International Long-Term Financing, Capital Structure and the Cost of Capital
10.1 INTERNATIONAL BANK LOAN FINANCING
Definition and classification
International bank loans are classified into two categories: foreign loans and Euroloans. Foreign loans are raised by borrowers who are foreign to the country where the loans are raised. International loans, however, mostly take the form of Euroloans or Eurocredits, which are denominated in a currency other than the currency of the country where the loans are raised. Euroloans and foreign loans are also distinguished as follows. While Euroloans are financed wholly out of Eurocurrency funds, irrespective of whether the borrower is a resident or a nonresident of the country in question, foreign loans are domestic currency credits extended to non-resident borrowers.
Syndicated loans (Euro or foreign) are characterised by being so large in size that it becomes necessary to form a syndicate or a group of lending banks to finance the loan. The advantage of syndication is that it enables banks to spread the risk of very large loans amongst themselves. This is important because a large multinational firm may need credit in excess of what a single bank can offer. A syndicated loan is arranged by a lead bank on behalf of a client such as a multinational firm. The lead bank seeks the participation of a group (syndicate) of banks, each providing a portion of the loan. One or more banks are designated as reference banks, which is necessary to establish the reference interest rate.
Pricing international loans
i
in the demand for and supply of loans. The following factors are important for determining the interest rate charged to the borrower.
The spread and the reference rate
The interest paid on syndicated loans is usually computed by adding a spread to the London interbank offer rate (LIBOR) or another reference rate such as the US prime rate or the Singapore interbank offer rate (SIBOR). The following factors determine the spread:
The availability of liquidity or loanable funds relative to demand. Spreads are likely to be higher in a market that is characterised by a shortage of liquidity and excess demand for loanable funds.
The creditworthiness of the borrower, as high-quality borrowers are charged lower spreads than low-quality borrowers. High-quality borrowers include OECD governments, multinational firms, major OECD companies and international organisations such as the World Bank.
The maturity of the loan, with higher spreads charged on long-maturity loans.
In domestic bank lending, interest rates allow for the narrowest loan spread when the central government is the borrower because there is no credit risk (the government can print money or tax people to meet its debt obligations). When non-government borrowers are involved the spreads increase as a function of credit risk. In international lending, central government borrowers pay varying interest rates because of differences in perceived country risk. Other borrowers pay higher interest rates because of (i) differences in country risk, (ii) differences in credit risk, and (iii) differences in the currency of loan denomination.
The fees charged
In addition to interest payments, the borrower is expected to pay management fees, participation fees, commitment fees and taxes. Management fees are charged by managing banks for their services. These are one-time charges levied when the loan agreement is signed. Participation fees are divided among all banks in relation to their share of the loan. Commitment fees are charged to the borrower as a percentage of the undrawn portion of the loan. There is normally a trade-off between fees and the spread over the reference rate. Banks prefer a combination of high fees and low spreads because they can advertise a low spread (which is good for business) without losing revenue.
Currency of denomination
The currency of denomination affects loan pricing in two ways: (i) interest rates vary from one currency to another; and (ii) the potential gain/loss on a currency must be considered when the currency of denomination is different from the base currency of the borrower.
The empirical evidence
Sargen (1976) attempted to explain differences in the loan spreads that borrowing countries pay. He used two estimated equations, the first of which shows how the loan spread varies between developing and developed countries. This equation includes the following explanatory variables: (i) type of borrower, (ii) year of loan commitment and (iii) length of loan commitment. The findings indicate that borrowers from developing countries pay an average spread of 140 basis points over LIBOR, while developed countries pay on average 25 or less. Since the maturity of the loan exerts a small influence on borrowing costs, the second equation attempts to consider variations in loan spreads within the groups of developing countries. The variables used to explain loan spreads include: (i) an income effect (high-income versus low- income LDCs); (ii) a Mexico effect, a dummy variable related to Mexico's long experience as an international borrower; (iii) the debt-services ratio, or the ratio of debt service payments to export receipts; (iv) inflation; (v) general increase in interest costs from 1974 to 1975; and (vi) loan maturity. All six variables turned out to be statistically significant.
Brittain (1977) carried out similar analysis, using a single variable to explain LIBOR spreads, the ratio of external debt to GNP. He found that LDC borrowers with higher debt to GNP ratios pay higher LIBOR spreads for medium-term funds. In an analysis by Angelini et al. (1979) the authors produced an equation in which three country risk variables proved helpful in accounting for differences in LIBOR spreads: export growth, growth in per capita GNP and the ratio of GNP to external debt. Other variables of importance were found to be the debt service ratio and the ratio of reserves to imports.
Loan documentation
Loan agreements specify the rights and obligations of the borrower and lender. They specify the timing, calculation and the method of paying interest, principal, and fees. Several clauses have been developed for international lending, including the following:
Changes in circumstances. If any law or regulation changes such that the loan becomes illegal, the borrower must repay the loan. A second part of the clause protects against changes in reserve requirements or changes that may lead to an increase in the bank's cost of funding the loan.
Sovereign immunity. Under most laws, a sovereign state is immune from the seizure of assets.
Governing law and jurisdiction. This clause specifies the law that governs the contract.
Cross default. A default by the borrower under any loan agreement constitutes an automatic default under the bank's agreement.
5. Negative pledge. This clause forbids any secured borrowing unless the bank is secured equally. It prevents a bank's position from deteriorating relative to other lenders.
Risk sharing and reduction
International banks use the following techniques to reduce and shift risks
involved in international lending:
Loan selection and structuring. This process includes an analysis of credits to screen out inferior loans, application of loan limits, emphasis on booking higher quality credits and adherence to country, customer and currency limits.
Participation in loans. Many banks participate in large loans, each taking a small portion of the amount.
Use of guarantees and insurance. Central government agencies, central banks, and commercial banks provide loan guarantees. A variety of agencies provide insurance, such as the US Import-Export Bank and those involved in providing insurance for FDI.
Floating rate loans. These loans provide protection for the lender bank against interest rate risk (risk is shifted to the borrower).
10.2 INTERNATIONAL BOND FINANCING
Eurobonds and foreign bonds
International bonds can be Eurobonds or foreign bonds. Again, the distinction depends on whether the borrower is a domestic or a foreign resident, and whether the issue is denominated in the domestic or a foreign currency. A Eurobond issue is underwritten by an international syndicate of banks and other financial institutions and placed (that is, sold) in countries other than the country in whose currency the issue is denominated.
The Eurobond market, which is an extension of the offshore or external financial markets, has emerged because of some of the same factors that have led to the emergence of the Eurocurrency market, or the market for short-term Eurocurrency funds. These include: (i) the absence of regulatory interference; (ii) less stringent disclosure requirements; and (iii) favourable tax status, as interest income is not subject to income and withholding tax.
A foreign bond is underwritten by a syndicate consisting of members from a single country, sold primarily within that country and denominated in its currency. The issuer (or borrower), however, is foreign. Even if the borrower is not particularly interested in the currency of the issue, the funds raised can be swapped for other currencies. Foreign bonds have nicknames: foreign bonds sold in the USA are Yankee bonds, in Japan they are Samurai bonds, and in the UK they are bulldogs.
Types of international bond
International bonds can be of several types. These are briefly described in turn.
Straight fixed-rate bonds
The most common type of bonds are straight bonds on which coupons are normally paid annually or semiannually. Interest payments are a fixed percentage (determined by the coupon rate) of the par or the face value of the bond. On maturity, the bondholder receives the face value and the last interest payment.
Floating rate notes (FRNs)
Unlike straight bonds, FRN holders receive a variable semiannual coupon payment. The variable coupon rate is determined with reference to (by adding a margin to) a variable reference rate, such as LIBOR. FRNs came to the market as a natural outcome of the increase in interest rate volatility, which caused investors to be reluctant to hold long-maturity straight bonds.
Convertible bonds
Convertible bonds are equity-related bonds. They resemble straight bonds with the added feature that they are convertible to equity prior to maturity at a specified price per share. This feature enables the borrower to issue debt instruments with lower coupon rates than the corresponding straight bonds. In this case, the lender is willing to accept a lower coupon rate than on a comparable straight bond because of the attractiveness of the feature of convertibility.
Bonds with equity warrants
These are another type of equity-related bonds. They give the holder the extra privilege of having the right (which may or may not be exercised) to buy the shares of the same company issuing the bonds. Thus warrants are like equity options except that the issuers of the bond and the warrant are the same party, unlike the case of options, in which the two issuers are different.
Zero coupon bonds
The holder of a zero coupon bond does not receive coupon payments prior to the maturity date. Upon maturity, the holder receives the full face value of the bond, which is initially purchased at a discount. The attractive feature of zero coupon bonds is that they are not subject to reinvestment risk, which is encountered in the case of straight bonds. With the changing level of market interest rates, the holder of a straight bond is exposed to reinvestment risk because the holder doses not know at what rate the coupon payments received prior to the maturity of the bond can be reinvested. Since zero coupon bonds offer no coupon payments prior to maturity, this kind of risk does not arise.
Multicurrency bonds
A multicurrency bond holder receives payments in more than one currency. One variant is a dual currency bond, which has different currency denominations for coupon payments and face value payments.
Global bonds
The concept of global bonds was introduced by the World Bank in 1989. Global bonds are defined as very large issues that are sold simultaneously in the world's major capital markets. Global bonds may be held and cleared through several different systems in the major geographical regions, and the securities can move freely from one system to another. The implication of these characteristics is that these bonds are highly liquid.
The primary market
A borrower wanting to raise funds by issuing Eurobonds to the investing public will invite an investment banker to serve as a lead manager of an underwriting syndicate that will bring the bonds to market. The underwriting syndicate is a group of investment banks, merchant banks and the merchant banking arms of commercial banks that specialise in some phase of a public issue. The lead manager usually invites co-managers to form a managing group to help negotiate terms with the borrower, assess market conditions and manage the issue. The managing group along with other banks serve as underwriters for the issue in the sense that they will commit their own capital to buy the issue from the borrower at a discount from the issue price. The discount or the underwriting spread is typically in the 2% to 2.5% range. Most of the underwriters, along with other banks, will be part of a selling group that sells the bonds to the investing public. Members of the underwriting syndicate receive a portion of the spread, depending on the number and type of function they perform. The lead manager gets the full spread, but a bank serving only as a member of the selling group receives a smaller portion.
The choice of the currency of denomination
Just like the case with short-term financing, the decision concerning the choice of currency depends on the relative cost of borrowing in various currencies. This is certainly true for a risk-neutral issuer, but for an issuer that is risk-averse, risk becomes another decision variable. For the purpose of the following discussion, we will assume that the issuer is risk neutral. However, it is straightforward to modify the decision rules for a risk-averse issuer by introducing a risk premium.
Suppose that a firm wants to raise an amount, K, of the base currency, x, by issuing either base currency bonds or foreign currency (y) bonds (which can be Eurobonds or foreign bonds). For simplicity let us assume that these are zero coupon bonds, such that all of the payments are made on maturity, which we will assume to be n years. If a domestic currency bond is chosen, then the amount to be paid by the firm will be
LxM n= K(1 + ix)n (10.1)
where ix is the base currency interest rate. If foreign currency denomination is used, the foreign currency amount raised is K/St where St is the initial exchange rate. On maturity, the base currency equivalent of the foreign currency amount due is
KS
L*X,t+ n= —^ (1 + iy )n (10.2)
S
where St+n is the exchange rate prevailing on maturity when the borrowed funds are to be repaid. Equation (10.2) can be rewritten as
L;,t+ n= K(1 + S)n(1 + iy )n (10.3)
where S is the annual percentage rate of change of the exchange rate between 0 and n.
Assuming risk neutrality, foreign currency denomination will be preferred
if Lx,t+ n < Lx,t+ n or if
K(1 + S)n(1 + iy )n <K(1 + ix)n (10.4)
which can be simplified to give the condition
iy + S <ix (10.5)
If this condition is satisfied the bond issue should be denominated in currency y rather than base currency x. Let us assume that, from a British perspective, currency y is the Australian dollar. A British firm should, if the condition represented by (10.5) is satisfied, choose an Australian dollar issue rather than a pound issue. If the firm sells the bonds in Australia, this would be a foreign bond issue. If the bonds are sold in any other country, this would be a Eurobond issue. On the other hand, if
iy + S >ix (10.6)
the firm should use base currency denomination. In the case of the British firm, if the bonds are sold in the UK, it would be a domestic (rather than an international) bond issue. If the bonds are sold outside the UK, it would be a Eurobond issue.
10.3 INTERNATIONAL EQUITY FINANCING
Unlike the case of loans and bonds, the internationalisation of equities did not take off until about 1983. International equity markets encompass primary market functions (underwriting of new equity issues) and secondary market functions (trading) of equities outside the issuer's home country. The London International Stock Exchange is the best example of an international secondary equity market, accounting for a large portion of international equity trading.
International business firms operate in international equity markets by listing their shares on foreign stock exchanges (the secondary market function) and by selling new shares to foreigners (the primary market function). We will deal with these functions in turn.
Listing on foreign stock exchanges
Cross listing refers to a firm having shares listed on one or more foreign exchanges in addition to the home country stock exchange. Although cross listing is not a new concept, the increased globalisation of world equity markets has caused the amount of listing to explode in recent years. A firm may decide to cross list for the following reasons:
Cross listing provides a means of expanding the investor base for a firm's stock, thus potentially increasing the demand for the stock. Increased demand may boost the price and improve liquidity.
It establishes name recognition of the company in a new capital market, thus paving the way for the firm to source new equity or debt capital from local investors.
It brings the firm's name before more investors and customers. International diversification is validated if investors can trade the security on their own stock exchanges.
Cross listing may mitigate the possibility of a hostile takeover of the firm through the broader investor base created for the firm's shares.
It may be helpful in supporting a new equity issue.
Broadening ownership outside the national frontiers, which can be accomplished via cross listing, may help reduce price fluctuations.
Cross listing obligates the firm to adhere to the securities regulations of its home country as well as the regulations of the countries in which it is cross listed. Thus the benefits of listing on foreign stock exchanges must be balanced against the cost of the implied commitment to full disclosure. Because the disclosure guidelines of the US Securities and Exchange Commission (SEC) are more stringent than in other countries, US firms find it easier to list on foreign stock exchanges than non-US firms wishing to list on US stock exchanges. But having decided to list on a foreign stock exchange, the question arises as to where to list. The choice depends on the motive behind foreign listing. If the motive is to support a new equity issue, the target market should be the listing market. If it is to boost the firm's commercial and political visibility, the market should be the one in which the firm has significant physical operations. If the motive is to improve the liquidity of existing shares, then the market should be a major liquid market such as New York, London and
Tokyo.
Selling new shares in international markets
A firm may sell its newly issued shares to foreign investors in one of the
following ways:
Selling shares in a particular foreign stock market underwritten in whole or in part by institutions from the host country. It may take the form of a private placement, in which the whole issue is sold to one or a few investors, typically institutional investors such as pension funds and insurance companies.
Selling Euro-equity issues to foreign investors in more than one country simultaneously. The prefix "Euro" has the same meaning we came across earlier. The integration of national capital markets has led to the emergence of a Euro-equity market.
Selling a foreign subsidiary's shares to investors in the host country. This can lower a firm's cost of capital if investors in the host country award a higher capitalisation rate on the subsidiary's earnings than on the firm's earnings.
Selling shares to a foreign firm as part of a strategic alliance. This may involve the sharing of the cost of developing new technology or pursuing complimentary marketing activities.
10.4 OTHER SOURCES OF FINANCING
There are some other means of long-term financing. These are: (i) parallel loans, (ii) credit swaps, (iii) government lending and (iv) development institution lending. These will be discussed in turn.
Parallel loans
A parallel loan involves an initial exchange of funds between firms in different countries, such that the transaction is reversed some time in the future. For example, suppose that a subsidiary of a US company in Japan needs some yen funds while the subsidiary of a Japanese company in the US needs funds in US dollar. The US company then lends the Japanese subsidiary US dollar funds, while the Japanese company lends the US subsidiary an approximately equivalent amount in yen. After an agreed period of time, the US subsidiary pays the yen loan (principal plus interest) while the Japanese subsidiary simultaneously pays off the US dollar loan. Obviously, this operation does not involve any foreign exchange risk because no currency conversion takes place.
Parallel loans were specifically designed to circumvent foreign exchange controls. However, they have the added advantage over bank lending that the two firms can avoid transaction costs in the form of bid-offer spread in both interest and exchange rates. The problem with parallel loans is that it is difficult to find two counterparties with exactly matching needs.
Credit swaps
A credit swap makes it possible to acquire a loan for a foreign subsidiary without having to send funds abroad. It involves the exchange of currencies between a bank and a firm, not between two firms. The procedure is best illustrated with the help of an example. A British company could place euro- denominated funds (deposited) with a German bank in Frankfurt for a certain period of time. The bank can then instruct its branch, corresponding bank or subsidiary in London to grant a British subsidiary of the German company a pound-denominated loan. On the maturity of the loan and the deposit, the bank's branch will receive the loan repayment while the British company receives the deposit.
Government lending
Host governments of foreign investments provide financing when they believe that the underlying projects will generate jobs, provide some transfer of technology, or train local workers. Countries acting as hosts for foreign investment often provide financial incentives to foreign investors including loans, subsidies, grants and loan guarantees.
Lending by international development institutions
There are a number of development institutions that grant developing countries loans to finance some infrastructure projects. While these loans are granted to the host governments, the companies working there are financed indirectly.
10.5 THE COST OF CAPITAL
A firm's capital consists of equity (retained earnings and funds obtained by issuing equity) and debt (borrowed funds). The firm's cost of retained earnings reflects an opportunity cost representing what the existing shareholders could have earned if they had received the earnings as dividends and invested the funds themselves. The firm's cost of new equity capital that is obtained by issuing new equity reflects the opportunity cost of what the new shareholders could have earned if they had invested their funds elsewhere. The cost of new equity capital is higher than the cost of retained earnings because it also includes the expenses associated with selling the new equity. The cost of debt is easier to measure because interest expenses are incurred by the firm as a result of borrowing funds.
The cost of capital has a major impact on a firm's value. To fund its operations, a firm uses a capital structure (that is, a combination of equity and debt) that minimises its cost of capital, and therefore maximises its value. The lower the firm's cost of capital, the lower is its required rate of return on a given proposed project. Therefore estimating the cost of capital is a step that must be taken before indulging in the capital budgeting exercise, as we shall see in Chapter 12.
For a multinational firm, financing can take a much wider range of forms than for a purely domestic firm. Generally speaking, a multinational firm can raise financing from either internal or external sources. Internal sources include retained earnings and funds provided by subsidiaries. External sources include national and international capital markets. Faced with such a lucrative menu, the multinational firm's choice depends on several factors, including the following: (i) the need to maintain or strengthen the extent of control over subsidiaries; (ii) the need to receive regular cash inflow from subsidiaries; (iii) the purpose for which financing is needed; (iv) other aspects of the overall business strategy, such as the objective of minimising global tax liabilities; (v) expectations concerning the future path of exchange and interest rates; and (vi) the desire to minimise exposure to various types of risk, such as foreign exchange risk and country risk.
The weighted average cost of capital
(10.7)
where t is the tax rate. The first term, which reflects the weighted cost of debt, [D/(D + E)]kd, is multiplied by the term (1 -1), which is less than unity. This is because debt financing involves tax saving, given that interest expenses are tax deductible.
The cost of equity capital, ke, is the equity market's expected rate of return on the firm's equity, based upon the equity market's opportunity cost of forgoing investment in other stocks with the same risk. In addition to the business risk of the firm's operations, the cost of equity capital depends on the firm's relative debt level, D/(D + E), since the degree of financial leverage influences the risk of equity.
(10.8)
(10.9)
D = Z D,
i=1
E = Z
i=1
The weighted average cost of capital raised in country i is
D
k
i
=
(10.10)
Di
+
Ei
(1 - ti ) +
Di + Ei
Hence the overall cost of capital is given by
Di + Ei
k = Z
(10.11)
D
+ E
k:
Otherwise, the overall cost of capital can be calculated from the overall debt and equity costs of capital, which are weighted averages of the individual countries' costs of debt and equity capital.
A number of factors can explain the observed difference between the cost of capital of a multinational firm and that of a domestic firm. Some of these factors make the cost of capital of a multinational firm lower than that of a domestic firm, whereas others do the reverse. Because of the diversity of these factors, one cannot reach a general conclusion as to whether the cost of capital of a domestic firm is higher or lower than that of a multinational firm: it all depends on the particular case of each firm.
To start with, size does matter. Indulging in international operations leads to growth beyond what is available from domestic operations only. Because of this factor, multinational firms tend (on average) to be larger in size than domestic firms. Larger sizes reduce the cost of both debt and equity capital. Large multinational firms borrow substantial amounts of funds, and in the process they receive preferential borrowing rates from creditors such as banks. Moreover, multinational firms exploit economies of scale through their relatively large issues of bonds and equity. Economies of scale lead to lower costs (as a percentage of the amount raised) of new bond or equity issues.
Access to international capital markets is another factor. Multinational firms source funds from domestic as well as international capital markets. Access to international capital markets allows multinational firms to obtain lower
borrowing rates. They could also obtain funds at lower costs through their subsidiaries. Or they could indulge in cross-border financing operations, such as parallel loans and swaps.
The cost of capital is also affected by the probability of bankruptcy, such that the higher this probability the higher will be the cost of capital, as creditors and shareholders demand higher rates of return on their funds. A basic principle in finance is that diversification reduces risk. In this case international diversification leads to stability of cash flows and hence to lower probability of bankruptcy.
Exposure to foreign exchange risk is yet another factor. Funds remitted to a multinational firm from its subsidiaries are converted into the firm's base currency. Because of the exchange rate factor, the base currency value of foreign currency cash flows will be highly volatile. The variability of the base currency value of foreign currency cash flows leads to a higher probability that the firm may go bankrupt, thus raising the cost of capital.
While international operations imply international diversification, which in turn implies stability of cash flows, they also lead to exposure to country risk. Extreme exposure to country risk (particularly political risk) may lead to an outright confiscation of the project, and hence big losses for the multinational firm. By following the same argument concerning the probability of bankruptcy, it is easy to conclude that exposure to country risk, just like exposure to foreign exchange risk, leads to a higher cost of capital.
10.6 VARIATIONS IN THE COST OF CAPITAL AND CAPITAL STRUCTURE
In this section we discuss the reasons for inter-country differences in the cost of capital and inter-firm differences in capital structure. We start with the first issue of cross-country differences in the cost of capital, which can explain why multinational firms based in some countries may have a competitive advantage over others. Furthermore, understanding the differences between the cost of debt capital and the cost of equity capital can explain why multinational firms based in certain countries have more debt-intensive capital structures.
Differences in the cost of debt capital
The cost of debt capital is determined by the risk-free interest rate and the risk premium. The cost of debt capital is higher in some countries than in others because the risk-free rate and/or the risk premium is higher. Differences in the risk-free rate are due to several factors that affect the supply of, and demand for, loanable funds and hence the level of the interest rate. For example, the interest rate varies with the state of the economy, tending to rise when the economy is booming and to decline when the economy is in a slump. There is also a direct positive relationship between the level of the nominal interest rate and expected inflation. Other factors that affect the level of the interest rate are the stance of monetary policy (tight or expansionary), tax laws (whether or not these laws encourage saving), and demographic factors (younger households tend to save less).
The risk premium is meant to compensate creditors for the risk of default by the borrower. This risk varies across countries because of differences in economic conditions, relationships between companies and creditors, government intervention, and the degree of financial leverage. The risk premium tends to be lower in countries where economic conditions are more stable. The risk of default increases as the economy moves into recession, so we should expect the risk premium to increase as economic activity slows down. The risk premium is also lower in countries where the relationship between creditors and companies is so close that creditors stand ready to extend credit in the event of financial distress.
Differences in the cost of equity capital
Now we turn to cross-country differences in the cost of equity capital. Recall that the cost of equity capital is an opportunity cost: what shareholders can earn on investments with similar risk if the equity funds were distributed to them. This return consists of the risk-free interest rate and a risk premium. Differences in the risk-free rates lead to differences in the cost of equity capital, which also depends on investment opportunities in the underlying country. Countries with abundant investment opportunities will have a higher cost of equity capital than countries with limited investment opportunities.
Choosing the capital structure
Choosing the capital structure is the choice of the debt-equity ratio. Debt is useful because interest payments are tax-deductible, but too much debt gives the impression that the company is financially vulnerable, which raises the cost of equity. The firm should aim at the level of debt-equity ratio that minimises the cost of capital and hence maximises the value of the firm. The advantages of using debt as opposed to equity vary from one company to another because of two sets of factors. The first set of factors pertain to the specific characteristics of the company, whereas the other factors pertain to the characteristics of the countries where the subsidiaries and the underlying projects are located.
There are three corporate characteristics that affect the capital structure: the stability of the firm's cash flows, its credit risk and access to earnings. Firms with more stable cash flows can handle more debt because these cash flows can be used to cover periodic interest payments. One way to achieve stability of cash flows is to diversify across countries, which means that more geographically diversified firms tend to have more stable cash flows and more debt-intensive capital structure (that is, a higher debt-equity ratio). Likewise, firms with lower credit risk (lower probability of default on loans) can handle a more debt-intensive capital structure. Lower credit risk would be the case if the firm has a strong and competent management and if it has marketable assets that can serve as a collateral. Finally, firms that are more profitable can use retained earnings to finance their operations, in which case they would use equity-intensive capital structures. This is why growth-oriented multinational firms have a higher debt-equity ratio than those with less growth.
There are factors that pertain to the host country, and this is why we can observe country differences in the capital structure. For example, firms in Japan and Germany have traditionally used a higher debt-equity ratio than those in the USA or the UK. This is because the probability of bankruptcy in Japan and Germany is lower, given that the governments in these countries are more willing to step in and rescue troubled firms. It is also a tradition that banks in these countries are not only creditors but also shareholders, in which case they have a vested interest in rescuing troubled firms.
The factors influencing the capital structure that pertain to the host country include the following. The first of these factors arises when there are restrictions on stock ownership in the host country. If, for one reason or another, investors in the host country are not allowed or are unwilling to invest in foreign shares, a multinational firm operating in that country will find it easier to raise equity capital there. In this case the multinational firm will have a more capital-intensive structure. Conversely, the multinational firm will have a more debt-intensive capital structure if it operates in a country where interest rates are low. The multinational firm will also opt for debt-intensive capital structure if it operates in a country with a weak currency. In this case most of the cash flows arising from the project are used to meet interest payments. A similar situation arises when country risk is high. A multinational firm that operates in a country where the risk of confiscation or blocked funds is high tends to borrow intensively in that country, and hence it will have a debt-intensive capital structure. Local debt financing will also be used when there is a withholding tax on remittances.
In general, therefore, multinational firms prefer to have a debt-intensive capital structure when their subsidiaries are subject to low local interest rates, weak currencies, a high degree of country risk and high taxes. A multinational firm may deviate from its target capital structure in each country where financing is obtained, while achieving its target capital structure on a consolidated basis. This policy of ignoring the local target capital structure in favour of a global capital structure can be justified under certain circumstances. For example, a multinational firm operating in a country that does not allow the listing of its shares on the local stock exchange will have a higher debt-equity ratio than desired otherwise. This high debt-equity ratio can be counterbalanced by using lower ratios in other countries.
Research findings on capital structure
Some recent research casts doubt on the validity of the traditional corporate finance model, suggesting that firms select optimal capital structures by trading off various tax and incentive benefits of debt financing against financial distress costs. Hovakimian et al. (2001) argue that while there is support for the trade-off models in the empirical literature, recent evidence suggests that a firm's history may play a more important role in determining its capital structure. Titman and Wessels (1988), for example, show that highly profitable firms often use their earnings to pay back debt, which makes them less levered than less profitable firms. Moreover, Masulis and Korwar (1986) and Asquith and Mullins (1986) show that firms tend to issue equity following an increase in stock prices. The implication of this observation is that firms that perform well tend to reduce their debt-equity ratio subsequently.
Some researchers argue that the negative correlation between profits and leverage is consistent with Donaldson's (1961) pecking order, which is used to describe how firms make their financing decisions. Donaldson argued that firms prefer to fund new investment with retained earnings (as opposed to borrowed funds), but they prefer debt to equity financing. If this is the case then firms accumulate retained earnings, becoming less levered when they are profitable and accumulate debt, becoming more levered, when they are unprofitable. If firms are indifferent about their capital structures, as suggested by Miller (1977), then they will not make future capital structure choices that offset their earnings history. Shyam-Sunder and Myers (1999) argue that the pecking order story provides a better empirical description of capital structure than do traditional trade-off models.
There are also dynamic models of capital structure, such as those of Fischer et al. (1989) and Leland (1998). In these models transaction costs are introduced to generate short-run pecking order behaviour. These models suggest that firms periodically readjust their capital structures towards a target ratio that reflects the costs and benefits of debt financing that are found in static tradeoff models. The models also suggest that firms repurchase equity after an increase in share prices to adjust towards an optimal capital structure. However, this prediction is inconsistent with the observation that firms tend to issue equity following stock price increases.
Hovakimian et al. (2001) test the hypothesis that firms tend to move towards a target debt-equity ratio when they either raise new capital or repurchase existing capital. Their results suggest that although past profits are an important predictor of observed capital structures, firms often make financing and repurchase decisions that offset these earnings-driven changes in their capital structures. The results also suggest that stock prices play an important role in determining a firm's financing choice. Firms that experience large stock price increases are more likely to issue equity and retire debt than are firms that experience stock price decline.
10.7 DEBT AND EQUITY EXPOSURE
In Chapter 4 we came across the definition of operating exposure. In this chapter we examine debt and equity exposure and show how they are related to operating and net cash flow exposures. To start with, let us define net cash flows as
N = p -I (10.12)
where I is the interest payment on debt capital, D, such that I = iD, where i is the interest rate. Thus, net cash flow exposure, which measures the sensitivity of base currency net cash flows to changes in exchange rate, which gives
En = Nr- (10.13)
We will use these definitions to illustrate the concepts of leverage and hedging effects of debt financing.
The leverage and hedging effects of debt financing
By using a two-period model, we can write equation (10.13) as
(Nx t+ 1/Nxt) -1
En
=
x,t+1
x,t— (10.14)
which gives
(p x,t+1 -lx,t+1 )/(p x,t -lx,t) -1
En = § ^ 5
Consider first the case of a firm that only raises base currency debt capital. In this case, Ej = I x/S = 0 and lx,t+1 = Ix,t, where Ej is the interest exposure. It follows that the net cash flow exposure of such a firm is given by
r, (p x,t+1 - lx,t )/(p x,t - lx,t) -1
En = § (10.16)
Hence
EN - Ep = [(p x,t+1 -lx,t )/(P x,t -lx,t) -1 -(p x,t+ 1/P t -1)] /S (10.17)
which can be simplified to
EN
-
Ep
=
lf(P
xrt+1
-p
"''I
> 0 (10.18)
Sp x,t(p x,t - lx,t )
Obviously, equation (10.18) means that EN > Ep , which means that the net cash flow exposure of a firm that raises base currency debt capital is greater than its operating exposure.
Now, consider the case of a firm that raises foreign currency debt capital. In this case, Ej > 0, such that Ix,t+1 > Ix,t for S > 0, even if Iy,t+1 = Iy,t. Hence
EN - en =
(p x,t+1 - jx,t )/(p x,t - Ix,t ) -1 -[(p x,t+1 - jx,t+1 )/(p x,t - jx) -1]
S
(10.19)
which can be simplified to
EN-
EN
= I.x,t+1
- jx
> 0 (10.20)
S(p x,t - jx,f )
Equation (10.20) means that En < EN. This is the currency exposure hedging effect of debt financing when operating cash flows are positively related to changes in exchange rates. It tells us that foreign currency financing reduces net cash flow exposure.
Figures 10.1-10.3 illustrate these possibilities when py = 100 and S assumes values ranging between 1.00 and 2.00. Figure 10.1 illustrates the case when there is no foreign currency borrowing, in which case Ix is unchanged at 40. In this case, net cash flows increase with the exchange rate. We can see from Figure 10.1(b) that the operating exposure is constant at 1, the interest rate exposure is constant at 0, and the net cash flow exposure is always higher than the operating exposure (exposures are plotted against S). In Figure 10.2 there is foreign currency borrowing in which case all exposures turn out to be equal to one (pure conversion exposures). We can also see that the net cash flow exposure is lower than in the previous case. Figure 10.3 illustrates the case when the interest rate on the foreign currency, and hence the interest payments, increases with the exchange rate. In this case the operating exposure is constant at 1, whereas the net cash flow exposure can be positive or negative, depending on the rate of change of the exchange rate.
Equity exposure
Equity exposure is the sensitivity of base-currency equity value to changes in the exchange rate. The total value of a firm in base currency terms is equal to the value of debt plus equity. Hence
Vx= Ex + Dx (10.21)
Then we can define total value exposure, equity exposure and debt exposure respectively as
Ev = Vr (10.22)
(a)
Cash flows
2.00
1.60 1.20 0.80 0.40 0.00 -0.40
(b)
Exposures
Net
Operating
Interest
2.50 3.00 3.50 4.00 4.50 5.00 5.50
FIGURE 10.1 Cash flows and exposures when base currency interest payments do not change with the exchange rate.
Ee = ESL (10.23)
ED = jr (10.24)
Vx may be regarded as the present value of the operating cash flows, which gives
Vx = ^ (10.25)
k
where k is the cost of capital. If k is independent of the exchange rate, it follows that Ev = Ep . Hence, Ep = Ee in the case of all-equity financing.
Now, consider the case of base currency debt financing, such that Ed = 0 and Dx,t+1 = Dx,t. The percentage change in the firm's total value is a weighted average of the percentage changes in debt and equity, which gives
(a)
Cash flows
1.4 1.6 1.8
3.00
2.00
(b)
Exposures
2.50
3.00
3.50
4.00
4.50
5.00
FIGURE
10.2
Cash
flows
and exposures when base
currency
interest payments change with the exchange rate.
5.50
(
F
Jx,t
(10.26)
+
E
x
è
Vx
,t
0
Vx = DD x
è Vx ,t 0
If we divide equation (10.26) by S, we obtain
œ
d
ö
(
F
Jx
,t
Vx
Dx
x
,t
(10.27)
+
Vxt
è
x't
Vxt
è
x,t
0
or
œ
Dxt
'
V
Vx,t0
E
Ex
,t
(10.28)
ep
=
ed
+E
Since Ed = 0, it follows that
250
200 150 100 50
(a)
Cash flows
1.4 1.6 1.8
(b)
Exposures
0
2.00
-0.50
FIGURE
10.3
Cash flows and exposures when foreign currency interest payments
change with the exchange rate.
E
EE = p (10.29)
E 1 - (D x,t / Vx,t)
ÔEe _ 1
> 0 (10.30)
ÔEp 1 -(D x/f /Vx,t ) and
dEE Ep
20
<D
S
15
10
5 0
0.4 0.6
Debt
ratio
FIGURE
10.4
Equity exposure as a function of the debt ratio for a zero debt
exposure.
<u
25
(10.32)
V
V
x,t
Ep -—— + E t
x,t
which gives
(10.33)
0.4 0.6
Debt
ratio
FIGURE
10.5
Equity exposure as a function of the debt ratio for a unit debt
exposure.
in which case 5Ee/5Ep > 0, as in equation (10.29), and
(10.34)
VPx,t Vx,t ) = [1 -(Dx,t /Vx,t )]2
which can be anything, depending on the value of Ep . Equation (10.33) embodies two effects on equity exposure: (i) the currency exposure hedging effect (the use of more debt reduces equity exposure); and (ii) the financial leverage effect (higher exposure for higher debt ratio). The ultimate effect on equity exposure depends on how the two effects are combined. Figure 10.5 shows how equity exposure is related to the debt ratio for various values of the operating exposure.
I
<