Chapter 20 Outline

Financing Decisions

When considering its options for financing a foreign investment, an international business must consider two factors. The first is how the foreign investment will be financed. If external financing is required, the firm must decide whether to borrow from sources in the host country or elsewhere. The second factor is how the financial structure of the foreign affiliate should be configured.

Source of Financing

If the firm is going to seek external financing for a project, it will want to borrow funds from the lowest-cost source of capital available. As we saw in Chapter 11, firms increasingly are turning to the global capital market to finance their investments. The cost of capital is typically lower in the global capital market, by virtue of its size and liquidity, than in many domestic capital markets, particularly those that are small and relatively illiquid. Thus, for example, a US firm making an investment in Denmark may finance the investment by borrowing through the London-based eurobond market rather than the Danish capital market.

However, host-country government restrictions may rule out this option. The governments of many countries require, or at least prefer, foreign multinationals to finance projects in their country by local debt financing or local sales of equity. In countries where liquidity is limited, this raises the cost of capital used to finance a project. Thus, in capital budgeting decisions, the discount rate must be adjusted upward to reflect this. However, this is not the only possibility. In Chapter 8, we saw that some governments court foreign investment by offering foreign firms low-interest loans, lowering the cost of capital. Accordingly, in capital budgeting decisions, the discount rate should be revised downward in such cases.

In addition to the impact of host-government policies on the cost of capital and financing decisions, the firm may wish to consider local debt financing for investments in countries where the local currency is expected to depreciate on the foreign exchange market. The amount of local currency required to meet interest payments and retire principal on local debt obligations is not affected when a country's currency depreciates. However, if foreign debt obligations must be served, the amount of local currency required to do this will increase as the currency depreciates, and this effectively raises the cost of capital. (We looked at this issue in Chapter 11 when we considered foreign exchange risk and the cost of capital.) Thus, although the initial cost of capital may be greater with local borrowing, it may be better to borrow locally if the local currency is expected to depreciate on the foreign exchange market.

Financial Structure

There is a quite striking difference in the financial structures of firms based in different countries. By financial structure we mean the mix of debt and equity used to finance a business. It is well known, for example, that Japanese firms rely far more on debt financing than do most US firms. Table 20.2 reproduces the results of a study comparing debt ratios for 677 firms in nine industries in 23 countries.⁷ As can be seen, there is wide variation in the average debt ratios of firms based in different countries. The average debt ratio of firms based in Italy, for example, is more than double that of firms based in Singapore.

	Alcoholic	Auto-				Iron &	Nonferrous			Country
	Beverages	mobiles	Chemicals	Electrical	Foods	Steel	Metals	Paper	Textiles	Mean
Singapore		.22		.57	.28	.28	.38			.34
Malaysia	.20	.60	.41		.30	.38	.30	.77	.69	.37
Argentina		.42		.44	.35	.32				.38
Australia	.29	.50	.52	.51	.45	.53	.34	.48	.54	.46
Chile			.33	.28	.70	.48	.50	.47		.46
Mexico	.18		.47	.57	.59	.53	.47	.47		.47
South Africa	.59	.50	.51		.46	.53	.32	.42	.69	.50
Brazil		.66	.48	.53	.57	.61		.37		.54
United Kingdom	.45	.73	.50	.60	.55	.51	.57	.56	.52	.55
United States	.51	.58	.55	.54	.56	.54	58	.58	.50	.55
Benelux	.41	.62	.60	.51	.64	.61	.49	.65	.54	.56
Canada	.55		.45	.52		.69	.61	.68		.58
India	.08	.75	.55			.49	.69	.74	.48	.60
Switzerland				.63	.54	.64				.60
Germany		.57	.56	.66	.49	.60	.70	.70	.65	.62
Denmark	.66		.47	.74	.69	.52	.61	.74		.63
Spain		.59	.64	.45	.66	.82	.70	.85	.43	.64
Sweden	.79	.75	.67	.67	.63	.67	.64	.61	.60	.68
France	.56	.67	.72	.72	.78	.73	.67	.74	.74	.71
Finland	.40	.82	.71	.73	.77	.73	.72	.76	.82	.72
Pakistan		.87	.87				.72	.66	.70	.72
Norway			.76	.67	.79	.62		.82	.75	.74
Italy		.49	.65	.79	.85	.87	.86	.77	.83	.76
Industry mean	.49	.58	.56	.59	.62	.61	.58	.63	.70

Note: Debt ratio is defined as total debt divided by total assets at book value.

Source: W. S. Sekely and J. M. Collins, "Cultural Influences on International Capital Structure," Journal of International Business Studies 19 (1988), p. 91.

Table 20.2

Debt Ratios for Selected Industrial Countries

It is not clear why the financial structure of firms should vary so much across countries. One possible explanation is that different tax regimes determine the relative attractiveness of debt and equity in a country. For example, if dividends are taxed highly, a preference for debt financing over equity financing would be expected. However, according to recent empirical research, country differences in financial structure do not seem related in any systematic way to country differences in tax structure.⁸ Another possibility is that these country differences may reflect cultural norms.⁹ This explanation may be valid, although the mechanism by which culture influences capital structure has not yet been explained.

The interesting question for the international business is whether it should conform to local capital structure norms. Should a US firm investing in Italy adopt the higher debt ratio typical of Italian firms for its Italian subsidiary, or should it stick with its more conservative practice? There are few good arguments for conforming to local norms. One advantage claimed for conforming to host-country debt norms is that management can more easily evaluate its return on equity relative to local competitors in the same industry. However, this seems a weak rationale for what is an important decision. Another point often made is that conforming to higher host-country debt norms can improve the image of foreign affiliates that have been operating with too little debt and thus appear insensitive to local monetary policy. Just how important this point is, however, has not been established. The best recommendation is that an international business should adopt a financial structure for each foreign affiliate that minimizes its cost of capital, irrespective of whether that structure is consistent with local practice.