Part 2 International Corporate Finance - Lecture n° 8 Financing the Global firm

1. International Finance Part 2 International Corporate Finance - Lecture n° 8 Financing the Global firm

2. International Corporate Finance • Global cost and availability of capital • Purpose of firms having access to global capital markets: • Minimize their cost of capital • Maximize the availability of capital • This allows them to : • Accept more long-term projects • Invest more in capital improvements and expansion • If markets are segmented : • A national capital market is segmented if the required rate of return on securities differs across markets, for comparable securities. • Market segmentation : due to various market imperfections

3. Market Liquidity for Firm’s Securities Highly liquid domestic market and broad international participation Illiquid domestic securities market and limited international liquidity Effect of Market Segmentation on Firm’s Securities and Cost of Capital Access to global securities market that prices shares according to international standards Segmented domestic securities market that prices shares according to domestic standards International Corporate Finance Local Market Access Global Market Access Firm-Specific Characteristics Firm’s securities appeal only to domestic investors Firm’s securities appeal to international portfolio investors

4. Global cost of capital • Weighted Average Cost of Capital (WACC) 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)

5. Global cost of capital • Weighted Average Cost of Capital (WACC) • Cost of equity : CAPM (Capital Asset Pricing Model) Where ke = expected rate of return on equity krf = risk free rate on bonds km = expected rate of return on the market βj = coefficient of firm’s systematic risk = jmj/m

6. Global cost of capital • Weighted Average Cost of Capital (WACC) • Cost of Debt • Requires the forecast of : • the interest rates for the next few years, • the proportions of various classes of debt used by the firm in the years • the corporate income tax (t) • if kd is the cost of debt before tax, • then : kd(1-t) = weighted average after-tax cost of debt • WACC • Usually used as the risk-adjusted discount rate whenever a firm ’s new projects are in the same general risk class as its existing projects.

7. Availability of capital • Availability of Capital • Demand for foreign securities • Role of International Portfolio Investors : international investment to increase the risk/return ratio of a portfolio invested globally in different regions, countries, stage of development. • Link between cost and availability of capital • If capital in indefinitely available its cost does not rise as demand for funds increases. This requires a very liquid market, which is not the case of most domestic markets. • An access to multinational markets improves the liquidity available to the firm and allows the firm to preserve its optimal financial financial structure (constant D/E ratio).

8. Availability of capital • Availability of Capital • Link between cost and availability of capital • If market are fully integrated, securities of comparable expected return and risk should have the same required rate of return in each national market, after adjustment for foreign exchange risk and political risk. • Capital market segmentation is a financial market imperfection caused by government constraints, institutional practices, and investors perception. • Segmentation does not imply that market are inefficient, at least a domestic level. • Influence of illiquidity and segmentation on MNE’s • Higher cost of capital / Rising cost of capital / Shifts in the optimal financial structure / Rising cost of projects

9. NOVO Industri • Illustrative case : NOVO industri • Novo : Danish pharmaceuticals company • Had a lack of availability and higher cost of capital than its main competitors, due to market segmentation. • P/E ratio of Novo: around 5; main international competitors : around 10. • Causes linked to several characteristics of the Danish equity market : • Asymmetric information base of Danish and foreign investors • Taxation : capital gains on equity taxed at 50%; capital gains on bonds tax free • Very few alternative set of feasible portfolios due to prohibition of foreign security ownership. Stock prices were then closely correlated with a high systemic risk.

10. NOVO Industri • Financial risk : high leverage of Scandinavian firms compared to US / UK standards • Foreign exchange risk • Steps taken by Novo to overcome the market segmentation: • Closing the information gap : disclosure of information in English version; issuance of Eurobonds with a UK investment bank as underwriter. • The biotechnology boom : seminar organised by Novo in NYC made investors flooding, the stock price doubled, P/E up to 16, share ownership rise from 0 to 30%. • Direct share issues in the US : prospectus made for an eventual registration of NYSE.

11. NOVO Industri • Impacts on Novo’s cost of capital : • Stock market reaction : price drop in Copenhagen by 10% at announcement of a US share issue (1981), where the loss was immediately recovered. Typical reaction of an illiquid market to a threat of dilution effect of the new share issue. • Effect on WACC : reduction of WACC and reduction of marginal cost of capital. • Nowadays • Significant reduction of market segmentation, following globalisation. But reduced gains of international portfolio diversification.

12. Cost of Capital in MNE ’s • Cost of Capital of MNE’s compared to domestic firms • Availability of capital : better. Allows firms to maintain their desired D/E ratio • Financial structure and systematic risk for MNE’s • Theoretically, MNE’s should be able to afford higher D/E ratios since their cash-flow are internationally diversified and yet their variability is minimised. • However, empirical studies show an opposite conclusion: international diversification does not compensate for higher agency costs, political risk, and foreign exchange risks that MNE’s face. • These lead to lower D/E ratios and rather higher cost of capital.

13. Cost of Capital in MNE ’s • Cost of Capital of MNEs compared to domestic firms • Is the WACC really higher for MNEs? • The explanation of this apparent contradiction may lie in the opportunity set of projects of international companies. As it increases, the firms needs to increase its capital budget to the point where its marginal cost of capital increases. • In that case, at constant opportunity set, the WACC of a domestic firm is higher. See graph. • Empirically: firms seems to show some risk aversion and try to avoid the point where their marginal cost of capital increases. So the observed WACC of international companies is higher. See equation.

14. Marginal cost of capital and rate of return (percentage) MCCDC 20% MCCMNE 15% 10% MRRMNE 5% MRRDC Budget (millions of $) 100 140 300 350 400 Cost of Capital in MNE ’s

15. ] [ ] [ Debt Equity kWACC = ke + kd ( 1 – tx ) Is MNEwacc > or < Domesticwacc ? Value Value Cost of Capital in MNE ’s Empirical studies : MNEs have a lower debt/capital ratio, leading to a higher cost of capital than their domestic counterparts. Indications are that : MNEs have a lower average cost of debt, leading to a lower cost of capital than their domestic counterparts. • Cost of equity required : higher for MNE’s. • Possible explanations : higher levels of political risk, foreign exchange risk, and higher agency costs of doing business in a multinational managerial environment. • However, at relatively high levels of the optimal capital budget, the MNE would have a lower cost of capital.

16. Sourcing Equity Globally • In order to benefit from global financial markets, a firm may decide to cross-list its shares on foreign stock exchanges. • More specifically, it can be motivated by one or more of the following reasons : • Improving liquidity of its existing shares and support a liquid secondary market for new equity issues in foreign markets. • Increase its share price by overcoming mispricing by a segmented, illiquid home market. • Establish a secondary market for shares used to acquire others firms in the host market. • Increase the firm’s visibility & political acceptance to its customers, suppliers, creditors and host governments. • Create a secondary market for shares that will be used to compensate local management and employees in foreign subsidiaries.

17. Sourcing Equity Globally • According to the goal pursued, the type of listing will be different : • If it is to support a new equity issue or to establish a market for share swaps, the target market should also be the listing market. • If it is to increase the firm’s commercial and political visibility or to compensate local management and employees, it should be in markets in which the firm has significant operations. • If it is to improve liquidity of a firm’s shares, the major liquid stock markets are New York, London, Tokyo, Frankfurt and Paris. • By cross-listing and selling equity abroad, a firm faces two barriers • Increased commitment to full disclosure • A continuing investor relations program

18. Financial Structure & i debt • Financial structure and international debt • Optimal financial structure • A firm should optimally have the mix of debt and equity that minimises the firm’s cost of capital for a given level of business risk. • The WACC decreases when debt increases, due to the lower cost of debt and the tax deductibility of interests. • But, partly offsetting this, the cost of equity increases because equity investors perceive a higher risk in a higher leveraged firm. The optimal range of debt ratio is estimated between 30% and 60%. • Within that range, the optimal ratio is influenced by : the industry of the firm; the volatility of the sales and operating income; the collateral value of the assets.

19. Cost of Capital (%) ke = cost of equity 30 Minimum cost of capital range 28 26 24 kWACC = weighted average after-tax cost of capital 22 20 18 16 14 12 10 kd (1-tx)= after-tax cost of debt 8 6 4 2 0 20 40 60 80 100 Total Debt (D) Debt Ratio (%) = Total Assets (V) Financial Structure & i debt • Optimal financial structure

20. Financial Structure & i debt • Financial structure and international debt • Optimal financial structure : the case of the MNE • Compared to domestic companies, the theory of optimal structure of capital needs to be adapted to the international case in four ways : • (1) The availability of capital : that allows a MCC constant (see previous section) • (2) Diversification of cash-flows : that could allow for higher D/E acceptable ratios

21. Financial Structure & i debt • (3) Foreign exchange risk : foreign currency denominated debt should be adjusted for any foreign exchange gains or losses. • 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. • (4) Expectations of international portfolio investors : dominance of US - UK norms on global markets, for firms overcoming market segmentation. 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

22. Financial Structure & i debt • Financial structure of foreign subsidiaries • Since MNE are assessed on consolidated statements, financial structures of subsidiaries are relevant only if they affect this overall goal. • Subsidiaries do not have independent cost of capital. Therefore, their financial structure should not be based on minimising it. • Empirically, studies show that country-specific environment are key determinants of debt ratios : historical development, taxation, corporate governance, bank influence, bond market, attitude toward risk… • Debts considered here : only those borrowed from sources outside the MNE : local and foreign currency loans, and Eurocurrency loans.

23. Financial Structure & i debt • Financial structure of foreign subsidiaries • Main advantages of localization • Localized financial structure reduces criticism of foreign subsidiaries that have been operating with too high proportion of debt (by local standards). • It helps management evaluate return on equity investment relative to local competitors in the same industry. • 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, there is probably a misallocation of domestic real resources, such as land and labor.

24. Financial Structure & i debt • Financial structure of foreign subsidiaries • Main disadvantages of localization • An MNE 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. This makes the debt ratio more cosmetic for the foreign subsidiary.

25. Financial Structure & i debt • Financial structure of foreign subsidiaries • Compromise solution • Both domestic firms and MNE’s should try to minimize their cost of capital. But if debt is available in a foreign subsidiary at equal cost than elsewhere after correcting for risk, then localizing the financial structure could be an advantage. • 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. In particular, between internal and external sources of funds.

26. Financial Structure & i debt • Financing the Foreign Subsidiary • Internal sources of funds (see graph below) • In general, although the equity provided by the parent, internal sources of funds are kept to the minimum to reduce risk of invested capital. • Debt is the preferable form for subsidiary financing. Since debt from host country is generally limited at early stages of the development, the foreign subsidiary must acquire its debt from the parent company or sister subsidiaries. • Next, its ability to generate funds internally may become critical for the subsidiary’s future growth. The sources of internal funds include retained earnings, depreciation, and other non-cash expenses.

27. Funds From Within the Multinational Enterprise (MNE) Funds from parent company Equity Cash Real goods Debt -- cash loans Leads & lags on intra-firm payables Funds from sister subsidiaries Debt -- cash loans Leads & lags on intra-firm payables Subsidiary borrowing with parent guarantee Funds Generated Internally by the Foreign Subsidiary Depreciation & non-cash charges Retained earnings Internal sources of funds

28. Financial Structure & i debt • Financing the Foreign Subsidiary • External sources of funds (see graph below) • There are 3 categories of external sources : debt from the parent’s country, from outside the parent’s country, and local equity. • Local debt is valuable for the foreign subsidiary, since it provides a financial hedge against the fluctuations of the operating cash inflows, by matching.

29. Funds External to the Multinational Enterprise (MNE) Borrowing from sources in parent country Banks & other financial institutions Security or money markets Borrowing from sources outside of parent country Local currency debt Third-country currency debt Eurocurrency debt Local equity Individual local shareholders Joint venture partners External sources of funds

30. The Eurocurrency Markets • The Eurocurrency Markets • One of the important innovation in international finance over the past 50 years. Provide a basis for many corporate finance innovation for multinational companies. • Eurocurrencies • Definition : Domestic currencies of one country on deposit in a second country. Time deposit maturities from overnight funds to longer periods. Any convertible currency can exist in “Euro-” form. • Eurocurrency markets serve two purposes : • Eurocurrency deposits are an efficient and convenient money market device for holding excess corporate liquidity • Eurocurrency market is a major source of short-tem bank loans to finance corporate working capital needs.

31. International Debt Markets • International Debt Markets • Variety of different maturities, repayment structures and currencies of denomination • Three major sources of funding are: • (1) International bank loans and syndicated credits • (2) Euronote market • (3) International bond market • Bank loan and syndicated credits • Traditionally sourced in eurocurrency markets, extended by banks in countries other than in whose currency the loan is denominated

32. International Debt Markets • Syndicated credits • Enable 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, e.g. Euro-commercial paper (ECP), Euro medium-term notes (EMTNs). • International bond market • Fall within two broad categories • Eurobonds • Foreign bonds

33. International Debt Markets • International bond market • The distinction between categories is based on whether the borrower is a domestic or a foreign resident and whether the issue is denominated in a local or in a foreign currency. • Eurobonds : underwritten by an international syndicate of banks and other securities firms, and sold exclusively in other countries than the currency of denomination. Issued by MNEs, large domestic corporations, sovereign governments, governmental enterprises and international institutions. • Success factors : absence of regulatory interference - favorable tax status (bearer from) - less stringent disclosure. • Foreign bonds : underwritten by a syndicate of members from a single country, and sold principally in that country. But the issuers is from another country.

34. Bank Loans & Syndications (floating-rate, short-to-medium term) International Bank Loans Eurocredits Syndicated Credits Euronote Market (floating-rate, short-to-medium term) Euronotes & Euronote Facilities Eurocommercial Paper (ECP) Euro Medium Term Notes (EMTNs) International Bond Market (fixed & floating-rate, medium-to-long term) Eurobond * straight fixed-rate issue * floating-rate note (FRN) * equity-related issue Foreign Bond International Debt Markets

35. Project Financing • Project Finance • Is the arrangement of financing for long-term capital projects, large in scale and generally high in risk. • Widely used by MNEs in the development of infrastructure projects in emerging markets. • Most projects are highly leveraged for two reasons: • Scale of project often precludes a single equity investor or collection of private equity investors, • Many projects involve subjects funded by governments. • This high level of debt requires additional levels of risk reduction.

36. Project Financing • Four basic properties that are critical to the success of project financing : • (1) Separation of the project from its investors: • Project is established as an individual entity, separated legally and financially from the investors; • Allows project to achieve its own credit rating and cash flows. • (2) Long-lived and capital intensive singular projects. • (3) Cash flow predictability from third-party commitments • Third party commitments are usually suppliers or customers of the project. • (4) Finite projects with finite lives.