International Corporate Finance

Prof. Edith Littich-Nemec

Financial Decisions of MNC’s

• Investment (Capital Budgeting)– Assessment Criteria and Selection of Assets

– Selection Among Competing Projects

– Growth Strategy (Natural Growth vs. M&A)

– Assets Management

• Financing– Capital Structure

– Cost and Risk

– Funding Considerations

• Dividend Policy– Payout Ratio

– Retained Earnings

Firm’ s CEO

Simulation Model

Investment Decision

PARENT COMPANY

FOREIGN AFFILIATE

HOME TAX AUTHORITY

Financial Resources

Know-How

Taxes

Interest Payments, Dividends, License Fees, Loan Repayment

InputMarket

ConsumerMarket

ForeignTaxAuthority

Foreign Direct Investment

• Why investing abroad?– risk-minimizing explanation– profit-maximizing explanation

• How to invest abroad– Joint Venture– Merger&Acquisition– Licensing and Management Contract– Strategic Alliance– Foreign Subsidiary

• Where to invest abroad? Political Risk Assessment

• Definition– possible occurence of political events of any kind (such as war,

revolution, expropriation, taxation, devaluation, exchange control and import restriction) at home or abroad that cause a loss of profit potential and/or assets in international business operations (Root,1968)

• Forms – Macro Risk

• affects all foreign firms

– Micro Risk• affects specific firms/industries

Political Risk

Political Risk Assessment

• macro techniques (scoring models, indexes)– Euromoney’s Country Risk Rankings

– Frost and Sullivan’s World Political Risk Forecasts

– Business International ‘s Country Assessment Service

• micro techniques– inspection visits, “the grand tour”

– old hands

– delphi techniques

– quantitative methods (sensitivity analisis, simulation models, decision trees)

Dimensions of Managerial Risk-Adjustment

• Parent/project viewpoint• Role of investment in MNE‘s portfolio• Cash Flow/Discounting Rate Adjustments

The EUROMONEY Country Risk Evaluation

• polls a cross-section of experts

• categories– economic data (25%)

– political risk (25%)• subjective scores made by risk analysts, risk insurance brokers and bank credit

officers

– debt indicators (20%)• debt service record, external debt, ease of rescheduling

– credit ratings (10%)• Moody’s, S&P

– market indicators (20%)• access to bank finance, access to short-term fiance, access to capital markets,

access to forfaiting market (discount rates)

• monthly published, extended annual analysis

Host Government Intervention

• Non-discriminatory regulations– e.g. Blocked Funds (limitation of transfers of foreign exchange out of the country)

• Discriminatory regulations– e.g. Joint Venture Minorities

• Wealth deprivation– e.g. nationalization of an entire industry

– e.g. expropriation of a single firm

Berger GmbH is a German firm located in Dortmund considering the establishment of a joint venture abroad which would produce and sell bricks. Two managers have been assigned the task of assessing the country risk (political and exchange transfer risk). The decision on whether to undertake this project will be made only once this country risk analysis is completed. Since Berger GmbH has focused exclusively on domestic business in the past, it is not accustumed to country risk analysis. In order to get first information, the country risk is analysed on the basis of published information. Compare the risk situation of three different countries, respectively, based on the assumption that Berger wants to enter a market in one of the following regions:

South-East Asia Arabia North Africa Central-America Latin America Baltic States

Assignment 1

Case Study IBM Thailanddue: 15/12

•IMPORTANT STEPS•DEFINE THE PROBLEM(S) INVOLVED•GENERATE ALTERNATIVES AND EVALUATE THEM•MAKE A DECISION AND EXPLAIN WHY

•SUGGESTIONS HOW TO PROCEED•READ THE CASE ONCE AND MAKE NOTES•DEFINE THE PROBLEM(S) AND DISCUSS YOUR RESULTS WITH COLLEGUES•READ THE CASE A SECOND TIME AND CREATE ALTERNATIVES (GROUP WORK)•MAKE A DECISION AND DO THE INDIVIDUAL (!) WRITE-UP

•CASES HAVE NO SINGLE SOLUTION !!!

Government Programs to Motivate International Trade

EXPORT CREDIT INSURANCE

protects exporters against the riskof nonpayment by a foreign buyer as a result of political or default risk

GUARANTEES

repayment of export loansextended by US banks to foreignborrowers

LOANS

loans to foreign buyers orfinancial intermediaries

FOREIGN CREDIT INSURANCE (FCIA ),OVERSEAS PRIVATEINVESTMENT Corp (OPIC)

PRIVATE EXPORT FUNDING CORP. (PEFCO)EXIMBANK

EXPORT CREDITS GUARANTEE DEPARTMENT (ECGD)

HERMES KREDITVERSICHERUNGS AG

COMPAGNIE FRANCAISE D’ASSURANCE POUR LE COMMERCE EXTERIEUR (COFACE)

OESTERREICHISCHE KONTROLLBANK (OKB)

Political Risk/Pre-Investment Phase

• Political Risk Insurance• Export Credit Institutions

• Private Insurance companies

• Host Government Arrangements (‘concession agreements’), Unconditional Guarantees

• capital transfer policy• access to local capital markets• ownership and control • transfer pricing• social and economic obligations• price controls• taxation• employment of expatriate personnel

PR II/Operating and Financial Strategies

• Keep the host country dependent– local sourcing (e.g. gearing)

• Create benefits for the host country– hire and train local employees – develop relationships (shareholders, creditors, suppliers)– support government programmes

• Plan an exit-strategy– short-term profit maximization

• quick withdrawal of profits, no reinvestment• deferring maintenance expenditures• maximize payments in the form of

– royalties, dividends, licence fees, transfer prices, etc.

– planned divestment

The EMS 79-92

• PRIMARY GOALS• establishment of a zone of exchange rate stability to foster trade and

growth

• accelerating the integration within the EU

• EMS MECHANISM IN THE PAST• exchange rate movements between EMS members within +/-

2.5%, ESP and PTE +/- 6%

• interventions to prevent participating currencies to exceed these margins

• EUROPEAN CURRENCY UNIT (ECU)• basket of fixed amounts of EU currencies

• actual use

– settlement between central banks within EU

– international credit and bond market

Recent Developments - the EMU

• PRIMARY GOAL– replacement of national currencies by a single EU currency

(“EURO”) managed by a sole central bank starting in 1999.

• STEPS TO CREATE THE EMU– Maastricht Treaty to set convergence criteria

• inflation rate within 1.5 percentage points of the average of three lowest inflation rate countries

• interest rates within 2 pp of the average of three lowest interest rate countries

• budget deficit below 3% of GNP

• national debt below 60% of GNP

• no currency devaluations in the last 2 years.

EMU- Timetable

spring 1998 31.12.1998

DEM/XEU

FRF/XEU

GBP/XEU

CHF/XEU

DEM/EURO

FRF/EURO

GBP/EURO

CHF/EURO

•selection of 11 EMU membersAustria, Belgium, Finland, France, Germany, Ireland, Italy, LuxembourgNetherlands, Portugal, Spain*)

•establishment of bilateral conversion rates

1.7.2002

establishment of e.g. DEM/EUROconversion rates with 1 ECU=1 EURO

*) UK, Sweden and Denmark chose to keep theircurrencies, Greece did not meet convergence criteria

What happens on ....• January 1st, 1999

– exchange rates between Euro and national member currencies were set– contracts, securities, deposits, loans atc. denominating in ECU were

transferred into Euro– books and accounts may be kept in Euro

• January 1st, 2002– national currencies do no longer exist as ‚book money‘

• money transfers only in Euro

• accounting only in Euro

– Euro in cash available

• July 1st, 2002– national currencies no longer exist in cash transactions

Euro- Effects on International Corporate Finance

• Exchange Rate Risk– no further risk with Euro members (e.g. France, Italy)

– limited risk with several non-members (e.g. Slovakia, Hungary, Poland, Bulgaria)

• New Money Market Reference Interest rate (EURIBOR= Euro Interbank Offered Rate) replaces VIBOR and other rates– quoted by a panel of 57 European banks

– daily quotation

– 1 week-12 months

• better access to international loans

FX Rate Determinants

Parity Conditions• Relative inflation rates (PPP)• relative interest rates (Fisher effect)•Forward exchange rates•Exchange rate regimes•Efficial monetary regimes

Infrastructure• Banking system•Securities markets•Outlook for growth and profitability

Speculation• Currencies• Securities• Uncovered Interest Arbitrage• Real estate• Commodities

Cross-BorderInvestment• FDI• Portfolio investment

Political Risk• Capital controls• Black market• Exchange Rate spreads• Risk premium

SPOT RATE

The Purchasing Power Parity (PPP)

P(USD) P(EURO)

USD/EURO EXCHANGE RATE

1 ph

1 p f

ER

The Purchasing Power Parity (PPP) Concept

• changes in the ratio of domestic prices of internationally traded goods should be offset by exchange rate differentials.

EV(Exchange Rate) in % = EV(Relative Prive Levels) in %

• Example:

– inflation 8% in the US

– inflation 12% in Italy

– expected exchange rate movement:• 0.08-0.12 = -0.036 (3.6% lira decrease in terms of dollars)

1.12

• Is PPP valid to forcast exchange rate movements?

Empiricism and PPP

• Hypothesis: PPP should hold if– changes in the economy originate from monetary sector

– internal relative price structures remain relatively stable

– no structural changes occur in the economy

• Empirically– PPP is substantially violated in the short run

• markets are not functioning perfectly

– international price segmentation

• local goods and services

– there is some (!) evidence it might hold in the long run

Interest rates and inflation rates

• Irving Fisher• “Nominal domestic interest rates reflect anticipated real returns

adjusted for local inflation expectations”

• internationally: interest rate differentials should be offset by expected inflation differentials

• + Expectations Theory• differences between forward and spot rates should be equal to

expected change in spot rate

• = International Fisher Effect• links interest rate differential with expected spot rates

• differences in domestic interest rates should be equal to expected change in spot rate

FX Market Participants

• Bank and Nonbank FX Dealers• Individuals and Firms• Speculators• Arbitragers• Central Banks and Treasuries• FX brokers

Arbitrage and Speculation

• ARBITRAGE– Process of simultaneously buying and selling to take

advantage of a price and yield differential

• SPECULATION– Process of taking an open position and hoping that e.g.

exchange rates will move towards the expected direction• spot market speculation

• forward market speculation

• option market speculation

Equivalence in the FX Market

Difference betweenspot and forward

i f ih

1 ih

Difference in interest rates

f 0 s0

s0

difference in ex-pected inflation

p f ph

1 ph

expected change inspot rates

s t s0

s0

equals

equals

equals equalsequalsINTEREST

RATEPARITY

INTERN.FISHEREFFECT

PURCHASINGPOWERPARITY

EXPECTATIONSTHEORY

FISHER EFFECT

Interest rate parity theory (IRP)

• prediction:• differences in national interest rates of securities with similar risk

and maturity should be equal to opposite forward rate discount/premium

• real-world-consequences• if IRP does not hold, profits from interest rate arbitrage become

possible

• interest arbitragers activities ensure quick reactions to deviations from IRP

• strict enforcement of IRP is often limited

– exchange restrictions impede the flow of arbitrage funds

– transaction costs reduce full capital mobility

– commercial and country risk of default are also reflected in exchange rate premia and discounts

– limited supply of arbitrage funds

Covered Interest Arbitrage

• investing in a foreign exchange on a covered basis with the objective to earn net profits

Australia New Zealand

current spot rates A$0.7415/NZ$ NZ$1.3488/A$ A$1.2601/US$ NZ$1.6695/US$

12 mo-forward rates A$0.7106/NZ$ A$1.3163/US$interest rates 15%p.a. 20% p.a.

Comparable US-interest rates are 12% p.a.

The Australian Challenge

Australia

12 months

New Zealand

NZ$ 6, 743.088 x 1.20 NZ$ 8,091.705

convert toNZ$

A$ 5,000.000 x 1.15 A$ 5,750.000

sell forwardforA$ 5,749.966

The Australian Challenge/2

Australia

12 months

USA

US$ 3,967.939 x 1.12 US$ 4,444.092

convert toUS$

A$ 5,000.000 x 1.15 A$ 5,750.000

sell forwardforA$ 5,849.758

Characteristics of the Global FX Market

• LARGEST MARKET IN THE WORLD (900 bn $ per day)• WIDE SPECTRUM OF PARTICIPANTS, CURRENCIES AND

TRANSACTION TYPES– BREADTH– DEPTH

• ABILITY TO ABSORB LARGE TRANSACTIONS• ABILITY TO RECOVER QUICKLY FROM PRICE DISTORTIONS• USE OF SOPHISTICATED COMMUNICATION AND INFORMATION

MEDIA– TELERATE– REUTER’S– BLOOMBERG

• WORLDWIDE 24-HOUR-TRADING

Foreign Exchange Rate Quotations

• BID/OFFER(ASK) RATE • bid: indicates the price at which the trader is willing to purchase the

foreign currency in terms of local currency

• offer (ask): indicates the price at which the trader is willing to sell foreign currency in terms of local currency

• DETERMINANTS OF SPREAD• currency involved

• volume of trade (market depth)

• market stability

• location of the market

• DIRECT/INDIRECT METHOD• indirect: number of foreign units to one local unit

• direct: number of local units to one foreign unit

Currency Cross Rates

Mex.Peso 3.3715/USD USD 0.915/EURO

3.3715 MP = 1/0.915 EURO3.3715 MP = 1.0929 EURO 1 EURO = 3.0849 MP

Forward transaction

Requires delivery

- at a future date- of a specified amount of one currency- for a specified amount of another currency

Requires delivery

- at a future date- of a specified amount of one currency- for a specified amount of another currency

Forward Exchange Market

• maturity– typically 1, 2, 3, 6, 9 and 12 months in major traded currencies

– odd maturities possible at a higher cost

• premium– if the forward rate is higher than the current spot rate

• discount– if the forward rate is lower than the current spot rate

• quotations– points

– outright forward rates

– percentages (swap rates)

Forward quotation

• POINT QUOTATION– USD 0.9050/0.915 per 1 EURO (Indirect quotation)

– “USD premium of 6 to 3 points”

– forward quotation

• bid: 0.9050-0.0006= 0.9044

• offer: 0.9150-0.0003=0.9147

• OUTRIGHT QUOTATION– 3 months: 0.9044/ 0.9147

• PERCENTAGE QUOTATION (SWAP RATES)– indirect quotation:

– 0.9050-0.9044 x 360 x 100 = 0.27% p.a. premium

0.9044 90

100360

1,

1, xn

xF

FSf

ttt

ttusd

Assignment 2

• EITEMAN/STONEHIL/MOFFETT (9th EDITION!)•Chapter3

•Question 1: Polish Zloty•Question 4: Covered Interest Arbitrage •Question 5: London and New York

Foreign Exchange Exposure

• Translation (accounting) exposure: measures accounting-based changes in a firm´s consolidated financial statements resulting from a change in exchange rates

• Transaction exposure: gains or losses arising from the settlement of transactions stated in foreign currency

• Economic exposure: Possibility of cash flow changes due to an unexpected change in exchange rates

Measurement of Economic Exposure

• Quantifying the effect of a currency devaluation (revaluation) is non-trivial because it influences– Export sales

• become more competitive when home currency is devaluated

– Domestic sales• margins and cash flows are endangered in the import competing

sector

– Costs of imported inputs• should rise in response to a devaluation

Internal Techniques of Exposure Management

• Netting– reduces inter-company payments and receipts

• Pooling– internal “netting” of related currencies (e.g. EMS member

currencies)

• Leading and lagging• Pricing Policy• Asset and Liability Management (Natural Heding)

•Applicable for MNC’s to reduce transaction exposure

•Establishment of specialized netting centers or use of banks

•Legal and tax limitations due to foreign exchange controls

Internal Netting

• Bilateral Netting

Multilateral Netting

UK subsidiary

Swisssubsidiary

French subsidiary

netting arrangement

UK subsidiary

Swisssubsidiary

French subsidiary

netting arrangementGrouptreasury

Leads and lags

Expected Depreciation

of Foreign Currency

Expected Appreciation of Foreign Currency

leading of accounts receivabledenominated in this currency

lagging of accounts payabledenominated in this currency

lagging of accounts receivabledenominated in this currency

leading of accounts payabledenominated in this currency

Natural Hedging

Matching of Currency Cash Flows

annual paymentsfor a JPY loan

RISK

purchases security

receives interest ordividend in JPY

Austrian Company

External Techniques of Exposure Management

• Forward/Futures Market Hedge

• Money Market Hedge– based on a short term borrowing or depositing

– future value of loan proceeds/?

• Option Market Hedge

• involves a forward (or futures) contract and a source to fulfil this contract

• locks in a forward rate

• covered (perfect) hedge

• uncovered (open) hedge

• cost is a function of forward rate quotation (e.g. discount or premium on spot exchange rate)

• can be extended

FX Risk - FMH vs. MMH

1 . A n A u s t r i a n f i r m h a s a n A / R o f U S D 2 0 , 0 0 0 w h i c h i s d u e i n 3 m o n t h s . T h e f i r m e x p e c t s t h eU S D t o d e p r e c i a t e a n d c o n s i d e r s t o h e d g e t h e p o s i t i o n v i a t h e f o r w a r d o r m o n e y m a r k e t .

W h a t w o u l d b e t h e p r o c e e d s ( i n E U R O ) i f t h e f i r m w o u l d h e d g e o n t h e f o r w a r d m a r k e t ?

C o m p u t e t h e p r o c e e d s , i f t h e e x p o r t e r w o u l d u s e t h e m o n e y m a r k e t i n s t e a d a n d f a c e s ai n t e r e s t r a t e o f 1 1 % p . a . f o r a E U R O - l o a n i n t h e m o n e y m a r k e t .

W h i c h i n s t r u m e n t s h o u l d t h e f i r m c h o o s e a n d w h y ?

S p o t r a t e E u r o : 0 . 9 5 0 0 U S DF o r w a r d r a t e : 0 . 9 5 7 6 U S D

M o n e y m a r k e t r a t e sU S D - b o r r o w i n g r a t e : 5 . 5 % p . a .U S D - i n v e s t i n g r a t e : 4 . 7 % p . a .C r e d i t f e e ( f o r E U R - u n d U S D - l o a n s ) : 0 . 8 %

F o r w a r d M a r k e t H e d g e

2 0 , 0 0 0 x 1 / 0 . 9 5 7 6 = 2 0 . 8 8 5 , 5 5 E U R

M o n e y M a r k e t H e d g e :

360

9011.01

9500.0

1008.0000,20

360

90055.01

000,20xxxxUSD

x

USD= 2 1 , 1 6 5 , 1 3 E U R

Assignment 3

• EITEMAN/STONEHIL/MOFFETT (9th EDITION!)•Chapter4

•Question 3: Forward Rates on the CAD •Question 4: Currency Cross Rates

Currency Options

• Definition: gives the buyer the right to buy or sell a given amount of foreign exchange at a fixed price (strike price) per unit for a specified time period from the seller.

• European vs. American Options

• Put and Call

• Exercise Price, Expiration Date

• Premium

• in, at, out-of-the money

• standardized options (Philadelphia, London, Amsterdam)

• OTC-options

– all major currencies

– any time period up to 12 months

Put and Call - Terminology

CALL

PUT

Buyer (Holder) Seller (Writer)

right to BUY fora specified price

right to SELL fora specified price

duty to SELL fora specified price

duty to BUY fora specified price

Call Option-Buyer

Limited Loss-0,5

0,5

Profit/Loss(cents/CHF)

Spot price(cents/CHF)57.5 58 58.5 59 59.5 60

Strike price

Unlimited Profit

OOMATM

ITM

Break-Even-Price

Profit=Spot Rate-(Strike price+premium)

Call Option-Writer

Limited Profit

-0,5

0,5

Profit/Loss(cents/CHF)

Spot price(cents/CHF)

57.5 58 58.5 59

59.5 60

Strike price

Unlimited Loss

Break-Even-Price

Profit=Premium -(Spot Rate-Strike price)

Put-Option-Buyer

Limited Loss-0,5

0,5

Profit/Loss(cents/CHF)

Spot price(cents/CHF)

57.5 58

58.5

59 59.5 60

Strike price

Break-Even-Price

OOM

ITM

ATM

Unlimited Profit

Profit=Strike price-(Spot rate+premium)

Limited Profit

Put-Option-Writer

-0,5

0,5

Profit/Loss(cents/CHF)

Spot price(cents/CHF)57.5

58 58.5 59 59.5 60

Strike price

Unlimited Loss

Break-Even-Price

Profit=Premium - (Spot Rate-Strike price)

Listed Options vs. OTC-Options

Listed Options OTC-Options

Amount standardized tailored

Maturity fixed maturities flexible maturities

Currency major currencies major currencies against USD, cross against USD currency options

Striking Price standardized individually

Premium listed individually priced

Secondary Market available not institutionalized

Managing Economic (Operating) Exposure

• Diversifying Operations• Diversifying Financing• Leading and Lagging• Currency Clauses• Reinvoicing Centers (Multilateral Netting)• Natural Hedges• Back-to-back loans• Currency swaps

Currency-Asset-Swap

FIRM BANK

Austria USprincipal payment in ATS*,interest payments in USD

bond portfolio

earns interest in FX

principal payment in USD*,interest payments in ATS

COMBINATION OF CURRENCY AND INTEREST SWAP

*) actual spot rates

Currency-Asset-Swap/2

FIRM BANK

Austria US

principal repayment in USD*

bond portfolio

earns interest in FX

principal repayment in ATS*

+) previously agreed exchange rates

Advantages of a Currency Swap

• right of offset– Nonpayment of one party’s principal or interest may be

offset by a comparable nonpayment

• off-balance-sheet-transaction• serves as a long-term financing instrument• overcomes restrictions on national FX and capital

markets

Advantages of a Currency Swap

• right of offset– Nonpayment of one party’s principal or interest may be

offset by a comparable nonpayment

• off-balance-sheet-transaction• serves as a long-term financing instrument• overcomes restrictions on national FX and capital

markets

Hedging in Austrian Companies

• STEYR-DAIMLER-PUCH• selective hedging (decision process)

• internal netting by financial holding

• case: tractors to Russia

• TETRA PAC • internal netting with Swiss holding

• extensive use of CHF

• ATS/CHF forward hedges

• CHF Call Options

• ALCATEL AUSTRIA • internal invoicing in ECU

• external invoicing in ATS,DEM,ECU, FFR

• proportional external hedging (money markets, forwards, currency clauses))

Cash Versus Futures Market

• Cash Market– Commodities (coffee, metals, oil, timber, ..)

– Financials (bonds, commercial deposits, equity, currencies,..)

• Futures Market– Commodity Futures

– Financial Futures• Currency Futures (DEM/USD)

• Interest Rate Futures (Bund Future, T-bill, ...)

• Stock Index Futures (ATX, DAX, S&P,...)

Currency Future Hedging

Bichler GmbH

A/P due in Oct

USD 1,2 MioIntertex Inc.

Strategy: Buy USD in exchange for DEM in the futures market (= sell a DEM Future) Lock in a favorable DEM/USD exchange rate

today: Dec-Future: 0.6071 USD/ DEM

Step 1: Bichler needs 1,2 Mio USD = 1,976 640 DEM ( app. 16 contracts) Bichler sells 16 DEM/USD dec-contracts @ 0.6071

Step 2: in oct Bichler buys USD 1,200 000 at spot rate 13 ATS/USD and pays his A/P plus Bichler buys 16 DEM/USD dec-contracts @ 0.5412 and closes the open position Consequences: costs for A/P 1,200 000 @ 13 = 15,600 000 ATS ./. earnings from future 0.6071 - 0.5412 = 0.0659 USD/DEM = 131 800 USD @ 13= 1,713 400 ATS total cost 13,886 600 ATS

equivalent to (11,57 ATS/USD)

Foreign Exchange Futures

• Marketplace• CME (Chicago Mercantile Exchange) , LIFFE (London Int. Financial

Futures Exchange), NYFE, SIMEX, Sydney, Montreal

• High Degree of Standardization• currencies• contract size and multiples (e.g. DEM 125.000)• fixed maturities (up to 9 months)

• No physical delivery• Secondary Market• Settlement

• contracts are usually settled before the value dates by payment or receipt of the difference between the contract and the current price rather than by actual delivery

Assignment 4

• EITEMAN/STONEHIL/MOFFETT (9th EDITION!)•Chapter 6

•Question 1: Tektronix, A/R•Question 2: Tektronix, A/P •Question 3: Taj Bakeries•Question 7: Seattle Scientific, Inc.

Forfaiting

• Purchase of financial obligations (B/E, promissory notes) without recourse to the original holder, usually the exporter.

• Restrictions to the underlying transaction– transactions in excess of $500,000

– denominated in certain currencies

– medium to long-term

– accompanied by aval or guarantee

Forfaiting transaction

Rationale for global financing

• MARKET LIQUIDITY ARGUMENT– to have access to additional funds– to decrease marginal cost of capital

• MARKET SEGMENTATION ARGUMENT– to decrease overall cost of capital by means of disintegrated

efficiently prices markets

• RISK REDUCTION (DIVERSIFICATION) ARGUMENT– reduces business risk– allows for a higher debt capacity

Empirical evidence on international capital structure

• Debt ratios differ substantially across industries and countries

• MNC’s and LC’s have different capital structures– In contradiction to the diversification argument MNC’s support less debt

in their capital structures (Lee/Kwok 1988, Burgman 1996).

– Why?

• Business Risk (volatility of earnings) of MNC’s and LC’s is identical.

• but: MNC’s are less exposed to FX risk.

• but: MNC’s are difficult to monitor

• Political risk is an important factor affecting MNC target debt levels (Burgman 1996)– Leverage is positively associated with political risk in MNC’s (hedging

tool)

Internationalizing Equity Financing

• 2 WAYS– crosslisting of existing shares on foreign stock exchanges

– selling new rights issues

• EQUITY MARKETS TO APPROACH– Host Country

– “Big Five”: New York, London, Frankfurt, Tokio, Paris

• FORMS OF EQUITY ISSUES– directed share issue

– Euro-equity issue

– American Depositary Receipt

– sale of a foreign subsidiaries shares to investors in host country

– sale of shares to foreign firm as part of a strategic alliance

American Depository Receipts (ADRs)

• tradeable receipt in USD representing a number of foreign shares that are deposited in a bank

• 1,800 ADR programs (USD 50 billion, 58 countries) traded on US exchanges at present

• similar programs in London (Global Depository Receipts) and Singapore• advantages

– no currency conversion (denomination and dividends in USD)

– no additional accounts with non-US brokers

– practices (settlement, quotes) according to US standards• Austrian ADR participants

– Bank Austria, Böhler Uddeholm, EVN, Flughafen, OMV, Wienerberger, Wolford,...

The Austrian Stock Exchange

• Historical problems– low liquidity

– low market capitalization

– lack of transparency and stringent insider rules

– image problems

• recent developments– new takeover code

– adoption of international accounting standards (IAS, GAAP)

– tax benefits

– privatization of Vienna Stock Exchange 1998

– alliance with Deutsche Börse

– adoption of a common trading system (XETRA) in 1999

– foundation of a Eastern European Stock Exchange in Vienna (NEWEX) in 2000

Euromarkets

• What is a Eurodollar?– dollars held in deposits outside the US

• Eurocurrencies– currencies (funds) being intermediated outside the country which has the

jurisdiction to issue this currency

• Euromarkets

– Banking and financial wholesale markets for Euro-deposits and -loans.• Incentives in Euromarkets

– not subject to domestic banking regulations

• favorable lending and credit terms

• Instruments in the Euromarket– Eurobonds

– Eurocredits, Eurodeposits

Euromarket Instruments• Eurodeposits

– fixed interest rate/short maturities

– floating rate notes (FRN’s)/longer maturities

• Eurocredits (Euroloans)– LIBOR + spread

– on a syndicated basis

• lead banks– receive a mandate from the borrower and assemble a management group– negotiate terms and conditions

• managing banks– commit themselves to provide the entire amount, if necessary (underwriting)

• participating banks– purchase portions of the loans from managing banks

• Eurobonds

Eurobonds

• FOREIGN vs. EUROBONDS• CHARACTERISTICS

– private placement rather than formal issuing

– simultaneous placement in various countries

– market is not subject to national regulations

– favorable tax status (no withholding tax)

– less stringent disclosure

– relatively low issue costs

– active secondary market

• TYPES– straight bond (fixed, floating)

– convertible bond

– medium-term Euronotes

Syndication

MNC as Issuer

Lead Manager

Co-Lead-Managers

Underwriting Banks

Participating or Selling Banks

Euromarket Instruments/II

• INTERNATIONAL BONDS

GBP-Bond issued by a Dutch firm

DEM-Bond issuedin Luxemburg

Management of Interest Rate Risk

Forward Rate Agreements (FRA’s)

• Interest Rate Swaps

Interest RateExpectations

Result

FRA-Buyer FRA-WriterStrategy

increasing

decreasing

Profit

Loss

Loss

Profit

Buy FRA

Write FRA

Forward Rate Agreement (FRA)

• Definition• contract to buy or sell interest payments on a notional

principal. A FRA can be bought to lock in an interest rate, i.e. the buyer will pay the seller the differential interest expense if interest rates fall below the agreed rate.

• Contract specifies– principal and currency

– maturity (typically 3, 6, 9 months)• 3/6 (“three against six”)

– FRA-rate

– reference interest rate • LIBOR, VIBOR, FIBOR

FRA- example

• principal

– 10 Mio DEM loan, 3 months roll-over

• interest rate

– LIBOR + marge

• 2/5 FRA at June, 19

– price: 3.5% p.a.

• settlement (August, 19)

– LIBOR at 3.825%

• result– buyer receives 10,000 000 * (0.03825-0.035) * 92/360 =

8,305.55

June, 19 August, 19 November, 19 interest payment

for period aug - nov

Interest Rate Options

• Definition– Option on a maximum or minimum interest rate payment.

– premium as a percenatge of principal is paid upfront

• Types– Interest Rate Cap

• Buyer will receive a cash payment if market interest rate exceeds cap strike rate.

– Interest Rate Floor

• Buyer will receive a cash payment if market interest rate falls below strike rate.

– Interest Rate Collar

• Simultaneous purchase (sale) of a cap and sale (purchase) of a floor to decrease total premia costs

• “zero-premium-collar”

Interest Rate Swap

• Definition– contract between two parties to exchange interest payments (notional amount is not

exchanges

• Types– Coupon Swap

• fixed-floating – Basis Swap

• floating-floating (e.g. LIBOR/USD Prime)

• Comparative Cost Advantage (CCA)– Unilever UK MIC, US

• fixed: 9% fixed:10%• floating LIBOR + 1/4% float: LIBOR +3/4%• which company has a CCA in the floating market?