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International Capital Structure (or part I of chapter 13)

International Capital Structure (or part I of chapter 13). Agenda. Theories of capital structure. Why MNE has special financial structure? Cost of debt & Forex risk Financial mix of foreign subsidiaries (talk by C. Fritz Foley). How to finance a foreign subsidiary?.

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International Capital Structure (or part I of chapter 13)

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  1. International Capital Structure (or part I of chapter 13)

  2. Agenda • Theories of capital structure. • Why MNE has special financial structure? • Cost of debt & Forex risk • Financial mix of foreign subsidiaries (talk by C. Fritz Foley). • How to finance a foreign subsidiary?

  3. Theory of Capital Structure • Modigliani-Miller: capital structure is irrelevant! • Trade-off theory: firm does have optimal financial structure. • Idea: minimize WACC. • Why? B/c of taxes & bankruptcy costs. • If new projects business risk differs from risk of existing projects, optimal mix would change (tradeoff between business and financial risks) • Market-timing: manager takes advantage of investor sentiment. • Managerial Entrenchment & Free Cash-flow: cash-rich firms’ managers dislike debt since it means more monitoring by banks!

  4. Cost of Capital (%) ke = cost of equity 30 Min cost of capital 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 0 20 40 60 80 100 Total Debt (D) Debt Ratio (%) = Total Assets (V) Optimal financial mix?

  5. Why financial mix for MNE is special? • A few facts: MNE • has access to more capital in global markets. • can achieve diversification of cash flows. • subject to foreign exchange risk. • has to cater for international portfolio investors.

  6. Optimal Financial Structure • Availability of capital • Allows MNE to lower cost of capital. • Permits MNE to maintain a desired debt ratio even when new funds are raised. • Allows MNEs to operate competitively even if their domestic market is illiquid and segmented. • Diversification of cash flows • Reduces risk as in portfolio theory. • Lowers volatility of cash flows among differing subsidiaries & forex rates. • Expectations of International Portfolio Investors • Most international investors for US and the UK follow the norms of a 60% debt-assets ratio.

  7. Forex Risk & Cost of Debt • Effective cost of debt example • Idea: have to account for forex changes. • US firm borrows SF 1,500,000 for 1 year @ 5% p.a. • SF appreciates SF1.50/$ --> SF 1.44/$ • Initial $ amount borrowed • At the end of the year, the US firm repays the interest plus principal • Actual $ cost of loan:

  8. Forex Risk & Cost of Debt: a shortcut • Rationale: total home currency cost higher b/c of SF appreciation • Can compute as: • Total cost is Where kd$ = Cost of borrowing (US firm in US$) kdSF = Cost of borrowing (US firm in SF) s = Percentage change in spot rate

  9. Shall MNE localize financial mix? • Pros: • Reduces criticism of subs operating with too much debt. • Helps management evaluate return on equity investment relative to local competitors. • Cons: • MNE has comparative advantage over local firms through better availability of capital • If each subsidiary localizes its financial structure, resulting consolidated balance sheet might show a structure that doesn’t conform with any one country’s norm • Usually subs’ debt is guaranteed by parent => parent won’t allow a default … so subs’ debt ratio is set by parent.

  10. Financing the Foreign Subsidiary • Internal vs. External Markets • In addition to choosing appropriate financial structure, managers need to choose alternative sources of funds for financing. • Sources of funds can be classified as internal& external to MNE

  11. MNE Funds Parent Equity Cash Goods Debt (cash loans) Leads & lags on intra-firm A/P Sister subsidiaries Debt (cash loans) Leads & lags on intra-firm A/P Borrows w/ parent’s collateral Internally generated funds Non-cash charges Retained earnings Subs’ Internal Financing

  12. External Funds Borrow in parent country Banks Money markets Borrow outside of parent country Local currency debt Third-country currency debt Eurocurrency debt Local equity Local shareholders Joint venture partners Subs’ External Financing

  13. Tax concerns (Guest Talk 11/6)

  14. Things to remember… • Theories of capital structure • Why MNE has special financial structure? • Cost of debt & Forex risk • Financial mix of foreign subsidiaries (talk by Professor C. Fritz Foley) • How to finance a foreign subsidiary?

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