International Finance Session 11-1 and 11-2

After-tax cost of debt

- After-tax cost of debt is calculated as A-T kd = kd x (1 - t), where kd is the yield to maturity of the firm's bond and t is the corporate tax rate. - The term (1 - t) is multiplied to the before-tax cost of debt (= kd) because the interest payment is tax-deductible.

- Reinvoicing Centers

- Firms can use a separate subsidiary, called a reinvoicing center, to manage transaction and operating exposures of various affiliates by making all currency transactions go through the reinvoicing center. - In the Session 9 lecture, we have seen many multinational firms use reinvoicing centers to net out the intrafirm transactions. Reinvoicing centers can also be used to handle operating exposures of multinational firms. - For example, Carlton, Inc., the U.S. manufacturing unit of Carlton invoices the firm's reinvoicing center in U.S. dollars. The reinvoicing center in turn resells to Carlton Brazil in Brazilian reais. In the mean time, the U.S. manufacturing unit of Carlton ships the actual goods directly to Carlton Brazil. - The next diagram shows how the reinvoicing center works. Consequently, all operating units deal only in their own currency, and all exchange exposure lies with the reinvoicing center. Therefore, the reinvoicing center takes on all currency hedging activities. - Since a reinvoicing center manages all FX transaction exposure for intracompany sales, reinvoicing center personnel can develop a specialized expertise in choosing which hedging technique is best at any moment.

1. Diversify Operating Base

- If management diversifies operations, i.e., has operations in plants in different countries, the firm can be in a position to take advantage of temporary disequilibrium conditions that cause changes in international competitive conditions. The firm does not need to predict or anticipate changes in rates that cause the disequilibrium, but rather be prepared to take advantage of the conditions when they arise. - For example, disequilibrium conditions can make the operations in a particular country more price competitive compared to imports into the country and compared to competing products in its export markets. Management could take advantage of this condition by increasing production in that operation while reducing production in other facilities. - Another way of operational exposure is to diversify the market for the firm's products. - For example, Goodyear's Mexico subsidiary could survive the devaluation of Mexican peso by expanding its operations into other areas such as the U.S., South America, and Europe. - By exporting more tires to other countries than the drop in the domestic (Mexican) market due to the drop in the Mexican peso, they could manage the operational exposure efficiently.

The Link between cost and availability of capital

- If the firm has access to the global capital markets, that access will provide greater availability and lower cost of capital. In order for a firm to have full access to global capital markets it must be able to move beyond illiquid or segmented markets.

2. Diversify Financing Base

- If the sources of the firm's financing (debt and/or equity) are diversified among several countries, the firm can be in a position to take advantage of disequilibrium conditions in interest rates. - Such conditions rarely last long, and to take advantage of these conditions, the firm must already have established sources of funds in the different markets. - Diversifying sources of financing could increase its availability of capital, and lower the cost of capital by diversifying such risks as restrictive capital market policies or government borrowing competition in the capital markets. - It could mitigate political risks such as expropriation, war, blocked funds, or unfavorable changes in laws that reduce or eliminate profitability.

- Timing Transfer of Funds

- Leading or lagging payments simply refers to accelerating or delaying payments from one currency into another. The idea is to pay with soft currencies before they depreciate or delay payment with hard currencies in hopes that appreciation will allow payment with less of the currency. - Firms can reduce both operating exposure and transaction exposure by accelerating or decelerating the timing of payments that must be made or received in foreign currencies. - Intra-firm leads and lags is more feasible as related companies presumably embrace a common set of goals for the consolidated group. - Inter-firm leads and lags requires the time preference of one independent firm to be imposed on another.

Change Financing Policies

- Management might use changes in financing policies to mitigate risks from operating exposure. - Common examples of financing policy changes include (1) matching currency cash flows, (2) the use of back-to-back loans or parallel loans, and (3) the use of currency swaps

3. Change Operating Policies

- Management might use changes in operating policies to mitigate risks from operating exposure. - Common examples of operating policy changes include (1) the use of leads and lags to adjust the timing of funds transfers, (2) requiring customers or suppliers to share risk through currency clauses and (3) using reinvoicing centers.

- Market liquidity for the firm's securities

- Market liquidity can be defined as the extent to which a firm can issue new securities without diminishing the market price of its equity shares. - The multinational firm, with access to global capital markets, can increase the liquidity of its capital market by raising capital funds in Euromarkets, and issuing securities in various individual markets and by using affiliates to tap foreign local capital markets. - This allows the firm access to capital funding in excess of what could have been issued in only the home capital market. The key to success is finding ways to attract international investors to the firm's securities.

-Market segmentation

- Market segmentation can be defined as the distortion of required return on securities in a market compared to required return for securities of comparable risk traded in other national markets. - If markets are integrated, then securities of comparable risk should have comparable required returns (adjusted for any foreign exchange or political risks). - Segmentation is caused mainly by government constraints, institutional practices, and investor perceptions. - The most important imperfections: include (1) Asymmetric information between domestic and foreign-based investors, (2) Lack of transparency (3) High securities transaction costs (4) Foreign exchange risks (5) Political risks (6) Corporate governance differences (7) Regulatory barriers - These irregularities create differences in the market pricing of securities in a local capital market compared to the pricing of comparable securities in the international capital market. - Market imperfections do not necessarily imply that national securities markets are inefficient. - A national securities market can be efficient in a domestic context and yet segmented in an international context. - The degree to which capital markets are illiquid or segmented has an important influence on a firm's marginal cost of capital and thus on its weighted average cost of capital.

- Matching Currency Cash Flows - Currency Switching

- One way to offset an anticipated continuous long exposure to a particular currency is to acquire debt denominated in that currency. - Suppose a U.S. firm is expecting continued export sales to Canada. To compete effectively in Canadian market, the firm invoices all its sales in Canadian dollars. As a result, the firm is going to receive series of Canadian dollars, and exposed to exchange risk. - To handle the exposure, the firm can use the forward market or other contractual hedges as discussed in Session 9 lecture. - Another way of hedging is to acquire some of its debt in the Canadian financial markets. We can understand this as a balance sheet hedging. - Before the firm borrows in the Canadian financial market, the firm has a C$-denominated asset. Therefore, the firm is exposed to exchange rate risk. - By borrowing in the Canadian financial market, the firm is creating a C$-denominated liability to match the C$-denominated asset. - In this way, the debt-financing hedge is acting as a balance sheet hedge against the C$-denominated cash flows. - The next diagram shows the balance sheet hedge created by the currency matching hedge.

Factors that have effect on the cost and availability of capital

- The cost and availability of capital are influenced by several factors including firm-specific characteristics, market liquidity for the firm's securities, and market segmentation.

Findings based on empirical studies on MNEs cost of capital

- The effect of international diversification on the firm's cost of capital depends on several factors, but in general MNE's located in emerging markets tend to lower their marginal cost of capital by successfully diversifying their sources of capital funds into the international capital markets. - On the other hand, as some empirical studies have shown, MNE's located in the U.S. or major European markets actually tend to increase their cost of capital (compared to a domestic counterpart) as they diversify their capital funding internationally because of increasing agency costs and other factors such as foreign exchange risk, political risk and other complications arising from global operations. - One study even found that the MNEs have a higher level of systematic risk than their domestic counterparts. It can be explained based on the same factors mentioned above. - The beta of a security i is defined as βi = (ρim σi) / σm, where ρim is the correlation coefficient between security i's return and the market portfolio, σi is the standard deviation of the return on security i, and σm is the standard deviation of the return on the market portfolio. - The study concludes that the increased σi of cash flows from internalization more than offset the lower correlation from diversification, ρim, and the beta increases. - The higher marginal cost of capital (MCC) for MNEs can be explained by the link between the cost of capital, its availability, and the opportunity set of projects. - As the opportunity set of projects increases, the firm will eventually need to increase its capital budget to the point where its marginal cost of capital is increasing. - The optimal capital budget would still be at the point where the rising marginal cost of capital equals the declining rate of return on the opportunity set of projects. - This would be at a higher weighted average cost of capital than would have occurred for a lower level of the optimal capital budget.

Strategies for Managing Operating Exposure

- The goal in managing operating exposure is to anticipate and influence the effect of changes in currency rates rather than simply hoping for the best. - To meet this objective, management can diversify the firm's operating and financing base. - Management can also change the firm's operating and financing policies. - A diversification strategy does not require management to predict disequilibrium, only to recognize it when it occurs. - Management must be able to recognize disequilibrium parity conditions and react appropriately to take advantage of them.

- Currency swaps

Currency swap is similar to back-to-back loans except it does not show up as debt on a firm's balance sheet. In a currency swap, a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time. For example, in the above back-to-back loan case, a swap bank can step in and work as a middle man in setting up the swap agreement between the British firm and the Dutch firm.

-Firm-specific characteristics

Firm-specific characteristics determine what types of investors are attracted to the firm's securities. If the characteristics of the firm appeal only to domestic investors, then availability of capital will be limited mainly to domestic sources.

- Risk Sharing through Currency Clauses

Firms with continuing buyer/seller relationships can share risk of currency movement by contractual arrangements where the impact of a currency movement outside of an agreed range is shared between the two firms.

Factors that contribute to the segmentation of capital markets

Segmented capital markets are those where factors such as regulatory controls, political risk, foreign exchange risk, insider trading, and other perceived system irregularities distort share prices reflecting the standards of those particular markets. By contrast, global markets with higher liquidity and transparency of market information allow share prices to be set efficiently by international standards and market forces. Firms that must rely on segmented capital markets for long-term financing will face higher cost of capital and limited capital availability.

Operating Exposure

Session 11-1

Global Cost of Capital

Session 11-2

- Back-to-Back Loans or Parallel Loans

Suppose a British parent firm wants to provide euros for its Dutch subsidiary. The British parent firm can raise pounds in the U.K. market and convert it into euros. Or, the British firm can borrow euros in the Dutch capital market. In the former case, the British firm is exposed to the exchange risk. In the latter case, the firm may have to pay interest rate higher than the current market rate because the firm is not well-known as in the British market. Suppose further that there is a Dutch parent company that wants to provide British pounds for its subsidiary in the U.K. This Dutch parent company also could use the FOREX market to provide the necessary pound capital for its subsidiary as the British parent company did. However, these two parent companies can avoid using the FOREX market to achieve the same objectives. The British parent firm lends pounds to the Dutch subsidiary in the U.K., while the Dutch firm lends euros to the British subsidiary in the Netherlands. The two loans would be for equal values at the current spot rate and for a specified maturity. At maturity, the two loans would be paid off to the original lender. Neither loans carries any foreign exchange risk. This arrangement is called a back-to-back loan. The next diagram shows how this back-to-back loan works. - By using back-to-back loans, firms in separate countries can arrange to borrow each other's currencies for use by their affiliates in the other country. The loans are repaid in the currency borrowed. Thus, by using the back-to-back loans, firms can avoid exchange risk. - However, sometimes it is not easy to find a counterparty for a back-to-back loan for a certain currency for a desired amount and timing. Also, credit risk still exists for a back-to-back loans, even though it is minimal because each party has in effect 100% collateral.

Weighted average cost of capital

The cost of capital is usually measured by the Weighted Average Cost of Capital (WACC), which combines the firm's cost of equity and cost of debt based on relative market value weights. kWACC = we ke + wd kd (1-t) kWACC = weighted average after-tax cost of capital ke = risk-adjusted cost of equity kd = before-tax cost of debt E = market value of the firm's equity D = market value of the firm's debt we = (E/V) = weight of equity wd = (D/V) = weight of debt V = D + E t = marginal tax rate

Cost of equity based of the capital asset pricing model (CAPM)

The cost of equity can be estimated using the Capital Asset Pricing Model (CAPM) shown in the next: ke = krf + βi (km - krf) where ke = expected return on equity krf = risk-free interest rate km = expected return on the market portfolio of risky assets (km - krf) = market risk premium βi = systematic risk of security i - The beta of a security i is defined as βi = (ρim σi) / σm, where ρim is the correlation coefficient between security i's return and the market portfolio, σi is the standard deviation of the return on security i, and σm is the standard deviation of the return on the market portfolio. - It is measured as the slope coefficient of the regression analysis where the independent variable is the return on the market portfolio and the dependent variable is the return on security i. - The CAPM states that the expected return of a security is determined as the risk-free rate of return (krf) plus the risk premium (βi (km - krf)), where the risk premium is in turn determined as the product of its beta and the market risk premium, (km - krf). - The systematic risk is the only important risk of a security because the non-systematic risk is removed through the diversification. - According to the theory, risk-averse investors would diversify their portfolios to the full extent so that they can maximize the return for any given level of risk. - As a result of the diversification, the expected return of a security is determined by its beta, which is a measure of its systematic risk.