International Finance
FIN456 ♦ Spring 2013
Michael Dimond
Financial Globalization and Strategy
• Global integration of capital markets has given many firms
access to new and cheaper sources of funds beyond those
available in their home market
• A firm that must source its long-term debt and equity in a
highly illiquid domestic securities market will probably have a
relatively high cost of capital and will face limited availability
of such capital
• This in turn will limit the firm’s ability to compete both
internationally and vis-à-vis foreign firms entering its market
Michael Dimond
School of Business Administration
Financial Globalization and Strategy
• Firms resident in small capital markets often source their
long-term debt and equity at home in these partially-liquid
domestic markets
• The costs of funds is slightly better than that of illiquid
markets, however, if these firms can tap the highly liquid
international capital markets, their competitiveness can be
strengthened
• Firms resident in segmented capital markets must devise a
strategy to escape dependence on that market for their longterm debt and equity needs
Michael Dimond
School of Business Administration
Financial Globalization and Strategy
• A national capital market is segmented if the required rate of
return on securities differs from the required rate of return on
securities of comparable expected return and risk traded on
other securities markets
• Capital markets become segmented because of such factors
as excessive regulatory control, perceived political risk,
anticipated FOREX risk, lack of transparency, asymmetric
information, cronyism, insider trading and other market
imperfections
Michael Dimond
School of Business Administration
Financial Globalization and Strategy
• Firms constrained by any of these above conditions must
develop a strategy to escape their own limited capital
markets and source some of their long-term capital needs
abroad
Michael Dimond
School of Business Administration
Cost and Availability of Capital
Michael Dimond
School of Business Administration
Cost of Capital
k WACC
E
D
 k e  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)
Michael Dimond
School of Business Administration
Cost of Equity and Debt
• Cost of equity is calculated using the Capital Asset Pricing Model
(CAPM)
k e  k rf   (k m  k rf )
Where
ke
krf
km
β
= expected rate of return on equity
= risk free rate on bonds
= expected rate of return on the market
= coefficient of firm’s systematic risk
• The normal calculation for cost of debt is analyzing the various
proportions of debt and their associated interest rates for the firm
and calculating a before and after tax weighted average cost of debt
Michael Dimond
School of Business Administration
The Cost of Capital
• The key component of CAPM is beta, the measure of systematic risk.
Systematic risk is a measure of how the firm’s returns vary with those of
the market in which it trades
• Beta will have a value of less than 1.0 if the firm’s returns are less volatile
than the market, 1.0 if the same as the market, or greater than 1.0 if more
volatile—or risky—than the market
• CAPM’s biggest challenge is that the beta used needs to be for the future
and not the past
• International CAPM (ICAPM) assumes that there is a global market in
which the firm’s equity trades, and estimates of the firm’s beta
• ke global = krfg + βjg (kmg – krfg)
Michael Dimond
School of Business Administration
Nestlé: An Application of the International CAPM
• The process of calculating an international WACC differs from a domestic
WACC in the selection of the appropriate market portfolio and beta
• Stulz (1995) suggests using a global portfolio of securities available to
investors rather than the world portfolio of all securities (some of which
may not be available to investors) when calculating a firm’s international
cost of equity
• The next slide shows the domestic and international risk-free rates,
market portfolios, and betas for Nestlé used to calculate required rates of
return for equity
• In this example the domestic required return for Nestlé of 9.4065% differs
slightly from Nestlé’s global required return of 9.3840%
Michael Dimond
School of Business Administration
The Cost of Equity for Nestlé of Switzerland
Michael Dimond
School of Business Administration
Calculating Equity Risk Premia in Practice
• Using CAPM, there is rising debate over what numerical
values should be used in its application, especially the equity
risk premium
– The equity risk premium is the expected average annual return on the
market above riskless debt
– Typically, the market’s return is calculated on a historical basis yet
others feel that the number should be forward looking since it is being
used to calculate expected returns
Michael Dimond
School of Business Administration
Calculating Equity Risk Premia in Practice
• The field of finance does agree that a cost of equity
calculation should be forward-looking, meaning that the
inputs to the equation should represent what is expected to
happen over the relevant future time horizon
• As is typically the case, however, practitioners use historical
evidence as the basis for their forward-looking projections
Michael Dimond
School of Business Administration
Geometric Average vs Arithmetic Average
• Arithmetic Average only shows the “typical” result
• Geo Avg = [(1+20%)*(1+-16.67%)* (1+20%)*(1+16.67%)]^(1/4) -1 = 8.78%
• CAGR also shows the result of compounding
• (14/10)^(1/4) – 1 = 0.878 = 8.78%
• The price didn’t increase 8.78% each year, but we end up with
the same final value if we compound it by 8.78% every year.
• 5 years means 4 periods of compounding, so we find the 4th root ( ^1/4 power)
Michael Dimond
School of Business Administration
Alternative Ke Estimates for Hypothetical U.S Firm
Assuming β = 1 and krf = 4%
Michael Dimond
School of Business Administration
The Demand for Foreign Securities
• International portfolio investment and cross-listing of equity shares on
foreign markets have become commonplace
• As both domestic and international portfolio managers are asset
allocators, their objective is to maximize a portfolio’s rate of return for a
given level of risk, or to minimize risk for a given rate of return
• International portfolio managers can choose from a larger bundle of
assets than portfolio managers limited to domestic-only asset allocations
• Some important diversification dimensions include diversification by
country, geographic region and/or stage of development
Michael Dimond
School of Business Administration
Link between Cost & Availability of Capital
• Although no consensus exists on the definition of market
liquidity, market liquidity can be observed by noting the
degree to which a firm can issue new securities without
depressing existing market prices
• In a domestic case, the underlying assumption is that total
availability of capital at anytime for a firm is determined by
supply and demand within its domestic the market
• In the multinational case, a firm is able to improve market
liquidity by raising funds in the Euromarkets, by selling
securities abroad, and by tapping local capital markets
Michael Dimond
School of Business Administration
Market Segmentation
• Capital market segmentation is a financial market
imperfection caused mainly by government constraints,
institutional practices, and investor perceptions
• Other imperfections are
–
–
–
–
–
–
–
Asymmetric information
Lack of transparency
High securities transaction costs
Foreign exchange risks
Political risks
Corporate governance differences
Regulatory barriers
Michael Dimond
School of Business Administration
Effects of Market Liquidity & Segmentation
• The degree to which capital markets are illiquid or segmented
has an important influence on a firm’s marginal cost of capital
• A MNC has a given marginal return on capital at differing
budget levels determined by which capital projects it can and
chooses to take on
• If the firm is limited to raising funds in its domestic market, it
has domestic marginal cost of capital at various budget levels
Michael Dimond
School of Business Administration
Effects of Market Liquidity & Segmentation
• If an MNC has access to additional sources of capital outside
its domestic market, its marginal cost of capital can decrease
• If the MNC has unlimited access to capital both domestic and
abroad, then its marginal cost of capital decreases even
further
Michael Dimond
School of Business Administration
Liquidity, Segmentation, and Marginal Cost of Capital
Michael Dimond
School of Business Administration
Globalization of Securities Markets
• During the 1990s, national restrictions on cross-border portfolio
investment were gradually eased under pressure from the Organization
for Economic Cooperation and Development (OECD)
• Presently, market segmentation has been significantly reduced, although
the liquidity of individual national markets remains limited
• Significantly higher value accrues to firms that have “imported” an AngloAmerican corporate governance system
Michael Dimond
School of Business Administration
Cost of Capital for MNCs versus Domestic Firms
• Is the WACC or an MNC higher or lower than for its domestic
counterpart?
– The answer is a function of
•
•
•
•
The marginal cost of capital
The after-tax cost of debt
The optimal debt ratio
The relative cost of equity
• A MNC should have a lower cost of capital because it has
access to a global cost and availability of capital
• This availability and cost allows the MNC more optimality in
capital projects and budgets compared to its domestic
counterpart
Michael Dimond
School of Business Administration
Cost of Capital for MNC and Domestic Compared
Michael Dimond
School of Business Administration
Do MNCs Have a Higher or Lower Cost of Capital?
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
Globalizing the Cost & Availability of Capital
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
The Cost of Capital and Financial Structure
Michael Dimond
School of Business Administration
Optimal Financial Structure & The MNC
• The domestic theory of optimal capital structure is modified
by four additional variables in order to accommodate the
MNC
–
–
–
–
Availability of capital
International diversification of cash flows
Foreign exchange risk
Expectation of international portfolio investors
Michael Dimond
School of Business Administration
Optimal Financial Structure & The MNC
• Availability of capital
– Allows MNCs to lower cost of capital
– Permits MNCs to maintain a desired debt ratio even when new funds
are raised
– Allows MNCs 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
Michael Dimond
School of Business Administration
Optimal Financial Structure & The MNC
• 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
 $1,000,000
Sfr1.500/$
Michael Dimond
School of Business Administration
Optimal Financial Structure & The MNC
– 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
Michael Dimond
School of Business Administration
Optimal Financial Structure & The MNC
– 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
Michael Dimond
School of Business Administration
Optimal Financial Structure & The MNC
• 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%
Michael Dimond
School of Business Administration
Optimal Financial Structure & The MNC
• 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
Michael Dimond
School of Business Administration
Financial Structure of Foreign Subsidiaries
• Debt borrowed is from sources outside of the MNC (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
Michael Dimond
School of Business Administration
Financial Structure of Foreign Subsidiaries
• Disadvantages of localization
– A MNC 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
Michael Dimond
School of Business Administration
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
MNC
• 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
Michael Dimond
School of Business Administration
Financial Structure of Foreign Subsidiaries
Michael Dimond
School of Business Administration
External Financing of the Foreign Subsidiary
Michael Dimond
School of Business Administration
The Sony Keiretsu: Interlocking Directorships
TRANSPORT
CO
SUPPLIER
NO.1
SUPPLIER
NO.2
SONY
BANK
NO. 1
BANK
NO. 2
Michael Dimond
43
School of Business Administration
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
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
American Depositary Receipts (ADRs)
Michael Dimond
School of Business Administration
Characteristics of Depositary Receipt Programs
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
Effect of Cross-Listing & 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)
Michael Dimond
School of Business Administration
Other Motives for Cross-Listing
• Increasing visibility and political acceptance
– MNCs list in markets where they have substantial physical operations
– Political objectives might include the need to meet local ownership
requirements for an MNC’s foreign joint venture
• Increasing potential for share swaps with acquisitions
• Compensating management and employees
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
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”
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
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, family-owned firms located in
emerging markets
• Strategic Alliances
– Normally followed by firms that expect to gain synergies from one or
more joint efforts
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
International Debt Markets & Instruments
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
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 Eurocommercial paper (ECP) and Euro Medium-term notes (EMTNs)
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
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 MNCs, large domestic corporations, governments,
government enterprises and international institutions
– Offered simultaneously in a number of different capital markets
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration
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
Michael Dimond
School of Business Administration