Chapter 14
Financial
Structure and
International
Debt
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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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14-2
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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14-3
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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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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Exhibit 14.1 The Cost of Capital
and Financial Structure
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14-6
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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14-7
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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14-8
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
Sfr1,500,0 00
 $1,000,000
Sfr1.500/$
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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
$
Sfr



k d  1  k 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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Exhibit 14.2 Costs of Borrowing in
Foreign Currency Denominated Bonds
(percentage)
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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
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14-14
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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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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14-16
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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Exhibit 14.3 Internal Financing of
the Foreign Subsidiary
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Exhibit 14.4 External Financing of
the Foreign Subsidiary
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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
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14-20
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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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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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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Exhibit 14.5 International Debt
Markets and Instruments
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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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14-28
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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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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Summary of Learning Objectives
• When a firm issues foreign currency-denominated 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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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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14-33
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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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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14-35
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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14-36