International Financial Strategy of a Company - Essay Example

? International Financial Strategy Table of Contents Table of Contents 2 Answer1 3 Reasons for which a company cross lists itself 3 Benefits associated with cross listing 5 Costs associated with cross listing 6 Answer 2 7 Identification and explanation of sources of long term finance 7 Identification of the possible rationale for the particular capital structure 9 Calculation of the cost of capital 10 Answer 3 11 Demonstration of the impact of exchange rate volatility 11 Explanation of the mechanism of the money market hedge and forward market hedge 12 Hedging using money market hedge and forward contract 13 Reference List 15 Appendix 17 Answer1 Any company that has operational base in various foreign lands or have trading relationship with companies from foreign lands is faced with lot of difficulties. The difficulties range from transactional risk, translational risk and other risk (Benner and Sandstrom, 2012). These risks are associated with the ups and downs of the business. Thus it is absolutely important that the companies take precautionary measures to minimize the risks (Bonaccorsi and Daraio, 2009). The present research study elucidates the benefits and costs and advantages that a company can enjoy if it is listed in more than one exchange. British Petroleum is used as an example to show how it finances its long term capital needs. Apart from that effort is also made to present the transaction risk faced by the company. Reasons for which a company cross lists itself A multinational company is spread all across the globe. Due to this reason such a company is involved in multiple numbers of trading relationships across multiple time zones and more importantly in multiple currencies. The company must be listed on the domestic exchange apart from the other foreign exchanges (Chiefele, 2012). The domestic exchange most of the time performs the job for currency exchange. If the operational base of the company is spread in more than 5 to 6 different international countries, then using the domestic exchange as the basis for all transactional requirements becomes complex and cumbersome (Garrick, 2011). The transactions which are settled in different foreign currencies may have different consequences on the company if they are settled through a foreign exchange rather than a domestic exchange. For example the exchange rate between two different currencies can be slightly different between a foreign exchange and a domestic exchange. Multinational companies can use this price difference for their own advantages. The difference in price is due to the information asymmetry. The financial system is connected by very complex network where any new information generated at one corner gets dispersed to other corners easily (Gulbrandsen and Smeby, 2008). The stock exchanges around the world are connected by vast system of networks. The networks carry large amount of information in a matter of seconds. Thus any lag in information between two time zones is almost negligible. Still the negligible difference when multiplied by transactions worth billions of dollars the resultant is completely different (Hakim, 2010). This entails the arbitraging concept. This kind of arbitraging has been reduced significantly due to superfast information dissemination and sharing. Despite that there are many deficiencies in the systems which are sometimes misused by multinational companies. One of the most important reasons for cross-listing is reducing the cost of equity. Finding sources of finance is a matter of perennial concern for any company. The difficulty becomes multiplied if it is a multinational company. If the multinational company is listed in a more than one exchanges then the probability of raising the capital increases. The company can use various modes of financing both debt and equity. Thus the dependency on one economy or the modes of finance decreases considerably. This in turn eases the rate of return that a company has to offer to the investors to raise the capital (Harvey, Smith and Wilkinson, 2007). This is because of the reason that with the higher need for capital and with fewer interested investors, a company has to offer higher rate of return to induce more investors. Thus cross listing helps the companies to raise the capital from more number of investors thus reducing the dependency on few investors from few selected economies. The studies indicate that an increasing number of companies are resorting to cross listing now because of access to larger number of investors. Besides reduced cost of equity a multinational company also enjoys declined cost of transaction (Lindheim and Swartout, 2003). The decreased cost of transaction helps the companies to reduce the cost of raising the capital. Most of the time the investors are wary that the particular company in which that are investing does not have strong line of credit. Even if the company does have a good line of credit the lack of information limits the ability of the investor to judge the company properly. Benefits associated with cross listing The benefits of cross listing are the increased ability to raise the capital. This is one of the most important benefits. The presence in more than one exchange helps in the spreading of information among the foreign investors. Studies have shown that the foreign companies which have listed their shares on the US exchange as well as the exchanges of other countries continue to have higher market valuation. The sustenance of the market valuation is a very important factor for a company to attract more and more investors (Mallon and Webb, 2006). If the market value is kept sustained for a considerable amount of time then the company can attract more and more investors. This is another benefit of cross listing. The cross listing also helps to increase the premium. Studies indicate that the premium for the stocks that are listed on foreign exchange are significantly more than the premium of the stocks listed on the domestic exchange. The cross listings are beneficial particularly for those companies which are growing faster than the industry average. The premium was found to be significantly more for these types of companies. Cross listing has special significance for those companies which are growing faster and at same time they belong from those countries which have poor financial institutions (Meyer, 2011). The cross listings are beneficial particularly for those companies which belong from the developing countries. Cross listings has a direct correlation with the private benefits. The firms which are listed on the foreign exchanges have different kind of private benefits. The private benefits indicate the amount of benefits enjoyed by the firm itself or which is utilised for the business purposes. The firms which are cross listed have lower private benefits. The firms which are listed only in the domestic exchange have higher amount of private benefits. Cross listing has got positive correlation with access to equity capitals also. Studies have indicated that after a firm gets cross listed it can increase the issue of the equity. The comparison of the firms who issued security before two years of listing and after two years of listing shows that there is almost 84% rise in the issue of equities after cross listing (Miles, 2006). This indicates that the firms which are listed on more than one exchange have larger access to equity capital. There are also other types of advantages like the increased stock price reaction. The stock price reaction is the reaction exhibited by the shareholders after getting access to some critical information like getting cross listed. There is a positive correlation in the stock price reaction and cross listing. The increased stock price reaction indicates that the investor’s reaction to the stock is unanticipated. For example when a company gets cross listed then the investors start buying more number of stocks of that particular company. There are positive abnormal returns following the announcements of cross listing. The abnormal return takes the investors by surprise. The investors start buying more number of stocks of that particular company due to announcement of abnormal returns on stock (Mintzberg and Waters, 2009). Cross listings and shareholder protection has got a positive correlation. Studies indicate that on an average basis the number of firms of those countries which provides weak shareholder protection cross lists in those exchanges where there is increased shareholder protection. Costs associated with cross listing If there are advantages associated with cross listings, there are costs and disadvantages too. Before getting cross listed in any exchange, the company has to make sure that the disclosures are done accordingly. The disclosures need to be done in accordance to the rules and regulation of the country where it wants to list its name. The requirement of proper disclosures involves stringent test by the auditors (Moessinger, 2007). This involves a significant amount of cost. The exchanges have devised various kind of listing categories. If a company decides to list itself in the premium listings category then it has to comply with stringent exchange standards. Some of the stringent requirements are ability to raise a minimum capitalisation maintaining complete transparency in its accounting standards. Apart from that the company must satisfy the standards and requirements as asked by the regulators. The regulators demand that the financial statements be prepared in line with the standards and principals as mandated by the accounting authority (Morgan and Linda, 2005). Apart from these the company has to make sure that the arrangements are made so that the trades and transactions are cleared and settled in the foreign country where the company want to get listed. Answer 2 In this particular section the various types of long term sources used by British Petroleum are identified and explained. In order to identify and explain the different types of long term finance used by British Petroleum the annual reports for the last four to five years are scrutinized. Identification and explanation of sources of long term finance The various types of the long term finances used by British Petroleum are shares, debentures, public deposits, retained earnings, term loans from banks, loans from financial institutions. The types of long term financing used are dependent upon the need of the business. The analysis of the financial reports indicate that the term loans from banks and loans from financial institutions figure is present in almost every year . Among five years starting from 2008 to 2013, term loans were used in significant amount in 2008. British Petroleum was on the verge of massive expansion during the period 2007 to 2011. The significant presences of the term loans indicate that the company was trying to meet the short demands of capital during these periods. BP insisted on equity and preference shares in order to finance its operations. The reliance on equity financing started declining from 2010 onwards. Fig 1: Balance sheet obligations Source: (Chiefele, 2012) The above diagram gives an indication of the various long term sources of finance used by British Petroleum. The long terms sources of finance are denoted by obligations in this diagram. There are as such two type of obligation. One is the balance sheet obligation and the other one is off balance sheet obligations. The total borrowings are highest in 2011. The borrowings decreased substantially in the year 2013, which is projected to decrease even further from 2014 onwards. The bond issuance totalled to $11 billion in year 2012. The bonds were issued in capital markets of Australia, USA and Europe. Apart from the issuance of bond and equities, BP raises capital from systematic divestment. BP (British Petroleum) sold its 50% share in TNK-BP to Rosneft. This allowed BP gain considerable financial flexibility. During 2011 BP took a total amount of $6.8 billion in the form of loan from 23 international banking counterparties under the agreement that the loan will be paid with a matter of 3 years. Apart from bonds and loans from banks and financial institutions, BP also uses a significant amount of equity as a long term source of finance (Mott, Callaway and Zettlemoyer, 2005). This is evident from the fact that the company is aiming to maintain a progressive dividend policy. Identification of the possible rationale for the particular capital structure British Petroleum had massive plans for expansion in 2009. The oil spill disaster derailed the plans for expansion. The company relied heavily on bonds, debentures and loans but the Gulf Oil Disaster made it quite difficult for the company to access bonds and debenture market. Thus the company had to resort to equity financing. This is exactly the reason why the company declared to pay dividends to the equity holders. Until before that the company used to finance a significant part of the operations from the retained earnings. The company maintained a more or less good balance between the long term and short term sources of finance (Norum, 2013). The operating activities would be sometimes financed using the long term sources of finance. While in other times only short term sources of finance would be used. The shares were mostly of equity types. This is the reason the company withheld from dividend to the shareholders for a significantly long period (Ohmae, 2009). As the equity holders enjoys less privilege in comparison to the preference share holder, so the company kept on deferring the dividend payments. Calculation of the cost of capital There are two different forms of finding out the cost of capital. One is the non weighed cost of capital and the other one is the weighed cost of capital. Since British Petroleum uses at least more than two different sources of finance so the weighed cost of capital is calculated here. The market value debt ratio is the ratio of the market value of the debt to the market value of the firm (Payne and Siow, 2008). The market value debt ratio is used to calculate the after tax cost of debt. This is because after tax of debt is fund out by multiplying the market value debt ration with after tax cost of debt. Market value debt ratio 6.29%     Cost of debt 8.50%     Cost of equity 12.75%     Tax rate 30%                   Weighted     Weights Costs         After-tax cost of debt 5.95% 6.29% 0.37% Cost of equity 12.75% 93.71% 11.95% WACC     12.32% (Source: Author’s Creation) The formulae for calculating the weighted average cost of capital is Source: (Salerno, 2006) Rd = cost of debt Re = cost of equity D = market value of the firm's debt E = market value of the firm's equity E/V = percentage of financing that is equity V = E + D Tc = corporate tax rate D/V = percentage of financing that is debt Source: (Whitworth and Christopher, 2008) The cost of debt is calculated by applying weighted cost of capital. Since there are 3 different kinds of debt, which are debentures/bonds, bank loans and term loans. By weighting the different types of debts the cost of debt is found out. The weighted cost of capital is found to be 12.32%. Answer 3 Demonstration of the impact of exchange rate volatility BP manages various kinds of currency exposures by economic value of the foreign currency at risk. Through this mechanism the company aims to risk of the foreign currency value below $250 million. As of 31 December 2012, to value of the foreign currency at risk was $91 million which was again $110 million in 2010. Through constant monitoring of the risk the company never allowed the risk limit to exceed the maximum allowed risk limit. BP locked in the probable forecast capital expenditures in US dollar cost of the non-US dollar using the currency forward and futures. The main exposure was sterling euro and by the end of December 2012 open contracts were in place which has a total worth of $853 million sterling. When it comes to hedging for UK operational requirements cylinders and currency forward are used by the company. The exposures are hedge on a rolling basis for 12 months. At 31 December 2012, the open positions connecting to cylinders were made up of receive sterling, pay US dollar, call purchased and put options sold (cylinders) for $2,876 million ($2,783 million 2011). Explanation of the mechanism of the money market hedge and forward market hedge Money market hedge The money market hedge instruments enable the user to hedge the position by exchanging at the current spot rate. This is done by borrowing or depositing the foreign currency until the actual commercial transfer for the cash flows take place (Chiefele, 2012). As the forward exchange rate is deduced from the spot rates and interest rate of the money market, the result from performing hedging operations will be more or less the same from both the operations. There are two different mechanisms of money market hedge. One is the hedging a future payment and the other one is the hedging a receipt. Forward market hedge The forward market hedging is the most frequently used method of hedging. The demand for each particular currency influences the depth as well as the existence of the forward market. There are various types of forward contract like the option dated forwards and the synthetic forwards. The forward contracts must be completed on the due date as this is mentioned so in the contractual commitment. This indicates when expense from the abroad client is behind, say, the company unloading the payment and wish to exchange it using its forward exchange contract faces problem (Hakim, 2010). The present forward exchange contract must be cleared; even then the bank will organize a new forward exchange contract for the new date when the currency cash flow is due. Hedging using money market hedge and forward contract Money market hedge Borrow for 1 year in the U.K. in BPs @ 10%, with a ?11m payoff, BPs converted to USDs at the spot rate and invested invest in the US @ 7.10%, and ?11m which is receivable from another subsidiary of British petroleum in another country is used in one year in order to pay for the BP loan in U.K. After those USDs is kept received from the payoff in the U.S. money market. Steps: 1. Borrow in UK: ?11m / 1.09 = ?9,174,312 today for one year @ 10%, pay back ?11m in one year 2. Convert the pounds into dollars today @S=$2.50/BP, for $23185780 (?9,274,312 x $2.50/?) 3. Invest $23185780 in the U.S. @ 7.1% 4. Collect ?11m in one year from another subsidiary of British petroleum in UK and pay off the loan in U.K. (pay back ?11m) 5. Receive the dollar proceeds of the investment in U.S. of $25114892.58 ($23185780x 2.061) Forward contract hedge British Petroleum sells a 6X9 FRA, which has a NP of $400MM, and a contract rate which is 6.8% (3-mo. forward LIBOR). On the day when the transaction needs to be settled (6 months from now), 4 month spot LIBOR is 6.1%. There are 91 days in the contract period (9-6=3 months), and a year has 360 days. Five months from now the firm will receive [(400000000)(0.068-0.061)(91/360)]/[1+(0.061)(91/3600] = 706688.104 Reference List Benner, M. and Sandstrom, U., 2012. Institutionalizing the triple helix: research funding and norms in the academic system. Research Policy, 2(9), pp. 291–301. Bonaccorsi, A. and Daraio, C., 2009. Age effects in scientific productivity — the case of the Italian national research council (cnr). Scientometrics, 5(8), pp. 49–90. Chiefele, U., 2012. Interest, learning, and motivation. Educational Psychologist, 26(3), pp. 299-323. Garrick, G., 2011. 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Administrative Science Quarterly, 2(4), pp. 590-601. Mintzberg, H. and Waters, J. A., 2009. Of strategies, deliberate & emergent. In Strategic Management Journal, 6(1), pp. 258-272. Moessinger, P., 2007. Piaget on equilibration. Human Development, 21(4), pp. 255-267. Morgan, G. and Linda S., 2005. The case for qualitative research. Academy of Management Review, 4(5), pp. 491-500. Mott, B., Callaway, C. and Zettlemoyer, L., 2005. Towards narrative centered learning environments. In Proceedings of the 1999 AAAI Fall Symposium on Narrative Intelligence, 21(6), pp. 78-82. Norum, K. E., 2013. Appreciative design. Systems Research and Behavioural Science, 1(8), pp. 323-333. Ohmae, K., 2009. The mind of the strategist. McGraw-Hill Publishing: London. Payne, A. A. and Siow, A., 2008. Does Federal research funding increase university research output. Advances in Economic Analysis and Policy, 3(1), pp. 1–21. Salerno, C., 2006. Funding higher education. 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Appendix Tax rate 30% 30% 30% 30% 30% 30%               Debt in the capital structure 0% 10% 20% 30% 40% 50%               EBIT 120,000 140,000 220,000 250,000 300,000 350,000 Interest - 4,250 8,750 14,625 22,000 31,250 Profit before taxes 120,000 135,750 211,250 235,375 278,000 318,750 Taxes 36,000 40,725 63,375 70,613 83,400 95,625 Profit after taxes 84,000 95,025 147,875 164,763 194,600 223,125 Dividends 84,000 95,025 147,875 164,763 194,600 223,125               Total payments to security holders 84,000 99,275 156,625 179,388 216,600 254,375               Required return on debt 8.00% 8.50% 8.75% 9.75% 11.00% 12.50% Required return on equity 12.00% 12.75% 13.00% 13.50% 14.50% 16.00% Market value of debt - 50,000 100,000 150,000 200,000 250,000 Market value of equity 700,000 745,294 1,137,500 1,220,463 1,342,069 1,394,531 Market value of the firm 700,000 795,294 1,237,500 1,370,463 1,542,069 1,644,531               Book value of debt - 50,000 100,000 150,000 200,000 250,000 Book value of equity 500,000 450,000 400,000 350,000 300,000 250,000 Book value of the firm 500,000 500,000 500,000 500,000 500,000 500,000               Return on total capital 16.8% 19.6% 30.8% 35.0% 42.0% 49.0% Return on equity 16.8% 21.1% 37.0% 47.1% 64.9% 89.3%               Number of shares outstanding 5,000 4,686 4,596 4,453 4,352 4,240 Price per share 140.0 159.1 247.5 274.1 308.4 328.9 Earnings per share 16.80 20.28 32.18 37.00 44.72 52.63 Price-earnings ratio 8.33 7.84 7.69 7.41 6.90 6.25               Book value debt ratio 0.0% 10.0% 20.0% 30.0% 40.0% 50.0% Market value debt ratio 0.0% 6.3% 8.1% 10.9% 13.0% 15.2%               Weighted average cost of capital 12.0% 12.3% 12.4% 12.8% 13.6% 14.9% Free cash flow 84,000 98,000 154,000 175,000 210,000 245,000 Market value of the firm 700,000 795,294 1,237,500 1,370,463 1,542,069 1,644,531 Data from Exhibit 1                       Market value debt ratio 6.29% 8.08% 10.95%     Cost of debt 8.50% 8.75% 9.75%     Cost of equity 12.75% 13.00% 13.50%     Tax rate 30% 30% 30%                       Weighted         Weights Costs                 After-tax cost of debt 5.95% 6.29% 0.37% 0.02% 0.00% Cost of equity 12.75% 93.71% 11.95% 11.20% 1.34% WACC     12.32% 11.22% 1.34% Read More