Question

Some special topics of finance within the framework of introduction to finance are listed below. You can prepare one of the topics individually or as a group member of two or three persons. Please, take care of using numerical examples in your study. The number of pages of your homework should be between 5 and 10 pages and the sources you use should be specified in the research in accordance with the research rules

Special topic:

-Financing of multi-national companies

Answer 1

Financing of multi-national companies

Multinational corporations (MNCs) are corporations that are registered in and have operations in more than one country. They are very large corporations that produce and sell their goods or services in almost every country, generating income and employment for the host countries. They have played a unique role in the philosophy of globalization, and they are its supporters and contributors.

The international trade among nations is a very old economic transaction, going back to ancient times in Greece, Egypt, and Middle East regions, but the multinational firms are only about 400 years old. The first multinational company was the British East India Company, founded in 1600, and the second MNC was the Dutch East India Company, founded on March 20, 1602. MNCs make foreign direct investment (FDI)1 in many different countries, as is discussed in chapter 5. Also, they have subsidiaries or daughter companies, which are companies that are completely or partly owned and wholly controlled by the parent company, which owns more than half of subsidiaries’ stocks. These MNCs choose to locate in some special economic zones, which are geographical regions that have economic and other laws that protect foreign firms. These areas are more free-market oriented inside the host country, with the objective being to attract foreign firms and their investments. These MNCs may create jobs and income for the host country, but many times the benefits are mostly to the corporation and not to the local communities. Historically, there has been a lot of exploitation by foreign firms, and they take advantage of the local government by bribing officials, who are usually corrupt in some nations. Also, conflict of laws2 exists in many of these cases because often the legal system and the jurisdiction applied to these foreign firms is not the domestic one, but determined by a foreign law (e.g., the British Law applied to the loans of Greece from the Troika). There are many imperfections in national markets for resources, factors of production, products, and financial markets. These imperfections in national markets are great opportunities for MNCs to take advantage and exploit these foreign markets. The MNCs become oligopolists, and in some cases even monopolists, in these markets, and their opportunities are enormous. For these reasons, firms become multinational to satisfy specific strategic motives: 1. Market Seekers: These firms seek to expand their demand abroad, to experience economies of scale, to establish product differentiation, and to take advantage of countries with large populations. As the MNCs are operating all over the world and have strong distribution networks, the economies of scale are achieved by efficient utilization of fixed costs. This is the greatest advantage over the local companies. 2. Market Development: A MNC may invest in a foreign country in order to expand to new markets. Such companies have very strong product lines and have expertise in the fields of sales and marketing. 3. Raw Material Seekers: Such firms want to extract raw materials (oil, mining, forest, plantation, and other industries) from countries that cannot utilize them due to their lack of capital or technology

1. Debt Financing The two most important forms of debt finance are publicly traded bonds and bank debt. Henderson, Jegadeesh, and Weisbach (2006) document that in their sample period (1990-2001), about 20% of all capital raised through bond issues comes from outside the issuing firm’s home country. The most common places of issue of international bonds are the U.S. and Europe, and many issuers are multinationals from countries with less liquid capital markets. 7 Most large bank loans are syndicated across multiple banks, and the participating banks often come from different countries. Therefore, loans are often made up of capital from multiple countries. Table 7 summarizes these patterns for syndicated loans made to U.S. firms during the period 1990 to 2018. For multinationals, 33% of loans had at least one participating bank from Canada and 32% had at least one from the U.K. Domestic firms also have syndicated loans with foreign banks participating, but to a lesser degree: 23% of syndicated loans to domestic firms had at least one lender from Canada and 16% had at least one lender from the U.K. Next, we examine the difference in bank loan sources between multinational firms and domestic firms in a regression setting. The sample includes syndicated loans issued to U.S. public firms during the period of 1990-2018 obtained from Dealscan, aggregated at the loan package level. We estimate OLS regressions, where the dependent variable is the indicator for including at least one foreign lender in its syndicate in columns (1) and (2), and the percentage of foreign lender as the total number of syndicate members in columns (3) and (4). The main independent variables are the multinational indicator based on non-zero foreign income in past three years and the percentage of foreign income. The regressions include controls of loan features and borrower characteristics and year, industry, borrower rating, and deal purpose fixed effects. Table 8 presents the results that examine the differences in the sources of loans between multinational and domestic firms, with controls for a number of variables that could potentially affect the structure of the loan. This table illustrates that multinationals are 5% more likely to have at least one foreign lender in the syndicate. In addition, they have 3.5% higher fraction of foreign lenders in the syndicate, which is equivalent to a 16% increase at the mean (0.22). The fraction of a firm’s foreign income positively and significantly affects both of these variables. The effects are economically large: they imply that a one-standard-deviation of foreign income (0.245) would increase the fraction of foreign lenders in the syndicate by 2.2 percentage points, which is equivalent to a 10% increase.

2. Equity Financing Firms can also issue equity outside their own country. Henderson, Jegadeesh, and Weisbach (2006) document that about 12% of capital raised by equity issues come from sources outside a firm’s home country. While international equity issues are less common than debt issues, they still represent an important consideration in multinational firms’ financial decisions. The most common way to issue equity in other countries is to cross-list the stock on a local exchange.8 International equity issues through cross-listings are more common for multinational firms than for domestic ones (see Doidge et al. (2009)). In addition, foreign institutional ownership increases with foreign sales (Ferreira and Matos (2008)). Table 9 compares foreign ownership and the incidence of equity offers from other countries across multinationals and domestic U.S. firms. It is evident from this table that multinational firms have more foreign ownership (4.3% for multinationals vs. 1.8% for domestic firms) than domestic firms. Foreign institutional ownership has constantly increased since 2000 and, as of 2017, 8.4% of equity of multinational firms and 4.0% of domestic firms are held by institutional investors outside U.S. Despite the increase in capital flow overseas, the difference in foreign ownership between multinational and domestic firms still remains significant. Like debt, the decision to raise equity overseas is a financial decision that is usually made by multinational firms rather than domestic ones.

As the world economy has become more integrated, there has been an increase in the number of multinational firms. As of 2017, about half of the publicly-traded firms in the U.S. are multinationals. For the average multinational firm, foreign income (sales) represent about 40% of aggregate income (sales). The extent of international operations of multinational firms is similar for international firms in MSCI World developed countries. As the global economy becomes more integrated, the fraction of firms with foreign sales also rose rapidly in emerging markets. Given that multinational firms are such significant players in the world economy, understanding their financial policies is an important task. Operating in more than one country can affect a firm’s financial decisions in a number of ways. Most importantly, being multinational appears to affect both firms’ cost of finance and their access to capital during poor economic times. An important reason for financing advantages of multinational firms is that they have more flexibility in their potential sources of financing than domestic firms. In principle, any firm could borrow from any bank in the world or issue public equity or debt in any country. However, for a number of reasons, it is usually much more cost-effective for firms to raise capital in locations where they have operations (see Jang (2017)). Financing international activities from local capital provides a natural hedge against currency risks. Furthermore, additional choices of where to raise capital can allow a firm to better optimize over rates, and also to diversify its sources of financing, which can be valuable when financing becomes scarce in one part of the world. In addition, being multinational diversifies a firm’s cash flows across countries and minimizes the impact of country-specific shocks. Therefore, multinational firms have lower cash- 2 flow volatility than otherwise similar domestic firms. This lower cash-flow volatility is likely to reduce a firm’s credit risk and cost of financing, and to increase its overall debt capacity. Consistent with the choice of location of borrowing and diversification across countries lowering the cost of debt, we document empirically that multinational firms pay lower spreads on their bank loans, holding other factors constant. However, the results on the cost of equity are mixed, with some studies finding that being multinational lowers the cost of equity while others find that it raises the cost of equity. While being a multinational incurs benefits through diversification of capital sources and by allowing for tax arbitrage across countries, it also entails costs. Firms operating in multiple countries face political risks that are likely to be larger than those faced by domestic companies. A multinational company is a “foreign” company in at least one country, and foreign companies are often discriminated against by regulatory authorities. Dinc and Erel (2013) provide empirical evidence on how economic nationalism, which is defined as preference for the native and against the foreigner, has both direct and indirect economic impact on acquisitions and impedes international capital flows. The authors show that governments implement national policies against foreign acquisition bids through a number of methods, including playing for time by delaying approvals by regulatory agencies, using golden shares in previously privatized companies, moral persuasion by publicly opposing the deals, and providing financing to the rival bidders from national bank. Even if a multinational firm is operating in a country in which it is treated well by the government, there is always risk of a policy shift, potentially occurring when the government changes, that could affect the multinational firm. This political risk is an incremental cost faced by multinational firms but not by domestic ones.

Multinational firms also face exchange-rate risk. They receive revenues in a mix of currencies and have liabilities, both in terms of production costs and interest payments, which are likely in a different mix of currencies. Therefore, movements in exchange rates create a mismatch between the income the company receives and its liabilities, creating a demand for hedging foreign exchange risk. This paper surveys the academic literature on the costs and benefits of multinational firms relative to domestic ones with respect to their corporate financial decisions. Section 2 characterizes multinational firms and presents detailed characteristics of multinationals in the U.S. and overseas. In Section 3, we provide detailed summary statistics on the capital structure of multinational firms and compare their capital structure with the capital structure of domestic firms. Section 4 discusses the way in which firms diversify their sources of financing and the impact of this diversification plays on multinational firms’ costs of financing. Section 5 discusses the additional risks faced by multinational firms in comparison to the domestic counterparts