a multinational perspective on capital structure c

THEJOURNALOFFINANCE•VOL.LIX,NO.6•DECEMBER2004AMultinationalPerspectiveonCapitalStructureChoiceandInternalCapitalMarketsMIHIRA.DESAI,C.FRITZFOLEY,andJAMESR.HINESJR.∗ABSTRACTThispaperanalyzesthecapitalstructuresofforeignaffiliatesandinternalcapitalmarketsofmultinationalcorporations.Tenpercenthigherlocaltaxratesareassoci-atedwith2.8%higherdebt/assetratios,withinternalborrowingbeingparticularlysensitivetotaxes.Multinationalaffiliatesarefinancedwithlessexternaldebtincountrieswithunderdevelopedcapitalmarketsorweakcreditorrights,reflectingsignificantlyhigherlocalborrowingcosts.Instrumentalvariableanalysisindicatesthatgreaterborrowingfromparentcompaniessubstitutesforthree-quartersofre-ducedexternalborrowinginducedbycapitalmarketconditions.Multinationalfirmsappeartoemployinternalcapitalmarketsopportunisticallytoovercomeimperfec-tionsinexternalcapitalmarkets.TOWHATEXTENTDOESCORPORATEBORROWINGincreaseduetothetaxdeductibilityofinterestexpensesanddeclineinresponsetocostsimposedbycapitalmarketunderdevelopmentorunfavorablelegalsystems?Dofirmsuseinternalcapitalmarketstosubstituteforexternalfinancewhenthelatteriscostly,andifso,howextensiveissuchsubstitution?Empiricalattemptstoanswerthesefunda-mentalquestionsfacesignificantchallenges.Limitedvariationintaxincentiveswithincountriesmakesitdifficulttoidentifytheeffectsoftaxes,anddetailedinformationontheworkingsofinternalcapitalmarketsisscarce.Recentef-fortsusingcross-countrysamplesexploittherichvariationthatinternationalcomparisonsoffer,butfrequentlyfaceproblemsassociatedwithnonstandard-izedmeasurementacrosscountriesandlimitedstatisticalpowerduetosmallsamplesizes.Cross-countrystudiesofcapitalstructurecommonlyignorethedistinctiveandilluminatingfeaturesofmultinationalfirms.Thesefirmsfacedifferingtaxincentivesandlegalregimesaroundtheworld,makingitpossibletoidentifytheimpactofthesefactorsonfinancingchoices.Analysisofthebehaviorof∗DesaiisfromHarvardUniversityandNBER,FoleyisfromHarvardUniversity,andHinesisfromtheUniversityofMichiganandNBER.Thestatisticalanalysisoffirm-leveldataonU.S.multi-nationalcompanieswasconductedattheInternationalInvestmentDivision,BureauofEconomicAnalysis,U.S.DepartmentofCommerceunderarrangementsthatmaintainlegalconfidentialityrequirements.TheviewsexpressedarethoseoftheauthorsanddonotreflectofficialpositionsoftheU.S.DepartmentofCommerce.Wethankvariousseminarparticipants,thereferees,RichardGreen,Ren´eStulz,andWilliamZeileforhelpfulcomments,aswellastheLoisandBruceZenkelResearchFundattheUniversityofMichiganandtheDivisionofResearchatHarvardBusinessSchoolforfinancialsupport.24512452TheJournalofFinancemultinationalfirmspromisescleanestimatesofthesensitivityofcapitalstruc-turechoicetotaxincentives,anunderstandingofthemechanismsbywhichweakcapitalmarketsaffectfinancingchoices,andinsightintothewaysinwhichinternalcapitalmarketscanfacilitatetaxminimizationandprovideanalternatefinancingsourcewhenexternalfinancingismostcostly.Thispaperanalyzesthedeterminantsofthecapitalstructuresofforeignaffil-iatesofU.S.multinationalfirms,therebyobtainingevidenceoftheworkingsoftheirinternalcapitalmarkets.Theuseofconfidentialaffiliate-leveldatamakesitpossibletodistinguishthebehaviorofforeignaffiliatesofthesameparentcompaniesoperatinginmarketswithdifferingtaxratesandcapitalmarketregimesandtodifferentiatethedeterminantsofexternalborrowingandbor-rowingfromparentcompanies.Asaresult,itispossibletoobtainestimatesoftheimpactoftaxationandlocalcapitalmarketconditions,whileimplicitlycontrollingforconsiderationsthatarecommontoallaffiliatesofthesamecom-pany.Thesampleincludesinformationontheactivitiesofroughly3,700U.S.multinationalfirmsoperatinginmorethan150countriesthroughapproxi-mately30,000affiliatesin1982,1989,and1994.SinceallreportingfollowsgenerallyacceptedU.S.accountingprinciples,andallfinancialinformationisfiledthroughU.S.entitiesfamiliarwithsuchpractices,itisnotnecessarytomakeproblematicassumptionsnormallyrequiredinordertoanalyzefinancialinformationcollectedindifferentcountries.Furthermore,sincethedatadistin-guishborrowingfromexternalsourcesandborrowingfromparentcompanies,itispossibletostudyaspectsofcapitalmarketsthatareinternaltofirms.Theanalysisfirstexaminestheeffectontotalaffiliateleverageoftaxin-centivesandlegalandcapitalmarketconditions.Thentheanalysisevaluatesthedeterminantsofborrowingfromexternalsourcesandborrowingfrompar-entcompanies,usinglegalandcapitalmarketconditionsasinstrumentstomeasuretheextenttowhichfirmssubstituteloansfromparentcompaniesforloansfromexternalsources.Nextcomesconsiderationoftheeffectoflegalandcapitalmarketconditionsonborrowingrates,includingdifferencesbetweenin-terestratesonexternaldebtandinterestratesonloansfromparentcompanies.Theanalysisconcludesbymeasuringtheextenttowhichinducedvariationinborrowingcostschangesdebtsourcingdecisionsofmultinationalaffiliates.Threemainempiricalfindingsemerge.First,thereisstrongevidencethataffiliatesofmultinationalfirmsaltertheoveralllevelandcompositionofdebtinresponsetotaxincentives.Theestimatesimplythat10%highertaxratesareassociatedw