DOMESTIC AND MULTINATIONAL CAPITAL STRUCTURE:

THEORY AND EVIDENCE

J. Edward Graham, Jr.

ABSTRACT

The capital structure of the firm is examined in the domestic environment under successively less restrictive

assumptions. Allowances are then made for agency costs and information asymmetries. The domestic capital

structure theory is extended to the multinational environment and examined empirically. Results broadly support

financial theory. Where the theory is restrictive in its assumptions, it describes multinational capital structure

poorly. Subsequent research is proposed.

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DOMESTIC AND MULTINATIONAL CAPITAL STRUCTURE:

THEORY AND EVIDENCE

Working Paper

Introduction

What is capital structure and how is capital structure chosen by a corporation? What are the

roles of debt and equity in this capital structure? How are these components chosen in a “perfect market”

without taxes or bankruptcy costs? How do these roles and proportions change as an allowance is made

for taxes and bankruptcy costs? What roles are played by debtholder and equityholder incentives in this

structure? What is the impact of agency costs and asymmetric information on the capital structure? How,

if at all are these factors and their impact on a firm’s capital structure changed when a provision is made

for international variables? Is the capital structure of the multination corporation (MNC) significantly

different from the domestic corporations (DC)?

These questions are addressed.

In Section 1, capital structure is defined and considered under the restrictive assumptions of a

“perfect market.” The implications of a frictionless capital market are examined. An allowance is made

for corporate and personal taxes in Section 2. The following section includes a provision for the impact of

uncertainty, leverage and bankruptcy costs. Agency costs, debtholder incentives, and agency cost of

debt are considered in Section 4. A brief examination of the impact of asymmetric information on capital

structure is presented in Section 5. Selected topics and empirical studies of MNC capital structure are

reviewed in Section 6. The paper closes with a summary and encouragement of subsequent research.

Each section provides the “domestic” theory relevant to the given topic on capital structure and extends

the theory to the multinational setting.

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Section 1

The financial structure of a firm is the mix of all the items that appear on the right-hand side of the

firm’s balance sheet. The capital structure is the mix of the long-term components of that financial

structure. The domestic and multinational corporate capital structure both consist of various elements of

liabilities and owner’s equity. Similarities and dissimilarities between MCN and DC capital structure are

considered. In the evaluations which follow, the stockholder-owned MNC or DC attempts to select a

capital structure that maximizes firm value: this value is composed of the market value of debtholder and

equity holder financing.

Does capital structure affect the value of the firm? Are investment decisions affected by the

manner in which they are funded? Until the seminal work by Modigliani and Miller (1958), the prevailing

view was that firm value was a concave function of its use of financial leverage; that an optimal mix of

debt and equity existed (a global maximum) which maximized firm value. Modigliani and Miller (M&M)

proposed that firm value was independent of its capital structure, subject to a set of restrictive

assumptions. 1

Central among the provisions of M&M (1958) is an assumption of “perfect” and frictionless capital

and financial markets; there is no allowance for taxes, bankruptcy costs or transaction costs. Coupling

these features of the M&M modeling with their other restrictions provides support for their proposals: that

capital structure is irrelevant as it effects firm value, that investment and financing decisions are

independent and that expected return increases linearly with debt, precluding an increase in firm value

through the use of leverage. Stiglitz (1969) relaxes the risk class, capital market competitiveness and

homogeneous expectations assumptions of M&M (1958) and is able to reach similar conclusions.

However, his modeling is not robust to the introduction of bankruptcy costs.2

1 Adler (1979) is one of many studies, which note that traditional financial theory, of which the work of M&M (1958) is a watershed, does not extend easily to a multinational setting. Nonetheless, M&M (1958) serves as a benchmark for an examination of domestic or multinational capital structure. 2 In later sections the relevance of bankruptcy costs to the capital structure of the DC (Kim. 1978) and MNC (Lee and Kwok, 1988) is considered.

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He does find the M&M proof holds, however, under much more general conditions than originally

supposed.

An extension of the fairly stringent assumptions of M&M to the multinational setting is difficult.

Senbet (1979) questions the extension of the perfectly competitive capital market assumption to the

international setting. Yet, given the assumption and the absence of taxes (or an “international tax

differential”), he finds the international financing mix is irrelevant. M&M (1958) holds.3 He still notes that

existing financial theory “ has to be amply modified if it is to accommodate” MNCs.

Stiglitz (1969) implicitly acknowledges the potential for an optimal capital structure for the

economy as a whole. He merely illustrates irrelevance for the individual firm, given his less-binding

restrictions. Nonetheless, he admits the non-robust nature of his M&M examination to bankruptcy costs

and the “crucial fallacies of the perfectly competitive capital market:” that lending rates different from

borrowing rates, that the nature of a firm’s risky debt changes as its debt ratio changes, and that one

firm’s bonds are different from another’s. These three factors are precluded in the perfectly competitive

capital market.

Errunza and Senbet (1981) note that any international investment by a firm competing with “the

locals” is a departure from “Market perfection.” Given perfectly competitive markets, these locals could

acquire the necessary technologies and capital on their own. Discovering a systematic positive

relationship between “current degree of international involvement and excess market value,” they

illustrate the abbreviation of market perfection in the international arena.4 They discover that the factors

leading to these financial market imperfections are priced. They provide an indication of the contributions

of international barriers to foreign direct investment. This impacts MNC capital structure.

Many of the arguments against the restrictive assumptions of M&M (1958) apply in both the

domestic and multinational setting. Differential tax, lending and borrowing treatment exist for

3 Corporate and personal taxes are considered in the next sections. An allowance for international tax differentials is shown to compromise M&M (1958).4 Imperfections in the international financial markets are also addressed in early work by Black (1974) and in later examination by Lee and Zechner (1984) and Hodder and Senbet (1990).

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Corporations with and between nations. The limitations mentioned above are addressed and

successively less restrictive assumptions are provided; a number of insights concerning the capital

structures of the DC and MNC are gleaned. Although capital structure theory is still inadequate, studies

since 1958 have encouraged certain tenets of this theory and discouraged others.5

Section 2

What is the impact on capital structure if an allowance is made for taxes? Revisiting their earlier

work, M&M (1963) reveal that taxes and leverage (an effective government subsidy of debt) do give the

firm an advantage. The implication is that an optimal cattail structure exists for the firm. Extending this

argument, if the only imperfection in the financial world is corporate taxes, the firm uses all debt

financing.6 Treating the tax shield as perpetuity, they find firm value is maximized through the use of

debt.

Specifying the value of the firm without a provision for personal taxation, M&M (1963) main point

is that required returns are lowered using debt. The value of the firm is an increasing function of debt.

Since firm value is more easily maximized using debt and the firm undertakes investment when the value

of the firm is increased, the probability of investment and magnitude of investment are also increased.

Perhaps some of the liveliest examinations of DC and MNC capital structure have had taxes and

international taxation as their fulcrum. Differential international taxation (a potential barrier to the smooth

operation of international financial markets) has invited extensive study. The differential government

subsidy of business has invited and discouraged the flow of capital across borders.7

5 See Myers (1984)6 Other “imperfections” may lead to an optimal interior mix of debt and equity. 7 International tax differentials are considered by Adler (1979), Black (1974), Errunza and Senbet (1981), Hodder and Senbet (1990), Lee and Zechner (1984) and Senbet (1979). Many other authors also address this issue.

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Black (1974) addresses capital market equilibrium, given explicit barriers to international

investment, as a function of international tax differentials. Broadly defining “tax” as any kind of barrier to

foreign investment, he posits that where these barriers are effective, a world CAPM does not hold. 8

Financial and capital markets are imperfect and a firm will structure its mix of debt and equity to take

advantage of these imperfections. An optimal multinational capital structure, long in domestic assets and

short in foreign ones, may exist. Where these barriers are ineffective, he seems to imply capital striker

irrelevance as it relates to international capital market imperfections. His work does not specifically model

the impact of personal taxes. His basic premise is that models of international investment assume

“specified or unspecified barriers” to multinational investment and that these barriers cause changes in

the pricing of international securities. Tax-free investors are subsidized by these barriers, to which they

are not subject. Senbet (1979) also notes that international tax differentials affect a firm’s financing mix

and investment.

Miller (1977) extends the theoretical consideration of capital structure to personal taxes.

Proposing that bankruptcy costs and agency costs are insufficient to offset the tax advantage of debt, he

posits that the value of the firm, in equilibrium, is independent of capital structure. He acknowledges (as

did Stiglitz (1969)) an aggregate macroeconomics capital structure, but denies an optimal structure for the

individual firm. 9 He proposes that, in equilibrium, the marginal tax rate for a buyer of corporate debt

equals the marginal tax rate for the issuing corporation; implying a macro-level capital structure optimum

but a micro-level irrelevance.

8 This “tax” can “represent various kinds of barriers to foreign investment, such as the possibility of expropriation of foreign holdings, direct controls on the import or export of capital, reserve requirements on bank deposits and other assets held by foreigners, and restrictions on the fraction of a business that can be foreign owned. It is even intended to represent the barriers created by the unfamiliarity that residents of one country have with other countries.” 9 This is countered in DeAngelo and Masulis (1980). The presence of non-debt tax shields such as depreciation and depletion and investment tax credits (foreign countries have similar provisions in their tax coeds) imply a market equilibrium in which each firm has a unique interior optimal leverage decision. They argue that these shields and optima are supported in preliminary empirical findings. Bankruptcy costs, in their analysis, become significant and mitigate Miller’s “horse and rabbit stew” argument concerning bankruptcy costs.

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Lee And Zechner (1984) extend the Miller (1977) hypothesis to the international setting and find

that the “Miller equilibria do not hold” in the presence of different tax subsidies between countries. They

analyze capital structure in a two country setting and find, on a theoretical basis, that firms tend to be all

equity or all debt depending on location. They likewise identify “differential tax subsidies of debt if inflation

rates differ across countries.” Differential rates of inflation and national corporate tax rates can change

the equilibrium structure of international capital markets. In the presence of barriers to international

investment (capital markets are not perfectly integrated), the Miller irrelevance theorem holds; in the

sense that “leverage is indeterminate for the individual firm while it is determinate for the aggregate

economy.” Given integrated international capital markets, high-tax country firms tend to be all debt-

financed and low-tax, all equity. 10

Hodder and Senbet (1990) also generalize the Miller analysis to an international setting. Given

differential international taxation, they note implications for national differences in capital structure, the

international Fisher effect and yield differentials. They propose that corporate tax arbitrage plays a key

role in generating an international capital structure equilibrium. Contrary to Lee and Zechner (1984) they

show that, “ if corporations engage in international tax arbitrage on an equal footing, no optimal capital

structure exists for the individual firms.” Miller (1977) holds. Thus, differences in international tax rates

alone are not sufficient to dictate a firm’s capital structure. Assuming otherwise “perfect” capital markets,

their international analogy of Miller is robust to different tax rates. 11 Apparent international differences in

capital structure are not due solely to differences in personal and corporate tax rates. The international

Fisher effect holds despite differences in taxes and inflation. Additionally, there exists no “induced

preference for corporate borrowing in a particular currency.” Much of the difference in the findings

between Lee and Zechner (1984) and Hodder and Senbet (1990) can be attributed to their adopted

10 With barriers to international investment, Lee and Zechner (1984) show that the Fisher hypothesis of equality in real returns is violated at the international level. 11 They assume no government restriction on individual or corporate response to differences in international tax rates.

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Restrictions. Nonetheless, the contrasts of those two studies are noteworthy.

Section 3

What are the implications for the firm’s cattail structure when an allowance is made for

uncertainty and bankruptcy costs? Kim’s (1978) modeling provides support for the traditional view; that a

firm’s value is a concave function of its debt financing and that an interior optimum exists where the slope

of these function equals zero. He proposes that the value of the levered firm is equal to the value of the

unlevered firm plus the present value of the tax-shield provided by debt less tax credits lost and costs

incurred in bankruptcy. This traditional argument flows from the M&M (1958 and 1963) argument by

allowing for taxes and bankruptcy costs. He shows an optimal level of debt financing (optimal capital

structure) at less than the firm’s debt capacity.

Haugen and Senbet (1978) counter that the expectations of bankruptcy costs and other costs of

financial distress do not impact capital structure. They also find Kim’s one-period model deficient. They

propose that the choice of liquidation and/or reorganization exists as an effective alternative to

bankruptcy. They argue that the costs of bankruptcy are bounded by the costs of informal reorganization.

They posit, given rationality and large financial markets, that the costs of bankruptcy “must be small” and

that the liquidation decision is made independently of capital structure. They note that all claimants have

“ an incentive to avoid bankruptcy.” Given the widespread use of bankruptcy in firm reorganization, their

arguments seem to lack intuitive appeal.

Titman (1984) notes that traditional approaches to the consideration of capital structure have not

considered all claimants. He introduces a third claimant – workers, customers, community, and suppliers.

Noting the shallow nature of the claims of Haugen and Senbet (1978) that these third parties should join

in reorganization coalitions to protect their interests, he proposes the use of preferred stock to protect

these third parties. His arguments do not extend easily into the multinational arena.

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Bradley, Jarrel, and Kim (1984) (BJK) acknowledge that the general view (though not a

consensus) is that optimal capital structure involves “balancing the tax advantage of debt against the

present value of expected bankruptcy costs.” The “upshot” of extensions of Miller’s (1977) modeling is

the recognition that the existence of an optimal capital structure is essentially an empirical issue as to

whether or not various leverage-related costs are significant enough to influence the costs of corporate

borrowing.12 Their examinations reveal that firm leverage ratios are negatively related to the volatility of

earnings (given non-trivial costs of financial distress) and that “permanent ratios” are related to the firm

industrial classification. They generate strong findings of intra-industry similarities in capital structure and

a persistence of inter-industry differences.

These theoretical and empirical considerations of capital structure, leverage, and bankruptcy

costs have been extended to the international setting. Shaked (1986) examines the failure probabilities of

a sample of MNCs. His findings suggest that the probability of bankruptcy is greater for DCs than MNCs.

He observes that MNCs are significantly more capitalized with lover returns volatility than DCs. His study

seems to lack an adequate explanation for these findings, however. MNCs might be expected to have

higher debt ratios, given their less volatile and internationally diversified operations, than their domestic

counterparts. Given also the hedging of local political risk with higher debt ratios by foreign affiliates and

the reduction of bankruptcy probability (expected bankruptcy costs) through international diversification,

this seems counter-intuitive.

Lee Kwok (1988) address the deficiency noted above. Commenting on the intuition of Myers

(1977) and Jennies and Mocking (1976) Lee and Kwok (1986) not that international environmental factors

lead to higher agency costs of debt. 13 These factors, in turn, offer one explanation for the lower debt

ratios of MNCs. Lee and Kwok also find that MNCs “do not have lower bankruptcy costs” than DCs.

12 These leverage-related costs can include bankruptcy costs, costs of reorganization, agency costs, and loss of non-debt tax shields (see DeAngelo and Masulis, 1980). 13 Agency costs and debtholder incentives and agency costs of debt are examined in the following section.

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Whereas contemporary capital structure theory as it relates to bankruptcy might imply the greater us of

leverage by the MNC, this does not appear to be the case. MNCs have lower means of bankruptcy costs

“not because of their international involvement but simply because of their large sizes. 14

Rajan (1993) examines the capital structure and term structures of debt of corporations in the G-7

countries. Given differential tax structures and cultural norms of those nations, one might expect

significant differences. His findings are surprising. Capital structures and maturity structures of debt –

after correcting for differences in accounting, reporting, and asset valuation – are similar across the G-7

countries. They also seem to be driven by similar factors. Leverage is broadly similar, through some

differences are noted. 15

Many international systems have been lauded for encouraging efficiency (i.e. Japan) or damned

for denying it (often the U.S.). However, Rajan (1993) notes that “there is little evidence on

competitiveness.” He closes noting that either the “theoretical underpinnings” of these factors or prior

studies on the “efficiency of different institutional settings are effective. “ His findings would seem to

complicate the comparison of the capital structure of MNCs and DCs, if one assumes broad differences.

Section 4

What are the implications of agency costs, debtholder incentives, and agency costs of debt for

the capital structure of the domestic and multinational corporation? The separation of ownership and

control and the pursuit of conflicting goals by management and shareholder are at the core of agency

14 The findings of BJK (1984), o f shared capital structures among members of an industry is blurred with the MNCs; the MNCs, as a result of their size and diverse activities, lose their industry distinction. (See also Sekely and Collins, 1988). These industry differences, however, “played an important part in explaining differences in capital structure between MNCs and DCs” in Lee and Kwok (1988). 15 The market-oriented economies of the U.S., U.K., and Canada would be expected to have significantly different ratios of debt and equity than the banking-oriented economies of France, Italy, Germany, and Japan.

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theory. Jensen and Meckling (1976) are among the first to model capital structure as a function of agency

costs. They develop a theory of capital structure where inside and outside ownership and leverage are

chosen to maximize firm value. There are agency costs (of monitoring, bonding, and residual losses)

suffered in the pursuit of equilibrium. These costs are borne by management and owners.

A number of claimants have an incentive to minimize agency costs. Management has the motive

to signal low agency costs (through greater management ownership and debt ratios) to maximize equity

value and their value of the job market. Debtholders have the incentive to create covenants to preclude

agency cost. Capital structure is chosen, in the Jensen and Meckling milieu, to minimize agency costs;

an optimal level of debt and “inside” equity are chosen to signal and insure desired management

behavior. Demsetz (1983) proposes that the stock and human capital markets preclude egregious

agency costs. He addresses the premise that the link between private ownership and efficient resource

utilization is presumable broken by a structure of ownership that reduces the incentive of management to

maximize profit. Given the imperfections in the international capital markets outlined earlier, an extension

of his argument to MNCs seems tenuous.

Fama and Jensen (1983) examine the survival of organizations characterized by the separation

of ownership and control. Considering the firm a nexus of contracts, they note the need for well-defined

decision-making processes, specified residual claimants and mechanisms for controlling agency costs.

Extending their proposals to the international setting seems fairly straightforward. The benefits of

specialization and the need for separation may be even more pointed in the MNC than in the DC.

Contracting, legal restraints, and cost functions need to be sensitive to multination requirements. Capital

structure might be impacted as the nature of claims responds to given multinational corporations issues

(i.e., increased/decreased foreign ownership, increased cost of foreign debt, management contracts

tailored to specific foreign requirements, etc.).

Free cash flow is the cash flow in excess of that needed to fund positive NPV projects. Jensen

(1986) considered the implications of free cash flow in the context of agency theory. With substantial

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Free cash flow, conflicts develop. He notes that management, in pursuit of their own agenda, is

motivated to over-in-invest or otherwise misallocate or misappropriate free cash flows. He concludes that

debt serves as an incentive to bond management and reduce agency costs (as does a fixed high-

dividend-payout policy).

Stulz (1990) gives Jensen objective support. He considers alternative financing policies to

mitigate agency costs in a theoretical framework. Like Jensen, he provides evidence of a favorable

bonding effect of debt and dividend payments. Given unobserved free cash flows, he composes a

comparative static that bounds this overinvestment issue; management is encouraged to commit funds

“properly.” He illustrates the positive impact on firm value of debt for equity swaps and of higher

dividends; he likewise shows the negative effect on firm value of new stock issues.

The extension of Jensen (1986) Jensen, and Meckling (1976) and Stulz (1990) to the

multinational arena can be appreciated with references to Myers (1977) and Lee and Kwok (1988). In

Myers (1977), many corporate assets are viewed as “real” options; growth opportunities are particularly

well-modeled as call options. According to Myers, issuing risky debt reduces the present market value of

the firm by inducing sub-optimal investment policy. Given that value accrues to risky Debtholders with

firms having substantial value in growth opportunities, an agency cost of debt develops. Equityholder

may forego favorable investments in the face of these costs. Lee and Kwok (1988(note that the

underinvestment problem of Myers (1977) is a factor in reduced levels of debt, ceteris paribus, for the

multinational firm.

Lee and Kwok also address the substitution problem of Jensen and Meckling (1976); wherein the fear of

wealth transfers from debtholders to equityholders lowers bond value, increases another agency cost of

debt (this is often and overinvestment problem for risky firms or firms near bankruptcy), and motivates

lower debt levels. Lower debt usage is encouraged for the MNC in the face of higher agency costs of

debt because of “several international environmental factors.”16 Lee and Kwok (1988) provide empirical

support for the premise that MNCs tend to have lower debt ratios than DCs.

16 See Lee and Kwok (1988).

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Section 5

Among the authors who address the implications of asymmetric information for the firm’s choice

of financial structure, Ross (1977) makes several points. Given management’s possession of “insider”

information and an incentive to signal the value represented by this information, a managerial incentive

schedule develops where valid inferences are drawn from the signals in equilibrium. One empirical

implication is that, in a cross-section, the value of the firm will increase with leverage – as leverage

increases the market’s perception of value. M&M (1958, 1963) “assume the market has full information

implicitly”; this is not true given information asymmetries. So the firm signals value with its debt level,

inasmuch as management runs the risk of bankruptcy and reduced compensation if they send a “false”

signal. The difficulty of extending Ross (1977) to the MNC due to agency cost of debt is outlined in

Section 4. The appropriateness of a signal by the management of a MNC using debt levels seems to be

compromised.

Similar to Ross (1977), Myers and Majluf (1984) consider capital structure as a signal to

outsiders. Assuming management acts in interest of “old “ shareholder, positive NPV projects may be

foregone to preclude wealth transfers to new shareholders. Management possesses information

unavailable to outsiders and may attempt to use the capital structure to signal this value. Optimal

resource allocation seems to be thwarted in the Myers and Majluf framework; contracts and institutions

should be structured to mitigate this resource allocation problem. “Stack” (cash on hand) mitigates the

problem but leads to agency costs of free cash flow. A desire to spin off new projects or finance them

separately may develop due to the information asymmetries, agency costs, and agency costs of debt 17

17 The Myers and Majluf (1984) study has been criticized for the simultaneity of their modeling equation and the lack of an illustration of equilibrium in the same equation.

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Section 6

Although the links between the capital structure of the MNC and financial theory are often

tenuous, a few features have come to light. Several related studies of MNC capital structure highlight

these features and the often “fluid” nature of that capital structure.

Given an assumption of exchange rate controls and restricted international flows of capital the

MNC is analogous to a domestic multi-divisional firm. Adler (1979) notes that this segmentation leads to

differing valuation objectives and investment-acceptance criteria. (If the segmentation is “extensive,” this

analogy may not apply.) The MNC capital structure may be unstable of inefficient. 18

Toy, Stonehill, Remmers, Wright, and Beekhuisen (1974) study differences in debt ratios between

countries in the manufacturing sector. They propose a linear model and test whether growth, profitability,

and risk impact debt ratios in the manufacturing sectors of industrialized countries. They examine

international corporate financial policy in the U.S., Japan, Norway, and Europe. Significant relationships

are found in all countries but France. A surprising result is that higher earnings risks are associated with

higher debt levels. Differing debt ratios between countries are attributed to differing cultural perceptions

of debt ratios (i.e. higher debt ratios are tolerated and expected in Japan than in the U.S.)

Stonehill, Beekhuisen, Wright, Remmers, Toy, Pores, Edgan, and Bates (1975) assume differences in the

capital structures of MNCs in their study. In examining whether the capital structures of foreign

subsidiaries differ from their parent, they find financial risk (and not parent structure) is the most important

debt ratio determinant.19 Their survey shows a clear preference of financial executives in France, Japan,

The Netherlands, and Norway for capital structures that respond to “local environmental factors”; those

countries have policies, which often mitigate the threat of bankruptcy. 20

18 Senbet (1979) also addresses foreign exchange risk. Like Adler (1979), he notes that existing financial theory has to be “amply modified” to accommodate MNCs and that studies of the time were subject to distinct limitations in scope and links to financial theory. 19 Stonehill, et al. (1975) use surveys data. Survey data is often suspect. 20 This contrasts with patterns in the U.S., the fifth country in their study.

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(Is social awareness impacting capital structure decisions?) They found international factors such as

government incentives to raise funds locally, hedging operations and repatriation of capital are important

in determining capital structure.

Kester (1986) compare the capital structure of manufacturers in the U. S. and Japan. He

responds to the purported competitive advantage of Japanese business through their greater use of

leverage. However, he finds that when leverage is measured on a market value basis and “adjusted for

liquid assets,” there are no significant overall differences in debt use between the U. S. and Japan. The

composition of Japanese capital and ownership structure is quite different than the U.S.; leverage is

simply not as great a factor as previously thought.21 Japanese corporate structure and financial

institutions do, however, seem to facilitate the use of debt. The competitive implications of the Japanese

financial system and corporate capital structure are by no means straightforward.

Sekely (1988) examines the significance of international cultural and industry factors in

determining capital structure. Similar to other studies, he fins “significant country and minimal industry

influences.” He provides evidence that “cultural influences” are highly correlated with capital structure

and that MNCs (due to their size and diversity) are losing their industry distinctions. He proposes that

financial theory tends to minimize the significance of cultural influences on capital structure. He finds that,

whatever the link between social, legal and commercial arguments within a given country (he studies 677

firms in 23 countries) there is a significant link. He also discovers distinct groups of countries ranked by

their average debt ratio; this may be due to shared cultural patterns.

Conclusions

What is the difference between the capital structure of the domestic and multinational

corporation? Although broad references have been made to differing components of capital structure

21 Higher leverage is found in Japan in “mature concentrated industries.”

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In different countries, what are the implications for the firm operating in many countries? Do foreign

subsidiaries adopt the parent’s capital structure? Does the parent adapt its striker to differing

international inputs? It appears there is no industry standard for the capital structures of U.S.-based

MNCs. Each firm adapts to its own circumstances. However, several features of these MNCs’ capital

structures have come to light. These firms must respond to features of risk, culture, and strategy

common only to the multinational.

In the simplest vein, Sekely (1988) notes that “if an optimal capital structure exists, management

need only finance the firm in that fashion and the objective of the maximization of firm value is achieved.”

In the strictest sense, his point is valid. However, given the dynamic nature of exchange rates,

international capital flows, government regulations and economic cycles, capital structure selection is not

a parsimonious as Sekely implies.

Harris and Raviv (1991) identify several categories of determinants of capital structure. These

include:

1. To ameliorate conflicts of interest among certain groups with claims to the firms resources (agency issue, debtholder incentives).

2. To convey private information to the capital markets or mitigate adverse selection effects (asymmetric information issue).

3. To influence the nature of products or competition in the product market, and4. Affect the outcome of corporate control contests.

They also identify properties of debt (bankruptcy provisions, convexity of payoffs, signaling features,

relation to management compensation and ownership) that influence capital structure.

Similar to the findings of Harris and Raviv (1991), this review has discovered empirical evidence

largely consistent with the theory, provided the theory is malleable. Where strict structure has been

imposed on the theoretical underpinnings of MNC capital structure, the theory has performed poorly. The

agency models, for example, generate interesting implications. 22

22 See Lee and Kwok (1988).

16

Much of the work considered by Harris and Raviv (1991) has been examined in this study. Many

of their postulates have been easily extended to the international setting, while others have not. Capital

structure theories as a function of information asymmetries did not lend themselves well to this

examination, for example. If investors are misinformed about inside information, securities may be

mispriced in the markets.

Myers (1984) echoes the inadequacies of financial theories on capital structure. Many of his

concerns are borne out in the review. His affinity for a “modified pecking order theory” is likewise

confirmed. The MNC seems to favor equity uniformly over debt.

Stulz (1998) notes that the market for corporate control also impacts capital structures. (See #4

above, this section.) Voting rights – especially those held by management – are at the center of his

study. The impact of this market on the capital structure of MNC should be considered in later studies.

There are a great many potential determinants of capital structure. This examination has considered only

a few of the “key players.” The roles played by asymmetric information and insider ownership, for

example, deserve greater scrutiny. A few general principles have been reviewed. There is a need,

however, to sort out which of these principles and what factors are dominant as the multination

corporation selects its capital structure.

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