Chapter 13

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Chapter 13
Sourcing Equity
and Debt Globally
Sourcing Equity and Debt
Globally: Learning Objectives
• Design a strategy to source equity and debt
globally
• Analyze the motivations and goals of a firm crosslisting its shares on foreign equity markets
• Analyze the motivations and goals of a firm
issuing new equity shares on foreign equity
markets
• Understand the many barriers to penetrate
effectively foreign equity markets through crosslisting and selling equity abroad
• Examine the various financial instruments which
can be used to source equity in the global equity
markets
13-2
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Sourcing Equity and Debt
Globally: Learning Objectives
• Extend the theory of optimal financial structure to the
multinational enterprise (MNE)
• Analyze the factors that, in practice, determine the financial
structure of foreign subsidiaries within the context of the
MNE
• Evaluate the various internal and external sources of funds
available for the financing of foreign subsidiaries
• Identify the relevant characteristics of different international
debt instruments in financing both the MNE itself, and its
various foreign affiliate components
13-3
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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
13-4
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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
13-5
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Exhibit 13.1 Alternative Paths to Globalize
the Cost & Availability of Capital
13-6
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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
13-7
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Exhibit 13.2 The Cost of Capital
and Financial Structure
13-8
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Optimal Financial Structure
& The MNE
• The domestic theory of optimal capital
structure is modified by four additional
variables in order to accommodate the MNE
–
–
–
–
13-9
Availability of capital
International diversification of cash flows
Foreign exchange risk
Expectation of international portfolio investors
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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
• 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
13-10
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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
Sfr1,500,000
 $1,000,000
Sfr1.500/$
13-11
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Optimal Financial Structure
& The MNE
– At the end of the year, the US firm repays the
interest plus principal
Sfr1,500,000 x 1.05
 $1,093,750
Sfr1.440/$
– The actual dollar cost of the loan is not the
nominal 5.00% paid in Swiss francs, but 9.375%
$1,093,750
 1.09375
1,000,000
13-12
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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

k  1  k
$
d
Sfr
d
 x 1 s1
Where
kd$
= Cost of borrowing for US firm in home country
kdSfr = Cost of borrowing for US firm in Swiss francs
s
13-13
= Percentage change in spot rate
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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
S1  S2
Sfr1.500/$- Sfr1.440/$
x 100 
x 100  4.1667%
S2
Sfr1.40/$
The total cost is then
k  1  .05 x 1  0.0416671  0.09375
$
d
= 9.375%
13-14
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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 up to a 60% debt ratio
13-15
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Financial Structure of
Foreign 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
13-16
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Financial Structure of
Foreign 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
13-17
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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 MNE
• 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
13-18
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Exhibit 13.3 Internal Financing of
the Foreign Subsidiary
13-19
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Exhibit 13.4 External Financing of the
Foreign Subsidiary
13-20
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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
13-21
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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
13-22
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Exhibit 13.5 American Depositary
Receipts (ADRs)
13-23
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Exhibit 13.6 Characteristics of
Depositary Receipt Programs
13-24
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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
13-25
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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
13-26
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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
13-27
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Effect of Cross-Listing and
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)
13-28
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Other Motives for Cross-Listing
• Increasing visibility and political acceptance
– MNEs list in markets where they have
substantial physical operations
– Political objectives might include the need to
meet local ownership requirements for an MNE’s
foreign joint venture
• Increasing potential for share swaps with
acquisitions
• Compensating management and employees
13-29
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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
13-30
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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
13-31
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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
13-32
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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”
13-33
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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
13-34
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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, familyowned firms located in emerging markets
• Strategic Alliances
– Normally followed by firms that expect to gain
synergies from one or more joint efforts
13-35
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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
13-36
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Exhibit 13.7 International Debt
Markets & Instruments
13-37
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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
13-38
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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)
13-39
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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
13-40
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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
13-41
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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
13-42
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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
13-43
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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
13-44
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Summary of Learning Objectives
• Designing a capital sourcing strategy requires
management to agree upon a long run financial
objective
• The firm must then choose among the various
alternative paths to get there, including where to
cross-list its shares and where to issue new equity
and in what form
13-45
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Summary of Learning Objectives
• A firm cross-lists its shares on foreign stock
exchanges for one or more of the following
reasons
– Improving liquidity of its existing shares through
depositary receipts
– Increase its share price by overcoming mispricing by a
segmented, illiquid home market
– Support a new equity issue sold in a foreign market
– Establish a secondary market for shares used in
acquisitions
– 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
subsidiary
13-46
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Summary of Learning Objectives
• 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
• The major liquid stock markets are the NYSE,
NASDAQ, LSE, Euronext, Tokyo, and Deutsche
Bourse
13-47
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Summary of Learning Objectives
• The choice among these six markets
depends on its size, and the sophistication
of its market-making activities, including
competitive transaction costs and
competent crisis management
• Increased commitment to full disclosure
• A continuing investor relations program
13-48
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Summary of Learning Objectives
• A firm can lower its cost of capital and increase its
liquidity by selling its shares to foreign investors in
a variety of forms
– Sale of a directed share issue to investors in one
particular foreign equity market
– Sale of a Euroequity share issue to foreign investors
simultaneously in more than one market, including both
foreign and domestic markets
– Private placement under SEC rule 144A
– Sale of shares to private equity funds
– Sales of shares to a foreign firm as part of a strategic
alliance
13-49
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Summary of Learning Objectives
• The domestic theory of optimal financial structures
needs to be modified by four variables in order to
accommodate the case of the MNE:
–
–
–
–
13-50
1)
2)
3)
4)
the availability of capital;
diversification of cash flows;
foreign exchange risk; and
the expectations of international portfolio investors.
© 2012 Pearson Education, Inc. All rights reserved.
Summary of Learning Objectives
• A multinational firm’s marginal cost of capital is constant for
considerable ranges of its capital budget. This statement is
not true for most small domestic firms because they do not
have access to the national equity or debt markets
• By diversifying cash flows internationally, the MNE may be
able to achieve the same kind of reduction in cash flow
variability as portfolio investors receive from diversifying
their security holdings internationally
13-51
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Summary of Learning Objectives
• When a firm issues foreign currency-denominated debt, its
effective cost equals the after-tax 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
• Therefore, regardless of other factors, if a firm wants to raise
capital in global markets, it must adopt global norms that
are close to the U.S. and U.K. norms. Debt ratios up to 60%
appear to be acceptable. Any higher debt ratio is more
difficult to sell to international portfolio investors
13-52
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Summary of Learning Objectives
• A compromise position is possible between minimizing the
global cost of capital and conforming to local capital norms
(localization) when determining the financial structure of a
foreign subsidiary. Both multinational and domestic firms
should try to minimize their overall weighted average cost
of capital for a given level of business risk and capital
budget, as finance theory suggests
• The debt ratio of a foreign affiliate is in reality only
cosmetic, because lenders ultimately look to the parent and
its consolidated worldwide cash flow as the source of
repayment. In many cases, debt of subsidiaries must be
guaranteed by the parent firm
13-53
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Summary of Learning Objectives
• The international debt markets offer the borrower a 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 international bank loans and syndicated credits,
the Euronote market, and the international bond market
13-54
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Summary of Learning Objectives
• Eurocurrency markets serve two valuable purposes:
– 1) Eurocurrency deposits are an efficient and convenient money
market device for holding excess corporate liquidity, and
– 2) the Eurocurrency market is a major source of short-term
bank loans to finance corporate working capital needs, including
the financing of imports and exports
• Three original factors in the evolution of the Eurobond
markets are still of importance:
– 1) absence of regulatory interference,
– 2) less stringent disclosure practices, and
– 3) favorable tax treatment
13-55
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