LO4: Week 11-13

Financial Decisions
Financing
Capital Budgeting
Working Capital
Management
 Optimal Financial Structure

A firm has an optimal financial structure

determined by that particular mix of debt and
equity that minimizes the firms 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

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 Optimal Financial Structure
& The MNE

The domestic theory of optimal capital

structure is modified by four additional
variables in order to accommodate the MNE
Availability of capital
International diversification of cash flows
Foreign exchange risk
Expectation of international portfolio investors

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 Optimal Financial Structure
& The MNE

Availability of capital
Allows MNEs to lower cost of capital
Permits MNEs to maintain a desired debt ratio
Allows MNEs to operate competitively

International diversification of cash flows

Reduces risk
Lowers volatility of cash flows among differing
subsidiaries and foreign exchange rates

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 Optimal Financial Structure
& The MNE

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

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 Financial Structure of
Foreign Subsidiaries

Debt borrowed is from sources outside of the MNE

(i.e. subsidiary borrows directly from markets)

Advantages of localization
Localized companies do not usually operate with too high
proportion of debt
Localized financial structure helps management evaluate
return on equity investment relative to local competitors
In economies where interest rates are high, local
borrowings reminds management to use funds effectively
and ensure that ROA is greater than cost of capital.

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 Financial Structure of
Foreign Subsidiaries
Disadvantages of localization

Local firms have less advantage over MNEs in

availability of capital and diversifying risk

Usually, any subsidiarys debt is guaranteed by the

parent, and the parent wont allow a default on the
part of the subsidiary. This may lead to inefficiencies
in management.

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 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 MNE
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

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 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

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 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 creating liquidity
Increase the firms visibility and political
acceptance to its customers, suppliers, creditors
& host governments

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 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

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 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

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 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

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 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

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 International Debt Markets

Euronote market
Collective term for medium and short term debt
instruments sourced in the Eurocurrency
market

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 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

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 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

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 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 MNEs, large domestic corporations,
governments, government enterprises and
international institutions
Offered simultaneously in a number of different
capital markets

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 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

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 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
Moodys, Fitch and Standard & Poors rate
bonds just as in US market

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 Complexities of Budgeting for a
Foreign Project

Like domestic capital budgeting, this focuses on

the cash inflows and outflows associated with
prospective long-term investment projects
Capital budgeting follows same framework as
domestic budgeting
Identify initial capital invested or put at risk
Estimate cash inflows, including a terminal value or
salvage value of investment
Identify appropriate discount rate for PV calculation
Apply traditional NPV or IRR analysis

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 Complexities of Budgeting for a
Foreign Project

Several factors make budgeting for a foreign

project more complex

Parent cash flows must be distinguished from project

Additional cash flows from new investment may in part or

in whole take away from another subsidiary;

Parent must recognize remittances from foreign

investment because of differing tax systems, legal and
political constraints

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 Complexities of Budgeting for a
Foreign Project
Non-financial payments can also generate cash flows to
parent in form of licensing fees, royalty payments, etc.
Differing rates of national inflation can affect differing
cash flows
Use of host government subsidies complicates capital
structure and parents ability to determine appropriate
WACC
Managers must evaluate political risk
Terminal value is more difficult to estimate because
potential purchasers have different views

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 Project versus Parent Valuation

Most firms evaluate foreign projects from both

parent and project viewpoints
The parents viewpoint analyses investments cash flows
as operating cash flows instead of financing due to
remittance of royalty or licensing fees and interest
payments
The parents viewpoint gives results closer to
traditional NPV capital budgeting analysis
Project valuation provides closer approximation of
effect on consolidated EPS

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 Cross-Border Mergers and
Acquisitions

Macro- and Microeconomic factors drive cross-

border mergers and acquisitions
The drivers of M & A activity are:
Gaining access to strategic proprietary assets
Gaining market power and dominance
Achieving synergies in local/global operations and across
different industries
Becoming larger, and then reaping the benefits of size in
competition and negotiation
Diversifying and spreading their risks wider
Exploiting financial opportunities they may possess and
others desire

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 Cross-Border Mergers and
Acquisitions

M & A vs. Greenfield Investments

Advantages:
M & A is quicker
acquisition may be a cost-effective way of
gaining competitive advantages such as
technology, brand names valued in the target
market, and logistical and distribution
advantages, while simultaneously eliminating a
local competitor
market imperfections, allowing target firms to
be undervalued

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 Cross-Border Mergers and
Acquisitions

M & A vs. Greenfield Investments

Disadvantages:
Paying too much
Different corporate cultures need to be managed
Downsizing to gain economies of scale and scope
in overhead functions may not be effective
Host government intervention

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 Cross-Border Mergers and
Acquisitions

The process of acquiring an enterprise anywhere

in the world has three common elements:
1) identification and valuation of the target,
2) completion of the ownership change
transactionthe tender, and
3) management of the post-acquisition transition

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 Cross-Border Mergers and
Acquisitions

Settlement may be very time-consuming

needing approval from management, target
ownership, regulatory bodies, and final
determination of methods of compensation
Friendly takeover
Hostile takeover
Regulatory bodies in each country may have different
requirements
Compensation usually via stock and/or cash

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 Cross-Border Mergers and
Acquisitions

Post-acquisition management probably the most

critical step of the M & A process

Currency Risks vary with timing of the takeover

process and with amount of available information

A foreign currency transaction exposure is created

that must be hedged.

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 Exhibit 16.9 Currency Risks in Cross-
Border Acquisitions

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 Working Capital Management

The operating cycle of a business generates

funding needs, cash inflows and outflows the
cash conversion cycle and foreign exchange rate
and credit risks
The funding needs generated by operations of the
firm constitute working capital
The cash conversion cycle is the period of time
extending between cash outflows for purchased
inputs and cash inflow from cash settlement

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 Working Capital Financing

Managing Receivables
A firms operating cash inflow is derived
primarily from the collection of receivables
There are several factors that go into the
management of receivables
Independent customers requires decisions about
currency of denomination and payments terms
Payment terms
Self-liquidating bills secured by physical inventory
that has been sold and the funds are lent based on the
securitization
Other terms

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 Working Capital Financing

Inventory Management
Anticipating devaluation management must
decide whether to build inventory of items that
carry foreign exchange exposure
Anticipating price freezes
Free trade zones and free industrial zones
free trade zones combines the idea of duty-free
ports with legislation that reduces customs
duties to retailers or manufacturers who
structure their operations to benefit from the
technique

18-
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 International Cash Management

International cash management is the set of

activities determining the levels of cash balances
held throughout the MNE, cash management, and
the facilitation of its movement cross border,
settlements and processing
Cash levels are determined independently of
working capital management decisions
Cash balances, including marketable securities, are held
partly for day-to-day transactions and to protect against
unanticipated variations from budgeted cash flows
These two motives are called the transaction motive
and the precautionary motive

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 International Cash Management

Cash disbursed for operations is replenished from

two sources
Internal working capital turnover
External sourcing, traditionally short-term borrowing
All firms engage in some sort form of the following
steps
Planning a financial manager anticipates cash flows
over future days, weeks, or months
Collection controlled through time lags between the
the shipment date and the payment date

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 International Cash Management

Disbursement steps included are avoiding

unnecessary early payment, maximizing float
and selecting a disbursement bank
Covering cash shortages anticipated cash
shortages can be managed by borrowing locally
Investing surplus cash if a subsidiary of an
MNE generates surplus cash, the MNE must
decide whether to handle its own short-term
liquidity or whether surplus funds should be
controlled centrally

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 International Cash Settlements
& Processing

Four techniques for simplifying and lowering the

cost of settling cash flows between related and
unrelated firms
Wire transfers
Cash pooling
Payment netting
Electronic fund transfers

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 International Cash Settlements
& Processing

Wire Transfers
Variety of methods but two most popular for cash
settlements are CHIPS and SWIFT
CHIPS is the Clearing House Interbank Payment System
owned and operated by its member banks
SWIFT is the Society for Worldwide Interbank Financial
Telecommunications which also facilitates the wire transfer
settlement process
Whereas CHIPS actually clears transactions, SWIFT is purely
a communications system

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 International Cash Settlements
& Processing

Cash Pooling and Centralized Depositories

Businesses with widely dispersed operating subsidiaries
can gain operational benefits by centralizing cash
management
Subsidiaries hold minimum cash for their own
transactions and no cash for precautionary purposes
All excess funds are remitted to a central cash depository
Information advantage is attained by central depository
on currency movements and interest rate risk
Precautionary balance advantages as MNE can reduce
pool without any loss in level of protection

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 International Cash Settlements
& Processing

Multilateral Netting
Defined as the process that cancels via offset all, or part,
of the debt owed by one entity to another related entity
Netting of payments is useful primarily when a large
number of separate foreign exchange transactions occur
between subsidiaries

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 Financing Working Capital

All firms need to finance working capital and most

of the short-term financing needs is done through
the use of bank credit lines
Banking sources available to MNEs are
In-house Banks
Commercial Banking Offices

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 Financing Working Capital

In-house Bank is not a separate corporation.

Rather it is a set of functions performed by the
existing treasury department
The purpose of the In-house Bank is to provide banking
services to the various units of the firm
It can provide lower credit spreads because it does not
have to meet any capital requirements imposed on
commercial banks
The In-house Bank can also better handle currency
related risks

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 Financing Working Capital

Commercial Banking can support MNEs needs

through various offices
Correspondent Banks with local banks in important cities
across the world
Representative Offices are established in a foreign
country to help parent bank clients
Branch Banks are foreign branches that are a legal and
operational part of the parent bank
Affiliates are locally incorporated banks owned in part by
a foreign parent

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 Financing Working Capital

Commercial Banking can support MNEs needs

through various offices
Edge Act Corporations are subsidiaries of US banks to
engage in international banking and financing operations

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