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Global Financial Markets - Update |
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PART 5: INTERNATIONAL FINANCING
Main Contents Page • Part 1 • Part 2 • Part 3 • Part 4 • About the book
This document contains updates to my book, Global Financial Markets (Houghton Mifflin, 1994). It also contains information on developments and research in the international financial markets that might be of interest to students and professionals.
Contents
Chapter 16: International Financing Decisions
Corporate Hedging and Speculation; Self-Financing; New research results
Chapter 17: The Future: Understanding and Using New Instruments
New structured floating-rate notes; Corridor Floaters
Chapter 16: International Financing Decisions
Corporate Hedging and Speculation
See Chapter 7, Forwards in Speculation.
See Chapter 15, Metallgesellschaft.
See Chapter 13, on Procter & Gamble's Diff Swap
Lease financing--The technique and an example
Lease financing is a technique whereby the user of equipment has a contract to rent it from a leasing company and make periodic lease payments rather than debt servicing payments. The leasing company ("lessor"), not the user ("lessee"), owns the equipment. The lease payments received by the leasing company are used to pay interest and principal on monies borrowed to purchase the equipment; indeed it is typical for the lessee to guarantee that payments will be sufficient to service the lessor's debt. A significant advantage to the user is that lease payments are generally tax deductible, while principal payments made to amortize debt are not.
In the autumn of 1994, Indian Airlines used a cross-border lease structure to finance four aircraft. The airline was able to achieve a significant saving on the financing of its fleet by taking advantage of the desire of certain Japanese entities to reduce their tax bills by offsetting capital allowances. Rather than the airline taking out a loan to buy four A320-200 aircraft, the equipment was bought by a Japanese company which then leased them on to Indian Airlines. The period of the lease was 10 years, at the end of which the airline has the option to purchase the aircraft.
The $170 million financing was arranged by ANZ International Merchant Banking, which had worked out that during the first 10 years it was cheaper for Indian Airlines to lease the aircraft than to pay the interest and principal on a loan. The basis for this was that the Japanese entity was able to take better advantage of the depreciation which goes with ownership of the aircraft.
A lease-based financing of this kind is explained in much greater detail in Cases in International Finance (2nd ed., Addison-Wesley, 1994), Case No. 35, "Limpopo Hydro."
Self-Financing
An important source of funding for corporations that is neglected in Chapter 16 is internal financing. Considerable academic research is currently focused on the old question of whether and when a company should use reinvested earnings as opposed to the external capital market to finance growth.
This ties in with the question of whether companies should pay dividends or retain earnings. In principle shareholders own all earnings, and expect management to retain only that proportion which is tax-advantageous. Payout ratio variations among countries should depend to a large extent on differences in the fiscal treatment of retained vs distributed earnings. In countries where the capital markets are well developed, allowing a high degree of separation of management from ownership, the transfer of cash to shareholders reduces the resources under managerial control. This makes it more likely that management will be monitored by the capital markets when the firm seeks to raise new capital. This in turn helps ensure that projects are undertaken only when they earn at least the market rates of return.
When earnings are retained, management need not face this scrutiny. Hence firms that do not distribute their free cash as dividends give their managers an often large source of funds that is free from capital-market monitoring. This offers greater scope to spend the cash on projects earning below-market rates of return.
In the United States and a few other countries, management teams squandering or hoarding their cash flows in this way face another form of monitoring, that of hostile takeovers. These occur when an outsider believes that he can use the target firm's resources more profitably than can its existing management. That is one reason why, as a rule, hostile takeovers involve large distributions of cash which increase the wealth of target shareholders.
Tax systems that favor retention of earnings remove some of the capital market's discipline; regulations that restrict dividends are worse, giving management a legitimate excuse to spend cash on projects that earn below-market rates of return. Governments that restrict hostile takeovers, domestic or foreign, further remove the market for corporate control as a way of scrutinizing managerial decisions. This offers management more scope for pursuing its own goals rather than maximizing shareholders' wealth.
New research results
"Asset sales, Leverage, and the Agency Costs of Managerial Discretion"
LARRY LANG
New York University
212-998-0300 (v)
212-995-4233 (f)
ANNETTE POULSEN
University of Georgia
404-542-8100 (v)
404-542-3835 (f)
e-mail: apoulsen@uga.cc.uga.edu
RENE M. STULZ
Ohio State University
614-292-1970 (v)
614-292-1651 (f)
Abstract
This paper investigates a sample of large asset sales. We find that the average stock-price reaction to asset sales is significantly larger when the proceeds are expected to be paid out to creditors and/or shareholders. Further, the stock-price reaction is insignificantly different from zero when the proceeds are kept within the firm. We also provide evidence that the typical firm that sell assets has performed poorly over the preceding year. The evidence is consistent with the hypothesis that asset sale proceeds kept within the firm are discounted because they increase the agency costs of managerial discretion by enabling management to keep investing in poor operations.
"Financing of Multinational Subsidiaries: Parent Debt vs. External Debt," Forthcoming, Journal of Corporate Finance by BHAGWAN CHOWDRY and VIKRAM NANDA
Abstract
Financing a multinational subsidiary by intra-firm parent debt has the advantage that while interest payments on the debt are tax deductible, there are no offsetting bankruptcy costs. When the foreign corporate tax rate is higher than the domestic rate, since the multinational firm has incentives to exaggerate the interest rate on the intra-firm debt, the tax authorities put limits on the rate the parent is allowed to charge. Since the interest rate on external debt - which entails potential bankruptcy costs - is determined competitively in the market, this can be used as a benchmark to justify the rate charged on intra-firm debt. We show that the firm would finance the subsidiary partly by intra-firm parent debt and partly by external debt, both of equal seniority, but the firm would, sometimes, choose to pay its external debtors in full even when it is not contractually obligated to do so. For any given level of total debt financing, higher corporate tax rates in the foreign country are associated with a larger proportion of debt financing by external debt, larger interest rates and a larger probability of bankruptcy; higher corporate tax rates in the home country are associated with a smaller proportion of debt financing by external debt, smaller interest rates and a smaller probability of bankruptcy.
"What Do We Know about Capital Structure? Some Evidence From International Data" (July 1994)
BY: RAGHURAM G RAJAN and LUIGI ZINGALES
CONTACT: LUIGI ZINGALES
E-MAIL: luigi@gsbgz.uchicago.edu
POSTAL: Graduate School of Business, The University of
Chicago, Graduate School of Business, 1101
East 58th Street, Chicago, Illinois 60637, USA
HONE: (312) 702-3196
FAX: (312) 702-0458
OTHER: Raghuram Rajan: fac_rajan@gsbvax.uchicago.edu
REF: WPS94-286
Abstract
We investigate the determinants of capital structure choice by analyzing the financing decisions of public firms in the major industrialized countries. At an aggregate level, firm leverage is fairly similar across the G-7 countries. We find that the factors identified by previous studies as important in determining the cross-section of capital structure in the US, affect firm leverage in other countries as well.
However, a deeper examination of the US and foreign evidence suggests that the theoretical underpinnings of the observed correlations are still largely unresolved.
"Financial Distress as a Collapse of Incentives", (February 9, 1994)
BY: WALTER NOVAES and LUIGI ZINGALES
CONTACT: LUIGI ZINGALES
E-MAIL: luigi@gsbgz.uchicago.edu
POSTAL: Graduate School of Business, The University of
Chicago, Graduate School of Business, 1101
East 58th Street, Chicago, Illinois 60637, USA
PHONE: (312) 702-3196
FAX: (312) 702-0458
OTHER: Walter Novaes: novaes@u.washington.edu
REF: WPS94-297
This paper explains why companies close to bankruptcy tend to lose their best workers and why the employees who remain lack proper motivation. This collapse of incentives within an organization arises because of a negative interaction between the system of incentives and the capital structure chosen by top management to avoid disciplinary takeovers. Furthermore, the same devices management creates ex ante to entrench itself also make it extremely difficult to renegotiate away the inefficiency ex post. This new approach identifies an additional source of financial distress and also provides a rationale for a mandatory bankruptcy law.
"The Costs of Corporate Bankruptcy: A U.S.-European Comparison" (August 1994)
BY: MICHELLE J. WHITE
CONTACT: MICHELLE J. WHITE
E-MAIL: micwhite@umich.edu
POSTAL: University of Michigan, Department of
Economics, University of Michigan, Ann Arbor,
MI 48109
PHONE: (313) 763-3096
FAX: (313) 764-2769
REF: WPS94-352
Both Britain and France have adopted new bankruptcy/insolvency laws since 1985 and a new bankruptcy law has also been proposed in Germany. Bankruptcy laws in the three European countries have traditionally been oriented toward liquidation, but the new laws move in the direction of allowing reorganization in some circumstances. This paper has several purposes. First, it identifies and compares basic differences in bankruptcy procedures in the four countries. Second, the costs (losses in economic efficiency) attributable to bankruptcy are identified. Bankruptcy costs incurred before it is known whether firms will be financially distressed are shown likely to be more important determinants of whether bankruptcy policy is economically efficient than bankruptcy costs incurred after firms have become financially distressed and/or have filed for bankruptcy. Third, the costs of bankruptcy under the laws of the four countries--as well as under various proposed bankruptcy reforms--are analyzed. The analysis suggests that bankruptcy costs incurred before it is known whether firms will be financially distressed are likely to pull bankruptcy policy in the opposite direction from costs incurred after firms become financially distressed. As a result, it is impossible to determine from theory whether the more liquidation-oriented bankruptcy policies of the European countries or the more reorganization-oriented policy of the U.S. is more economically efficient.
"How Different is Japanese Corporate Finance? An Investigation of the Information Content of New Security Issues" (Revised, August 1994)
BY: JUN-KOO KANG and RENE M. STULZ
CONTACT: RENE M. STULZ
E-MAIL: rstulz@magnus.acs.ohio-state.edu
POSTAL: Department of Finance, Max M. Fisher College
of Business, Ohio State University, 1775
College Road, Room 314, Columbus, OH 43210
PHONE: (614) 292-8449
FAX: (614) 292-2359
OTHER: Jun-Koo Kang: jkang@uriacc.uri.edu
REF: WPS94-356
This paper studies the shareholder wealth effects associated with 875 new security issues in Japan from January 1, 1985 to May 31, 1991. The sample includes public equity, private equity, rights offerings, straight debt, warrant debt, and convertible debt issues. Contrary to the U.S., the announcement of convertible debt issues is accompanied by a significant positive abnormal return of 1.05%. The announcement of equity issues has a positive abnormal return of 0.45%, significant at the 0.10 level, but this positive abnormal return can be attributed to one year in our sample and is offset by a negative issue date abnormal return of -1.01%. The abnormal returns are negatively related to firm size, so that for equity issues (but not for convertible debt issues), large Japanese firms have significant negative announcement abnormal returns. Our evidence is consistent with the view that Japanese managers decide to issue shares based on different considerations than American managers.
"Firm Valuation, Earnings Expectations, and the Exchange-Rate Exposure Effect" (August 1994)
BY: ELI BARTOV and GORDON M. BODNAR
CONTACT: ELI BARTOV
E-MAIL: ebartov@stern.nyu.edu
POSTAL: New York University, Stern School of Business
40 West 4th Street, New York, NY 10003
PHONE: (212) 998-0016
FAX: (212) 995-4004
OTHER: Gordon M. Bodnar: bodnar@finance.wharton.upenn.edu
REF: WPS94-360
This paper presents an empirical exploration of the relation between abnormal stock returns of U.S. firms with international activities and fluctuations in the U.S. dollar.
Consistent with previous research, we fail to find a significant correlation between abnormal returns of our sample firms and changes in the dollar. We investigate the possibility that this failure is due to mispricing. The main results are: 1) lagged changes in the dollar are a significant variable in explaining current abnormal returns of our sample firms suggesting that mispricing is occurring, and 2) this exchange-rate exposure effect weakens over time suggesting that investors learn about the mispricing over time. In addition, a simple trading strategy based upon lagged changes in the dollar generates abnormal returns that are economically as well as statistically significant. Corroborating evidence is also provided. One interpretation of these results is that investors do not use all freely available information--in particular, past changes in the dollar and the past interactions between dollar changes and firm performance, assets and liabilities--to predict changes in firm value. More specifically, by the end of the fiscal quarter investors observe the change in the value of the dollar over this period and have observed the impacts of past dollar changes on firm performance, assets and liabilities. Based upon this information, investor should be able to form an unbiased expectation about the economic impact of the recent change in the dollar on firm performance, assets, and liabilities, and incorporate this effect into firm value by that time.
However, at the end of the fiscal quarter, investors systematically under-estimate this impact (or perhaps even overlook it entirely). This under-estimation is corrected only when additional information that relates to the impact of the past change in the dollar on firm performance, assets, and liabilities is disclosed in the future.
Optimal Maturity Structure with Multiple Debt Claims, J of Financial and Quantitative Analysis, Vol 29. No. 2, June 1994 by JOEL F. HOUSTON AND S. VENKATARMAN.<žp>
Contact: Venkataraman, e-Mail: subuv@dale.cba.ufl.edu,
College of Business Administration, University of Florida,
Gainesville, FL 32611, Tel (904) 392-0153 Fax (904) 392-2086.
This paper provides an explanation for why firms may choose to simultaneously issue multiple debt claims with varying maturities. The optimal mix of short- and long-term debt allows the firm to precommit to a more efficient liquidation policy. Even in risk-neutral settings, the optimal mix hinges critically on the mean and the variability of the firm's liquidation value. Determining the optimal mix of debt is more complex than just weighing the costs of issuing short- or long-term debt exclusively. The implications of alternate priority structures, informational settings, interest rate uncertainty, and maturity matching strategies are also considered.
Main Contents Page Back to the top of this section
Chapter 17: The Future: Understanding and Using New Instruments
New structured floating-rate notes
Structured floating-rate notes are FRNs that allow investors to achieve a customized return profile, one that differs from that of conventional notes, through the use of embedded swaps and options. Most structured notes can be decomposed into a portfolio consisting of a pure floater (see Chapter 10 of GFM) and a combination of long or short option positions. For example, a capped floater is equivalent to being long a pure FRN and short a cap. A collared floater is equivalent to being long a pure FRN, short a cap and long a floor.
Periodic Capped FRNs
Floating-rate notes have coupons tied to an index rate such as Libor, one that is adjusted at certain intervals. With periodic capped floaters, any increase in the coupon from one period to the next is capped. For example, the increase could be limited to 30 basis points per period. The investor is in effect long a conventional FRN and short a 0.30% periodic cap.
A periodic cap is an interest rate cap in which the strike is determined by the value of the index in the previous period plus a predetermined spread. Through selling the periodic cap, the investor gets a higher spread than on a pure floater.
One-Way Floaters
A variation on the periodic capped FRN is the one-way Libor (OWL) floating-rate note, an instrument whose increase in coupon is capped from one period to the next and is non-decreasing. This type of note can be replicated by having a long position in a pure floater, a short position in a periodic cap, and a long position in a periodic floor.
Leveraged and Deleveraged Floaters
Inverse floaters, super or leveraged floaters, and deleveraged floaters are synthesized by means not of options, but of swaps--in particular, leveraged swaps.
A plain-vanilla FRN's coupon rate goes up or down with an index. But the investor's exposure to the floating-rate index can be easily increased or decreased, or even reversed, by means of swaps. The notional amount of the swap is adjusted to achieve the desired leverage. In this context, leverage means the ratio of coupon changes to index changes. A conventional FRN has a leverage of one.
A deleveraged floating-rate note is one bearing a coupon that is the product of the index and a leverage factor, where the leverage factor is between zero and one. A deleveraged floater, which gives the investor decreased exposure to the underlying index, can be replicated by buying a pure FRN and entering into a swap to pay floating and receive fixed, on a notional amount of less than the face value of the FRN. Thus:
Deleveraged FRN = Long Pure FRN + Short (1 - Leverage factor) x Swap
A leveraged or super floater gives the investor inreased exposure to an underlying index: the leverage factor is always greater than one. Leveraged floaters also require a floor, since the coupon rate can never be negative.
Leveraged FRN = Long Pure FRN + Long (Leverage factor - 1) x Swap + Long (Leverage factor) x Floor
Corridor Floaters
Background
The Eurobond market is known for its innovative, structured deals. Many of them embody options such as caps, floors and collars that are stripped off and sold at a profit by the issuer to a derivatives house, thus giving the issuer a subsidized cost of funds. The first few weeks of 1994 saw a proliferation of such deals, notably of corridor floating-rate notes, also known as "range floaters." The notes are short-term floating-rate notes that pay a generous spread over Libor, but they pay interest only when Libor falls within a specified range during certain periods. The notes seem to appeal to individual investors who like the good spread (and the high quality name of the issuer) and are convinced that short-term interest rates do not have too much further to fall, nor are they likely to rise a great deal within the next year or so.
One example is the Commerzbank International offering listed in the "New International Bond Issues" section of the Financial Times of January 18, 1994 (Exhibit 1). The terms can be summarized as follows:
| Issuer: | Commerzbank International | |
| Maturity: | February 1996 (two years) | |
| Amount: | US $75 million | |
| Interest rate: | 3-month Libor + 1.25%, subject to the condition that interest is paid only when Libor falls within the following ranges during the following periods: | |
|
1st 6 months 2nd 6 months 3rd 6 months 4th 6 months |
3%-4% 3.125%-4.625% 3.25%-5.625% 3.5%-6% | |
| Offering price: | 100 | |
| Fees: | 0.15% | |
| Book Runner | Goldman Sachs International | |
Analysis
Since the payouts are contingent upon certain interest rate events, the bond clearly has embedded options. A 2-year quarterly-pay floater has 8 payouts, of which 7 are unknown, so in effect the bonds contain a strip of 7 options. But what kind of options? And how can they be priced?
To answer this, let's begin with the first interest-reset date in the Commerzbank deal. We'll see what the investor got and what he gave. One way to break up the note is to say that the investor bought a conventional floating-rate note, and simultaneously sold two fixed-payoff options, and a collar, to Commerzbank. This constitutes a strong view that volatility will be low, as well as a view on the direction of rates relative to implied forward rates (shown in Figure 1). Since the investor receives no interest at all if one of the bounds (3% or 4%) is broken, he is in effect agreeing to pay to Commerzbank an amount equal to Libor and the 1.5% spread (fixed) if Libor is less than 3%, or if Libor is greater than 4%. This can be broken into fixed portions and variable portions. The payoffs from the various options are illustrated in Figure 2.
An option that pays a fixed amount when a price crosses a certain strike price is called a digital option, like the 1/0 signals that are the basis of digital computers. Part of the story, then, is that the investor is in effect writing a series of digital options to the issuer: at each reset date, an upper- and a lower-bound digital option. The derivatives whizzes have established pricing methods for digital options, although hedging them is by no means a piece of cake.
Part of the payoff is variable, however, and since the variable amount is directly related to the level of Libor, we can price and hedge this using conventional option-pricing techniques. The investor has effectively bought a call and sold a put to Commerzbank. This can be seen by dissecting the first-quarter payoffs in the Commerzbank corridor note:
| Condition | Commerzbank pays investor | Investor pays Commerzbank | Description | Net amount investor receives |
| L<3% | L+1.25% | Conventional FRN bought from Commerzbank | 0 | |
| 3%+1.25% | 1st digital option sold to Commerzbank (strike=3%) | |||
| 3%-L | Conventional Eurodollar call option bought from Commerzbank (strike=3%) | |||
| 3%L4% | L+1.25% | Conventional FRN bought from Commerzbank (both options out of the money so no payment made) |
L+1.25% | |
| L>4% | L+1.25% | Conventional FRN bought from Commerzbank | 0 | |
| 4%+1.25% | 2nd digital option sold to Commerzbank (strike=3%) | |||
| L-4% | Conventional Eurodollar put option sold to Commerzbank (strike=4%) |
The foregoing analysis applies to each of the 7 uncertain-payoff periods in the 2-year note. Hence we can say that the investor has
(1) bought a conventional FRN from Commerzbank
(2) sold a strip of lower-bound Libor digital options to Commerzbank
(3) sold a strip of upper-bound Libor digital options to Commerzbank
(4) bought a strip of Eurodollar calls from Commerzbank
(5) sold a strip of Eurodollar puts to Commerzbank.
Items (4) and (5) constitute a step-up collar that the investor has sold to Commerzbank. The bank, or more likely Goldman Sachs, can make good use of this collar in the corporate market. The digital-option position will have to be hedged or sold to a strong derivatives market-maker such as Bankers Trust. Commerzbank International would probably be able to fund itself at Libor flat or slightly above, but has almost certainly achieved a cost of funds significantly below Libor in this deal.
Source: International Bond Market Deals (Financial Times, January 18, 1994, p. 24)
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