Chapter 13
Financial
Structure &
International
Debt
Financial Structure & International
Debt: Learning Objectives
• Extend the theory of optimal financial structure
to the MNE
• Analyze the factors which, in practice,
determine the financial structure of foreign
subsidiaries within the context of the MNE
• Evaluate the various internal & external
sources of funds available for the financing of
foreign subsidiaries
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Financial Structure & International
Debt: Learning Objectives
• Identify the relevant characteristics of different
international debt instruments in financing both
the MNE itself, and its various foreign
subsidiaries
• Apply the strategies of project financing to the
funding of large global projects with unique
characteristics
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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
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13-4
Optimal Financial Structure
• The following exhibit illustrates how the cost of capital
varies with the amount of debt employed
• As the debt ratio (defined here as total debt divided by
total assets at market value) increases, the overall cost
of capital will decrease due to the heavier weight of
lower-cost debt (vis a vis equity)
• The tax deductibility of interest payments on debt helps
to bring its cost down
• However, increased debt increases perceived financial
risks and thus the cost of equity
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Optimal Financial Structure
Cost of Capital (%)
ke = cost of equity
30
28
26
24
22
20
18
16
14
12
10
8
6
4
2
Minimum cost
of capital range
kWACC = weighted average
after-tax cost of capital
kd (1-tx) = after-tax cost of debt
0
20
40
Debt Ratio (%) =
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60
80
100
Total Debt (D)
Total Assets (V)
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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
–
–
–
–
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
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13-8
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
= $1,000,000
Sfr1.500/$
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Optimal Financial Structure
& The MNE
– At the end of the year, the US firm repays the
interest plus principal
Sfr1,500,0 00 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
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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
= 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%
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13-12
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 a 60% debt ratio
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13-13
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
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13-14
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
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13-15
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
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13-16
Internal Financing of the Foreign
Subsidiary
Cash
Equity
Funds
From
Within
the
Multinational
Enterprise
(MNE)
Funds from
parent company
Real goods
Debt -- cash loans
Leads & lags on intra-firm payables
Funds from
sister subsidiaries
Debt -- cash loans
Leads & lags on intra-firm payables
Subsidiary borrowing with parent guarantee
Depreciation & non-cash charges
Funds Generated Internally by the
Foreign Subsidiary
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Retained earnings
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External Financing of the Foreign
Subsidiary
Borrowing from sources
in parent country
Funds
External
to
the
Multinational
Enterprise
(MNE)
Banks & other financial institutions
Security or money markets
Local currency debt
Borrowing from sources
outside of parent country
Third-country currency debt
Eurocurrency debt
Individual local shareholders
Local equity
Joint venture partners
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13-18
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
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13-19
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
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13-20
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)
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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
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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
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13-23
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
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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
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13-25
International Debt Markets
Bank Loans &
Syndications
(floating-rate,
short-to-medium term)
Euronote
Market
(floating-rate,
short-to-medium term)
International
Bond Market
(fixed & floating-rate,
medium-to-long term)
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International Bank Loans
Eurocredits
Syndicated Credits
Euronotes & Euronote Facilities
Eurocommercial Paper (ECP)
Euro Medium Term Notes (EMTNs)
Eurobond
* straight fixed-rate issue
* floating-rate note (FRN)
* equity-related issue
Foreign Bond
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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
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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
– 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
– Long-lived and capital intensive singular projects
– Cash flow predictability from third-party commitments
• Third party commitments are usually suppliers or
customers of the project
– Finite projects with finite lives
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13-29
Summary of Learning Objectives
• The domestic theory of optimal capital
structures needs to be modified by four
variables in order to accommodate the case of
the MNE. These four variables are (1)
availability of capital, (2) diversification of risk,
(3) foreign exchange risk and (4) expectations
of international portfolio investors
• An MNE’s marginal cost of capital is constant
for considerable ranges of its capital budget
• By diversifying cash flows internationally, the
MNE may achieve lower cash flow volatility
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13-30
Summary of Learning Objectives
• When a firm issues foreign currencydenominated debt, its effective cost of equals
the after-tax cost of repayment in terms of the
firm’s own currency. This amount included the
nominal cost of the loan adjusted for any
foreign exchange gains or losses
• Therefore, if a firm wants to raise capital in
global markets, it must adopt global norms that
are close to US and UK standards
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13-31
Summary of Learning Objectives
• A compromise position between minimizing the
global cost of capital and conforming to local
capital norms is possible when determining the
financial structure of a foreign subsidiary. Both
multinational and domestic firms should try to
lower their overall WACC
• The debt ratio of a foreign affiliate is in reality
only cosmetic because lenders ultimately look
at the parent and its consolidated cash flow
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13-32
Summary of Learning Objectives
• International debt markets offer the borrower a
variety of maturities, repayment options, and
currencies of denomination. These markets
also vary by source of funding, pricing
structure, subordination and linkage to other
securities
• Three major sources of debt funding are
international bank loans and syndicated
credits, euronote market and international bond
market
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13-33
Summary of Learning Objectives
• Eurocurrency markets serve two valuable
purposes (1) Eurocurrency deposits are an
efficient and convenient money market device
for excess corporate liquidity and (2) the
market is a major source of short-term bank
loans to finance working capital needs
• Three original factors in the evolution of the
Eurobond markets are the absence of
regulatory interference, less stringent
disclosure practices and favorable tax
treatment
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13-34
Summary of Learning Objectives
• Project finance is used widely in the
development of large-scale infrastructure
projects in emerging markets. Most are highly
leveraged transactions with debt making up
more than 60% of the capital structure
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13-35
Mini-Case: Tirstrup BioMechanics
• Please review the details of the case and answer the
following questions:
– Which of the many debt characteristics – currency,
maturity, cost, fixed versus floating rate – do you believe
are of the highest priority for Julie and Tirstrup?
– Does the currency of denomination depend on the
currency of the parent or the currency of the business
unit which will be responsible for servicing the debt?
– Exhibit 1 is Julie’s spreadsheet analysis of what she
considers relevant choices. Using these, what would
you recommend as a financing package?
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Exhibit 13.1 The Cost of Capital and
Financial Structure
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Exhibit 13.2 Costs of Borrowing in
Foreign Currency Denominated Bonds
(percentage)
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Exhibit 13.3 Internal Financing of the
Foreign Subsidiary
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Exhibit 13.4 External Financing of
the Foreign Subsidiary
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Exhibit 13.5 International Debt
Markets and Instruments
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Exhibit 13.6 Moody’s Investors Service’s
Sovereign Ceilings for Foreign-Currency Ratings
for Selected Countries (August 1999)
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Exhibit 13.7 Size and Structure of the
Global Bond Market, 2001 (nominal value,
billions of U.S. dollars)
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13-43
Exhibit 1 The All-in-Cost of the Debt
Financing Alternatives
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