Download Chapter 18

18
Chapter
Long-Term Financing
South-Western/Thomson Learning © 2003
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 longterm financing in foreign currencies can
be adjusted for bonds with floating
interest rates.
A18 - 2
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.
A18 - 3
The Long-Term Financing Decision
• 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.
A18 - 4
The Long-Term Financing Decision
• 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.
A18 - 5
Managing Exchange Rate Risk
• 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.
A18 - 6
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
A18 - 7
Managing Exchange Rate Risk
• The exchange rate risk from financing with
bonds in foreign currencies can be
reduced by using:
 parallel (or back-to-back) loans
 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)
A18 - 8
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.
A18 - 9
Floating-Rate Bonds
• 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.
A18 - 10
Floating-Rate Bonds
• Note that financial intermediaries are
usually involved in swap agreements.
They match up participants and also
assume the default risk involved for a fee.
A18 - 11
Use of Yield Curves
to 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 shortterm, medium-term, or long-term debt
financing may vary across countries too.
A18 - 12
Impact of Long-Term Financing Decisions
on an MNC’s Value
m

E CFj , t  E ER j , t 
n 
 j 1

Value =  

t
1  k 
t =1 



Parent’s Long-Term Financing
Decisions
E (CFj,t ) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k
= weighted average cost of capital of the parent
A18 - 13
Chapter Review
• 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
A18 - 14
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
A18 - 15