1 part 2 international corporate finance - lecture n° 8 financing the global firm international...

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Part 2International

Corporate Finance -

Lecture n° 8Financing the Global firm

International Finance

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International Corporate Finance

Global cost and availability of capital Purpose of firms having access to global capital

markets:Minimize their cost of capitalMaximize 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

of return on securities differs across markets, for comparable securities.

Market segmentation : due to various market imperfections

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International Corporate Finance

Market Liquidity for Firm’s Securities

Illiquid domestic securities marketand limited international liquidity

Highly liquid domestic market andbroad international participation

Effect of Market Segmentation on Firm’s Securities and Cost of Capital

Segmented domestic securitiesmarket that prices shares

according to domestic standards

Access to global securities marketthat prices shares according to

international standards

Firm’s securities appeal onlyto domestic investors

Firm’s securities appeal tointernational portfolio investors

Firm-Specific CharacteristicsLocal Market Access Global Market Access

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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)

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

)kk(k k rfmjrfe Where

ke = expected rate of return on equity

krf = risk free rate on bonds

km = expected rate of return on the market

βj = coefficient of firm’s systematic risk = jmj/m

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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

firm in 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 debt

WACCUsually used as the risk-adjusted discount rate

whenever a firm ’s new projects are in the same general risk class as its existing projects.

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Availability of capital

Availability of Capital Demand for foreign securities

Role of International Portfolio Investors : international investment to increase the risk/return ratio of a portfolio invested globally in different regions, countries, stage of development.

Link between cost and availability of capitalIf capital in indefinitely available its cost does not

rise as demand for funds increases. This requires a very liquid market, which is not the case of most domestic markets.

An access to multinational markets improves the liquidity available to the firm and allows the firm to preserve its optimal financial financial structure (constant D/E ratio).

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Availability of capital

Availability of Capital Link between cost and availability of capital

If market are fully integrated, securities of comparable expected return and risk should have the same required rate of return in each national market, after adjustment for foreign exchange risk and political risk.

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

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

Influence of illiquidity and segmentation on MNE’sHigher cost of capital / Rising cost of capital / Shifts in

the optimal financial structure / Rising cost of projects

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NOVO Industri

Illustrative case : NOVO industri Novo : Danish pharmaceuticals company

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

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

Causes linked to several characteristics of the Danish equity 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 to prohibition of foreign security ownership. Stock prices were then closely correlated with a high systemic risk.

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NOVO Industri

Financial risk : high leverage of Scandinavian firms compared 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 UK investment bank as underwriter.

The biotechnology boom : seminar organised by Novo in 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 an eventual registration of NYSE.

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NOVO Industri

Impacts on Novo’s 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. Typical reaction 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.

NowadaysSignificant reduction of market segmentation,

following globalisation. But reduced gains of international portfolio diversification.

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Cost of Capital in MNE ’s

Cost of Capital of MNE’s compared to domestic firms Availability of capital : better. Allows firms to

maintain their desired D/E ratio Financial structure and systematic risk for MNE’s

Theoretically, MNE’s should be able to afford higher D/E ratios since their cash-flow are internationally diversified and yet their variability is minimised.

However, empirical studies show an opposite conclusion: international diversification does not compensate for higher agency costs, political risk, and foreign exchange risks that MNE’s face.

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

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Cost of Capital of MNEs compared to domestic firms Is 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 capital budget to the point where its marginal cost of capital increases.

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 and try to avoid the point where their marginal cost of capital increases. So the observed WACC of international companies is higher. See equation.

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Budget(millions of $)

Marginal cost of capitaland rate of return (percentage)

100 140 300 350 400

15%

10%

5%

20%

MCCDC

MRRDC

MRRMNE

MCCMNE

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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 MNE’s. • Possible explanations : higher levels of political risk, foreign exchange risk, and higher

agency costs of 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

Equity

Value+ kd ( 1 – tx )

Debt

Value[ ]]

Is MNEwacc > or < Domesticwacc ?

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

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Sourcing Equity Globally

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

More specifically, it can be motivated by one or more of the following 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 others firms in the host market.

Increase the firm’s visibility & political acceptance to its customers, suppliers, creditors and host governments.

Create a secondary market for shares that will be used to compensate local management and employees in foreign subsidiaries.

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Sourcing Equity Globally

According to the goal pursued, the type of listing will be different : If it is to support a new equity issue or to establish a market for

share swaps, the target market should also be the listing market. If it is to increase the firm’s commercial and political visibility or

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

If it is to improve liquidity of a firm’s shares, the major liquid stock markets are New York, London, Tokyo, Frankfurt and Paris.

By cross-listing and selling equity abroad, a firm faces two barriers Increased commitment to full disclosure A continuing investor relations program

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Financial Structure & i debt

Financial structure and international debt Optimal financial structure

A firm should optimally have the mix of debt and equity that minimises the firm’s 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 increases because equity investors perceive a higher risk in a higher leveraged firm. The optimal range of debt ratio is estimated between 30% and 60%.

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

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Optimal financial structure

Debt Ratio (%) =Total Debt (D)

Total Assets (V)

3028262422201816141210 8 6 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 average

after-tax cost of capital

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Financial structure and international debt Optimal financial structure : the case of the

MNECompared to domestic companies, the theory of

optimal structure of capital needs to be adapted to the international case in four ways :

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

(2) Diversification of cash-flows : that could allow for higher D/E acceptable ratios

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(3) Foreign exchange risk : foreign currency denominated debt should be adjusted for any foreign exchange gains or losses.

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.

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


1s1 x k1k 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

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Financial structure of foreign subsidiaries Since MNE are assessed on consolidated

statements, financial structures of subsidiaries are relevant only if they affect this overall goal.

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

Empirically, studies show that country-specific environment are key determinants of debt ratios : historical development, taxation, corporate governance, bank influence, bond market, attitude toward risk…

Debts considered here : only those borrowed from sources outside the MNE : local and foreign currency loans, and Eurocurrency loans.

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Financial structure of foreign subsidiaries Main advantages of localization

Localized financial structure reduces criticism of foreign subsidiaries 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 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, there is probably a misallocation of domestic real resources, such as land and labor.

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Financial structure of foreign subsidiaries Main 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. This makes the debt ratio more cosmetic for the foreign subsidiary.

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Financial structure of foreign subsidiaries Compromise solution

Both domestic firms and MNE’s should try to minimize their cost of capital. But if debt is available in a foreign subsidiary at equal cost than elsewhere after correcting for risk, then localizing 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 alternative sources of funds for financing. In particular, between internal and external sources of funds.

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Financing the Foreign Subsidiary Internal 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 of the development, the foreign subsidiary must acquire its debt from the parent company or sister subsidiaries.

Next, its ability to generate funds internally may become critical for the subsidiary’s future growth. The sources of internal funds include retained earnings, depreciation, and other non-cash expenses.

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Internal sources of funds

Depreciation & non-cash charges

Retained earnings

Funds Generated Internally by theForeign Subsidiary

Debt -- cash loans

Leads & lags on intra-firm payables

Funds fromsister subsidiaries

Subsidiary borrowing with parent guarantee

Funds From

Withinthe

MultinationalEnterprise

(MNE)

Debt -- cash loans

Leads & lags on intra-firm payables

EquityCash

Real goodsFunds fromparent company

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Financing the Foreign Subsidiary External sources of funds (see graph below)

There are 3 categories of external sources : debt from the parent’s country, from outside the parent’s 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.

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External sources of funds

Banks & other financial institutions

Security or money markets

Funds External

tothe

MultinationalEnterprise

(MNE)

Borrowing from sourcesin parent country

Local currency debt

Third-country currency debt

Eurocurrency debt

Borrowing from sourcesoutside of parent country

Joint venture partners

Individual local shareholders

Local equity

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The Eurocurrency Markets

The Eurocurrency Markets One of the important innovation in international

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

Eurocurrencies Definition : Domestic currencies of one country on

deposit in a second country. Time deposit maturities from overnight funds to longer periods. Any convertible currency can exist in “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 bank loans to finance corporate working capital needs.

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International Debt Markets

International Debt Markets Variety 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 creditsTraditionally sourced in eurocurrency markets,

extended by banks in countries other than in whose currency the loan is denominated

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Syndicated creditsEnable banks to risk lending large amountsArranged 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

EurobondsForeign bonds

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International bond market The distinction between categories is based on whether the

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

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

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

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

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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 FacilitiesEuronoteMarket

(floating-rate,short-to-medium term)

Foreign Bond

Eurobond * straight fixed-rate issue * floating-rate note (FRN) * equity-related issue

InternationalBond Market

(fixed & floating-rate,medium-to-long term)

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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.

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Project Financing

Four basic properties that are critical to the success of 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.

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