ACCA P4 Advanced Financial Management - 2010 - Study text - Emile Woolf Publishing
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Chapter 17: Financial management and multinationals
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International and financial markets
International lending
International bond markets
International money markets
International equity
The World Bank
International Monetary Fund (IMF)
Systemic risk in the global financial system
Bank for International Settlements (BIS)
Raising capital in the world’s financial markets
4 International financial markets
4.1 International lending
The capital markets, as well as many markets for goods and services, are
international. Capital can be transferred freely between many countries, usually in
one of the major international currencies (particularly the US dollar, euro and
Japanese yen).
Large companies are able to obtain large syndicated bank loans in a major currency,
from syndicates of international banks.
4.2 International bond markets
Companies can raise debt finance by issuing bonds. There are domestic bond
markets in many countries, but these markets are often dominated by domestic
government bonds. For example, in the UK the domestic bond markets are
dominated by the market for UK government bonds (gilts). Some countries, notably
the US, have large domestic bond markets for corporate bonds.
International companies are able to obtain bond finance by issuing bonds:
in the international bond markets, or
in a domestic bond market such as the US.
The international bond markets are still often called the eurobond markets.
The main features of the international bond markets are as follows:
Governments, companies and other organisations are able to issue bonds in the
market, with the advice and assistance of financial institutions in several
countries.
Bonds can be denominated in any major currency, but the most commonly-used
currencies for the denomination of international bonds are US dollars and euros.
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The bonds are sold by banks in different countries to investment institutions in
different countries.
A second-hand market in the bonds is provided by some of the banks after the
issue has been made.
How do companies raise capital in the international bond markets?
The ability of companies to raise debt capital by issuing bonds varies between
countries as well as between different types of company.
It is much easier to issue bonds in the domestic US bond market than in other
countries. The UK, for example, has only a small sterling corporate bond market.
When there is a large domestic bond market, it is easier for smaller companies to
issue bonds, because investors in those markets are more willing to consider
investing in smaller companies. In the European bond markets, in contrast,
investors generally prefer to invest in bonds of large companies.
It is possible for foreign companies to issue bonds in a domestic bond market.
For example, foreign companies might be able to issue bonds in the US market.
However, foreign issuers need to be aware of the regulations in the bond
market, and they need to persuade investors in the market to buy their bonds.
Investors might be reluctant to buy bonds of foreign companies that they do not
recognise.
If you are asked in your examination about raising debt capital for a foreign
investment, you should consider the possibility of using a foreign subsidiary to
issue bonds in the country concerned. For example, it might be possible for a
company wanting to invest in China to issue bonds in the Chinese bond market.
Such a strategy might be possible, although this would depend on the size and
nature of the domestic bond market concerned and the amount of debt finance that
the company needs to obtain. You cannot be expected to know the current status of
bond markets in every financial centre in the world, but you should be aware in
general terms that a possibility of borrowing in other financial centres might exist.
(Bond issues are normally for large amounts of capital. Companies wanting smaller
amounts of debt capital are much more likely to try to obtain a bank loan.)
4.3 International money markets
The international money markets can be used to borrow short-term from banks in
foreign currencies. For example, companies can borrow US dollars short-term (up to
12 months or possibly longer) in London. There are several major international
money market centres around the world. The largest is London.
4.4 International equity
Investment institutions buy equity shares in countries throughout the world. Some
countries have larger and more liquid stock markets than others. Investment
institutions prefer to invest in stock markets that are properly regulated, and where
the market is ‘liquid’. (A liquid market for shares is a market in which shares can be
readily bought or sold at a price that is a fair market price. The fair price is usually
at or close to the most recent traded price for the shares).
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However, although investment institutions might invest internationally, most stock
exchanges are national. A company wishing to issue new shares (or to seek a
flotation for its shares, when it is coming to the stock market for the first time) will
issue them in a specific stock market, usually a domestic stock market in its own
country.
There have been some movements towards the creation of international stock
markets, but progress is slow. For example, the stock exchanges of Paris, Brussels
and Amsterdam and also the London-based LIFFE futures exchange, are now
combined within a single exchange organisation, Euronext.
4.5 The World Bank
The international capital and money markets are accessible for governments of
many countries and large companies. However, they are not accessible to
governments and companies in many developing countries or to governments of
under-developed countries.
However, unless under-developed countries and developing countries can improve
their infrastructure of transport and communication systems and standards of
education, foreign companies might be reluctant to invest in new capital projects.
Before companies invest large amounts of capital, governments therefore need to
invest heavily in their economic infrastructure
The difficulties of developing countries in gaining access to capital have been
recognised, and a role of the World Bank is to provide loan finance to countries in
need of capital. In practice, this means lending to developing countries, subject to
certain conditions (such as the requirement for the borrowing country to maintain
strict discipline over its economic policies).
The objective of the World Bank is to promote long-term economic development
and reduce poverty, by providing technical and financial support to help countries
reform particular sectors of their economy and implement specific projects such as
building schools, providing water and electricity and protecting the environment.
Financial support provided to countries by the World Bank is generally long-term,
and the World Bank obtains funding to provide this financial assistance:
from contributions by governments of wealthy countries, and
by issuing bonds in the international bond markets.
Even so, the funds provided by the World Bank are insufficient to meet the total
needs of developing and under-developed countries.
The World Bank consists mainly of two institutions:
the International Bank for Reconstruction and Development (IBRD)
the International Development Association (IDA).
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International Bank for Reconstruction and Development (IBRD)
The IBRD provides financial assistance to ‘middle income’ countries and
creditworthy poorer countries. This financial assistance is in the form of loans to pay
for projects that:
will reduce poverty and promote sustainable economic growth, and
private sector companies will not finance.
The IBRD obtains most of the finance for its loans from money raised through issues
of bonds by the World Bank. The loans are repayable.
International Development Association (IDA)
The IDA provides assistance to poorer countries in the form of interest-free loans
and grants (known as ‘credits’). Interest-free loans are repayable over a period of
about 35 – 40 years, often with a grace period of ten years during which no
repayments at all are made. Grants and loans are provided for projects relating to
health, education, infrastructure development and similar purposes.
Some examples of IDA projects in recent years are as follows:
In Nicaragua, finance was provided to restore a section of the Pan American
Highway, and other roads, after severe devastation by Hurricane Mitch.
In Bangladesh the IDA has provided finance for the building of a number of
secondary schools for girls.
In Vietnam, finance was provided to improve electricity supply.
4.6 The International Monetary Fund (IMF)
The International Monetary Fund (IMF) was established in 1944 as an international
organisation with member countries, whose purpose was to:
improve international monetary co-operation
promote exchange rate stability
foster economic growth, and
provide temporary financial assistance to countries with balance of payments
difficulties.
It has three main functions.
Surveillance. The IMF carries out regular in-depths appraisals of the economic
situation in each member country, and issues a report on its findings.
Providing temporary financial assistance to some countries.
Providing technical assistance to countries, for example on fiscal policy issues,
monetary policy, exchange rate policy and supervision and regulation of a
country’s financial system and markets.
Finance for the IMF comes from quota subscriptions by member countries, which
are denominated in Special Drawing Rights or SDRs. The maximum amount of
temporary financing that a company can obtain from the IMF is related to the size of
its quota subscriptions.
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4.7 Systemic risk in the global financial system
Systemic risk in the financial system refers to the risk that financial collapse in one
part of the system, such as the financial collapse of a large international bank or a
sharp fall in share prices in a major stock market, might have severe repercussions
throughout the world’s financial systems and lead to the collapse of other
institutions and markets.
Systemic risk has grown as the global economy has developed, because financial
institutions and markets are often very closely linked. International banks operate in
many countries of the world, and banks in different countries make financial
transactions with each other. Large investment institutions hold securities in many
different countries, and might therefore be vulnerable to a major collapse in share
prices in a foreign stock market.
The potential threat from systemic risk is recognised, and efforts have been made to
reduce risks globally in financial systems. The regulation of financial markets is
largely conducted at national level (or through EU Directives in the case of the
European Union). In banking, the prudential regulation of international banks is
based on rules developed by the Bank for International Settlements (BIS).
4.8 Bank for International Settlements (BIS)
The BIS is based in Basle in Switzerland and was established in 1930. Its aim is to
foster international monetary and financial co-operation, and its membership
consists of the central banks of many of the countries of the world. It also provides
financial services to assist central banks.
A committee of the BIS is the Basle Committee on Banking Supervision, which is a
forum for achieving co-operation on matters relating to the supervision of banks. In
1988, the Basle Committee produced a set of rules and guidelines for international
banks, known as the Basel Accord. (‘Basel’ is the German spelling of Basle, which is
a French spelling.)
The main purposes of the Basel Accord were to:
reduce systemic risk in the international banking system by requiring banks to
maintain a minimum amount of capital in relation to their credit risks
achieve a ‘level playing field’ in international banking, by preventing some
banks from competing over-aggressively by lending too much money with too
little capital.
The requirement for a minimum amount of capital in relation to credit risks meant
that banks would be much more secure financially. If a bank suffers large bad debt
losses on its lending, its capital should be sufficient to absorb the losses without
threatening the bank with financial collapse.
The Basel Accord did not have the force of law, but it was adopted by many
countries. Countries adopting the Basel rules monitor the financial position of
banks. In the UK for example the ‘prudential supervision’ of banks is the
responsibility of the financial markets regulator, the Financial Services Authority.
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The original Basel Accord required banks to have a minimum amount of capital to
cover credit risk. The rules were extended in 1996 to cover ‘market risks’ as well.
These are risks of losses by banks on their trading positions in the financial markets
– losses due to adverse movements in share prices, bond prices, interest rates,
currency exchange rates and commodity prices.
The Basel Accord is now being replaced in many countries by an ‘improved’ set of
capital adequacy rules for banks, known as Basel 2. Banks are required by the new
rules to maintain a minimum amount of capital to cover credit risks, market risks
and also more general operational risks. However, banks are allowed to use their
own internal computer models to calculate how much their minimum capital
requirement should be. (Another ‘pillar’ of the Basel 2 system is that banks should
be subject to supervision by a financial markets regulator or central bank.)
The Basel rules have reduced financial risks in the international banking system.
This also reduces risks for international companies that deal with banks in different
countries.
4.9 Raising capital in the world’s financial markets
Multinational companies might be able to raise capital in different financial markets
around the world, should they wish to do so. To be able to raise capital in any
financial market, a company must meet the legal, regulatory and compliance
requirements that apply in that particular market.
Legal requirements
There are certain legal requirements that must be met before a company can raise
capital from investors on a stock market. In the UK for example, companies cannot
raise capital from the general investing public unless they have the status of a public
limited company.
Regulatory requirements
There are also regulatory requirements that have to be met. These include
regulations relating to obtaining official permission to raise capital in the form of
shares or bonds, and issuing a prospectus to potential investors. Having obtained
approval from the regulatory authorities, the shares or bonds must be accepted for
trading by a stock exchange.
Compliance requirements
Having issued shares or bonds, the company must then continue to comply with
continuing obligations (rules) of the regulatory authorities and the stock market.
These include rules relating to the regular provision of information about the
company to the stock market (such as profit warnings and trading updates).
To meet the regulatory and compliance requirements for issuing shares or bonds on
a stock market, a company might have to commit considerable time and money. The
burden is greater for shares than for bonds. This is because bonds are often traded
‘privately’ between professional and institutional investors whereas shares are
traded much more on public stock markets.
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The process of raising capital by issuing shares in a stock market
Although the detailed rules vary between countries, the broad nature of the rules
for issuing shares in a stock market are fairly similar in most countries with a large
stock market. There is a two-stage process of acceptance before the shares can be
issued.
The company and its shares must be approved by a regulatory authority for the
country’s stock markets. In the UK, this involves getting the shares accepted on
to an ‘Official List’ by the Listing Authority, which is a department of the
financial markets regulator (the Financial Services Authority), or by a similar
listing authority in any other EEA country of Europe. Obtaining a listing for the
shares includes an approval process for a draft prospectus for the share issue.
Companies whose shares have been accepted on to the Official List are called
‘listed companies’. In the US, approval must be obtained from the US stock
markets regulator, the Securities and Exchange Commission or SEC.
The company must also apply to the country’s stock exchange for the shares to
be accepted for trading on the stock market operated by the exchange. In the UK,
for example, companies apply to the London Stock Exchange for the new shares
to be admitted to trading on the exchange. Similarly, in the US, a company might
apply for its shares to be traded on the New York Stock Exchange or NASDAQ.
When the shares have been issued and are trading on the stock market, the
company must comply with continuing regulations of both the financial markets
regulator and the stock exchange. In the UK for example, listed companies must
comply with the Listing Rules and the Disclosure and Transparency Rules of the
financial markets regulator, and must also comply with the Admission and
Disclosure Standards of the London Stock Exchange which require for example that
securities must be eligible for electronic settlement.
Some multinational companies obtain listings for their shares in two or more
countries. For example a company in Germany might obtain a listing in Germany
and its shares might be traded on the German stock market. In addition, the
company might obtain a listing for its shares in the USA or in the UK.
International companies might obtain a listing for their shares in a major
international stock market such as London, in addition to their own country. In
recent years, several major companies in countries such as Russia and Kazakhstan
have sought a listing in the UK. The advantage of a London listing for these
companies is that they gain access to global investment capital: it is much easier to
raise capital by issuing shares in the UK than in countries with financial markets
that are much less developed.
Raising capital by issuing bonds
In recent years, multinational companies have often preferred to raise capital by
issuing bonds rather than shares. Debt capital has been much cheaper than equity,
and institutional investors have been willing to invest in large quantities of bonds.
If a multinational company wants to raise capital in the international markets, it
might prefer to consider the possibility of issuing bonds in a national bond market
rather than consider the possibility of a share issue.
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Paper P4
Advanced Financial Management
Q&A
Practice questions
Contents
Page
The role and responsibilities of financial
managers
1 Corporate social responsibility 446
2 Corporate governance 446
3 Dividends and retentions 446
4 Financial plan 446
Capital investment appraisal
5 DCF exercises 448
6 DCF and tax 448
7 Free cash flow 449
Investing: portfolio theory and the CAPM
8 Two-asset portfolio 449
9 Risk and return 450
10 Coefficient of variation 450
11 Capital market line 451
12 Obtaining a beta factor 451
Cost of capital
13 WACC 452
14 Optimal WACC 452
15 Change in gearing 453
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16 Geared beta 453
Other aspects of capital expenditure appraisal
17 APV method 453
18 Adjusted present value 454
29 More APV 455
International investment and financing decisions
20 Cash flows from a foreign project 456
21 Foreign investment 456
Valuations. Mergers and acquisitions
22 Valuation 457
23 Valuation of bonds 457
24 Annuities and bond prices 458
25 EVA 458
26 MM, gearing and company valuation 458
27 Acquisition 459
28 Takeover 459
Foreign exchange risk and currency risk
management
29 Interest rate parity 461
30 Foreign exchange 459
31 Money market hedge 462
Interest rate risk. Hedging with FRAs and swaps
32 FRA 462
33 Swap 462
34 Credit arbitrage (1) 463
35 Credit arbitrage (2) 463
36 Currency swap 463
Futures and hedging with futures
37 Currency futures 464
38 More currency futures 465
39 Basis 465