Professional Documents
Culture Documents
Financial Structure
and International
Debt
Optimal Financial Structure
• The domestic theory of optimal financial structure must be
modified considerably to encompass the multinational firm.
• Most finance theorists are now in agreement about whether an
optimal financial structure exists for a firm, and if so, how it can
be determined.
• 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.
• As 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.
13-2
Financing Patterns of Firms in India
• In a study for World Bank it was found
that debt to asset ratios remained fairly
stable during the period 19942003.
• Debt growth fell considerably during this
period.
• Interest coverage ratio exhibited a U
shaped pattern.
• Bank financing rose whereas nonbank
debt declined.
13-3
Financing Patterns of Firms in India
• Young firms have lower debt ratios that
older firms.
• Foreign firms carry less debt than
domestic firms
• Manufacturing firms have higher debt
ratios than service firms.
• IT firms have lowest levels of debt and
highest debt coverage ratios.
13-4
Financing Patterns of Firms in India
• Smaller firms rely less on debt.
• Smaller firms also borrow less from
formal financial institutions.
• Smaller firms seem to be credit
constrained.
13-5
Optimal Financial Structure
• The following exhibit illustrates how the
cost of capital varies with the amount of
debt employed.
• As the debt ratio increases, the overall
cost of capital (kWACC) decreases because
of the heavier weight of lowcost (due to
taxdeductability) debt ([kd(1t)]
compared to high cost equity (ke).
13-6
Exhibit 13.1 The Cost of Capital
and Financial Structure
ke = cost of equity
Cost of Capital (%)
30 Minimum cost
28 of capital range
26 kWACC = weighted average
24 after-tax cost of capital
22
20
18
16
14
12
kd (1-tx) = after-tax cost of debt
10
8
6
4
2
0 20 40 60 80 100
13-9
Optimal Financial Structure
and the MNE
• Diversification of cash flows:
– The theoretical possibility exists that multinational
firms are in a better position than domestic firms to
support higher debt ratios because their cash flows
are diversified internationally
– As returns are not perfectly correlated between
countries, an MNE might be able to achieve a
reduction in cash flow variability (much in the same
way as portfolio investors who diversify their
security holdings globally)
13-10
Optimal Financial Structure
and the MNE
• Foreign exchange risk:
– When a firm issues foreign currency
denominated debt, its effective cost equals
the aftertax cost of repaying the principal
and interest in terms of the firm’s own
currency
– This amount includes the nominal cost of
principal and interest in foreign currency
terms, adjusted for any foreign exchange
gains or losses
13-11
Optimal Financial Structure
and the MNE
• Expectations of International Portfolio
Investors:
– The key to gaining a global cost and availability
of capital is attracting and retaining
international portfolio investors
– If a firm wants to raise capital in global
markets, it must adopt global norms that are
close to the US and UK norms as these markets
represent the most liquid and unsegmented
markets
13-12
Financial Structure
of Foreign Subsidiaries
• If the theory that minimizing the cost of capital for
a given level of business risk and capital budget is
an objective that should be implemented from the
perspective of the consolidated MNE, then the
financial structure of each subsidiary is relevant
only to the extent that it affects this overall goal.
• In other words, an individual subsidiary does not
really have an independent cost of capital;
therefore its financial structure should not be based
on an objective of minimizing it.
13-13
Financial Structure
of Foreign Subsidiaries
• Advantages to implementing a financing
structure that conforms to local norms:
– Reduction in criticisms
– Improvement in the ability of management
to evaluate ROE relative to local
competitors
– Determination as to whether or not
resources are being misallocated (cost of
local debt financing versus returns generated
by the assets financed)
13-14
Financial Structure
of Foreign Subsidiaries
• Disadvantages to localization:
– MNEs are expected to have a competitive advantage
over local firms in overcoming imperfections in national
capital markets; there would then be no need to dispose
of this competitive advantage and conform
– Consolidated balance sheet structure may not conform t
any country’s norm (increasing perceived financial risk
and cost of capital to the parent)
– Local debt ratios are really only cosmetic as lenders will
ultimately look to the parent, and its consolidated
worldwide cash flow as the source of debt repayment
13-15
Financial Structure
of Foreign Subsidiaries
• In addition to choosing an appropriate financial structure for
foreign subsidiaries, financial managers of MNEs must choose
among alternative sources of funds to finance the foreign
subsidiary.
• These funds can be either internal to the MNE or external to the
MNE.
• Ideally the choice should minimize the cost of external funds
(after adjusting for foreign exchange risk) and should choose
internal sources in order to minimize worldwide taxes and
political risk.
• Simultaneously, the firm should ensure that managerial
motivation in the foreign subsidiaries is geared toward
minimizing the firm’s worldwide cost of capital
13-16
Exhibit 13.3 Internal Financing of the Foreign Subsidiary
Cash
Equity
Real goods
Funds from
Funds parent company Debt -- cash loans
From
Within Leads & lags on intra-firm payables
the
Multinational
Debt -- cash loans
Enterprise
Funds from
(MNE) sister subsidiaries
Leads & lags on intra-firm payables
13-17
Exhibit 13.4 External Financing of the Foreign Subsidiary
Funds
External Local currency debt
to
Borrowing from sources
the Third-country currency debt
outside of parent country
Multinational
Enterprise Eurocurrency debt
(MNE)
Individual local shareholders
Local equity
Joint venture partners
13-18
The Eurocurrency Markets
• The Eurocurrency markets are one of the truly significant innovations
in international finance of the past 50 years.
• These markets have provided a foundation for a series of innovations
in both the structure of and choices in financing the MNE.
• Eurocurrencies are domestic currencies of one country on deposit in a
second country.
• Any convertible currency can exist in “Euro” form (not to be confused
with the European currency called the euro).
• These markets serve two valuable purposes:
– Eurocurrency deposits are an efficient and convenient money
market device for holding excess corporate liquidity
– The Eurocurrency market is a major source of shortterm bank
loans to finance corporate working capital needs (including
imports and exports)
13-19
International Debt Markets
• The international debt market offers the
borrower a wide variety of different maturities,
repayment structures, and currencies of
denomination.
• The markets and their many different
instruments vary by source of funding, pricing
structure, maturity, and subordination or
linkage to other debt and equity instruments.
• The three major sources of debt funding on the
international markets are depicted in the
following exhibit.
13-20
Exhibit 13.5 International Debt Markets & Instruments
International Eurobond
Bond Market * straight fixed-rate issue
* floating-rate note (FRN)
(fixed & floating-rate, * equity-related issue
medium-to-long term)
Foreign Bond
13-21
International Debt Markets
• Bank loans and syndications:
– International bank loans have traditionally been sourced in
the Eurocurrency markets, there is a narrow interest rate
spread between deposit and loan rates of less than 1%.
– Eurocredits are bank loans to MNEs, sovereign
governments, international institutions, and banks
denominated in Eurocurrencies and extended by banks in
countries other than the country in whose currency the loan
is denominated.
– The syndication of loans has enabled banks to spread the risk
of very large loans among a number of banks (this is
significant for MNEs as they usually need credit in an
amount larger than a single bank’s loan limit).
13-22
Exhibit 13.7 Comparative Spreads Between Lending
and Deposit Rates in the Eurodollar Market
Interest Rate
Domestic 7.000 %
Loan Rate
4.625 % Eurodollar Loan Rate
Domestic Spread
Eurodollar Spread of 0.500%
of 4.000%
4.125 % Eurodollar Deposit Rate
Domestic
3.000 %
Deposit Rate
13-23
International Debt Markets
• The Euronote market:
– Euronotes and Euronote facilities are short to
medium in term and are either underwritten and
nonunderwritten
– Eurocommercial paper is a shortterm debt
obligation of a corporation or bank (usually
denominated in US dollars)
– Euro mediumterm notes is a new entrant to the
world’s debt markets, which bridges the gap
between Eurocommercial paper and a longerterm
and less flexible international bond
13-24
International Debt Markets
• The International Bond Market:
– A Eurobond is underwritten by an international syndicate of
banks and other securities firms and is sold exclusively in
countries other than the country in whose currency the issue
is denominated
– A foreign bond is underwritten by a syndicate composed of
members from a single country, sold principally within that
country, and denominated in the currency of that country
– The Eurobond markets differ from the Eurodollar markets in
that there is an absence of regulatory interference, less
stringent disclosure rules and favorable tax treatments for
these bonds
13-25
Project Financing
• Project finance is the arrangement of financing for longterm
capital projects, large in scale, long in life, and generally high in
risk.
• Project finance is used widely today by MNEs in the development
of largescale infrastructure projects in China, India, and many
other emerging markets.
• Most of these transactions are highly leveraged, with debt making
up more than 60% of the total financing.
• Equity is a small component of project financing for two reasons;
first, the scale of investment projects is often too large for an
investor or group of investors to fund and second, many projects
involve subjects traditionally funded by governments
13-26
Project Financing
• Since project financing usually utilizes a
substantial amount of debt financing,
additional levels of risk reduction are needed in
order to create an environment whereby lenders
feel comfortable lending:
– Separability of the project from its investors
– Longlived and capitalintensive singular projects
– Cash flow predictability from thirdparty
commitments
– Finite projects with finite lives
13-27