Full transcript
0:00welcome to chapter 18 long-term debt
0:03financing first of all what is long-term
0:07we frequently hear about something is
0:09short term or long term and we have a
0:12vague feeling that one is somehow longer
0:15than the other one and at some point we
0:18may just accept it as a mystery and live
0:21with it then live and fear no more in
0:25the context of finance and also
0:27economics in general short term is one
0:30year or less and long term is more than
0:33one year when an MNC decides to make a
0:36DFI a direct foreign investment is
0:39usually a several years project meaning
0:42that is
0:44long-term and the MNC needs to finance
0:47this project one way or another and we
0:50have looked at Capital budgeting cash
0:52flows capital structure and so on taking
0:56on long-term debts to finance long-term
0:59projects like this is a
1:01no-brainer as a financial manager at an
1:04MNC you would have to think about the
1:07currency of denomination the maturity
1:10and if it's going to be fixed or
1:12floating rates let's get started when a
1:15us-based mnc's foreign subsidiary needs
1:18to borrow funds there are two choices to
1:22borrow in the local currency or to
1:24borrow in US Dollars the analysis MNC
1:28managers conduct to help them make these
1:31decisions is called debt denomination
1:33analysis borrowing funds denominated in
1:36the local currency where it is located
1:39can be advantageous the subsidiary can
1:42use funds generated from its local sales
1:45which are in the same currency to repay
1:47the debt if the subsidiary borrows funds
1:51denominated in dollars the funds would
1:53need to be converted from US Dollars
1:56into the local currency in order to
1:59support existing operations or expansion
2:02there let's look at the first option
2:04which is to borrow in the local currency
2:08many subsidiaries of mnc's Finance their
2:11operations or expansion by borrowing in
2:14their local currency which they also use
2:17to invoice their products this strategy
2:20allows a foreign subsidiary to match the
2:22currency received from its sales with
2:25the currency needed to repay its debt
2:28because the subsidiary does not need to
2:30convert its currency received from sales
2:32into another currency to repay its debt
2:36it avoids any exchange rate risk on its
2:38debt repayments while this is convenient
2:42what matters the most is that what the
2:45interest rate is for the debt it takes
2:47on interest rates can vary widely across
2:51countries and it's worth the effort to
2:53do some research and compare the rates
2:55between what the local lenders and the
2:57US lenders have to offer
3:00this table here provides us a snapshot
3:03of what long-term risk-free bond yields
3:06look like across countries the US rate
3:09is 3% Which is higher than some and
3:12lower than some other countries Brazil
3:15and turkey are especially High compared
3:18to the rest Germany is only half a
3:21percent Japan is
3:230.1% and we need to keep in mind that
3:26the actual cost of debt for the
3:28subsidiary will be higher than than
3:30these rates because it would also
3:31contain the credit risk premium on top
3:34of this the other option is to borrow in
3:37US dollars in general developing
3:41countries have higher interest rates
3:43because of lower stability level on the
3:46table we just looked at the rates in
3:48Brazil and Turkey were pretty high and
3:51it may be a no-brainer to borrow in US
3:53Dollars and convert to the local
3:55currencies of those countries but we
3:58always have to watch out for exchange
4:00rate movements because now the funds are
4:03converted back and forth if local
4:05currency depreciates against US Dollars
4:08over time then it would take more of
4:11that currency to make up the same amount
4:13of US Dollars leading to higher interest
4:16rate payments High interest currencies
4:19also tend to have high inflation and
4:22because of that tend to depreciate so a
4:25subsidiary tries to avoid the high
4:28interest rate by Bor borrowing in US
4:30Dollars exposes itself to a greater
4:33exchange rate risk which can make it
4:35worse off let's look at a that
4:38denomination analysis example Boise
4:41company a US company has a Mexican
4:44subsidiary that will need about 200
4:47million Mexican pesos mxp to finance its
4:51Mexican operations over the next three
4:54years the peso spot rate is 10 cents so
4:58the financing represents $20 million
5:01which can be computed as 200 million
5:04pesos multiplied by 10 cents all loan
5:08principle is repaid at the end of three
5:10years to finance its operations boisey
5:14considers two financing
5:16Alternatives in pzo it would be a 12% of
5:21a three-year fix rate pzo denominated
5:24loan or a dollar loan the interest rate
5:28on a threeyear fixed R Dollar
5:30denominated Loan is 7% so how do we
5:34decide which one is better for Boise to
5:37go with sometimes the best way is just
5:40to spell everything out and see what we
5:42got in this case this means determining
5:46the related cash flow amounts through
5:48the years we only care about the related
5:51cash flow pertaining to this loan and
5:54not other things like revenues and such
5:57so what sort of cash flows would come
5:59out of this loan well there would be a
6:02cash inflow of the loan amount then each
6:05year there is a cash outflow of Interest
6:08payment in the final year that would be
6:11the interest payment and the loan amount
6:14so let's determine those values the
6:17yearly interest payment for peso loan is
6:21200 million Mexican pesos multiply by
6:250.122 that's 12% we get 24 million
6:29Mexican
6:31pesos dollar alone we would have $20
6:34million multiplied by
6:370.07 we get $1.4
6:40million then the payment in year three
6:44would be that yearly interest payment
6:47already calculated and add the uh the
6:50original principal amount to it so for
6:53the peso loan that would be 224 million
6:56pesos for the dollar loan that would be
6:59$ 21.4
7:02million now that we have the cash flows
7:05calculated we can put them on a table
7:07like this one so you see for the PES
7:11loan we have the amounts for year one
7:14year two and year three and for the US
7:17loan we also have the amounts for year
7:19one year two and year three just like
7:22what we calculated on the previous slide
7:26on the next row we put the forecasted
7:29Exchange rate of peso for each year so
7:32that would be 10 cents for year one 9
7:35cents for year two and 9 cents for year
7:38three with that exchange rate we
7:41multiply that by the dollar amount and
7:43we get the Mexican peso amounts for each
7:46year the amount needed to repay the
7:50dollar loan for each year so that would
7:52be 14 million pesos for year 1 15.5
7:57Millions for year 2 200
8:0037.7 million for year
8:03three so which one should Boise go with
8:08maybe the US dollar loan option because
8:11the Mexican peso amount seem to be
8:15lower well that's true for year one and
8:18year two those amounts are lower than 24
8:21million pesos but year three the amount
8:25is higher is 237 million whereas going
8:29with the peso loan is only 224 million
8:33so how do we compare how do we figure
8:36this
8:37out well the way to truly compare
8:41between the two options is by comparing
8:43the interest rates that boisey has to
8:46pay the peso loans rate is 12% what is
8:51the interest rate for the US loan we
8:54know that is actually not
8:567% because of the exchange rate
8:58fluctuation
9:00the effective rate of the loan has to be
9:02calculated we can do that using the
9:05financial calculator here I really list
9:08out the cash flows for each year can you
9:10find the interest rate pause the video
9:13and give it a
9:16try let's do this using the calculator
9:20together first you're going to click on
9:22CF to get to that cash flow mode then
9:26we're going to click second clear work
9:30to clear any previous work and now we
9:33are ready to
9:34go the screen would ask for
9:38cf0 that would be the the principle of
9:42the loan so it's going to be 200 million
9:46so two z z just go by the millions here
9:52and press
9:54enter hit down button we get to the cf1
9:59value that's $14 million out of our
10:02pocket because now we're paying we
10:05receive those 200 millions that amount
10:08is positive coming into our pocket now
10:11we're paying so the payment amounts
10:13would be negative so cf1 would be
10:1914 14 and press this to make it negative
10:2314 and then press enter hit down it's
10:27asking for F1 the frequency of that
10:30amount it just happens one time so we
10:33leave it at one hit the down button
10:36again to get to cf2 that's
10:4115555
10:43556 for the millions so we're going to
10:47put that amount
10:48in and
10:50then press this button to make it
10:53negative and then press enter press down
10:57down again to get to year three the
11:00amount is
11:03237 so
11:05237
11:07Point
11:09777
11:11778 press this to make it negative press
11:16enter now we are ready to calculate the
11:20exchange rate so we're going to press
11:22this IR R stands for internal rate
11:26return then press compute and we get
11:3210.82% and that's the result so the
11:35interest rate that boy is charged for
11:38using the dollar loan is actually
11:4110.82% and this is a lot closer to 12%
11:45than we thought and if the exchange rate
11:48ends up changing even more than what is
11:51forecasted this exchange rate can exceed
11:5412% making the Dollar Loan option more
11:57expensive so in in reality Boise is
12:01likely to go with the first option of
12:03borrowing in Mexican
12:05peso as the example illustrates to us
12:08when the subsidiary borrows in a
12:10different currency other than that of
12:13its host country it is highly sensitive
12:16to the forecasted exchange rates mnc's
12:19can conduct a sensitivity analysis and
12:22see what happens if the forecasted
12:24exchange rate changes by
12:271% sometimes the effects of an 1%
12:30increase is a game changer convincing
12:33the company to change their financing
12:36decisions sometimes mnc's cannot borrow
12:40the local currency even though it's a
12:42cheaper route so instead they can try to
12:46hatch the exchange rate risk by using
12:48currency swaps or parallel loans a
12:52currency swap specifies the exchange of
12:55currencies at periodic intervals and may
12:58allow the MNC to take cash outflows in
13:01the same currency in which it receives
13:04most all of its revenue for example an
13:08American company Miller company has a
13:11subsidiary in Europe and it wants to
13:14take on Loan denominated in Euros but it
13:17can't back company is a German company
13:20with a subsidiary in the US and it wants
13:23to borrow in US dollars but it also
13:27cannot what these two comp companies can
13:29do is to have a currency swap meller
13:33company will issue Bonds in US Dollars
13:36while back company will issue Bonds in
13:39Euros meller will provide payments in
13:42Euros to Bank in exchange for dollar
13:45payments basically the two companies
13:47issue bonds and make payments on the
13:50other's behalf and help each other to
13:53avoid exposure to exchange rate risk in
13:56a parallel loan to comp companies
13:59provide simultaneous loans with an
14:01agreement to repay those loans at some
14:04specified future time here we have an
14:07example of a parallel loan there are two
14:10companies and Arbor is a US company that
14:14has a subsidiary in the UK Brit limited
14:17is a British company that has a
14:19subsidiary in the US at the same time
14:23the two companies provide loans to each
14:25other subsidiary at a specified time in
14:28the future
14:29the loans are repaid in the same
14:31currency that was borrowed one other
14:34decision MNC managers have to make is
14:37the debt maturity decision you may ask
14:41what is even there to decide shouldn't
14:44we just choose alone with a maturity
14:46that matches the length of the project
14:49well no we should go with the financing
14:52option that is the cheapest the one with
14:55the lowest interest rate and sometimes
14:58the best option are the ones with a
15:00different maturity than the life of the
15:02project to be funded mnc's make this
15:05kind of decisions by studying the yield
15:08curve of a host country this is what a
15:11yield curve looks like the shape of the
15:14yield curve illustrates the relationship
15:16between debt maturity and the annualized
15:19yield of the debt or the cost of the
15:21debt this can vary among countries
15:25looking at this we can see how the loans
15:27with short terms May have lower
15:30yields so when an MNC sees an upward
15:34slopping yield curve like that it may
15:36want to finance the project with debt
15:39over a shorter maturity so as to achieve
15:42a lower cost of debt financing even if
15:45it means that funds will still be needed
15:48after the loan
15:49matures let's look at this example there
15:53are two options for an MNC to choose to
15:56raise an amount of 40 million Swiss
15:58friends one is a 5-year loan with a
16:01fixed rate of 8% another is a three-year
16:04loan with a lower rate of 6% this loan
16:08can be extended for two additional years
16:11but the loan rate for those two years
16:13will be based on whatever rate at that
16:16time this future rate is forecasted to
16:19be 9% so 6% for the first two years 9%
16:24for the remaining two would the second
16:27option be cheaper for the the MNC how do
16:30we find out by comparing the annualized
16:33cost of financing for the two options
16:36right for the first option we already
16:39know that it is 8% we can calculate it
16:42if we want but we don't have to for the
16:45second option we'll have to use the
16:47financial calculator here I list out the
16:50cash flows through the years for you see
16:53if you can use the calculator to find
16:55out this annualized interest rate pause
16:58the video and give it a
17:01try did you get it the answer is
17:057.08% for the second option that's lower
17:09than 8% from the first option so the MNC
17:12should go with the second option with
17:14the lower rate let me know if you have
17:17any question on that when the long-term
17:20loan rate is too high besides switching
17:23to one with a shorter term like we just
17:26did mnc's can also use floating rate
17:29bonds the way to analyze the floating
17:32rate loan is to forecast the rate for
17:35each year and use that to determine the
17:39yearly interest payments then we can
17:42calculate the annualized rates and
17:44compare them like usual floating rates
17:47are often tied to the London in Bank
17:49offer rate what we call Liber let's
17:53revisit example four this time the MNC
17:56considers the third option which is to
17:59use a floating rate loan based on liable
18:02rate first the liable rate is forecasted
18:05for each year then the floating rate is
18:09this liable rate plus 3% of credit risk
18:12premium now that we have these
18:15forecasted floating rates for the three
18:17years I mean for the five years we can
18:20calculate the interest payments for each
18:22year with the cash flows figured out we
18:26can now use the financial calculator to
18:29calculate the annualized interest rate
18:31the
18:32IR this time is
18:357.48% this is lower than the first
18:38option of 8% but higher than the second
18:41option of
18:447.08% so the MNC will still decide to go
18:48with the second option this is where we
18:51end our discussion for chapter 18 let me
18:55know if you have any
18:56questions have a wonderful day okay