International Financial Management - Currencies and Costs - Essay Example

ACADEMIA RESEARCH ORDER No. 157066 7080 12 MARCH 2007 Examination Of The Rationale Behind Firms' Issuing Of Foreign-Currency-Denominated Debt And A Comparative Study Of How Vodafone Group Plc's Financial Structure Is Explained By These Reasons 2. Why companies Issue Foreign-Currency Denominated Debt: Evidence from Earlier Studies. A number of studies have provided reasons why firms issue debt in foreign currency. Some of the most important reasons that I came across include: Hedging foreign currency risk; Taking advantage of capital market imperfections to lower the cost of capital; and Speculative Motives; Issuing debt in foreign-currency increases firm value; and Tax Arbitrage. Hedging Foreign Currency Risk Inspite of the numerous opportunities of globalisation, multinational companies continue to face a number of risks with foreign exchange risk constituting an important component. Fluctuations in exchange rates can have significant impacts on the cash flows and profits of firms with foreign-currency-denominated assets and liabilities. (Nguyen and Faff, 2006: pp 184). Nguyen and Faff (2006) provide both financial and natural strategies of hedging currency risk and identify the issuing of foreign debt as a natural hedging strategy. Using a sample of large Australian firms for the year 1999 and 2000, they provide conclusive evidence that firms are more likely to issue foreign debt if they have a lot of foreign-currency-denominated assets and liabilities. That is, the probability of issuing foreign debt is highly correlated with the degree of foreign operations. Their results are consistent with those of Kedia and Mozumdar (2003), who conclude that firms have to satisfy a demand to hedge via foreign debt. Kedia and Mozumdar (2003), also conclude that the correlation between foreign operations and the probability of issuing foreign debt is consistent with both the role of foreign debt as a hedging instrument and the existence of information barriers. Taking Advantage of Capital Market Imperfections to Benefit from Low financing costs (low costs of capital) The integration of capital markets implies that financial assets traded in different markets should possess the same risk/return characteristics. Kedia and Mozumdar (2003) however note that the segmentation of capital markets and barriers to international investment could result in opportunities for choosing the currency of debt to minimize funding costs (interest rates). Kedia and Mozumdar (2003) identify two sources of segmentation including legal barriers and Informational sources. According to them legal barriers which constitute a broad variety of restrictions such as differences in tax treatment for foreign and domestic investments, capital controls, security law, and ownership restrictions could give rise to opportunities for multinational companies to reduce their funding rates. It is also evident in the study by Kedia and Mozumdar (2003) that foreign investors face high costs of gathering information about capital markets in different countries and as such domestic companies take advantage of this information asymmetry to issue debt at a low cost than they would have issued to domestic investors. According to Keloharju and Niskanen (2001), issuing in the Euromarket may be more economical since it helps to mitigate withholding taxes and capital controls. They further illustrate that borrowing cost in two currencies can be reduced by borrowing the weaker currency and that tax laws in Finland encourage companies to borrow the foreign currency. Allayannis et al (2003: pp 2669) in their study of the capital structure and financial risk of East Asian Firms with particular emphasis on foreign-currency debt use, provide evidence that differences in home country interest rates and foreign interest rates such as the London Interbank Offered Rate (LIBOR), are important determinants for both home country and foreign debt use. The study finds that the higher (lower) the difference in interest rates, the higher the level of foreign (home) currency debt. Their results are consistent with evidence that East Asian Firms are likely to borrow in foreign currency in an attempt to take advantage of lower interest rates. This evidence is also supported by Mcbrady and Schill (2005) who find that firms alter currency positions of their international bond issues to exploit differences in borrowing costs across currencies. Using a broad sample of international bonds denominated in eight major currencies, Mcbrady and Schill (2005) find strong consistent evidence that currency shares increase when covered interest yields (bond yield spreads over currency) decline relative to other currencies in the sample. Speculative Motives Foreign-currency-denominated debt may also be an attractive alternative for speculative reasons as a Financial manager may choose to deviate from a hedging oriented strategy if he/she feels that the risk-adjusted interest rate differential between two countries does not accurately represent the expected change in exchange rate between the two countries' currencies. (Keloharju and Niskanen, 2001: pp 482). Issuing Foreign Debt Increases Firm Value. According to a study carried out by Kang et al on a sample of Japanese equity-linked offshore issues from 1977 to 1989 by Kang et al (1995:pp 257), announcement of these equity-linked issues is accompanied by a significant positive abnormal return which implies an increase in stock price and thus firm value. The rise in stock price is as a result of investors' bullish views about the underlying stock on which the notes are based. The price is therefore bound to rise because many investors will be willing to buy the company's stock and therefore bid up its price. Tax Arbitrage Some companies can also issue debt to take advantage of differences between taxes on borrowing activities between currencies. For example, a U.K-based Company will issue U.S dollar-denominated bonds or warrants if the transaction costs and taxes on issuing US dollar denominated bonds is lower than for issuing sterling-denominated bonds and warrants. As a result the company will benefit from the spread resulting from the difference between transaction costs and taxes between US dollar bonds and warrant issues and sterling dollar bonds and warrant issues. As earlier mentioned in the previous section under imperfect capital markets, Kedia and Mozumdar (2003) note that differences in tax treatment for foreign and domestic investments, capital controls, security law, and ownership restrictions could give rise to opportunities for multinational companies to reduce their funding rates. 3 Overview of the Financial Structure of Vodafone Group Plc Vodafone Group Plc is the world leading mobile telecommunications company with significance presence in Europe, the Middle East, Africa, Asia Pacific and the United States of America. It provides its services and products through its subsidiary undertakings, joint ventures, associated undertakings and investments. Its subsidiaries and joint venture in Italy operate under the brand name "Vodafone", whereas in the United States its associated undertaking operates as Verizon Wireless. (Vodafone Group Plc Annual Report, 2006: Pp 12). It provides a wide range of voice and data mobile telecommunication services including text messages, picture messages, and other data services. It is also continuously developing and improving service offerings, mainly through third Generation (3G) mobile technology, which is being deployed in the majority of its operations. It provides its services to both consumer and corporate customers, through a variety of both prepaid and contract tariff arrangements. (Vodafone Group Plc Annual Report, 2006: Pp 12). Looking at the Balance sheet of the Group for the Year to March 31st 2006, (Vodafone Group Plc Annual Report, 2006: Pp 73), one can observe that it is financed through equity and debt holdings. Equity holdings amount to about 148,383million whereas debt holdings amount to a total of 67,589million with long-term debt amounting 40,649million and short-term debt holdings of 26,980million. Some of these debt holdings have been issued in foreign currency. For example, the Group has the following foreign bond issues: a 15 billion Euro Medium Term Note programme, a $12 billion US shelf programme and a 600 billion Japanese shelf programme, which are used to meet medium to long term funding requirements. At 31st March 2006, the total amount of issue under this programs amounted to $13.4 billion, 8.7 billion and 3 billion and the Group's discontinued operations in Japan had bonds in issue of 125 billion, which were transferred to softBank following completion of the sale of Vodafone in Japan. The amount in issue in pound sterling was only 1.5billion (Vodafone Group Plc Annual Report, 2006: Pp 41) see appendix C. Also, the Group has Commercial paper programs of $15 billion and 5 billion in the United States and Europe respectively which are used in funding its short-term liquidity requirements. As at 31st March 2006, $696 million and $80 million were drawn under the US and Euro commercial programmes respectively. Also a total of 285million was drawn under the Euro Programme. Considering the fact that the company is listed on the London Stock Exchange, its share price is quoted in pound sterling. According to the 2006 Annual Report, its share price represents the present value of its future multi-currency cash flows, which include euro-, Japanese yen and US-dollar flows. One can observe that the company likely faces a lot of exposure to currency risk as most of its expected future cash flows are denominated in currencies other than pound sterling. For example as we can see from Appendix A, the euro fell from 1.46 euro/pound to 1.43 euro/pound between March 2005 and March 2006 representing a 2.1% drop, whereas the US dollar fell from 1.89Usdollars/pound to 1.74 representing a 7.9% decrease during the same period. This provides evidence that the exposure to the US dollar is more than that for the euro. The Annual Report explains that the Group maintains the currency of debt and interest charges in proportion with its expected future principal multi-currency cash flows. For example, as at 31 March 2006, 11.3% of net debt was denominated in foreign currency with 73% euro, 21% yen and 14% US dollar and 5% other). (Vodafone Group Plc Annual Report, 2006: Pp 106) By so doing, a partial hedge is provided against income statement translation exposure as debt is serviced in proportion to expected future cash flows and interest cost will be denominated in foreign currencies. (Vodafone Group Plc Annual Report, 2006: Pp 106) This strategy is consistent with the first reason identified above for issuing foreign-currency-denominated debt, which says that companies issue foreign-currency-denominated debt to hedge against foreign exchange risk. This study was aimed at examining the reasons why companies issue debt in foreign currency and to study the financial structure of Vodafone Group Plc so as to understand how it is explained by the reasons for issuing foreign debt. Three main reasons for issuing foreign-currency-denominated debt were identified including: hedging foreign exchange risk, taking advantage of market imperfections and speculative motives. The Group's financial structure shows that a high percentage of it is financed through debt and the company maintains 11% of its debt holdings in foreign currencies to hedge against expected future cash flows in foreign currencies. This finding is consistent with the first reason identified for issuing debt denominated in foreign currency. However, I find no evidence to show that it issues foreign debt to take advantage of market imperfections or to speculate against disparities in parity conditions such as the international fisher effect which states that a currency's value will adjust to reflect differences in nominal interest rates between countries. (http://www.bsu.edu/classes/rrathina/course/unit3_7.htm). APPENDIX Appendix A. Pound Sterling Exchange Rates Of The Principal Currencies Of The Group as at 31 March 2005 and 2006 respectively. Appendix A Source: Vodafone Group Plc Annual Report, 2006 Pp 27 Appendix B Source: Vodafone Group Plc Annual Report, 2006 Pp 27 Appendix C Source: Vodafone Group Plc Annual Report, 2006 Pp 41 Appendix D. Appendix E Appendix F Source: Vodafone Group Plc Annual Report, 2006 Pp 74 BIBLIOGRAPHY Allayannis G., Brown G. W., Klapper L. (2003). Capital Structure and Financial Risk: Evidence from Foreign Debt Use in East Asia. The Journal of Finance. Vol. 58 (6), Pp 2667-2709. Deng P. (2007). Investing for strategic resources and its rationale: The case of outward FDI from Chinese companies. Business Horizons. Vol. 50 Pp 71-78. Kang J., Kim C., Park K., Stulz R. M. (1995). An Analysis of the Wealth Effects of Japanese Off-shore Dollar-denominated Convertible and Warrant Bond Issues. Journal of Financial and Quantitative Analysis. Vol. 30(2), Pp 257-270. Kedia S., Mozumdar A. (2003). Foreign Currency-Denominated Debt: An Empirical Examination. Journal of Business Vol. 76(4), Pp 521-546. Keloharju M., Niskanen M. (2001). Why do Firms Raise Foreign-Currency-Denominated Debt Evidence from Finland. European Financial Management, Vol. 7(4), Pp 481-496. McBrady, Matthew R. and Schill, Michael J., "The Currency Denomination Decision: Do Firms Seek Bargains in International Bond Markets" (January 15, 2005). AFA 2006 Boston Meetings Paper Available at SSRN: http://ssrn.com/abstract=672624 Nguyen H., Faff R. (2006). Foreign debt and financial hedging: Evidence from Australia. International Review of Economics and Finance. Vol. 15, Pp 184-201. http://www.bsu.edu/classes/rrathina/course/unit3_7.htm Vodafone Group Plc Annual Report for the year ended 31 March 2006. Read More