Financial Structure and International Debt Market

Financial Structure and International Debt Market 1. Optimal Financial i lstructure 2. Financial Structure of Foreign Subsidiaries 3. Debt Management and Funding Goal 4. International Debt Markets 5. Rating of Eurobonds 1 1. 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. As 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. 2 1

The following exhibit illustrates how the cost of capital varies with the amount of debt employed. As the debt ratio increases, the overall cost of capital (k WACC ) decreases because of the heavier weight of low- cost (due to tax-deductability) deductability)debt([k debt d (1-t)] compared to high cost equity (k e ). 3 Cost of Capital (%) Exhibit 1 The Cost of Capital and Financial Structure k e = cost of equity 30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 Minimum cost of capital range k WACC = weighted average after-tax cost of capital k d (1-tax) = after-tax cost of debt 0 20 40 60 80 100 Total Debt (D) Debt Ratio (%) = Total Assets (V) 4 2

2. Financial Structure of Foreign Subsidiaries In addition to choosing an appropriate financial structure, financial i managers of MNEs must choose among alternative sources of funds to finance the foreign subsidiary. These funds can be either internal or external to the MNE. Ideally the choice should minimize worldwide taxes and political risk. Simultaneously, the firm should ensure that managerial motivation in the foreign subsidiaries is geared toward minimizing the firm s worldwide cost of capital 5 Exhibit 2 Internal Financing of the Foreign Subsidiary Funds From Within the Multinational Enterprise (MNE) Funds from parent company Funds from sister subsidiaries Cash Equity Real goods Debt -- cash loans Leads & lags on intra-firm payables Debt -- cash loans Leads & lags on intra-firm payables Subsidiary borrowing with parent guarantee Funds Generated Internally by the Foreign Subsidiary Depreciation & non-cash charges Retained earnings 6 3

Exhibit 3 External Financing of the Foreign Subsidiary Borrowing from sources in parent country Banks & other financial institutions Security or money markets Funds External to the Multinational Enterprise (MNE) Borrowing from sources outside of parent country Local currency debt Third-country currency debt Eurocurrency debt Local equity Individual local shareholders Joint venture partners 7 3. Debt Management and Funding Goal Assuming the MNEs has determined its desired capital structure A. Maturity Matching Finance short-term assets with short-term liabilities or vice versa Prevent the firm from being exposed to significant interest rate and funding risk B. Currency Matching Emphasis on managing the transaction and operating exposures 8 4

C. The Cost of Foreign Debt k dh = [(1+ k df ) X (1+s)] - 1 k h= d Pretax cost of debt in local currency k df = Cost of debt in foreign currency s = The percentage change in exchange rate 9 4. International Debt Markets The international debt market offers the borrower a wide variety of different maturities, repayment structures, pricing structure, currencies of denomination, and subordination or linkage to other debt and equity instruments. The three major sources of debt funding on the international markets are depicted in the following exhibit. 10 5

Table 1. Sources of International Debt Financing Unit :Billion USD. Year 2008 2009 1. Cross-Border Bank Loans Developed Countries 24,320.8 23,295.7 Offshore Countries 3,678.5 3,599.5 Developing Countries 2,487.2 2,452.7 International Institutions 77.9 116.6 Unallocated 628.8 558.8 Total Cross-Border Bank Loans 31,193.3 30,023.3 2. International Money Market 1,113.7 932.2 3. International Notes and Bonds 22,717.1 26,078.5 Total Net Financing 55,024.1 57,034.0 Sources: Gathering Data from International Financial Statistics, Consolidated Banking and International Banking Statistics (Table 6A), Bank for International Settlements (BIS). 11 Exhibit 4 International Debt Markets & Instruments Bank Loans & Syndications (floating-rate, short-to-medium term) International Bank Loans Eurocredits Syndicated Credits Euronote Market (floating-rate, short-to-medium term) International Bond Market (fixed & floating-rate, medium-to-long term) 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 Global Bond 12 6

A. Bank loans and syndications: - International bank loans have traditionally been sourced in the Eurocurrency markets, there is a narrow interest rate spread between deposit and loan rates of less than 1%. - Eurocredits are bank loans to MNEs, sovereign governments, international institutions, and banks denominated in Eurocurrencies and extended by banks in countries other than the country in whose currency the loan is denominated. d -The syndication of loans has enabled banks to spread the risk of very large loans among a number of banks (this is significant for MNEs as they usually need credit in an amount larger than a single bank s loan limit). 13 The Eurocurrency Markets Eurocurrencies are domestic currencies of one country on deposit in another country. Any convertible currency can exist in Euro form (not the European currency called the euro). These markets serve two valuable purposes: - Eurocurrency deposits are an efficient and convenient money market device for holding excess corporate liquidity - The Eurocurrency market is a major source of short-term bank loans to finance corporate working capital needs (including imports and exports) 14 7

Exhibit 5 Comparative Spreads Between Lending and Deposit Rates in the Eurodollar Market Interest Rate Domestic Loan Rate Domestic Spread of 4.000% 7.000 % 4.625 % Eurodollar Loan Rate Eurodollar Spread of 0.500% 4.125 % Eurodollar Deposit Rate Domestic 3.000 % Deposit Rate 15 B. The Euronote market: - Euronotes and Euronote facilities are short to medium in term and are either underwritten and non-underwritten - Euro-commercial paper is a short-term debt obligation of a corporation or bank (usually denominated in US dollars) - Euro medium-term notes is a new entrant to the world s debt markets, which bridges the gap between Euro-commercial paper and a longer-term and less flexible international bond 16 8

C. The International Bond Market: -A Eurobond is underwritten by an international syndicate of banks and other securities firms and is sold exclusively in countries other than the country in whose currency the issue is denominated e.g. Eurodollar bond, Euroyen bond. -A Foreign bond is underwritten by a syndicate composed of members from a single country, sold principally i within that tcountry, and denominated din the currency of that country e.g. Yankee bond, Samurai bond, and Bull dog bond. -A Global bond is usually in denominated USD and registered in U.S.A. but sold worldwide 17 D. Sectors of Bond Market Government Bonds Agency Bonds Municipal Bonds Corporate Bonds 18 9

Table 2. Outstanding Value by Type of Issues Issuer Amount Outstanding in Billions of US. Dollars End. December End. March Percentage to Total End. December End. March 2008 2009 2010 2008 2009 2010 Financial Institutions 18,892.4 20,886.9 20,400.9 79.2 77.3 76.6 Corporates 2,422.9 3,059.1 3,103.3 10.1 11.3 11.7 Governments 1,876.3 2,265.1 2,290.6 7.9 8.4 8.6 Int. Organizations 657.2 799.6 820.9 2.8 3.0 3.1 Total 23,848.8 27,010.7 26,615.7 100.0 100.0 100.0 Source: International Financial Statistics, Securities Statistics (Tables 13A, 13B, 14A, 14B), Bank for International Settlements (BIS). 19 E. Types of Eurobond The straight fixed-rate issue Fixed coupon paid annually, set maturity date, full principal repaid at maturity The floating-rate note (FRN) Pays a semiannual coupon using a variable-rate base e.g. LIBOR, US. Prime Rate. The equity-related issue Resembles the fixed-rate issue with convertibility to stock prior to maturity at a specific price. 20 10

Table 3. Outstanding Value by Type of Instruments Amount Outstanding in Billions of US. Dollars Percentage to Total Year End. December End. March End. December End. March 2008 2009 2010 2008 2009 2010 International Money Market Commercial Paper 708.5 598.9 594.7 2.97 2.22 2.23 US. Dollar 212.6 174.7 182.6 - - - Euro 340.3 306.5 294.7 - - - Other 155.6 117.7 117.4 - - - Other Instruments 423.2 333.3 350.2 1.77 1.23 1.32 US. Dollar 157.6 145.4 156.5 - - - Euro 171.0 136.5 138.1 - - - Other 94.6 51.4 55.6 - - - Subtotal-Int' Money Mkt. 1,131.7 932.2 944.9 4.75 3.45 3.55 21 Amount Outstanding in Billions of US. Dollars Percentage to Total Year End. December End. March End. December End. March 2008 2009 2010 2008 2009 2010 International Bonds and Notes Floating Rate 7,892.0 8,357.2 7,988.8 33.09 30.94 30.02 US. Dollar 2,227.1 2,257.1 2,252.2 - - - Euro 4,462.8 4,671.5 4,379.1 - - - Other 1,202.1 1,428.6 1,357.5 - - - Straight Fixed Rate 14,428.4 17,274.2 17,235.9 60.50 63.95 64.76 US. Dollar 5,830.0 6,973.7 7,254.6 - - - Euro 6,297.8 7,591.5 7,322.8 - - - Other 2,300.6 2,709.0 2,658.5 - - - Equity-Related 396.7 447.2 446.1 1.66 1.66 1.68 US. Dollar 158.1 198.2 211.3 - - - Euro 113.3 124.5 111.9 - - - Other 226.6 124.5 122.9 - - - Subtotal-Int' Bonds&Notes 22,717.1 26,078.5 25,670.8 95.25 96.55 96.45 Total 23,848.8 27,010.7 26,615.7 100.00 100.00 100.00 Source: International Financial Statistics, Securities Statistics, Bank for International Settlements (BIS). 22 11

F. Unique Characteristics of Eurobond Absence of regulatory interference National governments often impose tight controls on foreign bonds. However, Eurobonds fall outside the regulatory domain of any single nation. Less stringent disclosure Non-US. firms prefer to issue Eurodollar bonds over Yankee bonds. Favorable tax status Interest paid on Eurobonds is generally free from income tax withholding. 23 5. Rating of Eurobonds Rating Agencies: Moody s, Standard & Poors Agency rates international bonds on request of the issuer. However, the issuer may decide not to have rating published. A. Review of political risk Government system Social environment External relations 24 12

B. Review of economic risk Debt burden and liquidity BOP flexibility Economic structure and outlook Growth performance 25 Table 4. Rating by Moody s Investor Service and Standard & Poor S&P Moody's ความหมายอย างแคบ Long-term Short-term Long-term Short-term AAA Aaa ความสามารถในการช าระดอกเบ ยและเง นต นส งท ส ด (Prime Rate Grade) ent Grade Investme AA+ Aa1 AA A-1+ Aa2 ความสามารถในการช าระดอกเบ ยและเง นต นส ง (High Quality Grade) AA- Aa3 Prime-1 A+ A1 ความสามารถในการช าระดอกเบ ยและเง นต นด ความสามารถในการชาระดอกเบยและเงนตนด แตอาจไดรบผลกระทบจากตวแปร แต อาจได ร บผลกระทบจากต วแปร A A-1 A2 ทางเศรษฐก จบ างเล กน อย (Upper-medium Grade) A- A3 BBB+ A-2 Baa1 Prime-2 ความสามารถในการช าระดอกเบ ยและเง นต นเก อบด แต อาจได ร บผลกระทบจาก BBB A-3 Baa2 ต วแปรทางเศรษฐก จพอสมควร (Medium Grade) BBB- Baa3 Prime-3 (Speculative Grade*) 26 13

S&P Long-term Short-term Moody's Long-term Short-term ความหมายอย างแคบ BB+ Ba1 ความสามารถในการชาระดอกเบยและเงนต นปานกลาง แตอาจได รบผลกระทบจาก BB Ba2 ต วแปรทางเศรษฐก จอย างม น ยส าค ญ (Districtly Speculative Grade) BB- Ba3 Speculative Grade B+ B B1 ความสามารถในการช าระดอกเบ ยและเง นต นต า แต อาจได ร บผลกระทบจาก B B2 Not-Prime ต วแปรทางเศรษฐก จอย างม น ยส าค ญ B- B3 (Districtly Speculative Grade except B- and B3 is Highly Speculative Grade ) CCC+ Caa ความสามารถในการช าระดอกเบ ยและเง นต นต ามาก ม ความเส ยงในการลงท นส งมาก CCC C Ca (Highly Speculative Grade) CCC- C Junk Bond D D เป นตราสารหน ท คาดว าจะเก ดการผ ดน ดช าระหน อย างแน นอน Remark: For S&P, the ratings from 'AA' to 'CCC' may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the rating categories. For Moody, Moody's applies numerical modifiers 1,2 and 3 in each generic rating classification from Aa through Caa. The modifier 1 indicates that the obligation ranks in the higher end of its generic rating categories; the modifier 2 indicates a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that generic rating category. Dotted lines indicate combinations that are highly unusual. * Such bonds lack outstanding investment characteristics and in fact have speculative characteristics as well. 27 14