Finance Cours8 2003

7/28/2019 Finance Cours8 2003

1/36

1

Part 2

International

Corporate Finance

-Lecture n 8

Financing the Global firm

International Finance


2/36

2

International Corporate Finance

Global cost and availability of capitalPurpose 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 ofreturn on securities differs across markets, for comparablesecurities.

Market segmentation : due to various market

imperfections


3/36

3

International Corporate Finance

Market Liquidity for Firms Securities

Illiquid domestic securities market

and limited international liquidity

Highly liquid domestic market and

broad international participation

Effect of Market Segmentation on Firms Securities and Cost of Capital

Segmented domestic securities

market that prices shares

according to domestic standards

Access to global securities market

that prices shares according to

international standards

Firms securities appeal only

to domestic investors

Firms securities appeal to

international portfolio investors

Firm-Specific CharacteristicsLocal Market Access Global Market Access


4/36

4

Global cost of capital

Weighted Average Cost of Capital (WACC)

V

Dt)1(k

V

Ekk deWACC

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)


5/36

5


Weighted Average Cost of Capital (WACC)Cost of equity : CAPM (Capital Asset Pricing Model)

)kk(kk rfmjrfe

Where

ke = expected rate of return on equity

krf = risk free rate on bonds

km = expected rate of return on the market

j = coefficient of firms systematic risk = jmj/m


6/36

6


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 firmin 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 debtWACC

Usually used as the risk-adjusted discount ratewhenever a firm s new projects are in the same generalrisk class as its existing projects.


7/36

7

Availability of capital

Availability of CapitalDemand for foreign securities

Role of International Portfolio Investors : internationalinvestment to increase the risk/return ratio of a portfolio

invested globally in different regions, countries, stage ofdevelopment.

Link between cost and availability of capital

If capital in indefinitely available its cost does not riseas demand for funds increases. This requires a very

liquid market, which is not the case of most domesticmarkets.

An access to multinational markets improves theliquidity available to the firm and allows the firm topreserve its optimal financial financial structure

(constant D/E ratio).


8/36

8

Availability of capital

Availability of CapitalLink between cost and availability of capital

If market are fully integrated, securities of comparableexpected return and risk should have the same required

rate of return in each national market, after adjustmentfor foreign exchange risk and political risk.

Capital market segmentation is a financial marketimperfection caused by government constraints,institutional practices, and investors perception.

Segmentation does not imply that market areinefficient, at least a domestic level.

Influence of illiquidity and segmentation on MNEs

Higher cost of capital / Rising cost of capital / Shifts inthe optimal financial structure / Rising cost of projects


9/36

9

NOVO Industri

Illustrative case : NOVO industriNovo : Danish pharmaceuticals company

Had a lack of availability and higher cost of capital thanits main competitors, due to market segmentation.

P/E ratio of Novo: around 5; main internationalcompetitors : around 10.

Causes linked to several characteristics of the Danishequity 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 toprohibition of foreign security ownership. Stock prices

were then closely correlated with a high systemic risk.


10/36

10

NOVO Industri

Financial risk : high leverage of Scandinavian firmscompared 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 UKinvestment bank as underwriter.

The biotechnology boom : seminar organised by Novoin 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 aneventual registration of NYSE.


11/36

11

NOVO Industri

Impacts on Novos 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. Typicalreaction 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, followingglobalisation. But reduced gains of internationalportfolio diversification.


12/36

12

Cost of Capital in MNE s

Cost of Capital of MNEs compared to domesticfirmsAvailability of capital : better. Allows firms to maintain

their desired D/E ratio

Financial structure and systematic risk for MNEsTheoretically, MNEs should be able to afford higher

D/E ratios since their cash-flow are internationallydiversified and yet their variability is minimised.

However, empirical studies show an oppositeconclusion: international diversification does notcompensate for higher agency costs, political risk, andforeign exchange risks that MNEs face.

These lead to lower D/E ratios and rather higher cost

of capital.


13/36

13


Cost of Capital of MNEs compared to domesticfirmsIs 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 capitalbudget to the point where its marginal cost of capitalincreases.

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 andtry to avoid the point where their marginal cost of capitalincreases. So the observed WACC of international

companies is higher. See equation.


14/36

14


Budget

(millions of $)

Marginal cost of capitaland rate of return (percentage)

100 140 300 350 400

15%

10%

5%

20%

MCCDC

MRRDC

MRRMNE

MCCMNE


15/36

15


Empirical studies : MNEs have a lower debt/capital ratio, leading to

a higher cost of capital than their domestic counterparts.

Cost of equity required : higher for MNEs.

Possible explanations : higher levels ofpolitical risk, foreign exchange risk, and higheragency costsof 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.

[kWACC = ke EquityValue

+ kd ( 1tx )Debt

Value[ ]]

Is MNEwacc > or < Domesticwacc ?

Indications are that : MNEs have a lower average cost of debt, leadingto a lower cost of capital than their domestic counterparts.


16/36

16

Sourcing Equity Globally

In order to benefit from global financial markets, a firm maydecide to cross-list its shares on foreign stock exchanges.

More specifically, it can be motivated by one or more of thefollowing 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 othersfirms in the host market.

Increase the firms visibility & political acceptance to itscustomers, suppliers, creditors and host governments.

Create a secondary market for shares that will be used tocompensate local management and employees in foreignsubsidiaries.


17/36

17

Sourcing Equity Globally

According to the goal pursued, the type of listing will bedifferent :

If it is to support a new equity issue or to establish a market forshare swaps, the target market should also be the listing market.

If it is to increase the firms commercial and political visibility or to

compensate local management and employees, it should be inmarkets in which the firm has significant operations.

If it is to improve liquidity of a firms shares, the major liquid stockmarkets are New York, London, Tokyo, Frankfurt and Paris.

By cross-listing and selling equity abroad, a firm faces twobarriers

Increased commitment to full disclosure

A continuing investor relations program


18/36

18

Financial Structure & i debt

Financial structure and international debtOptimal financial structure

A firm should optimally have the mix of debt andequity that minimises the firms 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 increasesbecause equity investors perceive a higher risk in a

higher leveraged firm. The optimal range of debt ratiois estimated between 30% and 60%.

Within that range, the optimal ratio is influenced by :the industry of the firm; the volatility of the sales andoperating income; the collateral value of the assets.


19/36

19


Optimal financial structure

Debt Ratio (%) =

Total Debt (D)

Total Assets (V)

30

28

26

24

22

20

18

16

14

12

10

86

4

2

0

Cost of Capital (%)

20 40 60 80 100

ke = cost of equity

Minimum costof capital range

kd (1-tx)= after-tax cost of debt

kWACC = weighted averageafter-tax cost of capital


20/36

20


Financial structure and international debtOptimal financial structure : the case of the MNE

Compared to domestic companies, the theory ofoptimal structure of capital needs to be adapted to the

international case in four ways :

(1) The availability of capital : that allows a MCCconstant (see previous section)

(2) Diversification of cash-flows : that could allow for

higher D/E acceptable ratios


21/36

21

(3) Foreign exchange risk : foreign currency denominateddebt should be adjusted for any foreign exchange gains orlosses.

When a firm issues foreign currency denominated debt, itseffective cost equals the after-tax cost of repayment in

terms of the firms own currency.

(4) Expectations of international portfolio investors :dominance of US - UK norms on global markets, for firms

overcoming market segmentation.


1s1xk1k Sfrd$d

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


22/36

22


Financial structure of foreign subsidiariesSince MNE are assessed on consolidated statements,

financial structures of subsidiaries are relevant only ifthey affect this overall goal.

Subsidiaries do not have independent cost of capital.Therefore, their financial structure should not be basedon minimising it.

Empirically, studies show that country-specificenvironment are key determinants of debt ratios :

historical development, taxation, corporate governance,bank influence, bond market, attitude toward risk

Debts considered here : only those borrowed fromsources outside the MNE : local and foreign currencyloans, and Eurocurrency loans.


23/36

23


Financial structure of foreign subsidiariesMain advantages of localization

Localized financial structure reduces criticism of foreignsubsidiaries 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 ofscarcity of capital and real resources are fully utilized, thepenalty paid for borrowing local funds reminds managementthat unless ROA is greater than local price of capital, there isprobably a misallocation of domestic real resources, such asland and labor.


24/36

24


Financial structure of foreign subsidiariesMain disadvantages of localization

An MNE is expected to have comparative advantage overlocal 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 structurethat doesnt conform with any one countrys norm; the debtratio would simply be a weighted average of all outstanding

debt.Typically, any subsidiarys debt is guaranteed by the parent,

and the parent wont allow a default on the part of thesubsidiary. This makes the debt ratio more cosmetic for theforeign subsidiary.


25/36

25


Financial structure of foreign subsidiariesCompromise solution

Both domestic firms and MNEs should try to minimize theircost of capital. But if debt is available in a foreign subsidiary

at equal cost than elsewhere after correcting for risk, thenlocalizing 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 alternativesources of funds for financing. In particular, betweeninternal and external sources of funds.


26/36

26


Financing the Foreign SubsidiaryInternal 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 ofthe development, the foreign subsidiary must acquire itsdebt from the parent company or sister subsidiaries.

Next, its ability to generate funds internally may becomecritical for the subsidiarys future growth. The sources ofinternal funds include retained earnings, depreciation, andother non-cash expenses.


27/36

27

Internal sources of funds

Depreciation & non-cash charges

Retained earnings

Funds Generated Internally by the

Foreign Subsidiary

Debt -- cash loans

Leads & lags on intra-firm payables

Funds from

sister subsidiaries

Subsidiary borrowing with parent guarantee

Funds

From

Within

theMultinational

Enterprise

(MNE)

Debt -- cash loans

Leads & lags on intra-firm payables

EquityCash

Real goodsFunds from

parent company


28/36

28


Financing the Foreign SubsidiaryExternal sources of funds (see graph below)

There are 3 categories of external sources : debt from the

parents country, from outside the parents 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.


29/36

29

External sources of funds

Banks & other financial institutions

Security or money markets

Funds

Externalto

the

Multinational

Enterprise

(MNE)

Borrowing from sources

in parent country

Local currency debt

Third-country currency debt

Eurocurrency debt

Borrowing from sources

outside of parent country

Joint venture partners

Individual local shareholders

Local equity


30/36

30

The Eurocurrency Markets

The Eurocurrency MarketsOne of the important innovation in international finance

over the past 50 years. Provide a basis for manycorporate finance innovation for multinational companies.

EurocurrenciesDefinition : Domestic currencies of one country on deposit

in a second country. Time deposit maturities from overnightfunds to longer periods. Any convertible currency can existin 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 bankloans to finance corporate working capital needs.


31/36

31

International Debt Markets

International Debt MarketsVariety 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, extendedby banks in countries other than in whose currency theloan is denominated


32/36

32


Syndicated creditsEnable 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 marketCollective 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


33/36

33


International bond marketThe distinction between categories is based on whether the

borrower is a domestic or a foreign resident and whether theissue is denominated in a local or in a foreign currency.

Eurobonds : underwritten by an international syndicate ofbanks and other securities firms, and sold exclusively in othercountries than the currency of denomination. Issued by MNEs,large domestic corporations, sovereign governments,governmental enterprises and international institutions.

Success factors : absence of regulatory interference - favorabletax status (bearer from) - less stringent disclosure.

Foreign bonds : underwritten by a syndicate of members froma single country, and sold principally in that country. But theissuers is from another country.


34/36

34


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 FacilitiesEuronote

Market

(floating-rate,

short-to-medium term)

Foreign Bond

Eurobond

* straight fixed-rate issue

* floating-rate note (FRN)

* equity-related issue

International

Bond Market

(fixed & floating-rate,

medium-to-long term)


35/36

35

Project Financing

Project FinanceIs 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 orcollection of private equity investors,

Many projects involve subjects funded by governments.This high level of debt requires additional levels of risk

reduction.


36/36

36

Project Financing

Four basic properties that are critical to the successof 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 commitmentsThird party commitments are usually suppliers or

customers of the project.

(4) Finite projects with finite lives.

Documents

Finance Cours8 2003