Long-Term FinancingLong-Term Financing

1818 Chapter Chapter

South-Western/Thomson Learning © 2003

C18 - 2

Chapter Objectives

• To explain why MNCs consider long-term financing in foreign currencies;

• To explain how the feasibility of long-term financing in foreign currencies can be assessed; and

• To explain how the assessment of long-term financing in foreign currencies can be adjusted for bonds with floating interest rates.

C18 - 3

The Long-Term Financing Decision

• Because bonds denominated in foreign currencies sometimes require lower yields, MNCs often consider long-term financing in foreign currencies.

• The actual cost of such financing depends on the quoted interest rate, as well as the changes in the value of the borrowed currency over the life of the loan.

C18 - 4

Annualized Bond Yields Across CountriesTen-year maturity, as of June 1998

0

5

10

15

20

25

30

35

Ann

ualiz

ed B

ond

Yie

ld

¥ £US$Swissfranc

Thaibaht

Canadian dollar

Australiandollar

Malaysianringgit

Indonesianrupiah

C18 - 5

• Long-term interest rates for major currencies for various maturities can be found at http://www.bloomberg.com/, while currency forecasts are available at http://biz.yahoo.com/ifc/.

Online Application

C18 - 6

• To make the long-term financing decision, the MNC must determine the amount of funds needed, forecast the price (interest rate) at which

the bond may be issued, and forecast the exchange rates of the

borrowed currency for the times when it has to make payments (coupons and principal) to the bondholders.

The Long-Term Financing Decision

C18 - 7

• Then the probability distribution of the bond’s financing costs may be determined.

• An MNC that denominates bonds in a foreign currency may achieve major cost reductions, but is subject to the possibility of incurring high costs if the borrowed currency appreciates over time.

The Long-Term Financing Decision

C18 - 8

Actual Costs of FinancingWith Pound-Denominated Bonds from a U.S. Perspective

0.0

0.5

1.0

1.5

2.0

2.5

3.0

1975 1980 1985 1990 1995 2000

0

500,000

1,000,000

1,500,000

2,000,000

2,500,000

3,000,000

ExchangeRate of £

US$ Needed to Cover Annual Coupon Payment of £1 million

C18 - 9

• Point-estimate exchange rate forecasts cannot adequately account for the potential impact of exchange rate fluctuations.

• Instead, the probability distribution of the exchange rate should be developed, so as to determine the expected financing cost and its probability distribution.

• Computer simulation may aid the process.

Managing Exchange Rate Risk

C18 - 10

Managing Exchange Rate Risk

• The exchange rate risk from financing with bonds in foreign currencies can be reduced by using:

offsetting cash inflows in the borrowed currency

forward contracts

currency swaps

C18 - 11

EuroPayments

DollarPayments

Investors in Dollar-denominated Bonds

Issued by Miller

DollarPayments

Euros Received FromOngoing Operations

Miller Company[known within the dollar-

denominated market]

EuroPayments

Beck Company[known within the euro-denominated market]

Dollars Received FromOngoing Operations

DollarPayments

Investors in Euro-denominated Bonds

Issued by Beck

EuroPayments

Illustration of A Currency Swap

C18 - 12

• The exchange rate risk from financing with bonds in foreign currencies can be reduced by using:

Managing Exchange Rate Risk

parallel (or back-to-back) loans

C18 - 13

Subsidiary ofU.K.- based MNC

that is locatedin the U.S.

Provisionof loans

Subsidiary ofU.S.- based MNC

that is locatedin the U.K.

British ParentU.S. Parent

Repaymentof loans in

the currencythat wasborrowed

Illustration of A Parallel Loan

C18 - 14

• The exchange rate risk from financing with bonds in foreign currencies can be reduced by using:

parallel (or back-to-back) loans

Managing Exchange Rate Risk

diversified portfolios of bonds that are denominated in several foreign currencies or currency cocktail bonds (which are bonds denominated in a multicurrency unit e.g. SDR)

C18 - 15

Floating-Rate Bonds

• Eurobonds are often issued with a floating coupon rate. For example, the rate may be tied to the London Interbank Offer Rate (LIBOR).

• If the coupon rate is floating, forecasts are required for both exchange rates and interest rates.

C18 - 16

• When MNCs issue floating-rate bonds that expose them to interest rate risk, they may use interest rate swaps to hedge the risk.

• Interest rate swaps enable a firm to exchange fixed rate payments for variable rate payments, and vice versa. They are used by bond issuers to reconfigure future bond payments to a more preferable structure.

Floating-Rate Bonds

C18 - 17

Quality CompanyChoice of 9% fixed

or LIBOR + .5%Prefers variable

Risky CompanyChoice of 10.5% fixed

or LIBOR + 1%Prefers fixed

Investors in Variable Rate

Bonds Issued by Risky Company

Variable RatePayments atLIBOR+1%

Investors inFixed Rate Bonds

Issued byQuality Company

Fixed RatePayments

at 9%

Variable RatePayments atLIBOR+.5%

Fixed RatePayments at

9.5%

Illustration of An Interest Rate Swap

Gains ½ % Saves ½ %

C18 - 18

• Note that financial intermediaries are usually involved in swap agreements. They match up participants and also assume the default risk involved for a fee.

Floating-Rate Bonds

C18 - 19

Use of Yield Curvesto Make Debt Maturity Decisions

• An MNC must decide on the maturity for any potential debt. To do this, the MNC may want to assess the yield curve in the country of the currency to be borrowed.

• Since the slopes of the yield curves may vary across countries, the choice of short-term, medium-term, or long-term debt financing may vary across countries too.

C18 - 20

Yield Curves Across CountriesAs of February 2001

4.0

4.4

4.8

5.2

5.6

6.0

0 5 10 15 20 25 30

0.0

0.5

1.0

1.5

2.0

2.5

Canada

Japan

ItalyGermany

U.S.

U.K.

Years to Maturity

An

nu

aliz

ed

Yie

ld (

ex

cep

t Ja

pa

n) A

nn

ualize

d Y

ield

(Ja

pan

on

ly)

C18 - 21

Impact of Long-Term Financing Decisionson an MNC’s Value

n

tt

m

jtjtj

k1=

1 , ,

1

ER ECF E

= Value

E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period tE (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period tk = weighted average cost of capital of the parent

Parent’s Long-Term Financing Decisions

C18 - 22

• The Long-Term Financing Decision¤ Measuring the Cost of Financing¤ Actual Effects of Exchange Rate

Movements on Financing Costs

• Managing Exchange Rate Risk¤ Accounting for Exchange Rate Risk¤ Reducing Exchange Rate Risk

Chapter Review

C18 - 23

Chapter Review

• Floating-Rate Bonds¤ Hedging Interest Rate Risk

• Use of Yield Curves to Make Debt Maturity Decisions

• Impact of Long-Term Financing Decisions on an MNC’s Value