International Finance

International FinanceFIN456

Michael Dimond

Michael DimondSchool of Business Administration

Financial Globalization and Strategy

• Global integration of capital markets has given many firms access to new and cheaper sources of funds beyond those available in their home market

• A firm that must source its long-term debt and equity in a highly illiquid domestic securities market will probably have a relatively high cost of capital and will face limited availability of such capital

• This in turn will limit the firm’s ability to compete both internationally and vis-à-vis foreign firms entering its market



• Firms resident in small capital markets often source their long-term debt and equity at home in these partially-liquid domestic markets

• The costs of funds is slightly better than that of illiquid markets, however, if these firms can tap the highly liquid international capital markets, their competitiveness can be strengthened

• Firms resident in segmented capital markets must devise a strategy to escape dependence on that market for their long-term debt and equity needs



• A national capital market is segmented if the required rate of return on securities differs from the required rate of return on securities of comparable expected return and risk traded on other securities markets

• Capital markets become segmented because of such factors as excessive regulatory control, perceived political risk, anticipated FOREX risk, lack of transparency, asymmetric information, cronyism, insider trading and other market imperfections

• Firms constrained by any of these above conditions must develop a strategy to escape their own limited capital markets and source some of their long-term capital needs abroad


Cost of Capital for MNCs versus Domestic Firms• Is the WACC or an MNC higher or lower than for its domestic

counterpart?– The answer is a function of

• The marginal cost of capital• The after-tax cost of debt• The optimal debt ratio• The relative cost of equity

• A MNC should have a lower cost of capital because it has access to a global cost and availability of capital

• This availability and cost allows the MNC more optimality in capital projects and budgets compared to its domestic counterpart


Cost of Capital for MNC and Domestic Compared


Do MNCs Have a Higher or Lower Cost of Capital?


Designing a Strategy to Source Equity Globally• This requires management to agree upon a long-run financial

objective and then choose among various alternative paths to get there

• Normally the choice of paths and implementation is aided by an early appointment of an investment bank as official advisor to the firm

• Investment bankers are in touch with the potential foreign investors and what they require in terms of risk/reward

• Investment bankers can also help navigate the various institutional requirements and barriers that must be satisfies to source equity globally


Designing a Strategy to Source Equity Globally• Most firms raise their initial capital in their own domestic market• While many can be tempted to skip the intermediate steps to complete

an Euroequity issue in global markets, good financial advisors will offer a ‘reality check’ on this strategy

• Most firms that have only raised capital in their domestic market are not well enough known to attract foreign investors

• The following exhibit walks through a more probable chain of events in accessing global capital markets with the end goal being equity capital


Globalizing the Cost & Availability of Capital


Optimal Financial Structure

• When taxes and bankruptcy costs are considered, a firm has an optimal financial 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

• 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


The Cost of Capital and Financial Structure


Optimal Financial Structure & The MNC

• The domestic theory of optimal capital structure is modified by four additional variables in order to accommodate the MNC– Availability of capital– International diversification of cash flows– Foreign exchange risk– Expectation of international portfolio investors



• Availability of capital– Allows MNCs to lower cost of capital – Permits MNCs to maintain a desired debt ratio even when new funds

are raised– Allows MNCs to operate competitively even if their domestic market is

illiquid and segmented

• International diversification of cash flows– Reduces risk similar to portfolio theory of diversification– Lowers volatility of cash flows among differing subsidiaries and

foreign exchange rates


• 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 up

to a 60% debt ratio



Financial Structure of Foreign Subsidiaries

• Debt borrowed is from sources outside of the MNC (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 of Foreign Subsidiaries• Disadvantages of localization

– A MNC 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 of Foreign 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 internal and external to the MNC

• Ideally the choice among the sources of funds should minimize the cost of external funds after adjusting for foreign exchange risk

• The firm should choose internal sources in order to minimize worldwide taxes and political risk


Financial Structure of Foreign Subsidiaries


External Financing of the Foreign Subsidiary


21

The Sony Keiretsu: Interlocking Directorships

SONY

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BANKNO. 1

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BANKNO. 2

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Sourcing Equity Globally

• Depositary Receipts– Depositary receipts are negotiable certificates issued by a bank to

represent the underlying shares of stock, which are held in trust at a foreign custodian bank

• Global Depositary Receipts (GDRs) – refers to certificates traded outside the US

• American Depositary Receipts (ADRs) – are certificates traded in the US and denominated in US dollars

• ADRs are sold, registered, and transferred in the US in the same manner as any share of stock with each ADR representing some multiple of the underlying foreign share


Sourcing Equity Globally

• Depositary Receipts– This multiple allows the ADRs to possess a price per share

conventional for the US market– ADRs are either sponsored or unsponsored– Sponsored ADRs are created at the request of a foreign firm wanting

its shares traded in the US; the firm applies to the SEC and a US bank for registration and issuance


American Depositary Receipts (ADRs)


Characteristics of Depositary Receipt Programs


Foreign Equity Listing & Issuance

• By cross-listing and selling its shares on a foreign stock exchange a firm typically tries to accomplish one or more of the following objectives:– Improve the liquidity of its existing shares and support a liquid

secondary market– Increase its share price by overcoming mispricing in a segmented and

illiquid home market– Increase the firm’s visibility and political acceptance to its customers,

suppliers, creditors & host governments– Establish a secondary market for shares used for acquisitions– Create a secondary market for shares that can be used to

compensate local management and employees in foreign subsidiaries


Size and Liquidity of Markets

• Three key trends in the evolution of modern exchanges:– Demutualization or the end of market ownership by a small, privileged

group of “seat owners”– Diversification by exchanges to trade a broader range of products– Globalization or effectively another form of diversification through

several techniques


Foreign Equity Listing & Issuance

• Cross-listing is a way to encourage investors to continue to hold and trade shares that may or may not be listed on an investors home market or in a preferred currency

• Cross-listing is usually done through ADRs (in the United States, where they are traded and quoted in U.S. dollars)

• Global Registered Shares (GRSs), on the other hand, are able to be traded on equity exchanges around the globe in a variety of currencies and are traded electronically


Effect of Cross-Listing & Equity Issuance on Share Price• The impact on price of cross-listing on a foreign stock market

depends on the degree to which the markets are segmented• As was the situation experienced by Novo, a firm can benefit

if a foreign market values a company more highly than a home market (in a highly-segmented situation)


Other Motives for Cross-Listing

• Increasing visibility and political acceptance– MNCs list in markets where they have substantial physical operations– Political objectives might include the need to meet local ownership

requirements for an MNC’s foreign joint venture

• Increasing potential for share swaps with acquisitions• Compensating management and employees


Barriers to Cross-Listing and Selling Equity Abroad• Commitment to disclosure and investor relations

– A decision to cross-list must be balanced against the implied increased commitment to full disclosure and a continuing investor relations program

• Disclosure is a double-edged sword

• Increased firm disclosure should have the effect of lowering the cost of equity capital

• On the other hand, this increased disclosure is a costly burden to corporations


Alternative Instruments to Source Equity• Alternative instruments to source equity in global markets

include the following:– Sale of a directed public share issue to investors in a target market– Sale of a Euro equity public issue to investors in more than one

market, including both foreign and domestic markets– Private placements under SEC Rule 144A– Sale of shares to private equity funds– Sale of shares to a foreign firm as a part of a strategic alliance


Alternative Instruments to Source Equity• Directed Public Share Issues

– Defined as one which is targeted at investors in a single country and underwritten in whole or in part by investment institutions from that country

• Issue may or may not be denominated in the currency of the target market

• The shares might or might not be cross-listed on a stock exchange in the target market

• A foreign share issues, plus cross-listing can provide it with improved liquidity


Alternative Instruments to Source Equity• Euroequity Public Issue

– Gradual integration of worlds’ capital markets has spawned the emergence of a Euroequity market

– A firm can now issue equity underwirtten and distributed in multiple foreign equity markets; sometimes simultaneously with distribution in the domestic market

– As we have reviewed, the term “Euro” does not imply that the issuers or investors are located in Europe, nor does it mean the shares are sold in the currency “euro”


Alternative Instruments to Source Equity• Private Placement Under SEC Rule 144A

– A private placement is the sale of a security to a small set of qualified institutional buyers

– Investors are traditionally insurance companies and investment companies

– Because shares are not registered for sale, investors typically follow “buy and hold” strategy

– Rule 144A allows qualified institutional buyers (QIB) to trade privately placed securities without previous holding period restrictions and without requiring SEC registration


Alternative Instruments to Source Equity• Private Equity Funds

– Limited partnerships of institutional and wealthy individual investors that raise their capital in the most liquid capital markets

– Then invest these funds in mature, family-owned firms located in emerging markets

• Strategic Alliances– Normally followed by firms that expect to gain synergies from one or

more joint efforts


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 & Instruments



• 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



• 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 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



• 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 MNCs, large domestic corporations, governments, government enterprises and international institutions

– Offered simultaneously in a number of different capital 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



• 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

Documents

International Finance