Basic18
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This chapter discusses long-term financing options for multinational corporations (MNCs), including issuing bonds denominated in foreign currencies. It explains that MNCs must forecast exchange rates and interest rates to evaluate the costs and risks of foreign currency financing. The chapter also covers how MNCs can use techniques like hedging with currency swaps or interest rate swaps to reduce exchange rate and interest rate risks from long-term financing denominated in foreign currencies.
![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
A18 - 13](https://image.slidesharecdn.com/basic18-140127113935-phpapp02/85/Basic18-13-320.jpg)
Basic18
- 2. 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
- 3. 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
- 4. 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
- 5. 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
- 6. 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
- 7. 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
- 8. 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
- 9. 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
- 10. 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
- 11. 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
- 12. 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
- 13. 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 A18 - 13
- 14. 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
- 15. 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