International Finance
Part 2
International
Corporate Finance
Lecture n° 8
Financing the Global firm
1
International Corporate Finance
Global cost and availability of capital
Purpose of firms having access to global capital markets:
Minimize their cost of capital
Maximize 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
2
International Corporate Finance
Local Market Access
Global Market Access
Firm-Specific Characteristics
Firm’s securities appeal only
to domestic investors
Firm’s securities appeal to
international portfolio investors
Market Liquidity for Firm’s Securities
Illiquid domestic securities market
and limited international liquidity
Highly liquid domestic market and
broad international participation
Effect of Market Segmentation on Firm’s Securities and Cost of Capital
Segmented domestic securities
market that prices shares
according to domestic standards
Access to global securities market
that prices shares according to
international standards
3
Global cost of capital
Weighted Average Cost of Capital (WACC)
k WACC
E
D
 ke
 k d (1  t)
V
V
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)
4
Global cost of capital
Weighted Average Cost of Capital (WACC)
Cost of equity : CAPM (Capital Asset Pricing Model)
k e  k rf   j (k m  k rf )
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 = jmj/m
5
Global cost of capital
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
WACC
Usually used as the risk-adjusted discount rate
whenever a firm ’s new projects are in the same general
risk class as its existing projects.
6
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 capital
If 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
7
(constant D/E ratio).
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’s
Higher cost of capital / Rising cost of capital / Shifts in
the optimal financial structure / Rising cost of projects 8
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. 9
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.
10
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.
Nowadays
Significant reduction of market segmentation, following
globalisation. But reduced gains of international
portfolio diversification.
11
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.
12
Cost of Capital in MNE ’s
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.
13
Cost of Capital in MNE ’s
Marginal cost of capital
and rate of return (percentage)
MCCDC
20%
MCCMNE
15%
10%
MRRMNE
5%
MRRDC
100
140
300
350
400
Budget
(millions of $)
14
Cost of Capital in MNE ’s
Is MNEwacc > or < Domesticwacc ?
kWACC = ke
[
Equity
Value
]
+ kd ( 1 – tx )
[
Debt
Value
]
Empirical studies : MNEs have a lower debt/capital ratio, leading to
a higher cost of capital than their domestic counterparts.
Indications are that : MNEs have a lower average cost of debt, leading
to a lower 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
15
a lower cost of capital.
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.
16
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
17
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.
18
Financial Structure & i debt
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 (%) =
60
Total Debt (D)
Total Assets (V)
80
100
19
Financial Structure & i debt
Financial structure and international debt
Optimal financial structure : the case of the MNE
Compared 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
20
Financial Structure & i debt
(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.
Where
$
kd


Sfr
1  kd
x 1  s1
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
(4) Expectations of international portfolio investors :
dominance of US - UK norms on global markets, for firms
21
overcoming market segmentation.
Financial Structure & i debt
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.
22
Financial Structure & i debt
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.
23
Financial Structure & i debt
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.
24
Financial Structure & i debt
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.
25
Financial Structure & i debt
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.
26
Internal sources of funds
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
Retained earnings
27
Financial Structure & i debt
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.
28
External sources of funds
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
29
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.
30
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 credits
Traditionally sourced in eurocurrency markets, extended by
banks in countries other than in whose currency the loan is
denominated
31
International Debt Markets
Syndicated credits
Enable banks to risk lending large amounts
Arranged by a lead bank with participation of other bank
Narrow spread, usually less than 100 basis points
Euronote market
Collective term for medium and short term debt
instruments sourced in the Eurocurrency market, e.g. Eurocommercial paper (ECP), Euro medium-term notes
(EMTNs).
International bond market
Fall within two broad categories
Eurobonds
Foreign bonds
32
International Debt Markets
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.
33
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)
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
34
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.
35
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 commitments
Third party commitments are usually suppliers or
customers of the project.
(4) Finite projects with finite lives.
36