Local and global capital structure dynamics

Capital Structure

There are a number of different factors that impact the choice of capital structure for foreign subsidiaries. Shapiro (p. 517) points out that the choice of discount rates for foreign subsidiary projects is impacted by variables such as the types of corporate proxies that can be used for the foreign subsidiary, the project and market risk associated with the subsidiary and company relative to the parent company and home market, and the differences in the country risk as well. Shapiro also argues that the capital structure of the foreign subsidiary should be determined within the context of the firm's desired worldwide capital structure (p. 528)

There are essentially three choices for multinational companies when determining the capital structure of a foreign subsidiary: adopt the capital structure of the parent company, reflect the capitalization norms of the foreign country or take advantage of opportunities to minimize the MNC's cost of capital. Gropp (2002, 51) reported that most German firms take the latter approach, in particular when local taxation policy encourages one form of financing over another. The cost of capital minimization theory could also extend to the degree of access the foreign subsidiary has to its local capital markets, the cost of which can vary significantly between foreign nations.

Another consideration is the source of the financing. In many countries, MNCs have significant incentive to utilize sources of financing from outside the country. Capital markets may be underdeveloped, or they may be subject to weak creditor protections, both scenarios significantly increasing the cost of borrowing. Subsidiaries that are subject to substantially higher country risk may also finance outside of the country (Desai, Foley & Hines, 2003, 2).

Shapiro (p.530) points out that the degree of leverage in a subsidiary does not reflect its degree of financial risk, unless the parent company is willing to let the subsidiary default on its debt. Thus, the cost of capital becomes a more important determinant of the capital structure of the subsidiary than it does of the parent company. In addition, the degree to which the subsidiary will contribute to the total capital structure of the parent company will play a role. International operations that play a significant role in the company's structure, such as Ford plants in Canada, would be expected to utilize a capital structure approaching that of the home company's desired structure. For minor subsidiaries, this would not be a necessity.

However, should a subsidiary adopt a capital structure approaching that of the parent company, this may not be optimized (Shapiro, 530). Thus, it is common that subsidiaries would adopt capital structures that are optimized for the local market conditions, in particular when the local market has a relatively low degree of country risk and has relatively transparent and liquid capital markets.

In practice, there are many examples from the corporate world of all the different strategies. Pepsi, for example, attempts to minimize the cost of capital at its foreign subsidiaries by taking advantage of local market conditions. The company finances foreign operations with debt from a number of different countries. It does this on the basis of the parent company's credit rating, which illustrates that the implicit understanding with respect to the parent company default guarantee of subsidiary debt holds across different debt markets (Stern & Chew, 2003, 394).

There are also times when the capital structure is determined more by strategic considerations than any other. Many firms operate foreign subsidiaries as joint ventures, for example, because this gives the firm greater access to foreign capital markets and usually reduces the country risk and market risk associated with the subsidiary, when compared to a greenfield subsidiary. There is evidence that firms using this tactic do so in part to reduce the costs associated with foreign market entry, including financing costs. Hennart's (1991, 483) study of Japanese subsidiaries in the United States showed that transaction costs played a critical role in the choice of capital structure for Japanese firms entering the United States. Local partners were found not only when this had strategic benefits but also when it would reduce the cost of capital. When a reduction of costs is not obtainable from a joint venture, a joint venture is typically not pursued. Toyota, which moved into the United States in the early 1980s, is an example of this theory in practice. Access to the U.S. market also gave the company access to U.S. capital markets, including the New York Stock Exchange. In this case, Toyota adopted the cost reduction strategy when it finally built its own plant in the U.S.