Prepared by Shafiq Jadallah

Chapter 13 Financial Structure & International Debt Prepared by Shafiq Jadallah To Accompany Fundamentals of Multinational Finance Michael H. Moffett, Arthur I. Stonehill, David K. Eiteman

Chapter 13Financial Structure &International Debt • Learning Objectives • Extend the theory of optimal financial structure to the MNE • Analyze the factors which, in practice, determine the financial structure of foreign subsidiaries within the context of the MNE • Evaluate the various internal & external sources of funds available for the financing of foreign subsidiaries

Chapter 13Financial Structure &International Debt • Learning Objectives • Identify the relevant characteristics of different international debt instruments in financing both the MNE itself, and its various foreign subsidiaries • Apply the strategies of project financing to the funding of large global projects with unique characteristics

Optimal Financial Structure • When taxes and bankruptcy costs are considered, a firm has an optimal financial structure determined by an optimal mix of debt and equity that minimizes the firm’s cost of capital • 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

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) Optimal Financial Structure

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

Optimal Financial Structure& The MNE • Availability of capital • Allows MNEs to lower cost of capital • Permits MNEs 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 similar to portfolio theory of diversification • Lowers volatility of cash flows among differing subsidiaries and foreign exchange rates

Optimal Financial Structure& The MNE • 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

Optimal Financial Structure& The MNE • 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%

Optimal Financial Structure& The MNE • 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

Optimal Financial Structure& The MNE • 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

Optimal Financial Structure& The MNE • 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 a 60% debt ratio

Financial Structure ofForeign Subsidiaries • Debt borrowed is from sources outside of the MNE (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

Financial Structure ofForeign Subsidiaries • 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 thus making the debt ratio more cosmetic for the foreign subsidiary

Financial Structure ofForeign Subsidiaries • 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 internaland external to the MNE

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 Financing ofthe 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 External Financing ofthe Foreign Subsidiary

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 • 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

International Debt Markets • 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)

International Debt Markets • 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 Debt Markets • 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

International Debt Markets • 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 MNEs, large domestic corporations, governments, government enterprises and international institutions • Offered simultaneously in a number of different capital markets

International Debt 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

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

International Debt Markets • 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

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

Project Financing • Four basic properties that are critical to the success of project financing • 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 • Long-lived and capital intensive singular projects • Cash flow predictability from third-party commitments • Third party commitments are usually suppliers or customers of the project • Finite projects with finite lives

Summary of Learning Objectives • The domestic theory of optimal capital structures needs to be modified by four variables in order to accommodate the case of the MNE. These four variables are (1) availability of capital, (2) diversification of risk, (3) foreign exchange risk and (4) expectations of international portfolio investors • An MNE’s marginal cost of capital is constant for considerable ranges of its capital budget • By diversifying cash flows internationally, the MNE may achieve lower cash flow volatility

Summary of Learning Objectives • When a firm issues foreign currency-denominated debt, its effective cost of equals the after-tax cost of repayment in terms of the firm’s own currency. This amount included the nominal cost of the loan adjusted for any foreign exchange gains or losses • Therefore, if a firm wants to raise capital in global markets, it must adopt global norms that are close to US and UK standards

Summary of Learning Objectives • A compromise position between minimizing the global cost of capital and conforming to local capital norms is possible when determining the financial structure of a foreign subsidiary. Both multinational and domestic firms should try to lower their overall WACC • The debt ratio of a foreign affiliate is in reality only cosmetic because lenders ultimately look at the parent and its consolidated cash flow

Summary of Learning Objectives • International debt markets offer the borrower a variety of maturities, repayment options, and currencies of denomination. These markets also vary by source of funding, pricing structure, subordination and linkage to other securities • Three major sources of debt funding are international bank loans and syndicated credits, euronote market and international bond market

Summary of Learning Objectives • Eurocurrency markets serve two valuable purposes (1) Eurocurrency deposits are an efficient and convenient money market device for excess corporate liquidity and (2) the market is a major source of short-term bank loans to finance working capital needs • Three original factors in the evolution of the Eurobond markets are the absence of regulatory interference, less stringent disclosure practices and favorable tax treatment

Summary of Learning Objectives • Project finance is used widely in the development of large-scale infrastructure projects in emerging markets. Most are highly leveraged transactions with debt making up more than 60% of the capital structure

Prepared by Shafiq Jadallah