Chapter

1 Long-Term Financing 8

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

C18 - 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.
C18 - 3

Annualized Bond Yields Across Countries

Ten-year maturity, as of June 1998
Indonesian rupiah

nualized Bond Yield

Canadian Australian dollar dollar

Malaysian ringgit

Swiss
franc

US$

Thai baht
C18 - 4

Online Application

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/.

C18 - 5

The Long-Term Financing Decision

To make the long-term financing decision,

the MNC must

odetermine the amount of funds needed,

oforecast the price (interest rate) at which
the bond may be issued, and

oforecast the exchange rates of the

borrowed currency for the times when it has to make payments (coupons and principal) to the bondholders.
C18 - 6

The Long-Term Financing Decision

Then the probability distribution of the

bonds 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.
C18 - 7

Actual Costs of Financing

With Pound-Denominated Bonds from a U.S. Perspective
Exchang e Rate of US$ Needed to Cover Annual Coupon Payment of 1 million

C18 - 8

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.
C18 - 9

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 - 10

Illustration of A Currency Swap

Euros Received From Ongoing Operations Dollars Received From Ongoing Operations

Euro Payment s Miller Company

[known within the dollardenominated market]

Dollar Payment s Investors in Dollardenominated Bonds Issued by Miller

Euro Payment s Dollar Payment s

Dollar Payment s Beck Company

[known within the eurodenominated market]

Euro Payment s Investors in Eurodenominated Bonds Issued by Beck

C18 - 11

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

C18 - 12

Illustration of A Parallel Loan

U.S. Parent

Provision of loans

British Parent

Subsidiary of U.S.- based MNC that is located in the U.K.

Repayment of loans in the currency that was borrowed

Subsidiary of U.K.- based MNC that is located in the U.S.

C18 - 13

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)
C18 - 14

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 - 15

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.
C18 - 16

Illustration of An Interest Rate Swap

Quality Company Choice of 9% fixed
or LIBOR + .5%

Variable Rate Payments at LIBOR+.5%

Risky Company Choice of 10.5% fixed

or LIBOR + 1%

Prefers variable Fixed Rate Payments at 9% Investors in Fixed Rate Bonds Issued by Quality Company Gains %

Fixed Rate Payments at 9.5%

Prefers fixedRate Variable Payments at LIBOR+1% Investors in Variable Rate Bonds Issued by Risky Company Saves %
C18 - 17

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.

C18 - 18

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.
C18 - 19

Yield Curves Across Countries

As of February 2001 Japa n

Canada

nualized Yield (except Japan)

Italy Germany U.S. U.K.

Annualized Yield (Jap only)

Years to Maturity
C18 - 20

Impact of Long-Term Financing Decisions on an MNCs Value

Parents 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

C18 - 21

Chapter Review

The Long-Term Financing Decision

oMeasuring the Cost of Financing oActual Effects of Exchange Rate
Movements on Financing Costs

Managing Exchange Rate Risk

oAccounting for Exchange Rate Risk oReducing Exchange Rate Risk
C18 - 22

Chapter Review

Floating-Rate Bonds
oHedging Interest Rate Risk

Use of Yield Curves to Make Debt Maturity

Decisions

Impact of Long-Term Financing Decisions

on an MNCs Value

C18 - 23