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Topic 8 Solutions to Cost & Availability of Capital and Political Risk
Reading: Eun Resnick Chapters 12, 13, 16, 17
International Bond Markets
You are an investment banker advising a Eurobank about a new international bond offering it is considering. The proceeds are to be used to fund Eurodollar loans to bank clients. What type of bond instrument would you recommend that the bank consider issuing? Why?
Since the Eurobank desires to use the bond proceeds to finance Eurodollar loans, which are floating-rate loans, the investment banker should recommend that the bank issue FRNS, which are a variable rate instrument. Thus there will a correspondence between the interest rate the bank pays for funds and the interest rate it receives from its loans. For example, if the bank frequently makes term loans at indexed to 3-month LIBOR, it might want to issue FRNS, also, indexed to 3-month LIBOR.
What should a borrower consider before issuing dual currency bonds? What should an investor consider before investing in dual currency bonds?
A dual currency bond is a straight fixed-rate bond that is issued in one currency and pays coupon interest in that same currency. At maturity, the principal is repaid in a second currency. Coupon interest is frequently at a higher rate than comparable straight fixed-rate bonds. The amount of the dollar principal repayment at maturity is set at inception; frequently, the amount allows for some appreciation in the exchange rate of the stronger currency. From the investor’s perspective, a dual currency bond includes a long-term forward contract. If the second currency appreciates over the life of the bond, the principal repayment will be worth more than a return of principal in the issuing currency. However, if the payoff currency depreciates, the investor will suffer an exchange rate loss. Dual currency bonds are attractive to MNCs seeking financing in order to establish or expand operations in the country issuing the payoff currency. During the early years, the coupon payments can be made by the parent firm in the issuing currency. At maturity, the MNC anticipates the principal to be repaid from profits earned by the subsidiary. The MNC may suffer an exchange rate loss if the subsidiary is unable to repay the principal and the payoff currency has appreciated relative to the issuing currency. Consequently, both the borrower and the investor are exposed to exchange rate uncertainty from a dual currency bond.
3. List some reasons why a U.S.‑based corporation might issue debt denominated in a foreign currency.
A U.S. company might issue foreign currency debt because:
1. it wants to hedge a foreign currency exposure.
2. it can borrow money at a lower effective interest rate. This is especially true for those bond issues that are combined with swaps.
4. What is the difference between a Eurocurrency loan and a Eurobond?
The fundamental distinction between a Eurobond and a Eurocurrency loan stems from the financing mechanism. A Eurobond is issued by the final borrower directly, whereas a Eurocurrency loan is made by a bank. Thus, Eurobond investors hold a claim on the issuer directly, whereas Eurocurrency loans are funded by investors who hold short‑term claims on banks that then act as intermediaries to transform these deposits into long‑term claims on final borrowers.
5. What is the basic reason for the existence of the Eurodollar market? What factors have accounted for its growth over time?
The Eurodollar market, exists because it enables borrowers and lenders alike to avoid a variety of U.S. banking regulations and controls, and it gives them an opportunity to escape the payment of some taxes. Some of the factors that have affected the growth of the Eurodollar market include the interest equalization tax, U.S. withholding tax on interest received by foreign owners of domestic securities, and Regulations M and Q.
6. IBM needs to raise $1 billion and is trying to decide between a domestic dollar bond issue and a Eurobond issue. The U.S. bond can be issued at a coupon of 6.75 percent, paid semiannually, with underwriting and other expenses totaling 0.95 percent of the issue size. The Eurobond would cost only 0.55 percent to issue but would bear an annual coupon of 6.88 percent. Both issues would mature in 10 years. Assuming all else is equal, which is the least expensive issue for IBM? The least expensive issue can be found by comparing the yield to maturity (YTM) for each bond, computed as the internal rate of return or IRR. For the domestic bond issue, the YTM is the solution r to the following equation:
where the $990,500,000 in bond proceeds equals the billion dollar issue less 0.95% in issuance costs. The solution turns out to be r = 3.44%. Since this is a semi-annual yield, we must convert it to annualized basis. The annualized YTM is found as (1.0344)2 – 1, or 7.00%.
For the Eurobond issue, the YTM is the solution k to the following equation: The solution to this equation turns out to be k = 6.96%. Since this YTM is less than the annualized YTM for the U.S. bond, the Eurobond is the less expensive bond to issue.
Note: You can use trial and error method or using an Excel Spreadsheet/financial calculator to solve for the yield to maturity. Or you can use the following formula to calculate the approximate yield to maturity.
****I would not expect you to do this type of calculation in an exam***
C=Coupon/Interest Payment; F=Face Value; P=Price; n=years to maturity Cost of Capital
Why are large multinational corporations located in small countries such as Sweden, Holland, and Switzerland interested in developing a global investor base?
Large MNCS located in these small countries often need to raise substantial amounts of capital to continue growing. Quite often, the domestic market cannot provide this amount of capital on reasonable terms because local investors already have a large exposure to the local MNC. To add additional MNC paper will make their portfolios even less diversified, leading local investors to demand an added risk premium. By going overseas, MNCs from small countries such as Sweden and the Netherlands can find investors who view stocks and bonds from Dutch and Swedish MNCs as a source of diversification. In other words, although stocks of Dutch and Swedish MNCs comprise a large fraction of local portfolios, they comprise a small fraction of global wealth. The net result is a lower cost of capital for these MNCs from small countries (and hence a higher market value). In addition, developing a global investor base gives these MNCs access to capital in the event their local markets are subject to some event (most likely political) that restricts the ability of MNCs to raise capital there regardless of price.
Suppose that your firm is operating in a segmented capital market. What actions would you recommend to mitigate the negative effects?
The best solution for this problem is the cross-listing the firm’s stock in overseas markets. This should reduce the cost-of-capital of the firm. In completely segmented markets, investors in these markets are forced to bear all the risk of its economic activities and would require risk premium to bear this risk. There are associated costs such as complying with the accounting and disclosure requirements etc.
Explain why and how a firm’s cost of capital may decrease when the firm’s stock is cross-listed on foreign stock exchanges.
If a stock becomes internationally tradable upon overseas listing, the required return on the stock is likely to decrease as the stock will be priced according to international systematic risk rather than local systematic risk. As a country opens up its capital markets and also allows its residents to invest overseas, the local investors will no longer have to bear the risks associated with the activities of the local companies on their own. If a firm is restricted to raising capital in the local market, the amount it can raise is dependant on the supply and demand in the domestic capital market. As the firm’s capital budget increases, its marginal cost of capital will increase, that is, it can only tap the local market for a limited a amount before which its marginal cost of capital starts to increase as investors are less willing to lend more. They can avoid this, by raising capital internationally. As is evident in Exhibit 16.1, the firm can reduce its marginal cost of capital while at the same time increasing the amount it can raise.
Discuss how the cost of capital is determined in segmented versus integrated capital markets.
In segmented markets, the cost-of-capital is essentially determined by the securities’ domestic systematic risks. In integrated capital markets, on the other hand, the cost-of-capital will be determined by the securities’ international systematic risk, regardless of nationality.
Explain how the premium and discount are determined when assets are priced to market. When would the law of one price prevail in international capital markets even if foreign equity ownership restrictions are imposed?
The pricing-to-market refers to the case where the same security is priced differently by different investors. The premium/discount at which shares restricted to foreign shareholders are determined by the (i) the severity of restrictions imposed on foreigners, (ii) foreigner’s ability to mitigate the effect of these restrictions using their own domestic securities
A firm with a corporate-wide debt/equity ratio of 1:2, an after-tax cost of debt of 7%, and a cost of capital of 15% is interested in pursuing a foreign project. The debt capacity of the project is the same as for the company as a whole, but its systematic risk is such that the required return on equity is estimated to be about 12%. The after-tax cost of debt is expected to remain at 7%.
What is the project’s weighted average cost of capital? How does it compare with the parent’s WACC?
WACC can be written as
If the project’s equity beta is 1.21, what is its unlevered beta?
We can use the following approximation to estimate the unlevered beta
We need to know the firm’s marginal tax rate to unlever its beta. Let us assume that it is 40%
Comment on the following statement: “There is a curious contradiction in Corporate Finance theory: Since equity is more expensive than debt, highly leveraged subsidiaries should be assigned a low hurdle rate. But, when the highly leveraged subsidiaries are in risky nations, country risk dictates just the opposite: a high hurdle rate.”
There are several issues that we need to consider.
Country risk is more likely to be unsystematic risk and hence should not affect the cost of capital for a project.
As leverage rises, the cost of equity capital rises as well, offsetting in whole or in part the advantage of debt.
Subsidiaries may or may not have independent capital structures therefore it may not be possible to determine if its cost-of-capital varies with it leverage.
Boeing Commercial Airplane Co. manufactures all its planes in the United States and prices them in dollars, even the 50% of its sales destined for overseas markets. What financing strategy would you recommend for Boeing? What data do you need?
Boeing faces foreign exchange risk for two reasons: (1) It sells half its planes overseas and the demand for these planes depends on the foreign exchange value of the dollar, and (2) Boeing faces stiff competition from Airbus Industrie, a European consortium of companies that builds the Airbus. As the dollar appreciates, Boeing is likely to lose both foreign and domestic sales to Airbus unless it cuts its dollar prices. One way to hedge this operating risk is for Boeing to finance a portion of its assets in foreign currencies in proportion to its sales in those countries. However, this tactic ignores the fact that Boeing is competing with Airbus. Absent a more detailed analysis, another suggestion is for Boeing to finance at least half of its assets with ECU bonds as a hedge against depreciation of the currencies of its European competitors. ECU bonds would also provide a hedge against appreciation of the dollar against the yen and other Asian currencies since European and Asian currencies tend to move up and down together against the dollar (albeit imperfectly).
The CFO of Eastman Kodak is thinking of borrowing Japanese yen because of their low interest rate, currently at 4.5%. The current interest rate on U.S. dollars is 9%. What is your advice to the CFO?
The advice should be “Don’t speculate.” The international Fisher effect says that the 450 basis point differential reflects a 4.5% expected annual appreciation of the yen against the dollar. Thus, the expected costs of dollar and yen financing should be the same. Unless Kodak needs yen financing to offset a yen transaction or operating exposure, it should stick to dollar financing.
Suppose that one of the inducements provided by Taiwan to woo Xidex into setting up a local production facility is a ten‑year, $12.5 million loan at 8% interest. The principal is to be repaid at the end of the tenth year. The market interest rate on such a loan is about 15%. With a marginal tax rate of 40%, how much is this loan worth to Xidex?
By borrowing at 8% when the market rate is 15%, Xidex saves 7% annually. This translates into annual before‑tax savings of $12,500,000(.15 ‑ .08) = $875,000. With a marginal tax rate of 40%, this yields annual after ‑ tax savings of $525,000. The value of this ten‑year annuity, discounted at Xidex ‘s after ‑ tax debt cost of 9% (15% x .6), is $525,000 x 6.4177 = $3,369,293.
11. Nord Resource’s Ramu River property in Papua New Guinea contains one of the world’s largest deposits of cobalt and chrome outside of the Soviet Union and South Africa. The cost of developing a mine on this property is estimated to be around $150 million.
a. Describe three major risks in undertaking this project.
The three principal risks faced by Nord Resource’s Ramu River project are the following:
1. Political risk. The government of Papua New Guinea may seize the mine if it turns out to be highly profitable. The government may also block repatriation of profits.
2. Reserve risk. There may be too few copper reserves or the ore may be too expensive to profitably mine.
3. Price risk. The price at which Nord can sell the ore may be too low.
Exchange risk is unlikely to be a major risk. The price at which the copper can be sold is set in dollars. In addition, Nord’s most important cost is the cost of developing the mine, which is largely set in dollar terms.
b. How can Nord structure its financing so as to reduce these risks?
Nord can use financing to reduce these risks as follows:
1. Political risk. Finance the project to the extent possible with funds from the host and other governments, international development agencies, overseas banks, and from customers‑‑with payment to be provided out of production‑‑rather than supplying parent company‑ raised or parent‑guaranteed capital.
2. Reserve risk. Use nonrecourse financing with a minimal amount of equity. In this way, the lenders bear the risk of the mine being uneconomical.
3. Price risk. Sell the ore in advance at a fixed price. Even if the price varies with the world market price, the typical take‑or‑pay contract, Nord will have a guaranteed outlet for its ore and will not have to engage in price cutting to sell more output.
c. How can Nord use financing to add value to this project?
To the extent that Nord can access subsidized financing for the purchase of equipment and contractor services to develop the mine, it should do so. In addition, Nord can add value to the project by using financing to reduce the various operating risks it faces.
12. Although the one‑year interest rate is 10% in the United States, one‑year, yen‑denominated corporate bonds in Japan yield only 5%.
a. Does this present a riskless opportunity to raise capital at low yen interest rates?
No. According to the international Fisher effect, the 5% interest differential reflects the market’s expectations that the yen will appreciate by approximately 5% relative to the dollar over the coming year.
b. Suppose the current exchange rate is ¥140 = $1. What is the lowest future exchange rate at which borrowing yen would be no more expensive than borrowing U.S. dollars?
The breakeven exchange rate is found as the solution to S = 140 x 1.05/1.10 = ¥133.64.
13. The manager of an English subsidiary of a U.S. firm is trying to decide whether to borrow, for one year, dollars at 7.8% or pounds sterling at 12%. If the current value of the pound is $1.70, at what end‑of‑year exchange rate would the firm be indifferent now between borrowing dollars and pounds?
The breakeven exchange rate change is
c = (rus– rUK)/(1 + rUK) = (0.078 – 0.12)/1.12 = -3.75%
In other words, the pound would have to depreciate by 3.75% during the year for the two loans to have the same dollar cost. A 3.75% pound depreciation would yield an end-of-year exchange rate equal to $1.63625 (1.70 x (1 – 0.0375)).
14. All‑Nippon Airways, a Japanese airline, flies exclusively within Japan. It is looking to finance a recent purchase of Boeing 737s. The director of finance for All‑Nippon is attracted to dollar financing because he expects the yen to keep appreciating against the dollar. What is your advice to him?
Since ANA’s yen cash flow will not vary in line with the dollar/yen exchange rate, using dollar financing will expose it to exchange risk. The implicit argument for using dollar financing is that yen appreciation will make it cheaper to repay. But this argument ignores the international Fisher effect, which says that a borrower should expect that any gain on loan repayment will be offset by the higher interest rate on a dollar loan. The key question to ask here is: “What’s your business? Is it speculating on the future course of the $/yen exchange rate or is it providing aviation service at a reasonable price?”
15. What factors should be considered in deciding whether the cost of capital for a foreign affiliate should be higher, lower, or the same as the cost of capital for a comparable domestic operation?
Key factors include whether the cash flows of the affiliate are closely tied to the state of the local economy or to the world economy, the correlation between the local and domestic economies, and the volatility of the foreign affiliate’s cash flows relative to that of the domestic operation. The greater (lesser) each of these factors, the higher (lower) the foreign affiliate’s cost of capital relative to that of the domestic operation. In general, the closer these factors are to each other, the closer their costs of capital.
16. A foreign project that is profitable when valued on its own will always be profitable from the parent firm’s standpoint. True or false. Explain.
There are many reasons why project cash flows can diverge from the incremental cash flows accruing to the parent. Increased project cash flows may have been at the expense of other operations (cannibalisation). Converting cash flows from foreign currencies to the home currency may result in lower revenues. Therefore, the correct answer is false.
17. Why have cross-listings on US stock exchanges become less popular in recent years?
The introduction of the Sarbanes-Oxley Act in 2002 has increased the cost of maintaining a listing on US stock exchanges. The act was introduced in response to several accounting scandals in the US – Enron, Worldcom etc. The act requires all companies, both US and foreign, listed on US exchanges to improve their internal control procedures and commits companies to enhanced certification and disclosure obligations and enhanced criminal sanction and SEC enforcement authority. Cost of complying with the act has been estimated at over US$500,000. This has been identified as the major reason why fewer companies are listing on US markets.
18. What are some of the market imperfections said to be important in the firm’s decision to make foreign investments overseas. (Give examples, with some discussion) Past Exam Question
The most important reason has to be a REDUCTION in its cost-of-capital, especially if the firm is from a segmented market.
By going overseas, they can not only reduce their cost of capital but also increase the amount of capital that they can raise. It will also increase the liquidity of its existing shares. This action is also likely to remove any potential mis-pricing that it might face in a segmented market, illiquid home capital market.
This would also enable the firm to establish a secondary market for shares used to acquire local firms in the foreign market.
It may also circumvent many regulatory restrictions, cost and information barriers that might prevent cross-border investment.
It also increases visibility of the firm and political acceptance to customers, suppliers, and host governments
It also allows firms to compensate local management and employees through stock options.
1. What factors affect the degree of political risk faced by a firm operating in a foreign country?
There is some evidence to indicate that the political risk faced by the firm is related to
a function of the industry the firm operates in
the cost to the country of replacing with a state-owned operation
the health of the economy
philosophical leanings of the government
potential for civil strife in the country
2. What are some indicators of country risk? Of country health?
Country risk in practice is concerned with sovereign credit risk and this determines the extent to which governments and its agencies have access to capital (credit) markets. For instance, the International Credit Risk Guide (ICRG) decomposes country risk into the country’s ability to pay and its willingness to pay.
Ability to pay: This is concerned with the country’s ability to meet its long- and short-term obligations. This encompasses financial and economic risk. This can be ascertained from an examination of its level of external debt and international reserves, its growth rate, government deficit relative to its GDP (GNP) and also by utilising a large number of other macroeconomic indicators.
Willingness to pay: Cash flow constraints can cause a country to default. Note, that a government can avoid default by allocating the entire proceeds of taxation (not very practical or realistic). Generally this represents political risk. Certain political characteristics can make it more feasible or easier for some political leaders to default on their loan. Generally, a change in leadership brought about by political instability, a coup, assassination etc. makes default more likely.
Indicators of country health include:
minimal regulations and economic distortions
incentives to save
an open economy
a legal structure that encourages private ownership of property (i.e. it enforces property rights)
3. How does a firm hedge against political risk?
The ways to hedge against this type of risk include (please note that this is not an exhaustive list):
obtaining insurance against political risk
negotiating with the government before investing (also known an concession agreements)
developing local stakeholders (consumers, suppliers, local employees local bankers etc. – could also be in the form of a joint venture with the government
planned divestment which would involve MNCs phase out their ownership over a fixed time period by selling all or a majority stake of their interest to local investors
short-term profit maximisation would entail the firm withdrawing the maximum amount of cash from the local operation.
4. What indicators would you look for in assessing the political riskiness of an investment in Eastern Europe?
Here are some key indicators to look for in assessing the political riskiness of investing in Eastern Europe:
a) Do they free prices quickly or continue the old system of administered prices that are based heavily on state subsidies? Although a free economy will need free prices, the public still expects the state to protect it against unexpected events. So the working public expects its wages to rise precisely in line with rising prices. If the governments give in on this point and index wages to inflation, they will institutionalize inflation.
b) Do they dismantle and sell state-owned monopolies quickly?
c) Do they establish all the paraphernalia of capitalism–including capital markets, tax regimes, and contract law–to go along with their new-found enthusiasm for free markets? These are not mere details. Completing such tasks will embroil the region in all the wrangles about wealth distribution and the size and role of the state which Western countries have spent generations trying to resolve.
Another key indicator of political risk would be seeing governments give in to the temptation to fine-tune their economies in order to reduce the costs of making the transition to a market economy. The constant changes of policy involved in fine-tuning will reduce government credibility–just when it is crucial–and increase the likelihood and costs of policy mistakes. The only hope for success is to devise a complete reform program and implement it as quickly as possible. Governments must convey that their commitment to the program is absolute. Perhaps most important of all, the reform program should include a set of simple rules to govern how policy makers and the public are to operate. This will boost credibility, reduce investor uncertainty, and discourage any efforts by special interest groups, who will be hurt by some of the reforms, to forestall the reform program.
5. What can we learn about economic development and political risk from the contrasting experiences of East and West Germany, North and South Korea, and communist China and Taiwan, Hong Kong and Singapore?
These countries provide us with as close to a controlled economic experiment as we are ever going to find in this world: same peoples, same language, same history, same culture, even members of the same families in many instances, divided by an accident of history. And what we see is that those societies that respect the rights of property and that subject their enterprises to the rigors of competition, particularly global competition, grow more rapidly, create far more wealth, are more innovative, more willing to take risk, and are far more productive than those nations with centrally planned economies. The lesson is as clear as possible: Incentives matter, and they matter greatly.
6. In the early 1990s, China decided that by 2000 it would boost its electricity-generating capacity by more than half. To do that, it is planning on foreigners’ investing at least $20 billion of the roughly $100 billion tab. However, Beijing has informed investors that, contrary to their expectations, they will not be permitted to hold majority stakes in large power-plant or equipment-manufacturing ventures. In addition, Beijing has insisted on limiting the rate of return that foreign investors can earn on power projects. Moreover, this rate of return will be in local currency without official guarantees that the local currency can be converted into dollars and it will not be permitted to rise with the rate of inflation. Beijing says that if foreign investors fail to invest in these projects, it will raise the necessary capital by issuing bonds overseas. However, these bonds will not carry the “full faith and credit of the Chinese government.”
a. What problems do you foresee for foreign investors in China’s power industry?
Since the return is set in nominal yuan terms, high inflation–a perennial Chinese problem–will reduce the real value of this return. This high inflation, in turn, will put pressure on the yuan to devalue, lowering the dollar value of the return. Finally, the local currency returns may be blocked. In other words, the dollar return is likely to be lower than the yuan return and the dollar return may never be realized because of inconvertibility.
b. What options do potential foreign investors have to cope with these problems?
Don’t invest under these terms. If they do invest, they can buy political risk insurance against currency inconvertibility. They should also negotiate for higher yuan returns to compensate for the anticipated yuan devaluation and the cost of political risk insurance.
c. How credible is the Chinese government’s fallback position of issuing bonds overseas to raise capital in lieu of foreign direct investment?
Not very credible. If the bonds don’t carry the “full faith and credit of the Chinese government,” then investors will either not buy them or, if they do, they will demand an interest rate that will compensate them for the political risks associated with the absence of the guarantee. The bonds will have to be dollar denominated and the interest rate will have to be as high as the dollar yield that investors would expect if they invested directly in the power plants themselves. In other words, the Chinese government will realize no benefit by financing the power projects through issuing bonds as opposed to enticing investors to provide equity financing for the projects.
7. What are some ways in which firms can minimize their exposure to political risk? (Give three examples, with some discussion) Past Exam Question
There are numerous ways in which a firm can minimize such a risk and some of these include avoidance, negotiation with the host government, insurance, develop local stakeholders, increase government’s cost of interfering with the firm’s operation. Make sure R&D facilities and proprietary technology is kept in the home country.
Guaranteed way to avoid political risk: Avoid investing in risky countries
Short-term profit maximisation
Negotiating investment agreements
Structuring the investment
Develop local stakeholders
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