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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


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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.
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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
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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/.

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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.
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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.
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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

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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.
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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


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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


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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

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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.

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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)
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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.
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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.
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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 %
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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.

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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.
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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
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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

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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
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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

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