chapter 13 sourcing equity and debt globally. © 2012 pearson education, inc. all rights...

Chapter 13

Sourcing Equity and Debt Globally

© 2012 Pearson Education, Inc. All rights reserved. 13-2

Sourcing Equity and Debt Globally: Learning Objectives

• Design a strategy to source equity and debt globally

• Analyze the motivations and goals of a firm cross-listing its shares on foreign equity markets

• Analyze the motivations and goals of a firm issuing new equity shares on foreign equity markets

• Understand the many barriers to penetrate effectively foreign equity markets through cross-listing and selling equity abroad

• Examine the various financial instruments which can be used to source equity in the global equity markets


Sourcing Equity and Debt Globally: Learning Objectives

• Extend the theory of optimal financial structure to the multinational enterprise (MNE)

• Analyze the factors that, in practice, determine the financial structure of foreign subsidiaries within the context of the MNE

• Evaluate the various internal and external sources of funds available for the financing of foreign subsidiaries

• Identify the relevant characteristics of different international debt instruments in financing both the MNE itself, and its various foreign affiliate components


Designing a Strategy toSource Equity Globally

• This requires management to agree upon a long-run financial objective and then choose among various alternative paths to get there

• Normally the choice of paths and implementation is aided by an early appointment of an investment bank as official advisor to the firm

• Investment bankers are in touch with the potential foreign investors and what they require in terms of risk/reward

• Investment bankers can also help navigate the various institutional requirements and barriers that must be satisfies to source equity globally


Designing a Strategy toSource Equity Globally

• Most firms raise their initial capital in their own domestic market

• While many can be tempted to skip the intermediate steps to complete an Euroequity issue in global markets, good financial advisors will offer a ‘reality check’ on this strategy

• Most firms that have only raised capital in their domestic market are not well enough known to attract foreign investors

• The following exhibit walks through a more probable chain of events in accessing global capital markets with the end goal being equity capital


Exhibit 13.1 Alternative Paths to Globalize the Cost & Availability of Capital


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

• 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


Exhibit 13.2 The Cost of Capital and Financial Structure


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



• Availability of capital– Allows MNEs to lower cost of capital – Permits MNEs to maintain a desired debt ratio even when new funds are raised

– Allows MNEs to operate competitively even if their domestic market is illiquid and segmented

• International diversification of cash flows– Reduces risk similar to portfolio theory of diversification

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


000,000,1$Sfr1.500/$

00Sfr1,500,0=


• Foreign exchange risk & cost of debt– When a firm issues foreign currency denominated debt, its effective cost equals the after-tax cost of repayment in terms of the firm’s own currency

– Example: US firm borrows Sfr1,500,000 for one year at 5.00% p.a.; the franc appreciates from Sfr1.500/$ to Sfr1.440/$• Initial dollar amount borrowed


750,093,1$Sfr1.440/$

1.05 x 00Sfr1,500,0=

09375.1000,000,1

$1,093,750=


– At the end of the year, the US firm repays the interest plus principal

– The actual dollar cost of the loan is not the nominal 5.00% paid in Swiss francs, but 9.375%


( ) ( )[ ] 1s1 x k1k Sfrd

$d −++=

Where

kd$ = Cost of borrowing for US firm in home country

kdSfr = Cost of borrowing for US firm in Swiss francs

s = Percentage change in spot rate


– This total home currency cost is higher than expected because of the appreciation of the Swiss franc

– This cost is the result of the combined cost of debt and the percentage change in the foreign currency’s value


( ) ( )[ ] 09375.01041667.01 x 05.1k$d =−++=

4.1667% 100 x Sfr1.40/$

Sfr1.440/$ - Sfr1.500/$ 100 x

S

SS

2

21 ==−

The total cost is then

= 9.375%


• The total cost of debt must include the change in the exchange rate

• The percentage change in the value of the Swiss franc is calculated as



• 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


Financial Structure ofForeign Subsidiaries

• Debt borrowed is from sources outside of the MNE (i.e. subsidiary borrows directly from markets)

• Advantages of localization– Localized financial structure reduces criticism of

foreign subsidiaries that have been operating with too high (by local standards) proportion of debt

– Localized financial structure helps management evaluate return on equity investment relative to local competitors

– In economies where interest rates are high because of scarcity of capital and real resources are fully utilized, the penalty paid for borrowing local funds reminds management that unless ROA is greater than local price of capital, misallocation of real resources may occur



• Disadvantages of localization– An MNE is expected to have comparative advantage over local firms through better availability of capital and ability to diversify risk

– If each subsidiary localizes its financial structure, the resulting consolidated balance sheet might show a structure that doesn’t conform with any one country’s norm; the debt ratio would simply be a weighted average of all outstanding debt

– Typically, any subsidiary’s debt is guaranteed by the parent, and the parent won’t allow a default on the part of the subsidiary thus making the debt ratio more cosmetic for the foreign subsidiary



• 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


Exhibit 13.3 Internal Financing of the Foreign Subsidiary


Exhibit 13.4 External Financing of the Foreign Subsidiary


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


Sourcing Equity Globally

• Depositary Receipts– This multiple allows the ADRs to possess a price per share conventional for the US market

– ADRs are either sponsored or unsponsored– Sponsored ADRs are created at the request of a foreign firm wanting its shares traded in the US; the firm applies to the SEC and a US bank for registration and issuance


Exhibit 13.5 American Depositary Receipts (ADRs)


Exhibit 13.6 Characteristics of Depositary Receipt Programs


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 overcoming mispricing in a segmented and illiquid home market

– Increase the firm’s visibility and political acceptance to its customers, suppliers, creditors & host governments

– Establish a secondary market for shares used for acquisitions

– Create a secondary market for shares that can be used to compensate local management and employees in foreign subsidiaries


Size and Liquidity of Markets

• Three key trends in the evolution of modern exchanges:– Demutualization or the end of market ownership by a small, privileged group of “seat owners”

– Diversification by exchanges to trade a broader range of products

– Globalization or effectively another form of diversification through several techniques


Foreign Equity Listing & Issuance

• Cross-listing is a way to encourage investors to continue to hold and trade shares that may or may not be listed on an investors home market or in a preferred currency

• Cross-listing is usually done through ADRs (in the United States, where they are traded and quoted in U.S. dollars)

• Global Registered Shares (GRSs), on the other hand, are able to be traded on equity exchanges around the globe in a variety of currencies and are traded electronically


Effect of Cross-Listing and Equity Issuance on Share Price

• The impact on price of cross-listing on a foreign stock market depends on the degree to which the markets are segmented

• As was the situation experienced by Novo, a firm can benefit if a foreign market values a company more highly than a home market (in a highly-segmented situation)


Other Motives for Cross-Listing

• Increasing visibility and political acceptance– MNEs list in markets where they have substantial physical operations

– Political objectives might include the need to meet local ownership requirements for an MNE’s foreign joint venture

• Increasing potential for share swaps with acquisitions

• Compensating management and employees


Barriers to Cross-Listingand 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• Disclosure is a double-edged sword• Increased firm disclosure should have the effect of lowering the cost of equity capital

• On the other hand, this increased disclosure is a costly burden to corporations


Alternative Instrumentsto 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



• Directed Public Share Issues– Defined as one which is targeted at investors in a single country and underwritten in whole or in part by investment institutions from that country• Issue may or may not be denominated in the currency of the target market

• The shares might or might not be cross-listed on a stock exchange in the target market

• A foreign share issues, plus cross-listing can provide it with improved liquidity



• Euroequity Public Issue– Gradual integration of worlds’ capital markets has spawned the emergence of a Euroequity market

– A firm can now issue equity underwirtten and distributed in multiple foreign equity markets; sometimes simultaneously with distribution in the domestic market

– As we have reviewed, the term “Euro” does not imply that the issuers or investors are located in Europe, nor does it mean the shares are sold in the currency “euro”



• Private Placement Under SEC Rule 144A– A private placement is the sale of a security to a small set of qualified institutional buyers

– Investors are traditionally insurance companies and investment companies

– Because shares are not registered for sale, investors typically follow “buy and hold” strategy

– Rule 144A allows qualified institutional buyers (QIB) to trade privately placed securities without previous holding period restrictions and without requiring SEC registration



• Private Equity Funds– Limited partnerships of institutional and wealthy individual investors that raise their capital in the most liquid capital markets

– Then invest these funds in mature, family-owned firms located in emerging markets

• Strategic Alliances– Normally followed by firms that expect to gain synergies from one or more joint efforts


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


Exhibit 13.7 International Debt Markets & Instruments



• 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



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

– Two major groups• Underwritten facilities and non-underwritten facilities

• Non-underwritten facilities are used for the sale and distribution of Euro-commercial paper (ECP) and Euro Medium-term notes (EMTNs)



– 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

• Bridged the gap between short-term and long-term euro debt instruments



• 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



• 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



• 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



• 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– Moody’s, Fitch and Standard & Poor’s rate bonds just as in US market


Summary of Learning Objectives

• Designing a capital sourcing strategy requires management to agree upon a long run financial objective

• The firm must then choose among the various alternative paths to get there, including where to cross-list its shares and where to issue new equity and in what form



• A firm cross-lists its shares on foreign stock exchanges for one or more of the following reasons– Improving liquidity of its existing shares through depositary receipts

– Increase its share price by overcoming mispricing by a segmented, illiquid home market

– Support a new equity issue sold in a foreign market– Establish a secondary market for shares used in acquisitions

– Increase the firm’s visibility & political acceptance to its customers, suppliers, creditors and host governments

– Create a secondary market for shares that will be used to compensate local management and employees in foreign subsidiary



• If it is to support a new equity issue or to establish a market for share swaps, the target market should also be the listing market

• If it is to increase the firm’s commercial and political visibility or to compensate local management and employees, it should be in markets in which the firm has significant operations

• The major liquid stock markets are the NYSE, NASDAQ, LSE, Euronext, Tokyo, and Deutsche Bourse



• The choice among these six markets depends on its size, and the sophistication of its market-making activities, including competitive transaction costs and competent crisis management

• Increased commitment to full disclosure

• A continuing investor relations program



• A firm can lower its cost of capital and increase its liquidity by selling its shares to foreign investors in a variety of forms– Sale of a directed share issue to investors in one particular foreign equity market

– Sale of a Euroequity share issue to foreign investors simultaneously in more than one market, including both foreign and domestic markets

– Private placement under SEC rule 144A– Sale of shares to private equity funds– Sales of shares to a foreign firm as part of a strategic alliance



• The domestic theory of optimal financial structures needs to be modified by four variables in order to accommodate the case of the MNE: – 1) the availability of capital; – 2) diversification of cash flows; – 3) foreign exchange risk; and – 4) the expectations of international portfolio investors.



• A multinational firm’s marginal cost of capital is constant for considerable ranges of its capital budget. This statement is not true for most small domestic firms because they do not have access to the national equity or debt markets

• By diversifying cash flows internationally, the MNE may be able to achieve the same kind of reduction in cash flow variability as portfolio investors receive from diversifying their security holdings internationally



• When a firm issues foreign currency-denominated debt, its effective cost equals the after-tax cost of repaying the principal and interest in terms of the firm’s own currency. This amount includes the nominal cost of principal and interest in foreign currency terms, adjusted for any foreign exchange gains or losses

• Therefore, regardless of other factors, if a firm wants to raise capital in global markets, it must adopt global norms that are close to the U.S. and U.K. norms. Debt ratios up to 60% appear to be acceptable. Any higher debt ratio is more difficult to sell to international portfolio investors



• A compromise position is possible between minimizing the global cost of capital and conforming to local capital norms (localization) when determining the financial structure of a foreign subsidiary. Both multinational and domestic firms should try to minimize their overall weighted average cost of capital for a given level of business risk and capital budget, as finance theory suggests

• The debt ratio of a foreign affiliate is in reality only cosmetic, because lenders ultimately look to the parent and its consolidated worldwide cash flow as the source of repayment. In many cases, debt of subsidiaries must be guaranteed by the parent firm



• The international debt markets offer the borrower a variety of different maturities, repayment structures, and currencies of denomination. The markets and their many different instruments vary by source of funding, pricing structure, maturity, and subordination or linkage to other debt and equity instruments

• The three major sources of debt funding on the international markets are international bank loans and syndicated credits, the Euronote market, and the international bond market



• Eurocurrency markets serve two valuable purposes: – 1) Eurocurrency deposits are an efficient and

convenient money market device for holding excess corporate liquidity, and

– 2) the Eurocurrency market is a major source of short-term bank loans to finance corporate working capital needs, including the financing of imports and exports

• Three original factors in the evolution of the Eurobond markets are still of importance: – 1) absence of regulatory interference, – 2) less stringent disclosure practices, and – 3) favorable tax treatment

chapter 13 sourcing equity and debt globally. © 2012 pearson education, inc. all rights...

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