the capital structure of multinational corporations entering the emerging market of India based on firm- specific information

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Table of Contents

Contents…………………………………………………………………… Page

Abstract……………………………………………………………………….6

Section 1: Introduction………………………………………………………7

Background……………………….…………………………………..8

Structure of the Thesis……………………………………………….9

Section 2 Literature Review…………….…………………………………..…10

2.1. Capital Structure Determinants …………………………………………10

2.2. Multinational Capital Structure in an Emerging Market………………….11

2.2.1 Institutions, Environment, and Firm Characteristics…………………….11

2.2.2 Diversification, Exposure to Exchange Rate and Politically Risky Environments…12

2.2.3 MNCs Entry Mode and Cost for Entering Emerging Markets………………….19

2.2.4 Foreign Affiliates Capital Structures…………………………………………….20

2.2.5 Effects of Social Violence………………….……………………………………22

2.2.6 Business Cycles of Capital Inflows, Capital Structure and Debt Maturity………23

Section 3: Data Description……………………………………………………….…..31

3.1 Capital Structure and Variable Definition…………………..…………………….31

3.1.1 The meaning of Capital Structure…………………………..………………..…32

3.1.2 Firm-Specific Information ………………………………….…………………..34

3.1.3. Macroeconomic Factors ………………………………………………….……35

3.1.4. Descriptive Statistics………………………………………………..……………35

3.1.5. Data Source ………………………………………………………………….……36

Section 4: Methodology..……….…………………………………………..………………………….36

4.1 Correlation Analysis…………………………………………………..…………..39

4.2 The Empirical Model ……….……………………………………………………41

4.3 Panel Data Analysis………………………………………………………………42

Section 5: Market Description ………………………………………………………42

5.1 The Indian Market………………………………………………………..…….43

5.1.1 An Emerging Economic Powerhouse………………………..………………45

5.1.2 Foreign Trade and Investment ………………………………………..…….45

5.1.3 More Economic Reforms……………………………………………..……. 46

6. 1. Russian Market………………………………………………………….. 47

6.2 Modigliani and Miller Theorem ………………………………………….. 49

7. China Market ……………………………………………………….…….53

8. Brazilian Market …………………………………………………………..58

9.1. Presentation and Examination of Results ……………………………………..63

9.1.2 Descriptive Statistics …………………………………………………………43

9.2. Correlation Analysis…………………………………………………………….65

9.3. Panel Regression ……………………………………………………………….68

10. Discussion of Results ………………………………………………………………..70

11. Conclusion………………………………………………………………………….. 79

12. Limitations of the Study and Areas for Future Research……………………….…….80

12.1. Key Challenges and Lessons Learnt………………………..……………….…….82

13. References………………………………………………………….…………………83

TOC o “1-3” h z u

Table of Figures

Figure 1…………………………………………………………………………………….. 34

Macroeconomic Performance, 2000-2007

Figure 2 …………………………………………………………………………………….47

Correlation Patterns

Figure 3 ……………………………………………………………………………………..48

Actual and Fitted Values and Residuals

Table 1…………………………………………………………………………………..43

Table 2………………………………………………………………………………….45

Table 3 …………………………………………………………………………………47

Table 4 …………………………………………………………………..…………….53

Fixed Effect Results

Equation (1) ………………………………………………………………………………..28

Equation (2)…………………………………………………………………………….…29

Equation (3) …………………………………………………………………………….….32

Equation (4)…………………………………………………………………………………38

Equation (5)…………………………………………………………………………………39

Equation (6)………………………………………………………………………………….40

Equation (7)…………………………………………………………………………………40

AbstractStudies on the determinants of MNC (Multinational Corporation) capital structure entering emerging markets have begun to emerge as an extended new line of research. Thus, this study aims to investigate the capital structure of multinational corporations entering the emerging market of India based on firm-specific information and macroeconomic determinants. The model is evaluated and tested by correlation analysis.

The main approach to fitting the regression equation is panel data using the fixed effects approach or least-squares dummy variable (LSDV) regression model. This investigation identifies firm-specific information and macroeconomic variables in driving MNCs financial leverage ratio. The results show that profitability, GDP growth volatility, inflation rate and stock market liquidity correlated positively with capital structure. On the other hand, firm size, business risk, and foreign exchange rate risk indicate an inverse relationship with capital structure.

The results of the panel data regression analysis denote that firm size has a significant effect on capital structure. Thus, if firm size goes up by 1 percent, on average, MNCs capital structure in terms of shareholder-liquidity ratio goes down by about €47.2383 million. GDP growth rate volatility significantly affects capital structure. If GDP growth volatility goes up by 1 percentage point, capital structure also goes down by about €12.4776 million, ceteris paribus. The regression equation also reveals that capital structure decreases by €1.1999 million for every 1-percentage point increase in inflation rate. Inflation rate significantly affect MNCs capital structure. In the case of profitability, business risk and foreign exchange rate the hypothesis of having no significant effect has to be accepted.

Section 1: Introduction1.1. BackgroundCapital structure in multinational companies is probably one of the major prolific fields of study within the corporate finance. All-embracing study over the last four decades has produced less conclusive guideline for finance managers choosing between equity and debt in financing their organizations.

Companies may raise money from both internal and external sources. They can raise money from internal sources by partly reinvesting back their profit or, they can raise money from external sources by issuing debt or equity. When a company issues shares, shareholders hope to receive dividend on their investment. However, the company is not obliged to pay any dividend. Because dividend is discretionary, it is not considered to be a business expense. When a company borrows money by way of debt, it promises to make regular interest payment and to repay the principal.

All gains go to the shareholders as profits rise and the debt holders continue to receive a fixed interest payment. Conversely, if profits fall, shareholders bear all the pain. In times of economic downturn, the company that has borrowed heavily may not be able to repay its debt. The company is then become bankrupt and shareholders lose their entire investment. Because debt increases returns to shareholders in good times and reduces them in bad times, it creates financial leverage. An unlevered firm uses only equity capital whereas a levered firm uses a mix of equity and various forms of debt. Common ratios such as debt-to-total capital or debt-to-equity quantify this relationship.

The importance of leverage in the capital structure of the company is that its efficient use reduces the cost of capital and in turn increases the net economic returns which, ultimately increases firm value. In sum, the guiding principle of leverage is to choose the course of action that maximizes the firm value and the value of the firm is maximized when the cost of capital is minimized.

Research on the determinants of MNC capital structure entering emerging markets has emerged as an extended new line of research for several reasons. Capital and stock markets in emerging economies are relatively less efficient than their developed counterparts. This causes financing decisions to be incomplete and subject to a considerable degree of irregularity. Companies in emerging markets may not be able to rationalize the financing decisions to follow a clear theoretical approach. This requires a thorough examination of the real determinants of capital structure in an emerging market and the results are to be compared with those reached in developed markets. Also, information asymmetry in emerging stock markets is considerably higher than the developed markets which lead to none optimal financing decisions in terms of the theoretical assumptions of capital structure theories. Finally, the literature on the determinants of capital structure has already been developed in developed markets that have different institutional financing arrangements from those in emerging markets. This requires a thorough examination of the predictors of capital structure in an emerging market.

Thus, this study aims to investigate the capital structure of multinational corporations entering the emerging market of India based on firm- specific information and macroeconomic determinants.

1.2. Structure of the ThesisThe sections that follow provide the outline for the research. Section 2 examines the existing literature on the determinants of capital structure. Section 3 discusses the methodology. Section 4 presents the markets description for India. Section 5 provides a description of the data used for the analysis. The results are presented and examined in Section 6. An analysis and critical discussion of the results follows in section 7. Section 8 provides the conclusion.

Section 2: Literature ReviewThe existence of three theories is well documented in the literature on determinants of capital structure, these are: pecking order, trade-off, and free cash flow. Each theory presents a different explanation of corporate financing. The trade-off theory is concerned with the trade-off between debt tax shields (or tax saving) and bankruptcy costs, according to which an optimal capital structure is assumed to exist. The pecking order theory assumes hierarchical financing decisions where firms depend first on internal sources of financing and, if these are less than the investment requirements, the firm seeks external financing from debt as a second source, then equity as the last resort. The free cash flow theory assumes that debt presents fixed obligations (debt interests and principals to pay) that have to be met by the firm. These obligations are assumed to take over the firm’s free cash flow (if it exists), therefore prevents managers from over consuming the firm’s financial resources.

It was recognized that the three theories are “conditional” in a sense that each works out under its own assumptions and propositions (Myers 2001). That is, none of the three theories can give a complete picture of the practice of capital structure. This means that firms can pursue capital structure strategies that are conditional as well. That means that when the business conditions change, the financing decisions and strategies may change, moving from one theory to another. This is the main reason that the literature does not include one theory (or one explanation) on the determinants of capital structure. In fact, an interrelationship can be observed between and among the three theories of capital structure. It was also found out that studies on the determinants of capital structure include selected determinants in a regression equation. The results in many cases turned out to be mixed (Fama & French 2002).

Capital Structure Determinants Copyright 2001 Blackwell Publishers Ltd.

Corporate capital structure remains a controversial issue in modern corporate finance. Since the seminal work by (Modigliani and Miller 1958), a plethora of research has been undertaken in an attempt to identify the determinants of capital structure, particularly on domestic corporations (DCs). Considerably less research has been undertaken to identify the determinants of capital structure for multinational corporations (MCs). Multinational corporations control considerable amounts of wealth and, if capital structure is relevant to firm value, then understanding the determinants of capital structure for MCs is important.

(Modigliani and Miller 1958) are widely regarded as the first authors who began the debate on the relevance of capital structure to firm value. Since then the debate has progressed from academic model to practical reality. It is now generally recognized that capital structure is relevant to firm value. The factors that determine capital structure are a combination of variables. Although these variables have been researched extensively for corporations, few studies have considered the relation these variables have with capital structure for MCs.

Theoretical studies based on international environmental factors predicted that MCs will have lower leverage than DCs (Lee & Kwok 1988; Burgman 1996; Shapiro 1996). Theoretical studies suggest there is a difference between MCs and DCs in terms of the determinants of leverage. Major determinants of capital structure include agency costs, bankruptcy costs, taxation, profitability, size, collateral value of assets and industry sector. For MCs additional determinants include level of overseas diversification, exposure to foreign exchange risk and exposure to political risk.

It is often argued that the international diversification of earnings should enable MCs to sustain a higher level of debt than DCs, without increasing their default risk (Shapiro 1996; Eiteman et al 2001). However, while it is believed that there are several gains to be made by venturing into overseas markets, it can be argued that continued foreign expansion has increasing risks. (Erunza and Senbet 1984) found that the incremental gains from international diversification beyond homemade diversification portfolios have diminished. It is not known whether MCs that have greater levels of geographic diversification of earnings have relatively less leverage. The more sensitive a firm’s cash flows and earnings are to foreign exchange rate fluctuations, the lower the expected level of debt (Burgman 1996). (Choi & Prasad 1995) analyzed the relationship between foreign exchange risk and corporate financing decisions and reported that foreign exchange risk significantly affects a firm’s financing decisions for international investments. Further, exchange rate movements affect both the cash flows of a firm’s operations and discount rate employed to value these cash flows (Bartov et al 1996). Therefore, MCs with higher foreign exchange risk are expected to have lower leverage. Political risk is the chance that political events will have an adverse effect on the operations of the firm. Political risks include expropriation of assets, trade controls, and institutional ineffectiveness, threat of war, social unrest, and disorderly transfers of power, political violence, international disputes, regime changes and regulatory restrictions (Jodice 1985). MCs that face higher political risk are expected to have less leverage due to greater probability of wealth loss.

The remaining determinants are common to capital structures for both MCs and DCs. Higher agency costs are expected to lower debt levels (Jensen 1986; Doukas and Pantzalis 2003). MCs agency costs are expected to be higher relative to DCs due to higher auditing costs, language differences, sovereignty uncertainties and varying legal and accounting systems (Burgman 1996). Therefore, leverage of MCs is expected to be relatively lower than DCs. Higher bankruptcy costs are expected to reduce debt levels. MCs are expected to have lower bankruptcy costs relative to DCs due to their ability to diversify across less than perfectly correlated markets (Burgman 1996; Reeb 1998). To proxy bankruptcy costs, several researchers, including Bradley et al (1984) and (Lee & Kwok 1988) used the standard deviation of the first difference in earnings before interest and taxes (EBIT) scaled by the mean value of the firm’s total assets.

(Myer’s 1984) pecking order theory of capital structure shows that if a firm is profitable then it is more likely that financing would be from internal sources rather than external sources. More profitable firms are expected to hold less debt, since it is easier and more cost effective to finance internally. (Cassar and Holmes 2003) provided support for (Myer’s 1984) pecking order theory in a sample of Australian firms. MCs have better opportunities than DCs to earn more profit mainly due to having access to more than one source of earnings and better chances to have favorable business conditions in particular countries (Kogut 1985; Barlett & Ghoshal 1989). Consequently, this would suggest that MCs are more profitable than DCs and therefore they are expected to have relatively lower debt levels than DCs.

Firm size has been found to be a determinant of capital structure (Agrawal & Nagarajan 1990). In relation to MCs and DCs, it is expected that MCs are larger in size than DCs and therefore would carry higher debt levels. The tangibility of assets, or collateral value of assets held by a firm has found to be a determinant of leverage (Rajan & Zingalis 1995). Firms with high collateral value of assets can often borrow on relatively more favorable terms than firms with high intangible assets or assets without collateral value. This would suggest that there is a positive relationship between leverage and collateral value of assets. In relation to MCs and DCs, it is uncertain whether the level of collateral assets is higher or lower for MCs relative to DCs. Myers (1984) suggests that asset risk, asset type, and requirements for external funds vary by industry. Firm debt ratios are also expected to vary by industry (Harris & Raviv 1991; Michaelas et al 1999). However, whether there is any difference in industry effects between MCs and DCs capital structure is not known.

Multinational Capital Structure in an Emerging MarketAccording to the three reasons above-mentioned, “in an emerging market, determinants of capital structure include mixed predictors from three theories: tradeoff, pecking order and free cash flow.”

Institutions, Environments, and Firm CharacteristicsThe paper of (Deesomsak et al 2004) contributed to the capital structure literature by investigating the determinants of capital structure of firms operating in the Asia Pacific region, in four countries with different legal, financial and institutional environments, namely Thailand, Malaysia, Singapore and Australia. The results suggested that the capital structure decision of firms is influenced by the environment in which they operate, as well as firm-specific factors identified in the extant literature. The financial crisis of 1997 is also found to have had a significant but diverse impact on firm’s capital structure decision across the region.

Institutions, environments, and firm characteristics are indeed important determinants of capital structure. From a sample of firms across 45 countries, (Cheng and Shiu 2007) found that investor protection plays an important role in the determinants of capital structure: firms in countries with better creditor protection have higher leverage, while firms in countries where shareholder rights are better protected use more equity funds. The other differences in institutions and environments also explain the cross-sectional variation in the aggregate capital structure across counties. Furthermore, firm characteristics identified by previous studies, as correlated in a cross-section with capital structure in developed markets, are similarly correlated in the present sample of countries. The evidence presented in this study indicated that institutional differences are as important as firm characteristics in determining capital structure.

The dynamics of the world economy and global competition patterns are encouraging multinational Corporations (MNCs) to expand into emerging economies. The study of (Luo 2002) validated the proposition that entry mode selection in an emerging economy is influenced by situational contingencies at four levels: nation, industry, firm, and project. Analysis of data collected from China suggested that joint venture is preferred when perceived governmental intervention or environmental uncertainty is high or host country experience is low. The wholly-owned entry mode is preferred when intellectual property rights are not well protected, the number of firms in the industry is growing fast, the need for global integration is high, or the project is located in an open economic region. The importance of these multilevel determinants requires simultaneous and inseparable considerations of the risk, return, control, and resource effects of the entry mode decision. This necessitates a theoretical integration of multiple perspectives such as transaction cost, the eclectic paradigm, bargaining power, and organizational capability.

Diversification, Exposure to Exchange Rate and Politically Risky EnvironmentsThe relationship between corporate diversification and firm performance represents one of the most extensively researched areas in the fields of corporate finance, strategic management and industrial organization. Efficient internal capital market argument typically suggests that corporate diversification creates firm value. A diversified firm has greater flexibility in capital formation because it has more access to internally generated resources as well as external funds. By forming an internal capital market, diversified firms are in a better position to allocate resources to more deserving and capital starved divisions. They do so by directing capital away from slow growing, cash generating operations to businesses that are expanding rapidly and have great commercial potential, but need investment. Both existing divisions as well as new ventures, which lack a track record and for which limited information is available to external sources, would benefit as a consequence.

Diversified firms can also employ a number of mechanisms to create and exploit market power advantages, tools that are largely unavailable to their more focused counterparts. These include predatory pricing (generally defined as sustained price cutting with the design of driving existing rivals from future entry), cross-subsidization (whereby the firm taps excess revenues from one product line to support another), entry deterrence (achieved by constructing a reputation for predatory behavior or by signaling that such a response is likely in the event of a new entry), reciprocal buying and selling (whereby the focal company gives preference in purchasing decisions or contracting requirements to suppliers). Further benefits of diversification include the ability to exploit excess firm specific assets and share resources such as brand names, managerial skills, consumer loyalty and technological innovations. Apart from financial and intangible resources, (Porter 1987) argued that resource sharing at the corporate level can create value by transferring skills and sharing rent-seeking activities among individual business units.

(Berger and Ofek 1995) found that benefits also stem from tax and other financial advantages associated with diversification and increased debt capacity due to reduced bankruptcy probabilities (Lewellen 1971). (Majd and Meyers 1987) for instance, noted that undiversified firms are at a significant tax disadvantage because tax is paid to the government when income is positive, but the government does not pay the firm when income is negative. This disadvantage is reduced, but not eliminated, by the tax code’s ‘carry back’ and ’carry forward’ provisions. Their analysis predicted that as long as one or more segments of conglomerate experience losses in some years, a conglomerate pays less in taxes than its segments would pay separately.

Despite considerable attention being devoted to the relationship between corporate diversification and firm performance, much of prior research has generally assumed away the impact of differences in the organizational form of firms. (George & Kabir 2005) attempted to address this lacuna and investigated how business groups – a widely prevalent organizational form in many developed and emerging markets – influences the diversification-performance relationship. Analyzing a large sample of firms from India, they found that firms affiliated to business groups are significantly more diversified than independent firms. They also documented that corporate diversification by independent firms reduces firm performance, but that undertaken by group affiliated firms has no impact. Additional analysis revealed that the impact of corporate diversification is not homogeneous across all business groups: for firms affiliated to smaller business groups, diversification significantly lowers profitability while for firms affiliated to larger business groups, diversification enhances profitability. Overall, the study points to the importance of factoring in a firm’s organizational form in investigating the influence of corporate diversification on firm performance.

The impact of the exchange rate variations on the firm value has been a focal issue in international finance as increasing exchange rate volatility proved to be a significant risk factor. Foreign currency exposure literature reflects a consensus view that exposure arises from direct involvement in exports, imports, and or foreign currency denominated funding of operations as well as impact of exchange rates on the competitive position of the firm in its industry. Although these four sources may lead to exposure for all firms involved in the global economy, two of these sources, namely, exports and foreign currency liabilities render a point of variation for the difference in the nature of exposure of Emerging Market Multinationals (EMNCs).The export oriented developed country multinationals follow an expansion strategy where they first move into other developed economies and, only at later stages of market expansion prefer to move into emerging markets. As posited in psychic distance theory or the stages model of internationalization (Johanson and Wiedersheim-Paul 1975, Johanson and Vahlne 1977, Kogut and Singh, 1988), multinational firms tend to expand into regions that exhibit economic and institutional similarities and only after they accumulate considerable international experience do they move on to locations with distinct economic and institutional characteristics. Therefore, it is plausible to argue that developed country MNCs are primarily exposed to fluctuations of stable currencies.

Following the same line of thought, it is believed that EMNCs follow an expansion strategy, where they first seek the markets of their peer emerging markets before expanding into economically and institutionally more developed economies (Kumar and McLeod 1981, Lecraw 1977, Ting and Schive 1981, Wells 1983). The Foreign Direct Investment (FDI) data offer unambiguous support for this argument. The FDI outflows from emerging markets have risen from $3 billion in 1991 to $16 billion in 2002 and then to an estimated $40 billion (Global Development Finance 2005). This argument is also supported by the evidence that EMNCs are more adept in dealing with the governments of other emerging markets, which are perceived to be too risky, and therefore are more active in countries largely neglected by the developed country MNCs (Grosse 2003). Obviously, EMNCs operating in politically and economically unstable environments are far more vulnerable to internal and external shocks, and are primarily exposed to fluctuations of more volatile currencies. A similar argument was constructed by (Kwok & Reeb 2000) in an attempt to explain variations in the systematic risk of DMNCs. In their “up-stream down-stream hypothesis” (Kwok & Reeb 2000) indicated that when developed country MNCs expands into a less developed countries, they tend to increase their systematic risks.

In contrast, firms from less developed countries tend to decrease their systematic risk by expanding into developed country markets. However, EMNCs find it difficult to establish operations in more developed economies because of sophisticated and mostly unfamiliar institutional infrastructure, complexity and intensity of rivalry in developed markets. For example Acer, one of the world’s largest computer manufacturers from Taiwan, tried to build a global brand, particularly by entering the developed countries. The branded business grew to significant volumes but continued to generate losses because the competitive environment was challenging for Acer. Meanwhile, customers for Acer’s contract manufacturing product line feared that their business secrets would spill over to competing lines of businesses. They also feared that Acer would cross-subsidize its own brand with profits from contract manufacturing and undercut their prices. In 2000, Acer’s strategy blew apart when IBM cancelled a major order, reducing its share of Acer’s total contract-manufacturing revenue from 53% in the first quarter to only 26% in the second quarter of 2001 (Khanna 2003).

Despite their growing sophistication and ambitious strategic or

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