Authors of international finance textbooks have suggested a number of practical concepts. First, MNCs should support more
Question:
Authors of international finance textbooks have suggested a number of practical concepts.
First, MNCs should support more debt in their capital structure than purely domestic companies.
They point out that an MNC should have a higher target debt ratio than its domestic counterpart because of its size, access to capital markets, diversification, and tax concessions.
The target debt ratio is the optimum capital structure, which is defined as the combination of debt and common equity that yields the lowest cost of capital. Second, MNCs should have lower business risk than purely domestic companies. Business risk, such as the cost of financial distress and expected bankruptcy cost, refers to the variability of operating profits or the possibility that the firm will not be able to cover its fixed costs. An MNC operates in many different countries and thus this diversification should translate into lower earnings volatility.
Some financial analysts argue that there is an inverse relationship between business risk and the optimum debt level. Companies with less business risk are supposed to assume more debt without added risk. Debt has two types of cost: explicit cost and implicit or bankruptcy cost.
The explicit cost is the interest rate, whereas the implicit cost refers to added debt, which increases the possibility of liquidating a business. Thus, given the traditional paradigm of a trade-off between the tax shelter of debt and the expected bankruptcy cost, MNCs should have lower expected bankruptcy costs and hence higher leverage ratios. In other words, MNCs should be able to carry higher debt loads because they are able to diversify their business risk across national economies.
Third, an MNC is more sensitive to exchange rate fluctuations than a purely domestic company. A purely domestic company may not face economic exchange rate risk because it operates in just one country. Finally, an MNC should have higher agency costs than a purely domestic company because the MNC faces higher auditing costs, language differences, sovereign uncertainty, divergent political and economic systems, and varying accounting systems.
To ascertain these four concepts, Burgman (1996) has conducted an extensive empirical study of 251 domestic firms and 236 MNCs. His findings are as follows. First, the mean leverage ratio for the multinational sample is significantly less than that for the domestic sample at the 1 percent level. Second, the operating profits of the multinational sample are more volatile than the domestic sample, although the statistical significance of the difference is weak. Third, domestic companies are significantly more sensitive to exchange rate risk than MNCs at the 5 percent level. Finally, MNCs have significantly higher agency costs than their domestic counterparts at the 1 percent level. Thus, Burgman’s study confirmed only the fourth concept and rejected the other three concepts.
Case Questions 1 What is the agency problem? What are agency costs? Why do multinational companies incur higher agency costs than domestic companies?
2 Contrary to common expectations, the 1996 study by Burgman has found that multinational companies have lower debt ratios and higher business risks than purely domestic companies. What are possible explanations for this finding?
3 What is economic exchange rate risk? Is it easy to hedge this risk? Contrary to common expectations, the 1996 study by Burgman has concluded that multinational companies have lower economic exchange rate risk than domestic companies. What are the possible explanations for this finding?
4 Use the website of Bloomberg, www.bloomberg.com/markets, to compare yield rates of government securities for several countries.
Step by Step Answer:
Global Corporate Finance Text And Cases
ISBN: 9781405119900
6th Edition
Authors: Suk H. Kim, Seung H. Kim