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Part 2 - International Corporate Finance


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Title: Part 2 - International Corporate Finance

Part 2 - International Corporate Finance
  • 2.1. Foreign Exchange Exposure

International Corporate Finance
  • Part 2 International Corporate Finance (10 hrs)
  • Foreign Exchange Exposure (Chap. Eiteman 8 9 -
  • Transaction exposure decision case
  • Operating exposure
  • Financing the Global Firm (Chap. 11 13 2h)
  • Global cost and availability of capital
  • Financial structure and international debt
  • Foreign Investment Decision (Chap. 15, 16 18
  • FDI theory and strategy
  • Multinational capital budgeting
  • Adjusting for risk in foreign investment
    decision case
  • Managing Multinational Operations (Chap. 21 22
  • Repositioning funds
  • Working capital management decision case

Foreign Exchange Exposure
  • Type of foreign exchange exposures
  • The three main types of foreign exchange exposure
    are transaction, operating, and translation
  • Transaction exposure
  • Impact of settling outstanding obligations
    entered into before change in exchange rates but
    to be settled after change in exchange rates.
  • Operating exposure
  • Change in expected future cash flows arising from
    an unexpected change in exchange rates.
  • Translation exposure
  • Changes in reported owners equity in
    consolidated financial statements caused by a
    change in exchange rates. Accounting exposure.

FX - To hedge or not to hedge?
  • There is a debate between supporters and
    opponents of FX hedging. Some arguments of the
    two groups are
  • NOT hedge, because
  • Shareholders are much more capable of
    diversifying currency risk than the management of
    the firm.
  • Currency risk management does not increase the
    expected cash flows of the firm, but rather
    decreases the variance of the CF, and decrease
    them as well by the hedging costs.
  • Managers cannot outguess the market, if and when
    markets are in equilibrium with respect to parity
    conditions, the expected net present value of
    hedging is zero.
  • In efficient markets, investors and analysts can
    see across the accounting veil and therefore
    have already factored the foreign exchange effect
    into a firm's market valuation.

FX - To hedge or not to hedge?
  • HEDGE, because
  • Reduction of risk in future cash flows reduces
    the likelihood that the firms cash flow will
    fall below the necessary minimum.
  • Management has comparative advantage over the
    individual shareholder in knowing the actual
    currency risk of the firm.
  • Markets are usually in disequilibrium because of
    structural and institutional imperfections, as
    well as unexpected external shocks. Management is
    in a better position than shareholders to take
    advantage of the one-time opportunities theses
    imperfections cause, to enhance the firm value
    through selective hedging.

Transaction Exposure
  • Transaction exposure
  • Transaction exposure arises from
  • Purchasing or selling on credit goods or services
    when prices are stated in foreign currency.
  • Borrowing or lending funds when repayments is to
    be made in a foreign currency.
  • Being a party to an unperformed foreign exchange
    forward contract.
  • Otherwise acquiring assets or incurring
    liabilities denominated in foreign currencies.
  • Most common example
  • Transaction exposure of a firm has a receivable
    denominated in a foreign currency.

Transaction Exposure
  • Transaction exposure - example
  • Sale of telecom equipment from Trident (US
    multinational corporation) to a British company.
  • Payment is made in 1 MM due in three months.
  • If the appreciate toward the , Trident makes a
    bigger profit, but if the depreciates, Tridents
    loses part (or all) of its margin transaction
  • Spot rate 1.7640/. The budget rate, the
    lowest acceptable dollar per pound exchange rate
    is established at 1.70/ to maintain acceptable
  • Four alternatives available to Trident to manage
    the exposure
  • Remain unhedged
  • Hedge in the forward market
  • Hedge in the money market
  • Hedge in the options markets

Transaction Exposure
  • Transaction exposure - example
  • Forward market hedge
  • This involves a forward (or futures) contract and
    a source of funds to fulfill that contract.
  • The forward contract is entered into at the time
    the transaction exposure is created.
  • The sequence is as follows
  • Day 0 sell 1 MM forward at 1.7540 (fwd rate 3
  • In 3 mths receive 1 MM (from buyer), deliver
    1 MM against forward sale, receive 1,754 MM
    (price of the fwd rate).
  • The forward contract is covered or square,
    the funds on hand or to be received are matched
    by the funds to be paid.

Transaction Exposure
  • Transaction exposure - example
  • Money market hedge
  • Like a forward market hedge, a money market hedge
    also includes a contract and a source of funds.
    The contract is here a loan agreement.
  • The firm seeking the hedge borrows in one
    currency and exchange the proceeds for another
    currency. If funds to fulfill the contract are
    generated by business operations, the hedge is
    covered. If the funds are to buy of the spot
    market, the hedge is uncovered or open.
  • The structure is similar to the forward hedge.
    Here, the price is determined by the interest
    rate differential between the two currencies,
    whereas in the fwd hedge, the price is the
    forward premium. In efficient fwd markets,
    interest rate parity states that these prices are
    the same.

Transaction Exposure
  • Transaction exposure - example
  • Money market hedge
  • The sequence is as follows
  • Day 0 borrow enough to repay 1 MM in 3mths
    that is 1MM / 10.25 975,610.
  • Day 0 exchange 975,610 against at spot rate
    (1.7640), that is 1,720,976
  • In 3 mths receive 1 MM (from buyer), deliver
    1 MM to repay the loan, that is 975,610
    principal 24,390 interests.
  • Depending on the relative prices of forward
    markets and interest rates differences, the money
    market hedge or the forward hedge will be

Transaction Exposure
  • Transaction exposure - example
  • Option market hedge
  • The transaction exposure could also be covered by
    a 1 MM put option. This technique allows
    speculation on the upside appreciation of the
    pound while limiting the downside risk to a know
    amount (the premium of the option).
  • The sequence is as follows
  • Day 0 buy put option to sell pounds at 1.75/,
    pay 26,460 for the option.
  • Option cost (size of option)x(premium)x(spot
    rate) 1,000,000 x 0.015 x 1.7640 26,460
  • In 3 mths receive 1 MM. Either deliver 1 MM
    against put, receiving 1,750,000 or sell 1 MM
    spot if current spot rate gt 1.75/

Transaction Exposure
  • Transaction exposure - example
  • Comparison of alternatives
  • In order to evaluate the full cost of the option
    hedge, one has to include the opportunity cost of
    the premium paid.
  • If one considers 12 of cost of capital ,it makes
    3 a quarter. The full premium cost of the option
    is thus 26,460x1.03 27,254. In contrast, the
    downside risk is limited to the premium cost
    incurred, in case of an option hedge. But the
    upside gain is unlimited.
  • We can calculate the trading range for the that
    defines the break-even for the option compared to
    others alternatives.
  • The upper bound of the range is determined
    compared to the forward rate. The must
    appreciate enough above the forward rate to cover
    the 0.0273/ to cover the cost of the option
    1.7540 0.0273 1.7813/.
  • The lower bound is is determined compared to the
    unhedged strategy. If the spot rate falls below
    1.75/, the option is exercised.

Transaction Exposure
  • Transaction exposure - example
  • Comparison of alternatives
  • One can thus compare the various gains or losses
    brought by the hedge at strike price 1.75/,
    depending on the realized FX rate
  • Option cost (future value) 27.254
  • Proceeds if exercises 1,750,000
  • Minimum net proceeds 1,722,746 (proceeds at
    strike - cost)
  • Maximum net proceeds unlimited
  • Break-even spot rate (upside) 1.7813/
  • Break-even spot rate (downside) 1.75/
  • Strategy choice and Outcome
  • Two selection criteria risk tolerance
    expectations of the direction and distance the
    exchange rate will move the period considered.

Transaction Exposure
Transaction Exposure
  • Risk Management in practice
  • No real consensus seems to emerge, according to
    international surveys.
  • In most firms, treasury functions are responsible
    for transaction exposure management and usually
    considered a cost function. Expected to act as
  • Transaction exposure generally allowed to be
    hedged once actually booked as receivables and
    payables (transaction certain).
  • Transaction management programs divided among
    those using options, and those who do not. The
    latter rely almost exclusively on fwd contracts
    and money market hedges.
  • Many firms establish risk mgt policy requiring
    proportional hedging on a of the total
    exposure. The remainder is selectively hedged on
    the basis of expectations and views.

Transaction Exposure
  • Risk Management in practice - Decision Case
  • See Lufthansas purchase of Boeing 737

Operating Exposure
  • Definition
  • Operating exposure (OE) measures any change in
    the present value of a firm resulting from
    changes in future operating ash flows caused by
    any unexpected change in exchange rates.
  • Operating exposure analysis examines the
    consequences of changing FX rates on a firms own
    operations over the coming months and years and
    on its competitive position relative to other
  • Operating exposure and transaction exposure are
    both related to future cash-flows. They differ in
    terms of which CF are considered and why they
    change when FX rates change.

Operating Exposure
  • Attributes of Operating exposure
  • Measuring the OE of a firm requires forecasting
    and analyzing all the firms future exposures of
    all the firms competitors and potential
    competitors worldwide. OE is far more important
    for the long-run health of a business than
    transaction exposure or translation exposure.
  • The CF can be divided in operating cash-flows and
    financial cash-flows.
  • Operating cash flows arise from intercompany and
    intracompany receivables and payables, rent and
    lease payments of facilities, royalties and
    license fees, etc.
  • Financial cash flows are payments for the use of
    intercompany and intracompany loans and
    stockholders equity.
  • Each of these CF can occur in different time
    intervals, amounts, currencies and denomination,
    and each has a different predictability of

Operating Exposure
  • Attributes of Operating exposure
  • Financial and Operating Cash Flows between a
    Parent and Affiliate

Operating Exposure
  • Attributes of Operating exposure
  • An expected change in FX rates is not included in
    the definition of OE, because it has already been
    included in the firms valuation parameters. Only
    unexpected changes in FX rate, or inefficient
    foreign exchange market should cause market value
    to change.
  • OE is not just the sensitivity of a firms future
    CF to unexpected change in FX rates, but also its
    sensitivity to other key macroeconomic variables.
  • Illustrating of Operating Exposure Trident
  • Suppose an MNE US Corp. Deriving much of its
    profits from its German subsidiary. If the euro
    unexpectedly falls in value
  • How will Trident Europes revenue change (prices
    in euro terms and volumes) ?
  • How will its costs change (input costs in euro) ?
  • How will its competitors react ?

Operating Exposure
  • Illustrating of Operating Exposure Trident
  • Imagine that input are bought in Europe, labeled
    in Euro. Half of the production is sold in
    Europe, half is exported to non-European
  • All sales are invoiced in Euros, and the average
    collection of period account receivables is 90
  • Following a Euro depreciation, Trident might
    choose to
  • maintain its domestic price constant in euro
  • try to raise domestic prices because competing
    imports are now priced higher in Europe
  • keep exports prices constant in terms of foreign
    currencies, in terms of euro, or some where in
    between (partial pass-through)

Operating Exposure
  • Illustrating of Operating Exposure Trident
  • The strategy undertaken depends largely on
    management's opinion about the price elasticity
    of demand.
  • On the cost side, Trident Europe might raise
    price because of more expensive imported raw
    material or components.
  • Tridents domestic sales and costs might also be
    partly determined by the effect of the euro
    devaluation on demand.

Operating Exposure
  • Strategic Management of Operating Exposure
  • The objective of both transaction and operating
    exposure management is to anticipate and to
    influence the effect of the changes in FX rates
    on a firms future cash-flows.
  • To this end, management can
  • Diversify operations sales, location of
    production facilities, and raw material sources.
    Flexibility can allow firms to change its
    operating structure according to international
    changes (ex. Goodyear and the Mexican Peso
  • Diversify financing raise funds in more than
    one capital market and in more than one currency.
  • A diversification strategy permits the firm to
    react either actively or passively, depending on
    managements risk preferences, and to
    opportunities presented by disequilibirum
    conditions in the FX, capital, or products

Operating Exposure
  • Proactive Management of Operating Exposure
  • Operating and transaction exposures can be
    partially managed by adopting policies that
    partially offset the effect of FX changes. The
    four most common used techniques are the
  • 1. Matching currency cash-flow Ex exporting
    US firm in Canada match the in flows of CAD from
    its sales by the outflows of part of its debt
    labeled in CAD.
  • 2. Risk sharing agreements contractual
    arrangements in which the buyer and the seller
    agree to split currency movements impacts on
    payments between them.

Operating Exposure
  • Proactive Management of Operating Exposure
  • 3. Back-to-back or parallel loans, or credit
    swaps two business firms in separate countries
    agree to borrow each others currency from a
    limited period of time. At an agreed terminal
    date, they return to their borrowed currencies.
    The transaction takes place outside of the FX
    markets, although the spot quotation can be used
    as a reference point.
  • 4. Currency swaps similar to a back-to-back
    loan but off balance sheet. Agreement between two
    parties to exchange a given amount of one
    currency for another and, after a period of time,
    to give back the original amounts swapped.
    Currency swaps can be negotiated for a wide range
    of maturities and currencies. The swap dealer or
    swap bank acts as a middleman in setting up the
    swap agreement.

Operating Exposure
  • Proactive Management of Operating Exposure
  • 4. Currency swaps

Part 2 - International Corporate Finance
  • 2.2. Financing the Global Firm

International Corporate Finance
  • Global cost and availability of capital
  • Purpose of firms having access to global capital
  • Minimize their cost of capital
  • Maximize the availability of capital
  • This allows them to
  • Accept more long-term projects
  • Invest more in capital improvements and expansion
  • If markets are segmented
  • A national capital market is segmented if the
    required rate of return on securities differs
    across markets, for comparable securities.
  • Market segmentation due to various market

International Corporate Finance
Local Market Access
Global Market Access
Firm-Specific Characteristics
Firms securities appeal only to domestic
Firms securities appeal to international
portfolio investors
Global Cost of Capital
  • Weighted Average Cost of Capital (WACC)

Where kWACC weighted average cost of
capital ke risk adjusted cost of
equity kd before tax cost of debt t
tax rate E market value of
equity D market value of debt V
market value of firm (DE)
Global Cost of Capital
  • Weighted Average Cost of Capital (WACC)
  • Cost of equity CAPM (Capital Asset Pricing

Where ke expected rate of return on
equity krf risk free rate on bonds km
expected rate of return on the market ßj
coefficient of firms systematic risk
Global Cost of Capital
  • Weighted Average Cost of Capital (WACC)
  • Cost of Debt
  • Requires the forecast of
  • the interest rates for the next few years,
  • the proportions of various classes of debt used
    by the firm in the years
  • the corporate income tax (t)
  • if kd is the cost of debt before tax,
  • then kd(1-t) weighted average after-tax cost
    of debt
  • WACC
  • Usually used as the risk-adjusted discount rate
    whenever a firm s new projects are in the same
    general risk class as its existing projects.

Availability of Capital
  • Availability of Capital
  • Demand for foreign securities
  • Role of International Portfolio Investors
    international investment to increase the
    risk/return ratio of a portfolio invested
    globally in different regions, countries, stage
    of development.
  • Link between cost and availability of capital
  • If capital in indefinitely available its cost
    does not rise as demand for funds increases. This
    requires a very liquid market, which is not the
    case of most domestic markets.
  • An access to multinational markets improves the
    liquidity available to the firm and allows the
    firm to preserve its optimal financial financial
    structure (constant D/E ratio).

Availability of Capital
  • Availability of Capital
  • Link between cost and availability of capital
  • If market are fully integrated, securities of
    comparable expected return and risk should have
    the same required rate of return in each national
    market, after adjustment for foreign exchange
    risk and political risk.
  • Capital market segmentation is a financial market
    imperfection caused by government constraints,
    institutional practices, and investors
  • Segmentation does not imply that market are
    inefficient, at least a domestic level.
  • Influence of illiquidity and segmentation on
  • Higher cost of capital / Rising cost of capital /
    Shifts in the optimal financial structure /
    Rising cost of projects

NOVO Industri
  • Illustrative case NOVO industri
  • Novo Danish pharmaceuticals company
  • Had a lack of availability and higher cost of
    capital than its main competitors, due to market
  • P/E ratio of Novo around 5 main international
    competitors around 10.
  • Causes linked to several characteristics of the
    Danish equity market
  • Asymmetric information base of Danish and foreign
  • Taxation capital gains on equity taxed at 50
    capital gains on bonds tax free
  • Very few alternative set of feasible portfolios
    due to prohibition of foreign security ownership.
    Stock prices were then closely correlated with a
    high systemic risk.

NOVO Industri
  • Financial risk high leverage of Scandinavian
    firms compared to US/UK standards
  • Foreign exchange risk
  • Steps taken by Novo to overcome the market
  • Closing the information gap disclosure of
    information in English version issuance of
    Eurobonds with a UK investment bank as
  • The biotechnology boom seminar organised by
    Novo in NYC made investors flooding, the stock
    price doubled, P/E up to 16, share ownership rise
    from 0 to 30.
  • Direct share issues in the US prospectus made
    for an eventual registration of NYSE.

NOVO Industri
  • Impacts on Novos cost of capital
  • Stock market reaction price drop in Copenhagen
    by 10 at announcement of a US share issue
    (1981), where the loss was immediately recovered.
    Typical reaction of an illiquid market to a
    threat of dilution effect of the new share issue.
  • Effect on WACC reduction of WACC and reduction
    of marginal cost of capital.
  • Nowadays
  • Significant reduction of market segmentation,
    following globalisation. But reduced gains of
    international portfolio diversification.

Cost of Capital in MNE s
  • Cost of Capital of MNEs compared to domestic
  • Availability of capital better. Allows firms to
    maintain their desired D/E ratio
  • Financial structure and systematic risk for MNEs
  • Theoretically, MNEs should be able to afford
    higher D/E ratios since their cash-flow are
    internationally diversified and yet their
    variability is minimised.
  • However, empirical studies show an opposite
    conclusion international diversification does
    not compensate for higher agency costs, political
    risk, and foreign exchange risks that MNEs face.
  • These lead to lower D/E ratios and rather higher
    cost of capital.

Cost of Capital in MNE s
  • Cost of Capital of MNEs compared to domestic
  • Is the WACC really higher for MNEs?
  • The explanation of this apparent contradiction
    may lie in the opportunity set of projects of
    international companies. As it increases, the
    firms needs to increase its capital budget to the
    point where its marginal cost of capital
  • In that case, at constant opportunity set, the
    WACC of a domestic firm is higher. See graph.
  • Empirically firms seems to show some risk
    aversion and try to avoid the point where their
    marginal cost of capital increases. So the
    observed WACC of international companies is
    higher. See equation.

Cost of Capital in MNE s
Cost of Capital in MNE s
Empirical studies MNEs have a lower
debt/capital ratio, leading to a higher cost of
capital than their domestic counterparts.
Indications are that MNEs have a lower average
cost of debt, leading to a lower cost of capital
than their domestic counterparts.
  • Cost of equity required higher for MNEs.
  • Possible explanations higher levels of
    political risk, foreign exchange risk, and higher
    agency costs of doing business in a multinational
    managerial environment.
  • However, at relatively high levels of the optimal
    capital budget, the MNE would have a lower cost
    of capital.

Sourcing Equity Globally
  • In order to benefit from global financial
    markets, a firm may decide to cross-list its
    shares on foreign stock exchanges.
  • More specifically, it can be motivated by one or
    more of the following reasons
  • Improving liquidity of its existing shares and
    support a liquid secondary market for new equity
    issues in foreign markets.
  • Increase its share price by overcoming mispricing
    by a segmented, illiquid home market.
  • Establish a secondary market for shares used to
    acquire others firms in the host market.
  • Increase the firms visibility political
    acceptance to its customers, suppliers, creditors
    and host governments.
  • Create a secondary market for shares that will be
    used to compensate local management and employees
    in foreign subsidiaries.

Sourcing Equity Globally
  • According to the goal pursued, the type of
    listing will be different
  • If it is to support a new equity issue or to
    establish a market for share swaps, the target
    market should also be the listing market.
  • If it is to increase the firms commercial and
    political visibility or to compensate local
    management and employees, it should be in markets
    in which the firm has significant operations.
  • If it is to improve liquidity of a firms shares,
    the major liquid stock markets are New York,
    London, Tokyo, Frankfurt and Paris.
  • By cross-listing and selling equity abroad, a
    firm faces two barriers
  • Increased commitment to full disclosure
  • A continuing investor relations program

Financial Structure int. debt
  • Financial structure and international debt
  • Optimal financial structure
  • A firm should optimally have the mix of debt and
    equity that minimises the firms cost of capital
    for a given level of business risk.
  • The WACC decreases when debt increases, due to
    the lower cost of debt and the tax deductibility
    of interests.
  • But, partly offsetting this, the cost of equity
    increases because equity investors perceive a
    higher risk in a higher leveraged firm. The
    optimal range of debt ratio is estimated between
    30 and 60.
  • Within that range, the optimal ratio is
    influenced by the industry of the firm the
    volatility of the sales and operating income the
    collateral value of the assets.

Financial Structure int. debt
  • Optimal financial structure

Financial Structure int. debt
  • Financial structure and international debt
  • Optimal financial structure the case of the MNE
  • Compared to domestic companies, the theory of
    optimal structure of capital needs to be adapted
    to the international case in four ways
  • (1) The availability of capital that allows a
    MCC constant (see previous section)
  • (2) Diversification of cash-flows that could
    allow for higher D/E acceptable ratios

Financial Structure int. debt
  • (3) Foreign exchange risk foreign currency
    denominated debt should be adjusted for any
    foreign exchange gains or losses.
  • When a firm issues foreign currency denominated
    debt, its effective cost equals the after-tax
    cost of repayment in terms of the firms own
  • (4) Expectations of international portfolio
    investors dominance of US - UK norms on global
    markets, for firms overcoming market segmentation.

Where kd Cost of borrowing for US firm in
home country kdSfr Cost of borrowing for US
firm in Swiss francs s Percentage
change in spot rate
Financial Structure int. debt
  • Financial structure of foreign subsidiaries
  • Since MNE are assessed on consolidated
    statements, financial structures of subsidiaries
    are relevant only if they affect this overall
  • Subsidiaries do not have independent cost of
    capital. Therefore, their financial structure
    should not be based on minimising it.
  • Empirically, studies show that country-specific
    environment are key determinants of debt ratios
    historical development, taxation, corporate
    governance, bank influence, bond market, attitude
    toward risk
  • Debts considered here only those borrowed from
    sources outside the MNE local and foreign
    currency loans, and Eurocurrency loans.

Financial Structure int. debt
  • Financial structure of foreign subsidiaries
  • Main advantages of localization
  • Localized financial structure reduces criticism
    of foreign subsidiaries that have been operating
    with too high proportion of debt (by local
  • It helps management evaluate return on equity
    investment relative to local competitors in the
    same industry.
  • In economies where interest rates are high
    because of scarcity of capital and real resources
    are fully utilized, the penalty paid for
    borrowing local funds reminds management that
    unless ROA is greater than local price of
    capital, there is probably a misallocation of
    domestic real resources, such as land and labor.

Financial Structure int. debt
  • Financial structure of foreign subsidiaries
  • Main disadvantages of localization
  • An MNE is expected to have comparative advantage
    over local firms through better availability of
    capital and ability to diversify risk.
  • If each subsidiary localizes its financial
    structure, the resulting consolidated balance
    sheet might show a structure that doesnt conform
    with any one countrys norm the debt ratio would
    simply be a weighted average of all outstanding
  • Typically, any subsidiarys debt is guaranteed by
    the parent, and the parent wont allow a default
    on the part of the subsidiary. This makes the
    debt ratio more cosmetic for the foreign

Financial Structure int. debt
  • Financial structure of foreign subsidiaries
  • Compromise solution
  • Both domestic firms and MNEs should try to
    minimize their cost of capital. But if debt is
    available in a foreign subsidiary at equal cost
    than elsewhere after correcting for risk, then
    localizing the financial structure could be an
  • Financing the Foreign Subsidiary
  • In addition to choosing an appropriate financial
    structure, financial managers need to choose
    among the alternative sources of funds for
    financing. In particular, between internal and
    external sources of funds.

Financial Structure int. debt
  • Financing the Foreign Subsidiary
  • Internal sources of funds (see graph below)
  • In general, although the equity provided by the
    parent, internal sources of funds are kept to the
    minimum to reduce risk of invested capital.
  • Debt is the preferable form for subsidiary
    financing. Since debt from host country is
    generally limited at early stages of the
    development, the foreign subsidiary must acquire
    its debt from the parent company or sister
  • Next, its ability to generate funds internally
    may become critical for the subsidiarys future
    growth. The sources of internal funds include
    retained earnings, depreciation, and other
    non-cash expenses.

Internal Sources of Funds
Financial Structure int. debt
  • Financing the Foreign Subsidiary
  • External sources of funds (see graph below)
  • There are 3 categories of external sources
  • debt from the parents country,
  • from outside the parents country,
  • and local equity.
  • Local debt is valuable for the foreign
    subsidiary, since it provides a financial hedge
    against the fluctuations of the operating cash
    inflows, by matching.

External Sources of Funds
External Sources of Funds
  • The Eurocurrency Markets
  • One of the important innovation in international
    finance over the past 50 years. Provide a basis
    for many corporate finance innovation for
    multinational companies.
  • Eurocurrencies
  • Definition Domestic currencies of one country
    on deposit in a second country. Time deposit
    maturities from overnight funds to longer
    periods. Any convertible currency can exist in
    Euro- form.
  • Eurocurrency markets serve two purposes
  • Eurocurrency deposits are an efficient and
    convenient money market device for holding excess
    corporate liquidity
  • Eurocurrency market is a major source of
    short-tem bank loans to finance corporate working
    capital needs.

External Sources of Funds
  • International Debt Markets
  • Variety of different maturities, repayment
    structures and currencies of denomination
  • Three major sources of funding are
  • (1) International bank loans and syndicated
  • (2) Euronote market
  • (3) International bond market
  • Bank loan and syndicated credits
  • Traditionally sourced in eurocurrency markets,
    extended by banks in countries other than in
    whose currency the loan is denominated

External Sources of Funds
  • Syndicated credits
  • Enable banks to risk lending large amounts
  • Arranged by a lead bank with participation of
    other bank
  • Narrow spread, usually less than 100 basis points
  • Euronote market
  • Collective term for medium and short term debt
    instruments sourced in the Eurocurrency market,
    e.g. Euro-commercial paper (ECP), Euro
    medium-term notes (EMTNs).
  • International bond market
  • Fall within two broad categories
  • Eurobonds
  • Foreign bonds

External Sources of Funds
  • International bond market
  • The distinction between categories is based on
    whether the borrower is a domestic or a foreign
    resident and whether the issue is denominated in
    a local or in a foreign currency.
  • Eurobonds underwritten by an international
    syndicate of banks and other securities firms,
    and sold exclusively in other countries than the
    currency of denomination. Issued by MNEs, large
    domestic corporations, sovereign governments,
    governmental enterprises and international
  • Success factors absence of regulatory
    interference - favorable tax status (bearer from)
    - less stringent disclosure.
  • Foreign bonds underwritten by a syndicate of
    members from a single country, and sold
    principally in that country. But the issuers is
    from another country.

External Sources of Funds
Project Financing
  • Project Finance
  • Is the arrangement of financing for long-term
    capital projects, large in scale and generally
    high in risk.
  • Widely used by MNEs in the development of
    infrastructure projects in emerging markets.
  • Most projects are highly leveraged for two
  • Scale of project often precludes a single equity
    investor or collection of private equity
  • Many projects involve subjects funded by
  • This high level of debt requires additional
    levels of risk reduction.

Project Financing
  • Four basic properties critical to the success of
    project financing
  • (1) Separation of the project from its investors
  • Project is established as an individual entity,
    separated legally and financially from the
  • Allows project to achieve its own credit rating
    and cash flows.
  • (2) Long-lived and capital intensive singular
  • (3) Cash flow predictability from third-party
  • Third party commitments are usually suppliers or
    customers of the project.
  • (4) Finite projects with finite lives.

Part 2 - International Corporate Finance
  • 2.3. FDI Theory Strategy

Why Do Firms Become Multinational?
  • Five categories of strategic motives
  • Market seekers
  • Raw material seekers
  • Production efficiency seekers
  • Knowledge seekers
  • Political safety seekers
  • In markets where oligopolistic competition
    subclassified into proactive and defensive

Why Do Firms Become Multinational?
  • Markets imperfections a rationale for the
    existence of multinational firms
  • Imperfections in the market for products
    translate into market opportunities for MNEs.
  • Sustaining and transferring competitive advantage
  • First step Identification
  • The competitive advantage must be firm-specific,
    transferable, and powerful enough to compensate
    the firm for the potential disadvantages of
    operating abroad.
  • It implies for an MNE to have one or several of
    the following elements, that would give them an
    edge over their local competitors to exploit
    these market opportunities.

Why Do Firms Become Multinational?
  • Sustaining and transferring competitive advantage
  • The superiority of a MNE may come from
  • Economies of scale and scope
  • Managerial and marketing expertise
  • Advanced technology
  • Financial strength
  • Differentiated products
  • Competitiveness of the Home Market
  • It can increase firms competitive advantage in
    operating abroad.
  • Referred to as the diamond of national

Why Do Firms Become Multinational?
  • Diamond of national advantages
  • Factor conditions availability of appropriate
    factor production
  • Demand conditions demanding customers increase
    marketing and quality control skills.
  • Related and supporting industries
  • Firm strategy, structure and rivalry a
    competitive home market forces firms to fine tune
    their strategy and operational effectiveness.
  • Global competitions in oligopolistic industries
    may substitute for domestic competition
    telecom, high-tech, cosmetics...

Why Do Firms Become Multinational?
  • The OLI paradigm and internalisation
  • Creates a framework to explain the prevalence of
    FDI over other forms of international expansion.
  • The conditions for a successful investment
    require a competitive advantage to be
  • O owner-specific can be transferred abroad.
    Ex. Product differentiation.
  • L location-specific will be exploitable in
    the targeted market. Ex. Market imperfections or
    competitive advantage.
  • I internalisation the competitive position is
    preserved by controlling the entire value chain
    in the industry. Ex. Proprietary information and
    human capital control in research-intensive

Where to Invest?
  • In theory, a firm should search the best location
    world-wide to take advantage of market
    imperfections and enjoy its competitive
  • In practice, firms have been observed to follow a
    sequential search pattern. This relates to two
    behavioral theories of FDI
  • Behavioral approach firms tend to invest first
    in countries that are not too far in psychic
    terms and for limited investments. Psychic
    distance is defined in terms of cultural, legal
    and institutional environment. As firms learn,
    they are willing to take more risks, both in
    terms of distance and size of investments.
  • International network theory sees MNE as a
    member of an international network with nodes
    based in each of the foreign subsidiaries,
    competing with each other and influencing the
    strategy and the reinvestment decisions.

How to Invest Abroad?
  • Modes of Foreign Involvement
  • Exporting versus Production Abroad
  • Exporting none of the risks faced with FDI
  • Disadvantages of exporting inability to
    internalise and exploit the results of RD
  • Risk of losing markets to imitators and global
  • Licensing and Management Contracts vs. Control of
    Assets Abroad
  • Licensing popular method to take advantage of
    foreign markets without committing sizeable
    funds. Political risk is minimized.
  • Disadvantages of licensing license fees lower
    than FDI profits

How to Invest Abroad?
  • Licensing and Management Contracts
  • Other disadvantages
  • Possible loss of quality control
  • Establishment of a potential competitor
  • Risk of technology stolen, or becoming outdated
  • High agency costs
  • In practice, MNEs use licensing with foreign
    subsidiaries or with joint ventures.
  • Management contracts are similar to licensing in
    terms of cash-flows, and reduce political risk
    since repatriation of managers is easy.
  • Cost effective of licensing with regard to FDI
    depends on the price host countries will pay for
    the services.
  • Since MNE continue to prefer FDI, the price is
    assumed to be too low (due to the lack of
    synergies in licensing?)
  • MINI - CASE Benecols global licensing

How to Invest Abroad?
  • Joint Venture vs. Wholly Owned Subsidiary
  • Partially owned foreign business termed as
    foreign affiliate (case of a joint venture).
    Foreign business owned at more 50 foreign
  • Key success factor of a joint venture find the
    right local partner.
  • Some advantages of a local partner
  • Better understanding of the local market
  • Provision of competent management, and/or
    appropriate local technology
  • Enhanced contacts and reputation, eased access to
    the local financial markets.
  • Potential disadvantages
  • Risk of conflicts and difficulties, divergent
    views, decreased control over financing or over
    production rationalisation
  • Increased political and reputation risk, if the
    wrong partner is chosen.

How to Invest Abroad?
  • Greenfield investment vs. Acquisition
  • Greenfield investment establishing a production
    or service facility starting from the ground up.
  • Cross-borders acquisitions quicker, could be
    more cost-effective in gaining competitive
    advantage such as technology, brand names,
    logistic and distribution.
  • Disadvantages of cross-borders acquisitions
  • Problems of paying a too high price (but some
    undervaluation cases, too, especially in crisis
  • Difficulties on the post-acquisition process, and
    the merger of different corporate cultures.
  • Additional difficulties from host governments
    intervention in pricing, financing, employment

How to Invest Abroad?
  • Strategic alliances - different stages
  • Simple exchange of share ownership (as a takeover
  • Establishment of a separate joint venture to
    develop and manufacture a product or a service
    (common in high-tech industries)
  • Joint marketing and servicing agreement (often
    forbidden by national laws)

Multinational Capital Budgeting
  • Multinational Capital Budgeting
  • Same theoretical framework
  • The net present value criteria can be applied
    based on the expected cash flows of the project,
    like in case of a domestic investment.
  • Complexities of budgeting a foreign project
  • Parent cash flows must be distinguished from
    project cash flows, each contributing to a
    different view of value
  • Financing mode, remittance of funds, tax systems,
    differing inflation rates and foreign exchange
    rate movements must be taken into account
  • Political risk and government interference should
    be included in the analysis
  • Terminal value is more difficult to estimate,
    because of various potential purchasers, in host
    country or abroad, public or private.

Multinational Capital Budgeting
  • Project versus Parent Valuation
  • Strong theoretical statement to analyse the
    project from the point of view of the parent,
    since it is the ultimate basis for dividend
    payments and other reinvestment decisions.
  • However, this violates the rule that, in capital
    budgeting, financial cash flows should not be
    mixed with operating cash flows.
  • Evaluation of a project from a local viewpoint
    serves some useful purposes and should be
    subordinated to evaluation from the parents
    viewpoint. In practice, firms use both viewpoints
    for evaluation.

Multinational Capital Budgeting
  • General rules
  • Almost any project should be at least giving the
    same return to that on host government bonds,
    that is generally the local risk-free rate
    including a premium reflecting the expected
    inflation rate (Ex. 33 in India).
  • Multinational firms should invest only if they
    can earn a risk-adjusted return greater than
    their locally based competitors.

Multinational Capital Budgeting
  • Illustrative case Cemex enters Indonesia
  • See reference textbook pp 354 - 365
  • For information and illustration
  • Project valuation sensitivity analysis
  • First valuation is made on a set of most likely
  • Next, and in particular in uncertain
    environments, a sensitivity analysis is required,
    under a variety of what if scenarios.
  • For example, in international projects
  • Political risk what if the host country imposed
    controls on dividend payment, what if funds are
  • Foreign exchange risk how is the value of the
    project affected by a x decrease (increase) in
    the host currency rate? What about the relative
    impacts of competitiveness and cash flows
  • Other sensitivity variables change in the
    assumed terminal value, the capacity utilisation
    rate, the initial project cost...

Multinational Capital Budgeting
  • Real Option Analysis
  • For investments that have long lives, cash flows
    returns in later years, or higher levels of risks
    compared to the current business of the firm, are
    often rejected by the DCF approach.
  • When MNEs evaluate competitive projects, DCF
    analysis fails to capture the strategic options
    that an investment may offer.
  • Real option analysis overcomes this weakness by
    applying option theory to capital budgeting
    decisions. It is a cross between decision-tree
    analysis and pure option-based valuation.
  • Very useful when analysing investment projects
    that can take very different values depending on
    the decisions made at certain points in time
    (defer, abandon, reduce capacity,..). The range
    of values give the volatility of the projects
  • MINI-CASE Tridents Chinese Market entry.

Adjusting for Risk
  • Defining Risk
  • One-sided risk only potential for loss. Example
    expropriation, blocked funds. Often described
    in probabilities of occurrence, qualitative in
    character. Best thought of as acceptable /
  • Two-sided risk risk of loss or gain. Example
    foreign exchange, host government economic
    policies. Often assessed through statistical
    analysis, allowing rank-order of investments
  • Risk Measurement Origins
  • From the market credit spreads, sovereign
  • From institutions constructed indices ranking
    countries on the basis of their macro risk
    fundamentals, i.e. political and economic
    stability. Inherently subjective.

Adjusting for Risk
  • Defining Foreign Investments Risks
  • Firm-specific risks micro risks, at project or
    corporate level
  • Country-specific risks macro risks, affecting
    the project, but originated at the country level
  • Global-specific risks
  • see illustration

Adjusting for Risk
Adjusting for Risk
  • Strategies of Foreign Investments Risks
  • Sensitivity Analysis
  • Minimize Assets at Risk
  • Diversification
  • Insurance
  • see illustration

Risk Management Strategies
Sensitivity Analysis Minimize Assets at Risk
Simulating business plans Minimize equity in
subsidiary Adjusting discount rate Borrow
locally Adjusting cash flows
Diversification Insurance
Plant location Hedging currency risk Source of
debt equity Risk-sharing agreement Currency
of denomination Country investment
agreements Supply sources Investment
guarantees Sales locations
Adjusting for Risk
  • Measuring and Managing Foreign Investments Risks
  • Business risk project viewpoint measurement vs.
    parent viewpoint measurement (adjusting discount
    rates or adjus