In: Finance
With greater financial integration in the last two decades, what are the main factors that affect their choices of capital? Are legal considerations, economic potentials and challenges, demographic and cultural transformations act as factors that determine their decisions-making process on capital structure? Explain your answer. (Dimention2)
Financial integration means when markets from neighbouring countries, regions and global economies are closely linked together. It is shared growth where there is exchange of best practices and work ethics and cultures and outsourcing of jobs to attain specialisation. There is immense exchange of latest technologies among financial markets and huge investments in global markets. It is a lot beneficial in developing countries and countries with hotspot of business.
What impact does it have on capital structure of a company? Capital structure of a company involves two things - Equity and Debt.
Higher level of credit market integration lead to higher leverage but higher equity market integration leads to lower leverage. It is observed that when financial integration increases, companies which have high growth potential and high growth opportunities seem to borrow more debt and want to earn greater profits using debt. One main reason behind increase of debt in capital structure in growth stage is that cost of capital decreases when debt is increased and also there is no further dilution of control. Also, in high growth stage companies, they aim for foreign investors and large pool in of investments. They mostly go for long-term debt. Regular and huge borrowing of short term debt can lead to asset-liability mismatch.
When equity markets are strongly integrated, companies are likely to build more sound governance mechanisms and deliver information more transparently and accurately.
So, it really depends on the growth of the firm and the integration level of the country.
With regards to legal systems, we see that the there is more borrowing of debt in developed countries with robust legal system in place. Often, foreign investors take short term debts in developing countries with weak legal and political systems.
All other factors such as economic potentials and challenegs, demographics, cultural transformation affect the capital structure. For example, countries with a dominant group of religion may have different beliefs accordig to their religions. Some religions do not believe in debt or interest through investment and in countries like this borrowing can be significantly lower than other countries. Demographics has its own advantage. Countries rich in natural resources are often cash rich and there is shortage of liquidity and hence they borrow less and there is more of equity in these companies. Infact, they lend more.
Firms having individualistic culture prefer more debt based capital than those of collectivism.
Countries and regions with high economic growth potential have high opportunity for investments from foreign institutions but their legal system, cultural differences, political situations decide whether the investment will be short term or long term. The more the flexibility, the more is the use of long term debt and more leverage.