Chapter 16

1. Chapter 16 Sourcing Debt Globally

2. The Goals of Chapter 16 0 • This chapter discusses the optimal capital structures for MNEs • In addition to the traditional capital structure theory, the effects of the availability of capital, the diversification of cash flows, the foreign exchange risk, and the expectations of international investors should also be taken into account for MNEs • Discuss how to determine the capital structure of foreign subsidiaries • Introduce the international debt markets and some debt instruments

3. Optimal capital structure • The classic theory of optimal capital structure must be modified considerably to encompass the multinational firm • In the classic theory, when taxes and bankruptcy costs are considered, a firm has an optimal capital 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

4. Optimal capital structure • Exhibit 16.1 illustrates how the cost of equity, cost of debt, and cost of capital vary with the debt ratio • The cost of equity (ke) increases with the debt ratio, because equity investors perceive greater financial risk when the firm employs more debt • As the debt ratio increases, the overall cost of capital (kWACC) decreases initially because of the heavier weight of lower-cost (partially due to tax-deductibility) debt (kd(1-t)) compared to the cost of equity (ke) • The cost of capital (kWACC) declines until financial risk becomes so serious and dominates the benefit from employing lower-cost debt

5. Exhibit 16.1 The Cost of Capital and capital structure 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-t) = after-tax cost of debt 8 6 4 2 Debt Ratio (%) 0 20 40 60 80 100 ※ Most theorists believe that the minimum cost of capital is a broad flat area, and the location of this minimum cost of capital range is determined by (1) the industry in which it competes, (2) volatility of its sales and operating income, and (3) collateral value of its assets

6. Optimal capital structure and the MNE • The classic theory of optimal capital structures focuses only on the tradeoff between the financial risk and the benefit of employing lower-cost debt • This classic theory needs to be modified by considering four more factors in order to accommodate the case of the MNE, including • Availability of capital • Diversification of cash flows • Foreign exchange risk • Expectations of international portfolio investors

7. Optimal capital structure and the MNE • Availability of capital: • Chapter 11 has shown that the availability of capital can permit MNEs to maintain their optimal debt ratios (through the viewpoint of minimizing the cost of capital) with a constant marginal cost of capital, even when significant amounts of new funds must be raised • This statement is not true for most small domestic firms (as they do not have access to international capital markets), nor for MNEs located in countries that have illiquid capital markets (unless they have gained a global availability of capital) • They must either rely on internally generated funds or borrow for the short and medium term from commercial banks

8. Optimal capital structure and the MNE • If they need to raise significant amounts of new funds to finance growth opportunities, they may need to borrow more than would be optimal from the viewpoint of minimizing their cost of capital • This is equivalent to the results in Ch11 that their marginal cost of capital is increasing at higher budget levels

9. Optimal capital structure and the MNE • Diversification of cash flows: • As returns are not perfectly correlated among countries, an MNE might be able to achieve a reduction in cash flow variability • Because of the lower cash flow variability, the theoretical possibility exists that multinational firms are in a better position than domestic firms to support higher debt ratios • It has be mentioned in Ch11 that some empirical researches find that MNEs in the U.S. actually have lower debt ratios than their domestic counterparts due to higher agency cost of debt, political risks, foreign exchange risks, and asymmetric information

10. Optimal capital 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 • In other words, this amount includes the nominal cost of principal and interest in foreign currency terms, adjusted for any foreign exchange gains or losses • Consider a U.S.-based firm borrow SF at the interest rate , the effective cost of debt for this firm can be calculated by the following equation where s is the percentage change in the SF/$ exchange rate

11. Optimal capital 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 U.S. and U.K. norms as these markets represent the most liquid and unsegmented markets • Debt ratios up to 60% appear to be acceptable, but any higher debt ratio is more difficult to sell to international portfolio investors

12. Capital structure of Foreign Subsidiaries • If the theory that minimizes the cost of capital for a given level of business risk and capital budget is an objective for MNE, then the capital 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 capital structure should NOT be based on an objective of minimizing its cost of capital • So, should an MNE take differing country debt ratio norms into consideration when determining its desired debt ratio for foreign subsidiaries?

13. Capital structure of Foreign Subsidiaries • Advantages of localization (conforming local debt norms): • Reduction in criticisms from local countries • Debt ratio is too high: the foreign subsidiary does not have enough economic capital to avoid default • Debt ratio is too low: the foreign subsidiary tries to escape the effect of the local monetary policy • Improvement in the ability of management to evaluate ROE relative to local competitors • Maintaining similar debt ratio levels with local competitors provides a fair condition for comparison • Reminding management not to misallocate resources • The high cost of local capital could make the management to be more cautious about the efficiency of allocating resources

14. Capital structure of Foreign Subsidiaries • Disadvantages of localization: • MNEs are expected to have a competitive advantage over local firms in overcoming imperfections in national capital markets; it is unreasonable to conform local norms to adopt a suboptimal capital structure • If each foreign subsidiary localizes its capital structure, the MNE’s financial risk and the cost of capital may increase provided two additional conditions are present: • The consolidated debt ratio is pushed out of the minimum cost of capital range for the MNE • The international Fisher effect does not hold, so the high cost of debt in the foreign country cannot be offset by the depreciation of the foreign currency • Local debt ratios are meaningless as lenders will ultimately look to the parent firm and its consolidated worldwide cash flow as the source of debt repayment

15. Capital structure of Foreign Subsidiaries • Compromise solution: • If the international Fisher effect holds, a MNE can replace the debt of a foreign subsidiary with the debt raised elsewhere at a equal cost after adjusting for foreign exchange risk • Therefore, a compromise solution exists, i.e. the foreign subsidiaries minimize their WACC for a given level of business risk and capital budget, and then the parent firm decide its capital structure to minimize the global WACC for the whole MNE • In this solution, foreign subsidiaries can enjoy the advantages of conforming local norms, and the MNE can maintain its desired consolidated capital structure and enjoy the lower global WACC

16. Capital structure of Foreign Subsidiaries • In addition to deciding an appropriate capital 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 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

17. Exhibit 16.3 Internal Financing of the Foreign Subsidiary 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 expenses Retained earnings

18. Exhibit 16.4 External Financing of the Foreign Subsidiary 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

19. 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 • Exhibit 13.5 provides an overview of the three major sources of debt funding on the international markets, see the next slide

20. Exhibit 16.5 International Debt Markets & Instruments 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

21. International Debt Markets • Bank loans and syndications: • International bank loans • They have traditionally been sourced in the Eurocurrency markets • The attractiveness is the narrow interest rate spread in the Eurocurrency load market, i.e. there is a narrow interest rate spread between deposit and loan rates of less than 1% • Eurocredits • The line of credit is an arrangement between a bank and its customers that establishes a maximum loan balance that the bank will permit the borrower to maintain. The borrower can draw down on the line of credit at any time, as long as he or she does not exceed the maximum set in the agreement • Eurocredits are a type of credit dominated in Eurocurrencies, i.e. the denominated currency is not the lending bank‘s national currency

22. International Debt Markets • Syndicated credits • The syndication of loans has enabled banks to spread the risk of very large loans among a number of banks • Syndication is particularly important for MNEs as they usually need credit in an amount larger than a single bank’s loan limit • The periodic expense of the syndicated credit are composed of two elements • The actual interest expense of the loan: normally states as a spread in basis points over a variable-rate base such as LIBOR • The commitment fees paid on any unused portions of the credit

23. International Debt Markets • The Euronote market: • It is a collective term used to describe short- to medium-term debt instruments sourced in the Eurocurrency markets • Euronotes and Euronote facilities • A major development in international money markets was the establishment of facilities for sales of short-term, negotiable, promissory notes–euronotes • The euronote is a cheaper source of short-term funds than international bank loans, because the notes are placed directly to the investing public, and the securitized and underwritten form help the establishment of liquid secondary markets (it is a kind of direct financing) • However, it needs substantial fees initially for the underwriting services

24. International Debt Markets • Euro-commercial paper (ECP) • ECP is a short-term debt obligation of a corporation or bank • Its maturities are typically one, three, and six months, and it is sold normally at a discount • Over 90% of issues outstanding are denominated in U.S. dollars • Euro medium-term notes (EMTNs) • EMTN 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 • The EMTN’s basic characteristics are similar to those of a bond, with principal, maturity, and coupon rates • The unique characteristics for EMTN • The EMTN allows continuous issuance over a period of time, whereas a bond issue is essentially sold all at once • For EMTN, to ease the management of coupon payments for continuous issuance, the coupons are paid on set calendar dates regardless of the date of issuance • EMTNs are in smaller denominations, from $2 to $5 million, than the minimum amount needed for international bonds

25. International Debt Markets • The International Bond Market: • The international bond market rivals the international banking market in terms of the quantity and cost of funds provided to international borrowers • International bonds can be classified as Eurobands and foreign bonds • Eurobonds • Which are underwritten by an international syndicate of banks and other securities firms and are sold exclusively in countries other than the country in whose currency the issue is denominated • For example, a bond issued by a U.S.-based firm and denominated in U.S. dollars, but sold to investors in Europe and Japan, would be a Eurobond

26. International Debt Markets • Foreign bonds • Which are underwritten by a syndicate composed of members from a single country, sold principally within that country, and denominated in the currency of that country • For example, a bond issued by a firm resident in Sweden, denominated in dollars, and sold in the U.S. by U.S. investment bankers, would be a foreign bond • The international bond has many innovative instruments created by investments bankers, who are free of controls and regulations in domestic capital markets • Straight fixed-rate issues: • It is like most domestic bonds, with a fixed coupon, a set of payment date, and full principal repayment at maturity • Coupons are normally paid annually, rather than semiannually

27. International Debt Markets • Floating-rate notes (FRNs) • The FRN normally pays a semiannual coupon that is determined using a variable-rate base, e.g. LIBOR plus a spread • It was the new and popular instrument on the international bonds in the early 1980s, since the interest rate is relatively high and unpredictable in that era • Equity-related issues • The most recent major addition to the international bond markets is the equity-related issue • The equity-related international bond resembles a straight fixed-rate issue with an additional feature that it is convertible to stock prior to maturity at the specified price per share, e.g. Euro-convertible bond (ECB) • The borrower is able to issue debt with lower coupon payments due to the added value of the equity conversion feature

28. International Debt Markets • Unique characteristics of Eurobond markets • Absence of regulatory interference • Governments in general have less rigorous limitations for securities sold within the county but denominated in foreign currencies • Thus, Eurobond sales fall outside the regulatory domain of any single nation • Less stringent disclosure • Disclosure requirements in the Eurobond market are much less stringent than those of the SEC for sales within the U.S. • Thus, non-U.S. firms often prefer Eurodollar bonds over bonds sold within the U.S., because they do not wish to undergo the costs and the disclosure needed to register with the SEC

29. International Debt Markets • Favorable tax status • Interest paid on Eurobonds is generally not subject to an income withholding tax, i.e. Eurobonds offer tax avoidance • This is because Eurobonds are usually issued in bearer form, under which the name of the owner is not on the certificate, and the bearer must cuts an interest coupon to exchange for interest receipt • On the contrary, for a registered bond, it is necessary for bond owners to register with the bond's issuer. Since the issuer knows the owner of the bond, it is possible to withhold tax from the interest payment

30. Project Financing • One of the hottest topics in international finance today is project finance • 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

31. Project Financing • Equity is a small component of project financing for two reasons: • First, the scale of investment project is often too large for a single investor or a group of investors to fund it • Second, many projects involve subjects traditionally funded by governments, such as electrical power generation, dam building, highway construction, etc. So, the future cash flows are predictable and thus able to serve the high debt ratio • 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

32. Project Financing • Four basic properties are critical to the success of project financing • Separability of the project from its investors • The project is established as an individual legal entity, separate from the legal and financial responsibilities of its equity investors • The separation not only protects equity investors but also enables creditors to evaluate clearly the risks associated with this project • The cash flows generated by the project will automatically be allocated to serve debt payments first • Long-lived, capital-intensive, and singular projects • The business line of the project must be singular in its construction, operation, and size

33. Project Financing • Cash flow predictability from third-party commitments • Thrid-party commitments to buy the product or to supply the material at a reasonable price enhance the predictability of future cash flows • For example, an electric power plant project can contract for selling electricity and purchasing raw material, like coal, through long-term contracts with price adjustment based on inflation • The predictability of net cash inflows eliminates much of the project’s business risk, allowing the capital structure to be heavily debt-financed and still safe from financial distress • Projects with finite lives • Because the project is a standalone investment whose cash flow go directly to service its capital structure, and not to reinvestment for growth or other investment, investors of debt and equity need assurances about the ending point at which all debt and equity has bee repaid