8.2 Cross-border debt and equity financing
9 min read•august 19, 2024
allows companies to access global capital markets, offering diverse funding options and broader investor reach. This chapter explores the intricacies of international debt and equity financing, comparing their advantages and disadvantages.
The discussion covers international bond markets, depositary receipts, and stock exchanges. It also delves into accounting for cross-border transactions, tax implications, and regulatory considerations that shape global financing decisions.
Sources of cross-border financing
- Cross-border financing involves raising capital from investors in foreign countries, enabling companies to access a broader pool of funds and diversify their financing sources
- Firms can choose between debt and equity financing instruments when raising capital internationally, each with its own advantages and disadvantages
- The choice between debt and equity financing depends on factors such as the company's financial health, growth prospects, and the prevailing market conditions in the target country
Debt vs equity financing
Advantages of debt financing
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- Debt financing allows companies to raise capital without diluting ownership, as bondholders do not have voting rights or a claim on the company's profits
- Interest payments on debt are tax-deductible, reducing the company's overall tax liability and lowering the effective cost of borrowing
- Debt financing can be less expensive than equity financing, particularly when interest rates are low or the company has a strong credit rating
Disadvantages of debt financing
- Debt financing requires regular interest payments and principal repayment, which can strain a company's cash flow and increase financial risk during economic downturns
- High levels of debt can make a company more vulnerable to bankruptcy if it fails to meet its payment obligations
- Restrictive debt covenants may limit a company's flexibility in making strategic decisions or pursuing growth opportunities
Advantages of equity financing
- Equity financing does not require regular payments to investors, providing more flexibility in managing cash flow and reinvesting profits into the business
- Issuing shares can help improve a company's financial stability and creditworthiness, as it reduces the debt-to-equity ratio
- Equity investors share in the company's success through capital appreciation and potential dividend payments, aligning their interests with the company's long-term growth
Disadvantages of equity financing
- Issuing new shares dilutes the ownership stake of existing shareholders, potentially leading to a loss of control or reduced earnings per share
- Equity financing can be more expensive than debt financing, as investors demand a higher return to compensate for the increased risk
- Public companies face increased scrutiny, disclosure requirements, and regulatory compliance costs, which can be time-consuming and expensive
International bond markets
Types of international bonds
- are issued in a currency different from that of the country where they are issued and are typically sold to investors in multiple countries (e.g., a USD-denominated bond issued by a German company in the UK)
- are issued by a foreign entity in the domestic market of another country and are denominated in the domestic currency (e.g., , )
- Global bonds are issued simultaneously in multiple markets and currencies, targeting a broad base of international investors
Eurobond market characteristics
- Eurobonds are typically issued in bearer form, meaning they are not registered in the name of a specific owner and are easily transferable
- The Eurobond market is less regulated than domestic bond markets, with fewer disclosure requirements and lower issuance costs
- Eurobonds are often listed on the Luxembourg Stock Exchange or the London Stock Exchange, which have less stringent listing requirements compared to other major exchanges
Yankee bond market characteristics
- Yankee bonds are foreign bonds issued in the United States by non-U.S. entities and denominated in U.S. dollars
- Issuers must comply with U.S. securities regulations, including registration with the Securities and Exchange Commission (SEC) and ongoing disclosure requirements
- Yankee bonds are attractive to U.S. investors seeking exposure to foreign companies while mitigating currency risk
Samurai bond market characteristics
- Samurai bonds are yen-denominated bonds issued in Japan by foreign entities
- Issuers must comply with Japanese securities regulations and disclosure requirements, which are generally more stringent than those in the Eurobond market
- Samurai bonds are attractive to Japanese investors seeking to diversify their portfolios with foreign investments while avoiding currency risk
Depositary receipts for equity financing
American Depositary Receipts (ADRs)
- ADRs are negotiable securities representing ownership of a specified number of shares in a foreign company, issued by a U.S. depositary bank and traded on U.S. stock exchanges
- ADRs are denominated in U.S. dollars and pay dividends in U.S. dollars, making it easier for U.S. investors to invest in foreign companies
- There are three levels of ADRs, each with different disclosure and reporting requirements:
- Level I: Traded over-the-counter, with minimal SEC registration and reporting requirements
- Level II: Listed on a U.S. stock exchange, requiring full SEC registration and compliance with U.S.
- Level III: Involves raising new capital through a public offering, with the most stringent SEC requirements
Global Depositary Receipts (GDRs)
- GDRs are similar to ADRs but are issued by international depositary banks and traded on stock exchanges outside the U.S., typically in Europe (e.g., London Stock Exchange)
- GDRs allow companies to raise capital from a broader base of international investors and can be denominated in various currencies
- GDRs are subject to the disclosure and reporting requirements of the stock exchange where they are listed
Sponsored vs unsponsored programs
- Sponsored depositary receipt programs are initiated by the foreign company, which works with a depositary bank to establish the program and comply with regulatory requirements
- Unsponsored programs are set up by depositary banks without the involvement of the foreign company, often in response to investor demand
- Sponsored programs generally have better liquidity, transparency, and investor relations support compared to unsponsored programs
International stock exchanges
Major stock exchanges worldwide
- New York Stock Exchange (NYSE) and NASDAQ in the United States
- London Stock Exchange (LSE) in the United Kingdom
- Tokyo Stock Exchange (TSE) in Japan
- Hong Kong Stock Exchange (HKEX) in Hong Kong
- Euronext, a pan-European exchange with markets in Amsterdam, Brussels, Dublin, Lisbon, London, Oslo, and Paris
Cross-listing on foreign exchanges
- Cross-listing involves listing a company's shares on one or more foreign stock exchanges in addition to its home exchange
- Companies can cross-list through direct listing, depositary receipts (e.g., ADRs, GDRs), or dual listing (i.e., meeting the full requirements of both exchanges)
- Cross-listing can be attractive for companies seeking to expand their investor base, increase liquidity, and raise their international profile
Benefits of cross-listing
- Access to a larger pool of investors, potentially leading to higher demand for the company's shares and improved liquidity
- Enhanced visibility and credibility in foreign markets, which can support the company's international growth strategy
- Potential for lower cost of capital, as a larger investor base and increased liquidity may lead to higher valuation multiples
Challenges of cross-listing
- Compliance with multiple regulatory regimes, including different accounting standards, disclosure requirements, and corporate governance rules
- Increased costs associated with legal, accounting, and investor relations services to meet the requirements of multiple exchanges
- Potential for reduced managerial control, as the company may need to adapt its practices to meet the expectations of foreign investors and regulators
Accounting for cross-border transactions
Translation of foreign currency debt
- Companies with foreign currency-denominated debt must translate the debt into their functional currency for financial reporting purposes
- The translation method depends on whether the debt is considered a monetary or non-monetary item:
- Monetary items (e.g., bonds payable) are translated at the closing exchange rate on the balance sheet date
- Non-monetary items (e.g., debt with equity conversion features) are translated at the historical exchange rate prevailing when the debt was issued
- Foreign gains or losses on monetary items are recognized in the income statement, while those on non-monetary items are recorded in other comprehensive income
Translation of foreign currency equity
- Investments in foreign subsidiaries or associates are translated using the current rate method, where assets and liabilities are translated at the closing exchange rate and income statement items are translated at the average exchange rate for the period
- Translation adjustments arising from changes in exchange rates are recorded in the account within other comprehensive income
- Upon the sale or liquidation of a foreign investment, the CTA balance is reclassified to the income statement as part of the gain or loss on disposal
Hedging foreign currency exposure
- Companies can use various hedging strategies to manage their foreign currency risk exposure, such as:
- : Matching foreign currency revenues with expenses to create a self-hedging mechanism
- : Using derivatives like forward contracts, options, or swaps to offset potential foreign currency losses
- : Designating foreign currency debt or derivatives as a hedge of the net investment in a foreign subsidiary
- Hedge accounting allows companies to defer the recognition of gains or losses on hedging instruments until the hedged transaction occurs, minimizing volatility in the income statement
Tax implications of cross-border financing
Withholding taxes on interest and dividends
- Many countries impose withholding taxes on interest and dividend payments made to foreign investors, which can range from 0% to 30% or more
- The applicable rate depends on the domestic tax laws of the source country and any in place between the source and recipient countries
- Companies must consider the impact of withholding taxes when structuring cross-border financing arrangements, as they can significantly affect the overall cost of capital
Double taxation treaties
- Double taxation treaties are bilateral agreements between countries designed to prevent the double taxation of income and promote cross-border investment
- Treaties often reduce or eliminate withholding taxes on interest, dividends, and royalties paid between the contracting states
- Companies should carefully assess the provisions of relevant double taxation treaties when planning cross-border financing transactions to optimize their tax position
Transfer pricing considerations
- refers to the pricing of transactions between related parties, such as a parent company and its foreign subsidiaries
- Cross-border financing arrangements between related parties must adhere to the arm's length principle, ensuring that the terms and conditions are comparable to those that would be agreed upon by unrelated parties
- Companies must maintain proper transfer pricing documentation to support the arm's length nature of their intercompany financing transactions and avoid potential tax audits and penalties
Regulatory considerations
Securities regulations across jurisdictions
- Companies engaging in cross-border financing must comply with the securities regulations of each jurisdiction in which they offer securities
- Key regulatory considerations include:
- Prospectus requirements: The level of disclosure and approval process for offering documents
- Ongoing reporting obligations: Periodic financial reporting and material event disclosures
- Market abuse and insider trading rules: Prohibitions on manipulative practices and trading on non-public information
- Navigating the complex web of securities regulations across multiple jurisdictions can be challenging and requires careful planning and expert advice
Disclosure requirements for foreign issuers
- Foreign companies accessing capital markets in another country may be subject to additional or different disclosure requirements compared to domestic issuers
- For example, foreign private issuers in the U.S. can follow home country accounting standards (e.g., ) and have more lenient reporting deadlines than domestic issuers
- However, foreign issuers may still need to provide reconciliations to U.S. GAAP and comply with other SEC rules, such as those related to corporate governance and internal controls
Compliance with local accounting standards
- Companies must ensure that their financial statements comply with the accounting standards required by the jurisdiction in which they are raising capital
- This may involve preparing multiple sets of financial statements or reconciliations to bridge the gap between different accounting frameworks (e.g., IFRS and U.S. GAAP)
- The adoption of IFRS by many countries has helped reduce the burden of complying with multiple accounting standards, but significant differences remain in certain areas (e.g., revenue recognition, leases)
- Companies should work closely with their auditors and accounting advisors to ensure compliance with the relevant accounting standards and disclosure requirements
Key Terms to Review (29)
American Depositary Receipts (ADRs): American Depositary Receipts (ADRs) are financial instruments that allow U.S. investors to buy shares in foreign companies without dealing with the complexities of foreign stock markets. Each ADR represents one or more shares of a foreign stock, making it easier for American investors to participate in cross-border equity financing by purchasing these receipts through their brokers as if they were domestic stocks.
Basel III: Basel III is a global regulatory framework established to strengthen the regulation, supervision, and risk management within the banking sector. It was developed by the Basel Committee on Banking Supervision and focuses on improving the banking sector's ability to absorb shocks arising from financial and economic stress, enhancing risk management, and promoting transparency. This framework has significant implications for emerging market financial instruments and cross-border debt and equity financing, as it sets higher capital requirements and introduces liquidity standards that banks must adhere to when operating internationally.
Comparative financial statements: Comparative financial statements are financial reports that present the financial position and performance of a company for multiple periods side by side, allowing for an easy comparison of financial data over time. This presentation is essential for analyzing trends, identifying growth patterns, and assessing the company's performance relative to its past results. These statements can also help users understand the impact of changes in accounting policies, particularly when transitioning to new standards like IFRS.
Country risk assessment: Country risk assessment is the process of evaluating the potential risks and rewards associated with investing in or doing business within a specific country. This assessment takes into account various factors such as political stability, economic performance, and social conditions that could impact business operations and profitability. Understanding these risks is crucial for making informed decisions in international finance and investments, particularly when considering cross-border debt and equity financing.
Credit Rating Agencies: Credit rating agencies are organizations that assess the creditworthiness of entities, including governments and corporations, by analyzing their ability to repay debts. They provide ratings that help investors understand the risk associated with investing in a particular bond or security, influencing the cost of borrowing and investment decisions.
Cross-border financing: Cross-border financing refers to the process of raising capital from investors or lenders in different countries than the one where the company or project is located. This form of financing enables businesses to access a larger pool of resources and investment opportunities, often resulting in better terms and conditions. It can take the form of debt or equity financing and is essential for companies operating in a globalized economy, helping them to fund operations, expand internationally, and diversify their funding sources.
Cumulative Translation Adjustment (CTA): Cumulative Translation Adjustment (CTA) refers to the accounting process used to translate the financial statements of foreign subsidiaries into the reporting currency of the parent company. This adjustment accounts for changes in exchange rates over time, ensuring that the financial results accurately reflect the economic reality of operations across different currencies, especially important in cross-border debt and equity financing.
Currency translation: Currency translation is the process of converting financial statements and transactions from one currency to another to ensure accurate financial reporting. This process is crucial for companies operating in multiple countries, as it allows them to present their financial performance in a consistent currency for stakeholders and investors. Currency translation plays a key role in valuation, impacts participation in global capital markets, and is essential for cross-border financing activities.
Double Taxation Treaties: Double taxation treaties are agreements between two or more countries aimed at avoiding the taxation of the same income in multiple jurisdictions. These treaties play a crucial role in international taxation by determining which country has the right to tax specific income types, thus providing relief for individuals and businesses that operate across borders. By clarifying tax liabilities, these treaties facilitate cross-border investment and trade, promoting economic cooperation and reducing the risk of double taxation.
Eurobonds: Eurobonds are international bonds that are issued in a currency not native to the country where they are sold, typically underwritten by an international syndicate and traded in multiple markets. They play a significant role in cross-border debt financing as they allow issuers to tap into a broader pool of investors, facilitating capital raising in a global context.
Eurocurrency market: The eurocurrency market is a global financial market for the borrowing and lending of currencies that are deposited in banks outside the country that issues them. This market enables participants to access various currencies without the constraints of domestic regulations, allowing for cross-border transactions and international financing opportunities.
Exchange rate risk: Exchange rate risk refers to the potential for financial losses that a company may experience due to fluctuations in currency exchange rates. This risk is especially relevant for companies involved in cross-border transactions, as changes in the value of currencies can impact the cost of goods, revenues, and overall financial performance. Companies must manage this risk to safeguard their investments and ensure profitability when dealing in multiple currencies.
Financial hedges: Financial hedges are risk management strategies employed to offset potential losses in investments by taking an opposite position in a related asset. They play a crucial role in cross-border debt and equity financing, as they help manage exposure to fluctuations in currency rates and interest rates, which can significantly impact the financial performance of international investments.
Foreign bonds: Foreign bonds are debt securities issued by a foreign borrower in a domestic market, denominated in the currency of that market. These bonds allow international issuers to tap into local investor bases while also providing domestic investors with opportunities to diversify their portfolios by investing in foreign entities without the need for currency conversion.
Foreign currency accounting: Foreign currency accounting is the method of recording and reporting financial transactions that involve foreign currencies. This practice is essential for companies operating internationally, as it helps in accurately reflecting the financial position and performance of businesses in a global context. Foreign currency accounting accounts for fluctuations in exchange rates and ensures that financial statements are presented in a consistent currency, typically the entity's functional currency.
Foreign Direct Investment: Foreign direct investment (FDI) refers to an investment made by a company or individual in one country in business interests located in another country. This can include establishing business operations, acquiring assets, or expanding existing operations. FDI is crucial for global capital markets as it facilitates cross-border financial flows, enhances economic development in host countries, and creates international corporate partnerships.
GAAP: GAAP, or Generally Accepted Accounting Principles, refers to a collection of commonly followed accounting rules and standards for financial reporting. These principles provide a framework that ensures consistency, transparency, and comparability in the financial statements of companies, making it easier for investors and stakeholders to analyze financial data across different organizations.
Global Depositary Receipts: Global Depositary Receipts (GDRs) are financial instruments that allow investors to hold shares of foreign companies without needing to trade on foreign exchanges. They represent a bank's promise to pay dividends and sell shares, simplifying the process of investing in international markets. GDRs are particularly important for cross-border debt and equity financing as they facilitate access to global capital for companies while providing investors an easier way to invest in foreign securities.
Global Depositary Receipts (GDRs): Global Depositary Receipts are financial instruments that allow investors to buy shares in foreign companies without dealing directly in foreign stock markets. A GDR represents a company's shares and is traded on international exchanges, typically in U.S. dollars or euros, making it easier for companies to access global capital while providing investors with a way to invest in foreign entities without the complexities of cross-border transactions.
IFRS: International Financial Reporting Standards (IFRS) are a set of accounting standards developed by the International Accounting Standards Board (IASB) that provide a global framework for financial reporting. These standards aim to bring consistency, transparency, and comparability to financial statements across different countries and industries, making it easier for investors and stakeholders to understand and analyze financial information.
International Monetary Fund: The International Monetary Fund (IMF) is an international organization that aims to promote global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world. It plays a crucial role in assessing country risk and providing financing options for countries in need, making it essential for evaluating the economic health of nations and their ability to access cross-border debt and equity financing.
MiFID II: MiFID II, or the Markets in Financial Instruments Directive II, is a comprehensive regulatory framework established by the European Union to improve transparency, investor protection, and the functioning of financial markets. This directive enhances the original MiFID regulation by introducing stricter rules on trading practices, reporting requirements, and the provision of investment services. It aims to create a more integrated and competitive financial market across Europe while ensuring a higher level of protection for investors.
Natural hedges: Natural hedges refer to risk management strategies that businesses use to mitigate exposure to fluctuations in exchange rates or interest rates by creating offsets through their operations. These strategies often involve matching cash flows in the same currency or aligning assets and liabilities to reduce the impact of currency risk or interest rate volatility, particularly in cross-border financing arrangements.
Net Investment Hedges: Net investment hedges are financial instruments used by companies to manage the risk associated with foreign investments and currency fluctuations. By hedging their net investments in foreign operations, companies can reduce the impact of currency exchange rate changes on their consolidated financial statements, allowing for more stable reporting of their international business activities.
Samurai bonds: Samurai bonds are yen-denominated bonds issued by foreign entities in Japan's financial markets. These bonds allow non-Japanese companies and governments to tap into the Japanese investor base, providing them with an opportunity for cross-border debt financing while also contributing to the liquidity of the Japanese bond market.
Transfer pricing: Transfer pricing refers to the pricing of goods, services, and intangibles between related entities within multinational enterprises. This concept is crucial for international taxation as it affects how income is allocated across different jurisdictions, especially when dealing with controlled foreign corporations. The arm's length principle is a key benchmark for determining appropriate transfer prices, ensuring transactions are consistent with market conditions. Disputes may arise over transfer pricing practices, leading to resolutions that impact cross-border financing arrangements.
Withholding tax: Withholding tax is a government-required deduction from an individual's or entity's income, typically applied to wages, dividends, and interest payments made to foreign investors. This tax is designed to ensure that tax obligations are met on income earned in a different jurisdiction, especially in cross-border transactions involving debt and equity financing. By deducting this tax at the source, governments can prevent tax evasion and ensure that they receive revenue from foreign entities operating within their borders.
World Bank: The World Bank is an international financial institution that provides loans and grants to the governments of low and middle-income countries for the purpose of pursuing capital projects. It aims to reduce poverty and support development by offering financial resources, technical expertise, and knowledge sharing. The World Bank plays a crucial role in country risk analysis by assessing economic conditions and governance, as well as in cross-border debt and equity financing by providing funding for development projects that may attract private investment.
Yankee Bonds: Yankee bonds are U.S. dollar-denominated bonds issued in the United States by foreign entities, including governments and corporations. These bonds provide a way for foreign issuers to access the U.S. capital markets while appealing to American investors, who may seek exposure to international issuers without dealing with currency risk.