is a financial market imperfection caused mainly by government constraints, institutional practices, and investor perceptions Other imperfections are Asymmetric information Lack of transparency High securities transaction costs Foreign exchange risks Political risks Corporate governance differences Regulatory barriers

Effects of Market Liquidity & Segmentation
The degree to which capital markets are illiquid or segmented has an important influence on a firm’s marginal cost of capital A MNC has a given marginal return on capital at differing budget levels determined by which capital projects it can and chooses to take on If the firm is limited to raising funds in its domestic market, it has domestic marginal cost of capital at various budget levels

Effects of Market Liquidity & Segmentation
If an MNC has access to additional sources of capital outside its domestic market, its marginal cost of capital can decrease If the MNC has unlimited access to capital both domestic and abroad, then its marginal cost of capital decreases even further

Liquidity, Segmentation, and Marginal Cost of Capital

Globalization of Securities Markets
During the 1990s, national restrictions on cross-border portfolio investment were gradually eased under pressure from the Organization for Economic Cooperation and Development (OECD) Presently, market segmentation has been significantly reduced, although the liquidity of individual national markets remains limited Significantly higher value accrues to firms that have “imported” an Anglo-American corporate governance system

Cost of Capital for MNCs versus Domestic Firms
Is the WACC or an MNC higher or lower than for its domestic counterpart? The answer is a function of The marginal cost of capital The after-tax cost of debt The optimal debt ratio The relative cost of equity A MNC should have a lower cost of capital because it has access to a global cost and availability of capital This availability and cost allows the MNC more optimality in capital projects and budgets compared to its domestic counterpart

Cost of Capital for MNC and Domestic Compared

Do MNCs Have a Higher or Lower Cost of Capital?

Designing a Strategy to Source Equity Globally
This requires management to agree upon a long-run financial objective and then choose among various alternative paths to get there Normally the choice of paths and implementation is aided by an early appointment of an investment bank as official advisor to the firm Investment bankers are in touch with the potential foreign investors and what they require in terms of risk/reward Investment bankers can also help navigate the various institutional requirements and barriers that must be satisfies to source equity globally

Designing a Strategy to Source Equity Globally
Most firms raise their initial capital in their own domestic market While many can be tempted to skip the intermediate steps to complete an Euroequity issue in global markets, good financial advisors will offer a ‘reality check’ on this strategy Most firms that have only raised capital in their domestic market are not well enough known to attract foreign investors The following exhibit walks through a more probable chain of events in accessing global capital markets with the end goal being equity capital

Globalizing the Cost & Availability of Capital

Optimal Financial Structure
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 If 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

The Cost of Capital and Financial Structure

Optimal Financial Structure & The MNC
The domestic theory of optimal capital structure is modified by four additional variables in order to accommodate the MNC Availability of capital International diversification of cash flows Foreign exchange risk Expectation of international portfolio investors

Availability of capital Allows MNCs to lower cost of capital Permits MNCs to maintain a desired debt ratio even when new funds are raised Allows MNCs to operate competitively even if their domestic market is illiquid and segmented International diversification of cash flows Reduces risk similar to portfolio theory of diversification Lowers volatility of cash flows among differing subsidiaries and foreign exchange rates

Foreign exchange risk & cost of debt When a firm issues foreign currency denominated debt, its effective cost equals the after-tax cost of repayment in terms of the firm’s own currency Example: US firm borrows Sfr1,500,000 for one year at 5.00% p.a.; the franc appreciates from Sfr1.500/$ to Sfr1.440/$ Initial dollar amount borrowed

At the end of the year, the US firm repays the interest plus principal The actual dollar cost of the loan is not the nominal 5.00% paid in Swiss francs, but 9.375%

This total home currency cost is higher than expected because of the appreciation of the Swiss franc This cost is the result of the combined cost of debt and the percentage change in the foreign currency’s value Where kd$ = Cost of borrowing for US firm in home country kdSfr = Cost of borrowing for US firm in Swiss francs s = Percentage change in spot rate

The total cost of debt must include the change in the exchange rate The percentage change in the value of the Swiss franc is calculated as The total cost is then = 9.375%

Expectations of International Portfolio Investors If firms want to attract and maintain international portfolio investors, they must follow the norms of financial structures Most international investors for US and the UK follow the norms of up to a 60% debt ratio

Financial Structure of Foreign Subsidiaries
Debt borrowed is from sources outside of the MNC (i.e. subsidiary borrows directly from markets) Advantages of localization Localized financial structure reduces criticism of foreign subsidiaries that have been operating with too high (by local standards) proportion of debt Localized financial structure helps management evaluate return on equity investment relative to local competitors In economies where interest rates are high because of scarcity of capital and real resources are fully utilized, the penalty paid for borrowing local funds reminds management that unless ROA is greater than local price of capital, misallocation of real resources may occur

Disadvantages of localization A MNC is expected to have comparative advantage over local firms through better availability of capital and ability to diversify risk If each subsidiary localizes its financial structure, the resulting consolidated balance sheet might show a structure that doesn’t conform with any one country’s norm; the debt ratio would simply be a weighted average of all outstanding debt Typically, any subsidiary’s debt is guaranteed by the parent, and the parent won’t allow a default on the part of the subsidiary thus making the debt ratio more cosmetic for the foreign subsidiary

Financing the Foreign Subsidiary In addition to choosing an appropriate financial structure, financial managers need to choose among the alternative sources of funds for financing Sources of funds can be classified as internal and external to the MNC Ideally the choice among the sources of funds should minimize the cost of external funds after adjusting for foreign exchange risk The firm should choose internal sources in order to minimize worldwide taxes and political risk

External Financing of the Foreign Subsidiary

The Sony Keiretsu: Interlocking Directorships
TRANSPORT CO SUPPLIER NO.1 SUPPLIER NO.2 SONY BANK NO. 2 BANK NO. 1

Sourcing Equity Globally
Depositary Receipts Depositary receipts are negotiable certificates issued by a bank to represent the underlying shares of stock, which are held in trust at a foreign custodian bank Global Depositary Receipts (GDRs) – refers to certificates traded outside the US American Depositary Receipts (ADRs) – are certificates traded in the US and denominated in US dollars ADRs are sold, registered, and transferred in the US in the same manner as any share of stock with each ADR representing some multiple of the underlying foreign share

Sourcing Equity Globally
Depositary Receipts This multiple allows the ADRs to possess a price per share conventional for the US market ADRs are either sponsored or unsponsored Sponsored ADRs are created at the request of a foreign firm wanting its shares traded in the US; the firm applies to the SEC and a US bank for registration and issuance

American Depositary Receipts (ADRs)

Characteristics of Depositary Receipt Programs

Foreign Equity Listing & Issuance
By cross-listing and selling its shares on a foreign stock exchange a firm typically tries to accomplish one or more of the following objectives: Improve the liquidity of its existing shares and support a liquid secondary market Increase its share price by overcoming mispricing in a segmented and illiquid home market Increase the firm’s visibility and political acceptance to its customers, suppliers, creditors & host governments Establish a secondary market for shares used for acquisitions Create a secondary market for shares that can be used to compensate local management and employees in foreign subsidiaries

Size and Liquidity of Markets
Three key trends in the evolution of modern exchanges: Demutualization or the end of market ownership by a small, privileged group of “seat owners” Diversification by exchanges to trade a broader range of products Globalization or effectively another form of diversification through several techniques

Foreign Equity Listing & Issuance
Cross-listing is a way to encourage investors to continue to hold and trade shares that may or may not be listed on an investors home market or in a preferred currency Cross-listing is usually done through ADRs (in the United States, where they are traded and quoted in U.S. dollars) Global Registered Shares (GRSs), on the other hand, are able to be traded on equity exchanges around the globe in a variety of currencies and are traded electronically

Effect of Cross-Listing & Equity Issuance on Share Price
The impact on price of cross-listing on a foreign stock market depends on the degree to which the markets are segmented As was the situation experienced by Novo, a firm can benefit if a foreign market values a company more highly than a home market (in a highly-segmented situation)

Other Motives for Cross-Listing
Increasing visibility and political acceptance MNCs list in markets where they have substantial physical operations Political objectives might include the need to meet local ownership requirements for an MNC’s foreign joint venture Increasing potential for share swaps with acquisitions Compensating management and employees

Barriers to Cross-Listing and Selling Equity Abroad
Commitment to disclosure and investor relations A decision to cross-list must be balanced against the implied increased commitment to full disclosure and a continuing investor relations program Disclosure is a double-edged sword Increased firm disclosure should have the effect of lowering the cost of equity capital On the other hand, this increased disclosure is a costly burden to corporations

Alternative Instruments to Source Equity
Alternative instruments to source equity in global markets include the following: Sale of a directed public share issue to investors in a target market Sale of a Euro equity public issue to investors in more than one market, including both foreign and domestic markets Private placements under SEC Rule 144A Sale of shares to private equity funds Sale of shares to a foreign firm as a part of a strategic alliance

Directed Public Share Issues Defined as one which is targeted at investors in a single country and underwritten in whole or in part by investment institutions from that country Issue may or may not be denominated in the currency of the target market The shares might or might not be cross-listed on a stock exchange in the target market A foreign share issues, plus cross-listing can provide it with improved liquidity

Euroequity Public Issue Gradual integration of worlds’ capital markets has spawned the emergence of a Euroequity market A firm can now issue equity underwirtten and distributed in multiple foreign equity markets; sometimes simultaneously with distribution in the domestic market As we have reviewed, the term “Euro” does not imply that the issuers or investors are located in Europe, nor does it mean the shares are sold in the currency “euro”

Private Placement Under SEC Rule 144A A private placement is the sale of a security to a small set of qualified institutional buyers Investors are traditionally insurance companies and investment companies Because shares are not registered for sale, investors typically follow “buy and hold” strategy Rule 144A allows qualified institutional buyers (QIB) to trade privately placed securities without previous holding period restrictions and without requiring SEC registration

Private Equity Funds Limited partnerships of institutional and wealthy individual investors that raise their capital in the most liquid capital markets Then invest these funds in mature, family-owned firms located in emerging markets Strategic Alliances Normally followed by firms that expect to gain synergies from one or more joint efforts

International Debt Markets
These markets offer a variety of different maturities, repayment structures and currencies of denomination They also vary by source of funding, pricing structure, maturity and subordination Three major sources of funding are International bank loans and syndicated credits Euronote market International bond market

International Debt Markets & Instruments

Bank loan and syndicated credits Traditionally sourced in eurocurrency markets Also called eurodollar credits or eurocredits Eurocredits are bank loans denominated in eurocurrencies and extended by banks in countries other than in whose currency the loan is denominated Syndicated credits Enables banks to risk lending large amounts Arranged by a lead bank with participation of other bank Narrow spread, usually less than 100 basis points

Euronote market Collective term for medium and short term debt instruments sourced in the Eurocurrency market Two major groups Underwritten facilities and non-underwritten facilities Non-underwritten facilities are used for the sale and distribution of Euro-commercial paper (ECP) and Euro Medium-term notes (EMTNs)

Euronote facilities Established market for sale of short-term, negotiable promissory notes in eurocurrency market These include Revolving Underwriting Facilities, Note Issuance Facilities, and Standby Note Issuance Facilities Euro-commercial paper (ECP) Similar to commercial paper issued in domestic markets with maturities of 1,3, and 6 months Euro Medium-term notes (EMTNs) Similar to domestic MTNs with maturities of 9 months to 10 years Bridged the gap between short-term and long-term euro debt instruments

International bond market Fall within two broad categories Eurobonds Foreign bonds The distinction between categories is based on whether the borrower is a domestic or foreign resident and whether the issue is denominated in a local or foreign currency

Eurobonds A Eurobond is underwritten by an international syndicate of banks and sold exclusively in countries other than the country in whose currency the bond is denominated Issued by MNCs, large domestic corporations, governments, government enterprises and international institutions Offered simultaneously in a number of different capital markets

Eurobonds Several different types of issues Straight Fixed-rate issue Floating rate note (FRN) Equity related issue – convertible bond Foreign bonds Underwritten by a syndicate and sold principally within the country of the denominated currency, however the issuer is from another country These include Yankee bonds Samurai bonds Bulldogs

Unique characteristics of Eurobond markets Absence of regulatory interference National governments often impose controls on foreign issuers of securities, however the euromarkets fall outside of governments’ control Less stringent disclosure Favorable tax status Eurobonds offer tax anonymity and flexibility Rating of Eurobonds & other international issues Moody’s, Fitch and Standard & Poor’s rate bonds just as in US market

International Finance

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