Interest Rate

1
International Capital Structure (or part I of
chapter 13)
2
Agenda

• Theories of capital structure.
• Why MNE has special financial structure?
• Cost of debt Forex risk
• Financial mix of foreign subsidiaries (talk by C.
  Fritz Foley).
• How to finance a foreign subsidiary?

3
Theory of Capital Structure

• Modigliani-Miller capital structure is
  irrelevant!
• Trade-off theory firm does have optimal
  financial structure.
• Idea minimize WACC.
• Why? B/c of taxes bankruptcy costs.
• If new projects business risk differs from risk
  of existing projects, optimal mix would change
• (tradeoff between business and financial risks)
• Market-timing manager takes advantage of
  investor sentiment.
• Managerial Entrenchment Free Cash-flow
  cash-rich firms managers dislike debt since it
  means more monitoring by banks!

4
Optimal financial mix?
5
Why financial mix for MNE is special?

• A few facts MNE
• has access to more capital in global markets.
• can achieve diversification of cash flows.
• subject to foreign exchange risk.
• has to cater for international portfolio
  investors.

6
Optimal Financial Structure

• Availability of capital
• Allows MNE to lower cost of capital.
• Permits MNE 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.
• Diversification of cash flows
• Reduces risk as in portfolio theory.
• Lowers volatility of cash flows among differing
  subsidiaries forex rates.
• Expectations of International Portfolio Investors
• Most international investors for US and the UK
  follow the norms of a 60 debt-assets ratio.

7
Forex Risk Cost of Debt

• Effective cost of debt example
• Idea have to account for forex changes.
• US firm borrows SF 1,500,000 for 1 year _at_ 5 p.a.
• SF appreciates SF1.50/ --gt SF 1.44/
• Initial amount borrowed
• At the end of the year, the US firm repays the
  interest plus principal
• Actual cost of loan

8
Forex Risk Cost of Debt a shortcut

• Rationale total home currency cost higher b/c of
  SF appreciation
• Can compute as
• Total cost is

Where kd Cost of borrowing (US firm in
US) kdSF Cost of borrowing (US firm in
SF) s Percentage change in spot rate
9
Shall MNE localize financial mix?

• Pros
• Reduces criticism of subs operating with too much
  debt.
• Helps management evaluate return on equity
  investment relative to local competitors.
• Cons
• MNE has comparative advantage over local firms
  through better availability of capital
• If each subsidiary localizes its financial
  structure, resulting consolidated balance sheet
  might show a structure that doesnt conform with
  any one countrys norm
• Usually subs debt is guaranteed by parent gt
  parent wont allow a default so subs debt
  ratio is set by parent.

10
Financing the Foreign Subsidiary

• Internal vs. External Markets
• In addition to choosing appropriate financial
  structure, managers need to choose alternative
  sources of funds for financing.
• Sources of funds can be classified as internal
  external to MNE

11
Subs Internal Financing
12
Subs External Financing
13
Tax concerns (Guest Talk 11/6)
14
Things to remember

• Theories of capital structure
• Why MNE has special financial structure?
• Cost of debt Forex risk
• Financial mix of foreign subsidiaries
• (talk by Professor C. Fritz Foley)
• How to finance a foreign subsidiary?