Financial structure and international debt

• 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 capit

Chapter 13

Financial Structure and International Debt

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.

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

of the heavier weight of low-cost (due to tax-deductability) debt ([kd(1-t)]

Exhibit 13.1 The Cost of Capital

and Financial Structure

30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0

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

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)

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)

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

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

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.

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)

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

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

Exhibit 13.3 Internal Financing of the Foreign Subsidiary

Funds Generated Internally by the

Subsidiary borrowing with parent guarantee

Funds from sister subsidiaries

Funds from parent company

Depreciation & non-cash charges

Equity

Cash Real goods Debt cash loans

Leads & lags on intra-firm payables

Debt cash loans

Leads & lags on intra-firm payables

Exhibit 13.4 External Financing of the Foreign Subsidiary

Funds

External

to the

The Eurocurrency Markets

• The Eurocurrency markets are one of the truly significant innovations in

international finance of the past 50 years.

• These markets have provided a foundation for a series of innovations in both the structure of and choices in financing the MNE.

• Eurocurrencies are domestic currencies of one country on deposit in a second

country.

• Any convertible currency can exist in “Euro” form (not to be confused with the European currency called the euro).

• These markets serve two valuable purposes:

– Eurocurrency deposits are an efficient and convenient money market

device for holding excess corporate liquidity – The Eurocurrency market is a major source of short-term bank loans to finance corporate working capital needs (including imports and exports)

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.

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

(floating-rate, short-to-medium term)

International Bond Market

(fixed & floating-rate,

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).

Exhibit 13.7 Comparative Spreads Between Lending

and Deposit Rates in the Eurodollar Market

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

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

Project Financing

• Project finance is the arrangement of financing for long-term

capital projects, large in scale, long in life, and generally high in risk.

• Project finance is used widely today by MNEs in the development

of large-scale infrastructure projects in China, India, and many other emerging markets.

• Most of these transactions are highly leveraged, with debt making

up 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 an

investor or group of investors to fund and second, many projects involve subjects traditionally funded by governments

Project Financing

• Since project financing usually utilizes a

substantial amount of debt financing, additional levels of risk reduction are needed in order to create an environment whereby lenders feel comfortable lending:

– Separability of the project from its investors– Long-lived and capital-intensive singular projects– Cash flow predictability from third-party

commitments– Finite projects with finite lives