Long-term Financing
Lecture for Corporate Finance
Ing. Tomáš Heryán, Ph.D.
Corporate Finance
FIU/BAFIK
Outline of the lecture
• Debt financing
• External vs. Internal financial sources
• Assessing the exchange rate risk of debt financing
• Reducing exchange rate risk
Introduction
Firms typically seek to match the
duration of their finance with the
duration of the investment so that
long-term sources of funds are used
to finance long-term projects.
They have access to both domestic
and foreign sources of funds and
companies do consider long-term
financing in foreign currencies.
Financial managers must be aware of
their sources of long-term funds so that
they can finance international projects in
a manner that maximizes the wealth of
the company.
Financial managers also need to consider
the structure of the investment, whether
it is a partnership, subsidiary or project
finance.
Cost of debt financing
Firm’s long-term financing decision is commonly influenced by the
different interest rates that exist among currencies. The actual cost of
long-term financing is based on both the quoted interest rate and the
short-term percentage change in the exchange rate of the currency
borrowed over the loan life.
Because bonds denominated in foreign currencies sometimes have
lower yields, corporations often consider issuing bonds denominated in
those currencies. Since the total financing cost to a firm issuing a
foreign currency/denominated bond is affected by that currency’s value
relative to the company’s main currency, there is no guarantee that the
bond will be less costly than a home currency/denominated bond.
Long-term financing decision
• The company must determine the amount of funds needed.
• The firm should forecast the price at which it can issue the bond.
• Then it should forecast periodic exchange rate values for the currency
denominating the bond.
• These information can be used to determine the bond’s financing
costs, which can be compared with the financing costs that firm
would incur its home currency.
• The uncertainty of the actual financing costs to be incurred from
foreign financing must be accounted for as well.
Financial sources
Financial sources
Financial sources
Long-term means that availability of these
sources is longer than one year: INT: retained
earnings; EX: bonds, bank loans, financial
leasing or forfaiting.
Capital shares can be internal whether the
company is not join stock company. Otherwise it
is external.
Financial
resources
Debt
financing
Short-term external
Long-term internal
Equity
financing
Long term
external
internal
External financial sources
External financial sources are e. g.: bonds, bank loans, financial leasing or forfaiting.
Long term means, that duration is longer than one year. Long-term sources could be
external or internal.
A bond is an instrument of indebtedness of the bond issuer (debtor) to
the holders (creditors).
There are several kinds of bonds. For example, zero coupon bond,
which does not have any coupons and debtor sell it to the creditor for a
price which is lower than its nominal value.
After time of expiration (at maturity) the debtor pays to the creditor its
nominal value.
Bonds
• By bonds a company can obtain a significant amount of financial
sources for anonymous creditor, what could be quite risky for them in
case that the company is not successful.
• Quicker amortize the debt is possibly sometimes too.
• Disadvantages of bonds could be in necessity to confirm emission and
costs of this emission.
• There must be investors (creditors) who would buy this emission of
bonds.
• Market price is then related to the acceptable amount of risk.
• The higher risk means the lower price of bonds.
Bank loans
A bank loan (credit) is a next possible external financial source.
A bank lends a company some amount of money. In comparison to bonds a loan could
be for company very expansive in case of low quality of a company.
Interest rate reflects amount of risk of lent money and maturity time.
If payments are regularly paid and they are constant or regularly growing, it could be
calculated using growing annuity calculated from present value, because value of lent
money is its present value and payments are paid from next period.
Financial leasing
It is a contract between lessee and lessor. Lessee (tenant) is using
subject of lessor in the long term (for the duration of subject
amortization). Lessee carries main part of risks related to ownership.
After the contract expires the lessee buys the subject for a lower price.
By leasing it is possible to finance up to 100 % of subject value from
external (foreign) financial source. Payments are usually paid after
placing equipment in operation and they are fixed and determinable. In
some ways it is very easy to get leasing.
Sometimes the payments could be higher than real asset price and
higher in comparison to the bank loan, but it depends on every
particular situation. Payments usually include insurance.
Forfaiting
Forfaiting is a possibility how to get money if a company owns some bills
(debts). It is selling of single debts to a forfaiting company without possibility
for regression.
It is sold for lower price than is value of debt. It means some costs for the
company, but interest and monetary risk is transferred to forfaiter.
Company can offer deliveries on credit without using of bank loan.
Debts for forfaiting have several conditions: longer term of expiration, they
should be debts from selling of capital equipment, engineering products, etc.,
they should be secured and in free convertible currency.
How forfaiting works ???
Figure title 1
External or internal financial sources
• Financial sources created own capital.
• It is financed by shares emitted within a stock exchange.
• It includes basic capital, capital in excess of industry (emission agio),
and profit in a given accounting period and retained income from
previous years (these sources are internal).
• A company can increase of shareholders’ capital by share issue
(emission) or alternatively by GDR (global deposit receipts) or ADR
(American deposit receipts).
Initial public offering (IPO)
• IPO could be way of getting finance too.
• It is the issuing of shares for the first time in order to obtain a listing.
• It could be related to many disadvantages for companies which were
not publicly listed before.
• They must be so attractive, credible and trustworthy for potential
investors to they buy the shares and not only buy, but pay for them
good price.
• In this way the company can get enough money for their business
plans.
Venture capital
• A venture capital is a kind of long-term financial sources of some
other company, which becomes part of shareholders’ capital of a
company. Giving company gets some power in management.
• There are three types of it: speed capital, start-up capital and early
stage expansion capital according the phase of a company and
purpose.
• It is useful in cases that company’s business project is very risky and
it cannot get bank loan or sell bonds, or it would cost so much, that
the company would be incapable of paying.
• It is an opportunity for a high building up of the company value in the
future and it is high risk for investor as well. It usually brings
experience (know-how) to the company.
Assessing the exchange rate risk of debt financing
The expected value of the exchange rate can be computed for each period by
multiplying each possible exchange rate by its associated probability and totaling the
products.
Then, the exchange rate’s expected value can be used to forecast the cash outflows
necessary to pay the bondholders over each period.
After developing probability distributions and computing the expected values, the
company can estimate the expected cost of financing and compare that with the cost of
financing with a bond denominated in the home currency.
Reducing exchange rate risk
• The exchange rate risk from financing with bonds in foreign
currencies can be reduced by using one of those alternative strategies.
• Offsetting cash inflows – some firms may have inflow payments in
particular currencies, which could offset their outflow payments
related to bond financing.
• However, it is unlikely that the firm would be able to perfectly match
the timing and amount of the outflows an foreign currency
denominating the bond to the inflows in that currency.
• Therefore some exposure to exchange rate fluctuations will exist.
UK i rates compared with the effective foreign i rate
Comparison of the interest rates
Comparison of the interest
rates
Since early 90s there was a higher volatility in
the U.K.
The bottom of interest rates was caused by the
global financial crisis.
During the sovereign debt crisis the short-term
interest rates were even negative.
Forward contracts
• When a bond denominated in a foreign currency has a lower coupon
rate than the firm’s home currency, the firm may consider issuing
bonds denominated in that currency and simultaneously hedging its
exchange rate risk through the forward market.
• Because the forward market can sometimes accommodate requests of
5 years or longer, such an approach may be possible. The firm could
arrange to purchase the foreign currency forward for each time at
which payments are required.
• However, hedging through forward may not be less costly than the
outflow payments needed if a dollar-denominated bond were issued.
Currency swaps
A currency swaps enables firms to exchange currencies at periodic intervals. The
motive for such swaps is to make payments in a currency where revenues are being
earned and thereby reduce exposure to exchange rate movements.
Many firms simultaneously swap interest payments and currencies at agreed rates.
Rates can also be fixed with forward and futures.
Swaps have also been used for window dressing balance sheets – an attempt to deceive
the investment markets. Both the Greek and Italian governments have been accused of
this practice that originated in Japan and was given the name Tobashi, or Make go
away. In essence the company arranges a swap with counterparty at very unfavourable
rates.
Illustration of interest rate swap
Illustration of interest rate swap
Parallel loans
• Firms can also obtain financing in a foreign currency through a
parallel [or back-to-back] loan, which occurs when two parties
provide simultaneous loans with an agreement to repay at a specific
point in the future.
• Sometimes, parallel loans can function as a useful alternative to
forward or futures contracts as a way to finance foreign projects
abroad, when foreign currency will depreciate substantially.
• If the foreign currency is not heavily traded, forwards as well as
futures contracts may not be available.
Illustration of parallel loan
Illustration of parallel loan
Literature
1. MADURA, J., FOX, R., 2014. International Financial Management. Mason etc.:
South-Western Publishing., pp. 509-534. ISBN 978-1-4080-7981-2.
2. HALTOFOVÁ, P. 2015. Case Studies in Finance Management. SU OPF, pp. 36-47.
ISBN 978-80-7510-028-3.
3. BERK, J. & P. DeMARZO, 2017. Debt Financing. In: Corporate Finance, Chap.
24, pp. 897-949. ISBN 978-1-292-16016-0.
4. ROSS, S. A., R. W. WESTERFIELD, J. JAFFE & B. D. JORDAN, 2019. Longterm
Financing. In: Corporate Finance, Chap. 15, pp. 468-486. ISBN 978-1-260-
09187-8.
Thank you for
your attention!
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