Foreign Currency Debt at Vodafone Group - Case Study Example

Foreign Currency Debt at Vodafone Group plc Table of Contents Table of Contents ii Introduction Question Why Companies Borrow in Foreign Currency 1 Tax Shields 3 Hedging Exchange and Interest Risks 3 Conflicts of Interest and Dividend Policy 3 Inefficient Legal Systems and Other Factors 4 Question 2: Analysing the 2006 Annual Report of Vodafone Group plc 4 Hedging against Interest and Currency Risks 4 Tax Shields and Dividend Policy 5 Conclusion 6 Reference List 7 List of Figures 10 Figure 1: Major Outstanding Foreign Currency Debt of Vodafone Group plc 11 Figure 2: Performance of Vodafone stock compared to FTSE Indices 12 Introduction This paper uses recent research to explain why companies raise debt in foreign currencies and looks at the latest annual report of Vodafone Group plc to analyse the extent that its foreign debt exposure explains the firm's financial structure. Vodafone started in 1984 as a supplier of military electronics equipment. Through a series of business deals financed by debt and cash flow, Vodafone has become the market leader in the U.K. and is the world's 66th largest corporation on turnover of 29.4 billion, assets of 127 billion, total net debt of 17.3 billion, and stockholders' equity of 85.4 billion, making it the largest telecoms company in the world with over 170 million customers in six continents (Vodafone, 2006, p. 2-3; Lustgarten, 2006, p. F-22). Question 1: Why Companies Borrow in Foreign Currency Answering this question requires a brief review of the important concepts of shareholder value and how changes in interest and currency rates affect it. The aim of management is to give investors the highest possible return on their investment (Jensen and Meckling, 1976). A common strategy is to bring up the stock price if the company, like Vodafone, is listed. Since stock price is based on net present value of all future cash flows of the company, and cash flow depends on profits, the price goes up if profits go up. Profits go up if turnover increases or expenses go down, or both. The stock price reflects the value of the company, so an increase in the price results in the growth of the stock's value to its shareholders. This is known as shareholder value. The growth in shareholder value and the increase in the stock price depend on the growth of profits, which in turn depends on how well the management raises turnover or controls costs. Since Vodafone does business all over the world, it earns and spends money in different currencies. This exposes it to several risks that can bring down revenues or bring up expenses: political, market, interest, or currency risks. Each risk can affect the firm's finances. Political risk can lead to changing firm ownership and loss of investment and value, as when government takes over the firm. Market risk can collapse the stock price and shareholder value when investors lose confidence in the stock market. Interest risk can raise expenses if interest rates on the firm's debts go up; financial income can also decrease if interest rates go down. Currency risk can raise (or bring down) expenses or sales if exchange rates change: if the home currency (sterling) weakens relative to the host (or foreign) currency (dollar), dollar loans would be more expensive and increase expenses in sterling. Of these four types of risk, the last two - interest and currency risks - can be minimised by using foreign currency debt (Allayannis et al., 2001; Keloharju et al., 2001). How does this happen If a firm is well-managed, its assets produce a stream cash flow that goes to shareholders if the firm is financed entirely by common stock. But if it issues debt securities, which is borrowing money from lenders, the firm would divide the cash flows between holders of debt and the stockholders or holders of equity securities. The firm's mix of securities is known as its capital structure. Since the most important task of managers is to maximise the firm's market value, is there a combination of debt and equity securities that would achieve this in the best possible way Modigliani and Miller (1958) and Stiglitz (1974) answered this capital structure problem by proposing that in a perfect capital market, such financing decisions (debt or equity) do not matter. They argued that a firm's value depends on how much cash it gets from its assets and not on how it splits cash flows between debt and equity. Thus, capital structure is irrelevant as long as the firm's investment decisions are made independent of financing decisions. However, capital markets are not perfect. There are imperfections such as taxes, the cost of bankruptcy, legal system inefficiencies, conflicts of interest between owners and managers and between holders of debt and equity, and exchange rates that change because of sociological, psychological, economic, and technological factors. Investment and financing decisions cannot be totally separated (Shleifer et al., 1997; Shiller, 2000), so capital structure and debt policy do matter. Tax Shields Velez-Pareja (2003) found that tax savings had an effect on the weighted average cost of capital (WACC) of a company with foreign currency debt, contrary to the findings of Kedia and Mozumdar (2003). Other firms may borrow funds in a country where interest payments are deductible to finance dividend payments where it is non-taxable. Hedging Exchange and Interest Risks Most studies cited (Judge et al., 2005; Elliott et al., 2003; Kedia et al., 2003) showed the hedging benefits of foreign currency debt because of market liquidity, information asymmetries, and enforcement of creditor rights. Similar findings in Denmark (Aabo, 2005) and Brazil (Rossi, 2005) showed evidence of hedging by the use of derivatives or foreign currency debt in a floating exchange rate regime to protect against volatility. Conflicts of Interest and Dividend Policy There is conflict of interest between manager-agents and owner-principals (Jensen and Murphy, 2004). One area of conflict is where managers borrow funds for projects or to reward themselves instead of raising funds from equity. Managers may borrow in foreign currencies to buy back shares or pay dividends. Debt may also be used to force a company's management to improve efficiency in operations because it is an obligation (Wruck, 1995). Inefficient Legal Systems and Other Factors Companies take advantage of legal systems to gain protection from creditors using bankruptcy laws, and the amount of foreign debt depends on the value of assets, firm size, and debt ratios (Allayannis et al. 2003/2005; Doukas et al., 2001). Question 2: Analysing the 2006 Annual Report of Vodafone Group plc The second part of this paper analyses the latest annual report of Vodafone Group plc (VOD) to see which of the above reasons for taking on foreign currency debt explains the firm's financial structure. As of the reporting year ended 31 March 2006 (p. 41), VOD's stockholders equity was 86.9 billion and its total debt was 20.1 billion for a debt-to-equity ratio of 0.23. Net debt was 17.3 billion after taking out cash and cash equivalents. The company has Free Cash Flow of 6.4 billion a year. Which factors discussed above explain the firm's capital structure Hedging against Interest and Currency Risks In line with VOD's policy to maintain the currency of debt and interest charges in proportion with expected future principal multi-currency cashflows, 113% of its net debt is denominated in currencies other than sterling: 73% Euro, 21% Yen, 14% US Dollar, and 5% other currencies whilst 13% of net debt is in purchased forward in sterling in anticipation of sterling denominated shareholder returns via share purchases, dividends, and share distribution (p. 41). If the value of sterling weakens against certain currencies in which VOD has foreign debt, this would result in increase in net debt from currency translation differences. However, if sterling strengthens against all exchange rates, which happened in the past year, operating profit would increase. This is good for VOD shareholders. As VOD generates revenues in several markets, dominated by the U.S. and Europe, it would be able to fund these foreign debt exposures using the host currency, as shown in Figure 1. The report (p. 2-3) shows that the U.S. and the U.K. are the firm's most profitable markets and have a growing and cash-generating customer base. Vodafone is listed on the London Stock Exchange and its stock price in sterling represents the value of its future multi-currency cash flows. The firm is therefore able to hedge external foreign exchange risks on transactions denominated in other currencies if it maintains the currency of debt and interest charges in proportion with expected future cash flows. This provides a partial hedge against income statement translation exposure as interest costs will be denominated in foreign currencies. Tax Shields and Dividend Policy Tax shields can help a firm generate additional cash and profits. Debt financing is a tax-deductible expense in most countries whilst dividends and retained earnings are not. Therefore, firms with debts in these countries enjoy a tax shield, which results in reducing taxable income and that result in a constant annual cash flow. This is one main reason why Vodafone takes on foreign currency debt. Dividends are non-taxable in the U.K., which explains the increase (49%) of its dividends payout to 3.7 billion for the financial year (p. 2 and p.144). VOD issued during the year a total of $5.95 billion U.S. Shelf medium- and long-term bonds (p. 41). This is slightly higher than 3 billion and may have been used by management to fund the dividends paid out to shareholders. VOD uses long- and short-term debt to meet anticipated funding requirements and has in place three debt protection ratios that establish levels of debt the firm should not exceed (p. 41). Based on these, VOD reported (p. 11) it had decided to continue increasing the dividend payout ratio to 60% in the coming years to improve shareholder returns, and to support its business strategy the firm is planning to increase the level of gearing. This means it would tap foreign currency debt markets such as the U.S. and the Eurozone where interest payments are tax deductible and take advantage of free cash flow from the benefits provided by tax shields to increase its dividend payouts. VOD admits that increasing its gearing would lower its credit rating and increase the level of its interest payments (p. 40) but, overall, it thinks that this would be better for shareholders who would continue getting annual dividends. Why VOD puts much priority to pay dividends is evident in a graph of its Total Shareholder Return Performance (see Figure 2) which is below that of its FTSE industry and equity market peers. Perhaps, if management fails to pay dividends, their jobs would be threatened. They are fortunate that foreign debt markets allow them to do this by giving them the cash they need to fund their operations. Access to London, the world's financial capital, is certainly an advantage for Vodafone because it can raise funds in foreign currencies where it does business. Conclusion There are several reasons why a firm would borrow in a foreign currency. An analyses of the latest annual report of Vodafone Group plc, a U.K.-based firm that is the world's market leader in mobile telecommunications, show that the firm's predominantly foreign currency debt (113% of net debt!) amounting to some 23% of its shareholder equity is being used to fund operations in several countries. Foreign currency debt helps Vodafone to hedge against interest and currency risks. It also helps the company generate cash flow by taking advantage of tax shields from the tax deductibility of interest payments. Lastly, its foreign debt helps increase shareholder value by allowing the company to increase dividend payouts to shareholders, taking advantage of the fact that dividends are not taxable. Due to advantages from its foreign currency debt, Vodafone plans to increase future gearing for the same reasons as it continues growing even bigger and improving its profitability. Reference List Aabo, T. (2005). The importance of corporate foreign debt as an alternative to currency derivatives in actual management of exchange rate exposures. Aarhus School of Business Working Paper, Version of February 7, 2005. Aarhus: ASB. Allayannis, G. and Ofek, E. (2001). Exchange rate exposure, hedging, and the use of foreign exchange derivatives. Journal of International Money and Finance, 20, p. 273-296. Allayannis, G., Brown, G.W. and Klapper, L. (2003). Capital structure and financial risk: Evidence from foreign debt use in East Asia. Journal of Finance, 58 (6), p. 2667-2709. Allayannis, G., Brown, G.W. and Klapper, L.F. (2005). Legal effectiveness and external capital: The role of foreign debt. World Bank Policy Research Working Paper WPS 3530 (March 2005). Washington: World Bank. Doukas, J.A., Hall, P.H. and Lang, L.H.P. (2001). Exchange rate exposure at the firm and industry level. (June 2001). Accessed on 15 February 2007 at SSRN: http://ssrn.com/abstract=291684 or DOI:10.2139/ssrn.291684. Elliott, W.B., Huffman, S.P. and Makar, S.D. (2003). Foreign-denominated debt and foreign currency derivatives: complements or substitutes in hedging foreign currency risk Journal of Multinational Financial Management, 13, p. 123-139. Jensen, M.C. and Meckling, W.H. (1976). Theory of the firm: Managerial behaviour, agency costs and ownership structure. Journal of Financial Economics, 3, p. 305-360. Jensen, M.C. and Murphy, K.J. (2004). Remuneration: Where we've been, how we got to here, what are the problems, and how to fix them. Finance Working Paper No. 44/2004: European Corporate Governance Institute (July 2004). Judge, A.P., Clark, E. and Namata, F. (2005). The fixed-floating interest rate profile and foreign currency debt mix of UK non-financial firms: An empirical analysis. Discussion Paper. Middlesex University Business School. Kedia, S. and Mozumdar, A. (2003). Foreign currency-denominated debt: An empirical examination. Journal of Business, 76, p. 521-546. Keloharju, M. and Niskanen, M. (2001). Why do firms raise foreign currency denominated debt Evidence from Finland. European Financial Management, 7 (4), p. 481-196. Lustgarten, A. (2006, July 24). The Fortune Global 500. Fortune Magazine, 154 (2), 65-70 (Tables on F-1 to F-45). Modigliani, F. and Miller, M.H. (1958). The cost of capital, corporation finance and the theory of investment. American Economic Review, 48 (6), p. 261-297. Rossi, J.L. Jr. (2005). Corporate foreign vulnerability, financial policies and the exchange rate regime: Evidence from Brazil. Working Paper, Yale School of Management. Shiller, R. (2000). Irrational Exuberance. New Jersey: Princeton. Shleifer, A. and Vishny, R. (1997). Limits of arbitrage. Journal of Finance, 52, p. 35-55. Stiglitz, J.E. (1974). On the irrelevance of corporate financial policy. American Economic Review, 64 (12), p. 851-866. Velez-Pareja, I. (2003). The use of capital cash flow and an alternate formulation for WACC with foreign currency debt. Politcnico Grancolombiano Working Paper (May 2, 2003). Bogot: Colombia. Vodafone (2006). Expanding the power of mobile communication: Annual report for the year ended 31 March 2006. Newbury: Vodafone Group plc. Wruck, K.H. (1995). Financial policy as a catalyst for organizational change: Sealed Air's leveraged special dividend. Journal of Applied Corporate Finance, 7 (Winter), p. 20-37. List of Figures Figure 1: Major Outstanding Foreign Currency Debt of Vodafone Group plc Figure 2: Performance of Vodafone stock compared to FTSE Indices Figure 1: Major Outstanding Foreign Currency Debt of Vodafone Group plc (Source: Vodafone, 2006, p. 41) Figure 2: Performance of Vodafone stock compared to FTSE Indices (Source: Vodafone, 2006, p. 64) Read More