F5: International capital markets and capital issues Flashcards
What are costs of financial distress?
The value of the firm can be expressed as: value of equity financed firm + PV(tax shield) - PV(financial distress)
1: legal and administrative fees (direct cost)
2: employees leaving the firm (indirect cost)
3: suppliers refusing credit (indirect cost)
4: suppliers refusing products (indirect cost)
5: increased scrutiny by investors (indirect cost)
What distinguishes bond holders and investors?
The above graph show us that bond holders are risk-averse and equity (investors) are more risk-neutral. This is because bond holders maximumly can receive the interests the firm has to pay on its loan and therefore bond holders are not interested in the firm takes on more risk after the point where it is capable of paying its interest payments.
Investors on the other hand essentially own a share of the company so there’s no ceiling on the profit they can make and therefore they’re more risk-neutral.
This is also why cost of debt is lower than cost of equity.
What is the link between cost of financial distress and internationalization?
Risk links to internationalization – more international firms carry more risk. Through the link of cost of financial distress we can expect the capital structure (the amount of debt a firm has) to depend on how international the firm is
What are the two counterbalancing effects of internationalization?
On one hand if a firm enters a distant market if will have difficulty understanding the market and selling its products, but at the same time when the market is very different the sales on the market may not be correlated with the sales on the home market and this results in a diversification benefit to reap
Under which circumstances will internationalization influence capital structure?
The link is through risk because the risk drives the probability of financial distress under trade-off theory and as a consequence higher risk should be associated with lower debt level
Among other things the relationship between capital structure and internationalization depends on the capital structure the firm had before it internationalized
Companies with a high debt-ratio prior to the internationalization will be dominated by financial risk
Companies with a low debt-ratio prior to the internationalization will be dominated by business risk
Explain the pecking order theory
The pecking order theory suggests that firms don’t just have a preference between equity and debt but also a preference internal and external sources of funds. Firms prefer internal funds over external funds The pecking order is: 1: Internal funds (retained earnings) 2: External debt (bank loans) 3: External equity (issuing stocks)
Why are bond markets more international than stock markets?
The most important reason for this is that the debt market requires less interpretation of information because the pay-off usually is fixed
It’s much more difficult to predict what the profit in the future is going to be than it is to understand what a 3% interest payment every year means.
So for investors it’s easier to understand a Spanish security, even if I don’t speak the language, than it is to determine the future profits of this Spanish firm, because much of the information will be in Spanish.
Why does liability of foreignness lead to a propensity to invest at home?
Liabilities of foreignness can be soft and hard
Soft: this can be unfamiliarity of the market or lack of legitimacy
Hard: this is regulation. There are different regulations in different countries. Firms issuing securities in two different countries have to comply with regulations in both countries
Mention the 4 broad groups of legal systems
1: English (US, UK, Canada)
2: French (France, Spain, Italy)
3: German (Germany, Austria)
4: Scandinavian (Denmark, Norway, Sweden)
If firms do want to cross-list shares or debt (raise money in another country than their home country) they should do it within the same cluster. Otherwise it will be difficult to comply with regulation.
What are the consequences of this home bias?
Investors do miss substantial amounts of risk diversification if they invest following the home bias (only invest a small part of their money abroad) and as a consequence investors will lose out because they take on more risk than they have to to achieve a given return.
If investors do prefer to invest domestically then by cross-listing into a foreign market the firm may benefit from more investor attention in other countries.
i.e. if BMW issues securities in Japan the attention to BMW will increase and it could lead to higher sales for BMW. There will be a spill-over into the product market.
Why would a company cross-list shares?
The pecking order theory says that raising equity is the last resort but if there’s not enough funding available through internal funding or debt, then firms will need to increase their equity to finance projects and so on.
It could also lead to a higher stock price. Stocks listed in a foreign exchange will be subject to local fluctuations of the market but by cross-listing the total fluctuations of the stock can be reduced
What are the costs of cross-listing?
Issue costs: prospectus and due diligence and up to 5 years of financial statements have to be re-evaluated (IFRS, US GAAP, etc.)
Recurrent costs: the firm has to prepare 2 or more versions of the accounts (IFRS and US GAAP) and listing fees
Liquidity is split: liquidity is now split between markets and bid-ask spreads will increase
How can cross-listing diversify local risks?
Shares in a market have a joint behavior e.g. against other asset classes (bonds, real estate, commodities, etc.): If a common factor affects all companies in Spain then a Spanish company cross-listing into the US will be affected less than if it was 100% Spanish listed and cross-listing thereby diversify local risks.
Natural hedge: If a firm plans to spend a lot of money in Russia it makes sense to raise money is Russia too because this creates a natural hedge. This is when there is no exchange rate exposure between the countries where capital is raised and the capital is spent. Therefore, risk is reduces because the FX risk is removed.
Analyst-coverage: By being present in several markets analyst-attention can increase and this can lead to more independence from the aforementioned factor (in Spain) because more analyst-coverage will translate into more company specific information being available to investors.
What are the signalling effects of cross-listing?
- If a company is ready to pay for a costly signal (cross-listing) it signals that the company if really committed to doing it.
- The company can signal that it is prepared to comply with more rigorous regulation (maybe in the US) than it is subjugated to at home (maybe Brazil)
- Listing in a foreign market is also a sign of confidence (particularly in the likes of LSE, NYSE, NASDAQ). The firm sends a signal that even though it will have to pay extra costs and have its liquidity split it is confident that over the long run performance will be good enough to make up for these losses.
- If cross-listing goes to a larger market, exposure to more potential buyers ensues and the stock price can increase from this
