Effect of Financial Structure on Net Cash Flow
As mentioned earlier, this approach concentrates exclusively on risk reduction rather than on cost reduction. When financial market imperfections are significant, a firm might consider exposing itself to more exchange risk in order to lower its expected financing costs.
Application South Korean Companies and Banks Mismatch Their Currencies
An important contributing factor to the magnitude of the collapse of the South Korean won was the currency mismatch faced by Korean companies and banks. Specifically, Korean banks lent huge amounts of won to the Korean chaebol, or conglomerates. The banks, in turn, financed their loans by borrowing dollars, yen, and other foreign currencies. The chaebol also borrowed large amounts of foreign currencies and invested the proceeds in giant industrial projects both at home and abroad. Considering how highly leveraged the chaebol already were, with debt-to-equity ratios on the order of 10:1, everything had to go right in order for them to be able to service their debts. When the won lost 40% of its value against the dollar during 1997, the chaebol had difficulty servicing their debts and many of them became insolvent. To the extent the Korean banks continued to receive won interest and debt repayments from the chaebol, devaluation of the won meant that the banks’ won cash flows were insufficient to service their foreign debts. Similarly, although the chaebol’s overseas projects were expected to generate foreign exchange to service their dollar debts, these projects turned out to be ill-conceived money losers. With both banks and chaebol scrambling to come up with dollars to service their foreign debts, the won was put under additional pressure and fell further, exacerbating the problems faced by Korean borrowers. In the last three months of 1997, eight out of the 30 largest chaebol went bankrupt.