Advantages Of Eurobond Financing

Published Date: 02 Nov 2017

1.0 Introduction

Companies, whether they operate within national boundaries alone, or beyond may borrow in their domestic market or they may move international markets to finance their operations. Normally, international borrowing enable companies to lower their average cost of finance and it may be an important part of the funding for major multinational companies (Adrian Buckley 2003).

Rather than raising capital in domestic market, many of the large multinational corporations have recently started to raise their funds by other alternatives such as an international bond issue in a target market or Eurobond market, international SWAP, and cross-list shares on a highly liquid foreign stock exchange. Unlike domestic alternative (bonds); Eurobonds, Swap and cross-list shares are designed for multimarket trading. These global alternatives include features such as; hedging, arbitrages and speculative that facilitates trading, clearing, settlements in the share and bond markets and hence, increasingly corporation funds (Lubomir Petrasek 2010).

This report focuses on evaluating each of the alternatives pondering by the British company for raising funds and explaining the way in which each of the alternative works, commenting on any risks involved, the advantages and disadvantages of each method and why. In the next section provides a brief discussion about ways of raising capital and the evaluation of the alternatives and the final section is the conclusion and recommendation part.

2.0 Discussion and Evaluation.

2. a Eurobond alternative.

A Eurobond can be defined as in international bond underwritten by an international syndicate and sold in countries other than the country of the currency in which the issue is denominated (Adrian Buckley, 2003). The evaluation of British Company through Eurobond alternative are analysed as follow:-

Seeking amount $600,000,000

Expiration period 2 years

Debt financing $600,000,000 Eurobond

Cost of debt (fixed interest) 6% per annum

Suggested evaluation

For the fixed interest rate payment

At the end of first year interest payment (6% of $600,000,000) $36,000,000

At the end of Second year interest payment (6% of $600,000,000) $36,000,000

Add principal paid at the end of period $600,000,000

Total amount to be paid at the end of year two $636,000,000

Effective cost of debt will be ($636,000,000 – $600,000,000) $36,000,000

The effective rate of interest will be ($36,000,000/$600,000,000x100%) 6%p.a

Therefore, the total debt cost will be $72,000,000

The computations above show that the costs of debt remain the same for the whole period. Therefore, the risk associated with Eurobond financing is the decrease of the bond market interest rate.

Advantages of Eurobond financing

Eurobonds gives issuers the opportunity to take advantage of favourable regulatory and lending conditions in other countries. Eurobonds are not usually subject to taxes or regulations of any one government, which can make it cheaper to borrow in the Eurobond market as compared to other debt markets.

Obtaining financing by issuing Eurobonds is often cheaper than obtaining a foreign currency bank loan.

It is a way for companies to obtain financing in an economy where financing is hard to obtain. Issuing Eurobond gives companies wider access to the international market which they may normally not be able to access.

Since Eurobonds are normally aimed at institutional investors and not the public, there are no advertisement costs involved and this means lower cost for the issuing firm.

Disadvantages of Eurobond financing

There is restrictive clause. Company can be restricted to issue other bonds, to pay dividend and to make Manger and Acquisition (M&A).

2. b Domestic debt financing.

Domestic bonds issued and traded within the internal market of a country and denominated in the currency of that country. The alternative of domestic debt financing by the British Company can be evaluated as follow:-

Seeking amount $ 600,000,000

Expiration period 2 years

Debt financing £400,000,000

Cost of debt (interest) 8% per annum

Spot exchange rate $1.5/ £

Assumptions

Assume USD interest rate to be 6% and the Interest Rate Parity (IRP) are hold.

End of first year (F1) = F0 (1+i$/1+i£)

F1 = $1.5/£ ((1+6%/1+8%)

F1 =$1.5/£ (1.06/1.08)

F1 =$1.472222/£

Therefore, two year forward exchange rate will be calculated as;

F2 = F0(1+i$/1+i£) 2

F2 = $1.5/£ ((1+6%/1+8%)2

F2 = $1.5/£(0.96331)

F2 = $1.445/£

Schedule of payments

At the end of first year interest required (8% of £400,000,000) £32,000,000

Effective amount at the end of year one (£432,000,000 x $1.4722/£) $636,000,000

The effective cost at the end of year one ($636,000,000-$600,000,000) $36,000,000

The effective interest ($36,000,000/$600,000,000 x100%) 6%

At the end of year two, interest required (8% of £400,000,000) £32,000,000

Amount of principal to be paid £400,000,000

Total amount to be paid at the end of year two £432,000,000

The amount required to redeem £432,000,000 will be

£432,000,000 x $1.445/£ $624,240,000

The effective cost of debt will be ($624,240,000 – $600,000,000) $24,240,000

The effective rate of interest will be ($24,240,000/$600,000,000 x100%) 4.04%p.a

Total interest payment after two year will be $60,240,000

By assumption of USD interest rate of 6%; which show that the two year forward pound depreciate from $1.5/£ to $1.445/£. Thus, causes cost of capital (interest) in to decrease from 6% to 4.04%.

Now, assume at the end of year two forward exchange rate is $1.55/£

Therefore, the amount will be (£432,000,000 x $1.55/£) $669,600,000

The effective cost of debt will be ($669,600,000 – $600,000,000) $69,600,000

The effective rate of interest will be ($69,600,000/$600,000,000 x100%) 11.6%p.a

By assumption of little appreciation of pound from $1.5/£ to $1.55/£ caused to shift the cost of debt to be 11.6%.

The risk associated by the British Company due the domestic finance is the interest rate to decrease to the bond market while the company has already entry in to fixed rate. Also currency risk is subject to the company due to the fluctuation of exchange rate changes.

The advantages of financing domestic bond are investors normally hopeful to the company, hence increase the source of capital and smooth operation.

Domestic financing reduces the debt costs when the local currency depreciates.

Disadvantages of domestic debt financing

Domestic bonds operate within a national system of regulation and might be subject to more regulation than the Eurobond market. The system of regulation varies from country to country.

Lack of investor’s interest to the domestic bonds and poor liquidity in the secondary market.

2.c Currency Swap alternative.

A swap is a financial contract between two parties where each party agrees to pay other party loan obligation (periodic payment) over the life of the contract at a predetermined condition. If the principal swapped are in the same currency the agreement is known as interest rate swap and if the payment is on different currency the agreement is known as currency swap. The currency swap financing by British Company evaluating as follow:

Amount seeking $600,000,000

Expiration period 2 years

Debt financing £400,000,000

Cost of debt (interest) 8% per annum

Actual cost of debt to be paid (8% of £400,000,000) £32,000,000

Currency swap arrangements

Initiation. British Coy. Counterparty.

Payments £400,000,000 $600,000,000

Receipts $600,000,000 £400,000,000

Settlements (yearly payments and receipts)

First year; payments (5% of$600,000,000) $30,000,000. £30,000,000.

Receipts (7.5% of £400,000,000) £30,000,000. $30,000,000.

Second year; payments (7.5% of £400,000,000) $30,000,000. £30,000,000.

Receipts (5% of $600,000,000) £30,000,000. $30,000,000.

Net borrowing cost for British Company of $600,000,000

Details Amount

Actual payment (£432,000,000x$1.445/£ – $600,000,000) $24,240,000

Swap arrangements;

Payments second year $30,000,000

Receipts second year (£430,000,000x$1.445/£- $600,000,000) ($21,350,000)

Net borrowing cost $32,890,000

Effective rate ($32,890,000/$600,000,000 x100%) 5.5%

Swap arrangement diagram

COUNTERPARTY

BRITISH

COMPANY 5% of US$ 600m

7.5% of £400m

8% 6%

The risk associated to currency swap alternative through British Company is the credit risk. This is the counterpart to default before the end of the swap and fail to carry out their agreed obligation. Also the sovereign risks which are associated with the country in whose currency swap are being considered.

Advantages of swap

Reducing costs of debts

Assume a company wants to borrow fund for two years but the company finds out the current rate is higher. At the time management believe that interest rate will go up or down and they need the fund immediately, they can take the loan than swap.

Flexible

The maturity of swap can be negotiable and can be arranged for any amount. Entering into a swap can help both parties to limit, manage interest rate exposure or to obtain lower rate, also reduce transaction which are limited to legal and arrangement fees.

Capitalization

It is very easily to raise company capital through currency swap alternative.

Disadvantages

The swap agreement is said to be illiquid if one party wish to exit the swap before maturity must secure other party before carryout agreed exit strategy because it is difficult to find other party who interested to inter into swap term. Also there is high rate of default risks, the other party may fail to meet its obligation during the time or at maturity.

2. d Cross- listing shares.

The alternative refers to a firm having its equity shares listed on one or more foreign exchanges. The international equity financing are evaluating through British Company down here as:-

Seeking amount $600,000,000

Assume the price which is US investors will be willing to buy British Company’s share is$ 600 per share; by assumption from the quotation of New York Stock Market Exchange.

Therefore, number of shares to be sold to obtain the required amount will be

Required amount = share price x number of shares

$600,000,000 = $600 x number of shares

Number of shares = $600,000,000/$600

Number of shares = 1,000,000 shares

Therefore, British Company should issue new share of 1,000,000 for financing through cross-listing shares.

Assumptions

No transaction costs will be incurred under this alternative

The risk associated with cross-listing alternative is the overseas listing too. There may be harsher and more expensive disclosure requirement. And there is the problem of flow back. This is the tendency for share issued into a foreign market to be sold back into the domestic market. This may the effect of depreciating the price of the share to the domestic market.

Advantages of cross-listing shares financing

Under equity financing the investor may use his own money and those of other investors, family and friends as initial amount to finance the operation of the business rather than taking loan either from bank, other institution or individual that are subjected to higher interest payment and must be repaid back at maturity but for shares you only share risks and liabilities of business ownership with new investors so leave the business in a better position of obtaining loan in the future when needed. (http://www.smallbusiness.chrone.com)

Issuing of shares may lead to outside investor to take part in the management of business so they may provide valuable business assistance that may not have depending on how your investors are.

Cross-listing shares increase in investor base which increase demand and increase stock price. Name recognition in new countries may lower the cost of capital for future projects it also increase reporting standard and transparency. It is an international diversification and may protect against hostile takeover.

Disadvantages of cross-list share

Consider that when issuing shares mean that you divide some business ownership to your investors. Remember that actually own a piece of your business, and that share depends on how much they contribute to your business. Investors always expect to get a return on their investment as dividend obtained from the annual profit after deducting all operating expenses. Also equity financing gives up partial ownership and some level of decision making of your business to investors, investors may insist on placing their representative in the company boards or in an executive position of your business. (www.budgeting.thenest.com).

Automatically when investment fail the investors may think that they lose their money and become more painful, as we know that the person feels more painful when incur loss of even one cent. Also raising equity finance is time consuming, costly, demanding and may take away management focus on other core activities.

3. Conclusion and recommendation

Our evaluating analysis shows that the use of currency swaps with long term or short term debt is a value maximizing alternative for companies. Mere use of domestic debts or global debts in segmented international capital markets when bankruptcy due to unexpected exchange rate changes is probable does not provide a value maximizing financing alternative.

Currency swaps are beneficial, from the hedging motive as well as from the financing (value maximization) motive. The hedging motive differentiates the currency swap alternative from the domestic debt financing alternative. Thus borrowing domestic currency debt creates a mismatch between the cash inflows and the currency of the domestic debts. The circumstance exposes the firm to the prospect of bankruptcy. The expected bankruptcy costs render the domestic currency debt financing alternative inferior to the currency swap alternative. As compared to the other global alternatives financing, the currency swap is superior due to the economic exposure effect. In evaluating alternatives also suggests that long term or short term exposure to the exchange rate changes is best addressed by use of currency swap and other alternatives such as cross-listing, Eurobond and domestic financing cannot achieve the dual objectives of long term or short term hedging and financing for companies. Therefore, currency swap alternative is the best and profitable way for the British Company and other companies for raising funds.