relevance of cost of capital essay assignment
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relevance of cost of capital essay assignment
The issue faced by Lehman Brothers is just a consequence of bad decisions from many parties involved. The fact that this investment bank had been the only one that didn’t receive any governmental help, begs the question why the US government did not struggle to let Lehman Brothers survive. Many issues were out of control. Merrill Lynch, another major investment bank, was also facing a similar situation. After an emergency meeting called by the Federal Reserve (Fed); Bank of America announced its decision to buy Merrill Lynch.
The Investment banks Morgan Stanley, JP Morgan, and Golden Sachs were called by the Fed to find a way to rescue Lehman; however, no bank was interested in investing in the firm (Ferguson 2010). Just one week before Lehman’s bankruptcy, Fannie Mae, and Freddy Mac had to bail out with the intervention of the US Treasury and the Fed. Two days after its bankruptcy, the Fed provided $85 billion loan to American International Group (AIG) as an insurance conglomerate to prevent its failure (Elteman et al 2011, 132 – 134). Both, Fed and Treasury, argued that while Lehman could not post sufficient security in affording reasonable assurance that a loan from the Fed would be repaid, the Fed credit was adequately secured by AIG’s assets (USNews 2008).
Whether US government position was appropriate or not, depends on the interest of the parties involved. Hank Paulson, the US Treasury Secretary said, bailing out Lehman Brothers might still not be enough to halt the large crisis. Although it is true that the US government’s threat was not the same among the institutions affected by the crisis, it is also true that the firm was facing the effect of putting itself in too much risk for high profits. Merrill Lynch was also facing the same problem at that time; however, because of the pressure from the US Treasury and some Fed regulators, it was acquired by Bank of America (Mybanktracker.com 2009).
The intervention of the government through those institutions was highly criticized. They didn’t look the same interest in Lehman Brothers case, and when British regulators from Barclays, the only bank interested in buy the firm demanded financial warranty from the US Government; both Hank Paulson, and Ben Bernanke, FED Chairman 2008; were reluctant arguing that bail out Lehman was just unfeasible, whenever the Treasury did not have the authority to absorb billions of dollars of expected losses to facilitate Lehman’s acquisition by another firm (USNews 2008). At the end, the firm was the scapegoat who faced the consequences of an uncontrolled financial system, and its fall was seen as a wake- up call in dealing with the ensuring financial crisis.
At first sight, it seems only logical to think, that a private financial institution like Lehman Brothers would take more risk when it knows that the government would bail it out if it gets into any financial trouble. “Human nature“ would cause bankers (in this case) to take huge risks for large short-term gains, as they know that a safety net would eventually catch them if something goes wrong (Johnson/Kwak 2009).
However, others state, that the “moral hazard“ argument isn’t as strong as its supporters might think. Even though this argument states that banks would take huge risks if they think that they would be rescued anyway, Surowiecki states that ‘Wall Street was reckless because it never believed failure was even a possibility’ (Surowiecki 2009). In this case, as a bail out was never considered as an option, the irresponsible behaviour of bankers from Lehman Brothers can’t be explained by that.
We think that the “moral hazard“ problem is indeed overestimated. Not only do we support this just stated argument of Surowiecki, but also the point in time of the bail out led us to that conclusion. As Surowiecki states, Bear Stearns was only bailed out after its shares had dropped by 95% (Surowiecki 1999). Hence, the road to a bail-out is a tedious process where heavy financial and job losses are certain even before the company gets actually bailed out. In that sense the chance is only very slim that in these complicated times, bankers would think about taking even more risks.
Furthermore, even if a bail out would be seen as a possible outcome by bankers that take huge risks for large gains, the consequences of a bail out are often not desirable for them, as rigid austerity measures are then demandend by the government for the bail-out to take place. This can cause loan or even job losses which is not at all a favourable effect for bankers affected by the bail-out.
Question 3: Do you think that the U.S government should have allowed Lehman Brothers to fail?
In this case, as we have known, one week prior to Lehman Brothers got bankrupted; the Federal Reserve and U.S. Treasury had bailed out both Fannie Mae and Freddie Mac, putting them into U.S government receivership (Moffett 2011). In addition, the Federal Reserve had extended AIG an $85 billion loan package to prevent its failure. But an exception is that they have allowed Lehman Brothers to fail (Moffett 2011).
Apparently, it was a debatable issue that whether U.S. government should have allowed Lehman Brothers to fail or not. There is no doubt that letting Lehman Brothers failed in 2008 not only caused a massive loss in U.S. financial and credit market, but also in global market and many multinational enterprises invested by Lehman Brothers (Finance503 2010). Some people think that government should not have allowed it to fail. However, we believe that the U.S government letting Lehman Brothers to fail is reasonable and understandable due to the following points.
First of all, if the government had not allowed Lehman Brothers to collapse, a question has to be considered as to who would pay the huge price for Lehman Brothers? Moffett (2011) showed that the U.S. government already provided AIG an $85 billion in federal assistance. Consistently paying the price for Lehman Brothers by utilizing taxpayers’ funds, it thus could lead to public anger and social discontent. Secondly, if government bailed out Lehman brothers, it might create a bad taste in the mouths of individuals, as what AIG’s upper management did that they awarded themselves with lavish bonuses and vocations after the bailout, the U.S. government was unlikely to it again in this case (Finance503 2010).
Additionally, there were many people believing that Lehman Brothers was “too big to fail” or “Big is beautiful” with such an air of arrogance (Finance503 2010). In addition, Weber (2011) said that “banks actually enjoy being too big to fail, because that guarantees them a government bailout. And once they have this implicit guarantee, they find it cheaper to borrow money, because it’s less risky to lend to them.” Therefore, the U.S. government allowing it collapse, that could have made a warning and set the tone for other large corporations to operate more responsibly and ethically in future (Finance503 2010).
In fact, Hank Paulson, the U.S. Secretary of Treasury, also pointed out that it was becoming clear that a large systemic solution was required in resolving this crisis, rather than continuing to be bounced from one individual institutional crisis to another (Moffett 2011). In the meanwhile, he realized that saving Lehman Brothers might still not be able to halt the large crisis eventually (Moffett 2011).
If the Yuan had been revalued by 20%, rather than 2.1%, the Chinese Yuan’s value would be 6.9/U.S. dollar. This change would have dramatically increased the strength of the Yuan in comparison to the U.S. dollar, thus making Chinese goods more expensive to purchase as well as increasing the costs of manufacturing and outsourcing to China. The value of the U.S. dollar per Yuan would be approximately .14/Chinese Yuan. If China had revalued the Yuan by 20%, the buying power of the United States dollar would weaken which would minimize trade between the United States and China.
The reevaluation of the Chines Yuan was both politically and economically motivated. In fact, the “Public Announcement of the People’s Bank of China on Reforming the RMB Exchange Rate Regime,” states that this change will be reevaluation “to establish and improve the socialist market economic system” (p. 73). Socialism is a form of government that favors the distribution of resources across the government, and a market economic system favors market forces to dictate natural changes in the economy. It is in this public announcement that China appears to hang on to its socialist reforms on the 20th century, while entering into a global economy where market forces may dominate change from the outside. True to socialism, China will manage the floating rate. China also frees itself with the release of its connection to the U.S. dollar.
U.S. treasury members had warned China that a revaluation of at least 10% would be needed to prevent protectionist legislation in Congress. According to a recent New York Times article, “after keeping the renminbi tightly pegged to the dollar for nearly three years, China announced on June 19 that it would allow greater flexibility. But the renminbi has inched up less than 1 percent since then against the dollar.” What is important to note is, despite China having switched from a dollar-pegged regime to a managed floating one, China is still behaving as if it were still pegged to the dollar. Its rigid fluctuations with the dollar keeps its currency from appreciating which preserves its controversial export advantage. On the other hand, it was also economically motivated in a sense that China acknowledged that it was costly to maintain a pegging policy to the dollar, as China’s central bank continued to buy up USD. Considering the opportunity cost of pegging the Yuan to the USD was seen unbearable by Chinese officials who elected to float the Yuan. Overall, future exchange rate strategies of Yuan will be less restrictive and ,to certain degree, follow a balanced equation that make China an active healthy player within the WTO while safeguarding its leading sourcing position for many MNE’s.
If the Yuan starting at a value of $8.11 US Dollars were to appreciate or depreciate over a 30 or 60 day period the formula would be as follows:
Depreciation over 30 days (8.11(1+.003)^30) = [email protected] Yuan 8.87; Depreciation over 60 days (8.11(1+.003)^60) = $1 = Yuan 9.71 Appreciation over 30 days (8.11(1-.003)^30) = $1 = Yuan 7.41; Appreciation over 60 days (8.11(1-.003)^60) = $1 = Yuan 6.77
China is currently receiving a lot of pressure from the U.S. and India to change its currency policy because it is thought that the Yuan is undervalued – the U.S. has even claimed that China is keeping the Yuan artificially low in order to increase its exports. While the switch to the flexible exchange rate was radical at the time, in reality, the fluctuation allowances have never really been taken as is proven by the current exchange rate of Yuan @ 6.8/$. In 5 years of fluctuating the Yuan has only moved 1.31/$. That being said, the fluctuating is more risky for Chinese multinationals than their pegged currency system was. The U.S. and other Global MNE’s will face increases in costs with the change in the exchange rate. However, Chinese companies now face uncertainty in terms of what the Yuan will cost to operate. What Chinese companies should do at the outset is to budget for increased costs, and offset those costs by taking advantage of arbitrage opportunities when dealing with MNE’s from all over the world, especially if serving as a sourced company in China. As multinational business continues to bode well for China, the government may choose to base their currency system on a currency other than the dollar – perhaps the Euro, as Europe is China’s biggest importer.
Most of the major multinational oil firms are treated equally, with comparable costs of capital and assessments of their earning potential. Petrobrás, however, was a Brazilian oil company which was distinctly domestic in its activities. Even major oil companies like PDVSA, a Venezuelan oil company (not discussed in the case), were considered of lower relative risk and possessed a lower relative cost of capital because of the magnitude of their export sales. Petrobrás was a Brazilian oil company producing for Brazilian markets. There is good argument that the company‟s cost of capital should not be “burdened” by the additional charges of the Brazilian sovereign spread when calculating its cost of debt and equity. It is operating in a global industry which has a global price, in U.S. dollars, and a global market, which could potentially be accessed for sales if the company wished. There are obviously a multitude of different ways to calculate the company‟s cost of capital, but most methods would require some additional risk premium being added to in some way compensate investors for the perceived risk of Brazilian political or country risks (not particularly currency risks).
The sovereign spread is technically the international debt markets‟ opinion of the creditworthiness of the Brazilian government when borrowing U.S. dollar-denominated debt. This is not the same thing as currency risk. The credit analysis would in principle reflect the market‟s opinion of the
Brazilian government‟s capability to earn or generate U.S. dollar hard-currency earnings in order to repay the debt, which may or may not be directly related to changes in the value of the Brazilian reais itself. The fact that Petrobrás‟ share price had shown a high correlation with the EMBI+ sovereign spread for Brazil, is however, a very interesting factor. As long the spread is used by investors in calculating the company‟s cost of capital, it would seem to be reflecting changes in the exchange rate, regardless of its theoretical validity.
This argument is consistent with the market‟s opinion that Petrobrás is a Brazilian company first and an oil company second. If investors wish to invest in a firm of its character they must therefore
have bullish expectations on the potential of the Brazilian equity market more than a positive opinion on the possibilities of the global or even Brazilian oil markets.
The cost of capital is always a factor in considering a company‟s competitiveness. For a company like Petrobrás, operating in one of the world‟ most capital-intensive industries, the cost of capital is considered critically important. Theoretically, the company will only undertake new investments which are expected to possess rates of return which exceed the cost of capital; the higher the cost of capital, the fewer potential investments which can be considered and the fewer potential investments likely to be undertaken. A final note. Although students of finance are clearly and consistently taught that the cost of capital, specifically the cost of equity, is important to the ability of a company to compete, there are also those who argue (convincingly sometimes) that the cost of equity is a „paper-cost‟, and therefore is not as material as the cost of debt which is an actual cash outflow which must be paid on a regular basis. Equity cost is largely that calulated through methods like CAPM, where the cost is actually and expected return, not a contractual cash flow commitment.
Most automobile manufacturers move manufacturing plants to the country they are selling in. Examples of this are Toyota and BMW. This reduces the risk of currency spot exchange rates changing. Labor and other expenses are thus based on the currency of the country. Unfortunately for Porsche this may not be a good option. Manufacturing in the U.S. may not be in line with the Brand strategy which relies upon the strong European identity of Porsche. Another option for Porsche to minimize risk due to currency fluctuations is the use of currency derivatives to hedge risk. This would not damage the brand image.
Question 1: Which of the many debt characteristics – currency, maturity, cost, fixed versus floating rate – do you believe are of the highest priority for Julie and Tirstrup?
According to the case study, Julie Harberj is assembling a proposal pertaining to the financing requirements for the acquisition of Medtechnics. The main concern of her supervisor is that she should issue any additional equity or convertible shares. In other words, Julie’s objective is to figure out how to finance the acquisition using the least expensive manner possible. Ultimately, after analyzing the several debt characteristics, longer-term fixed debt rate seems to be the most important characteristic, in addition to the currency of denomination being in US Dollar.
Question 2: Does the currency of denomination depend on the currency of the parent or the currency of the business unit that will be responsible for servicing debt?
The currency denomination depends on the parent currency, when a firm issues a foreign currency that is denominated in debt; the actual cost is equal to the after-tax cost. The majority of multinational companies have centralized financial management which includes where, how and why they raise funds. Most government limit the greater part of their debt interest obligation tax deductions to debt capital raised for domestic investment, not international financing. In this specific case, we most note that the Danish government has tax regulations which prevent tax deductions on debt held by a company once used for foreign investment. We believe that it will be most beneficial for the servicing of Tirstrup’s debt to be nominated in U.S. Dollars since the business responsible for servicing the debt will have a significant amount of their operating cash inflows in this currency (US$.)
Question 3: Exhibit 1 is Julie’s spreadsheet analysis of what she considers relevant choices. Using these, what would you recommend as a financial package? The purchase price of the acquisition is $410 million, Tirstrup has roughly $30 million in cash on hand, and the seller has offered to carry a note for $75 million of the total. Purchase Price:$410 million Five-year note to Medtechnics:($75) million Cash on hand:($30) million New funds required:$305 million Out of the five options displayed in exhibit 1 below Julie needs to come up with $305 million to complete the funding of the acquisition. Exhibit 1[pic]
Our recommendation is that the following financial package be recommended to meet the company’s needs and minimize cost and risk: • $100 Million Eurodollar Bond: This market could provide Tirstrup with fixed-rate funds for maturities up to twelve years. The bankers feel that since Tirstrup’s name is sufficiently well-known in Europe that they could float Eurobonds at a fixed rate of 5.6% with fees of 2%. The all-in-cost would be 5.836%. $200 Million Private Placement: Several bankers have recommended a private placement of debt with an institutional investor in the United States. Two or three life insurance companies had shown an interest in fixed-rate, long-term paper of prominent Scandinavian issuers. Long-term private placement in the U.S. equates to roughly ten years. Nordea bank feels their New York specialists can place as much as $200 million with an immediate cost of 5.3% with fees of 7/8% of the principal. The fixed rate would be 6.5% and the all-in-cost would be 5.617%. We are not recommending the Danish Kroner option, even though it offers the lowest all-in-cost at 4.908% and would be limited to seven years with fees as low as 1.5%, due to the foreign exchange risk that it carries in that a change in currency exchange rates could drive up the cost. We are also not recommending the euro denominated Eurobond that offers a fixed rate of 4.8%, 2% fees and an all-in-cost of 5.147% because we feel that maintaining a localized financial structure (dollar denominated) outweighs the lower all-in-cost then the two recommended options. Lastly, we are not recommending the Yankee bond because we feel it would be difficult for Tirshrup to obtain the $100 million because they have no operations in the United States and very little name recognition as a borrower. To obtain the last $5 million needed to complete the financing package we are recommending that Tirshrup work at obtaining a Yankee bond. We feel the lower amount will increase their odds of obtaining one plus it would help to position them in the United States market and help them gain the name recognition and the visibility needed. Yankee bonds can help issuers take advantage of relatively favorable regulatory and lending conditions in the U.S. as well as the large bond market. Plus investors like Yankee bonds because they offer geographic and currency diversification as well as some tax advantages. (Yankee Bonds) Below is the overall financing package recommendation for Tirshrup: Five-year note to Medtechnics:$ 75 million Cash on hand:$ 30 million US$ Eurobond:$100 million Private Placement:$200 million Yankee Bond:$ 5 million Total Funding:$410 million
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