Academic journal article International Journal of Business

On Corporate International Investment under Incomplete Information

Academic journal article International Journal of Business

On Corporate International Investment under Incomplete Information

Article excerpt

ABSTRACT

This paper presents a simple model in which real exchange risk, the competition between firms in different markets and diversification gains affect corporate international investment. By accounting for the role of information, the model embodies different existing explanations based on economic and behavioral variables. We show that real exchange risk, diversification motives and information costs are important elements in the determination of corporate international investment decisions. Using optimal control methods, we provide the general solution for the proportion of firm's total capital budget. We apply the method in Bellalah and Zhen (2002) that can be used to solve other financial control problems.

JEL: G1, G2

Keywords: Corporate investment; Information costs; Diversification

I. INTRODUCTION

Several factors argue for international diversification at the corporate level (Choi (1989), Stulz (1981), Adler and Dumas (1983) and Solnik (1974)). The first explanations are barriers due to the partial segmentation of international capital markets. Segmentation results from regulations, transactions costs, information considerations and unfamiliarity with foreign markets. These costs in segmentation apply to corporate and individual investors. Segmentation may leave room for profitable corporate international investments. The second reason giving rise to the relevance of corporate international investment is agency costs. With these costs, there is some room for corporate activity independent of investor diversification as shown in Choi (1989) and the references therein. The third reason for corporate diversification has some link with the uncertainty of operational cash-flows. The gains from international diversification can be important given the partial segmentation of national economies and markets. The fourth reason for international diversification is due to the effect of exchange risk on corporate international investment. In fact, some authors argue that exchange risk can create a difference in the cost of capital of firms located in different currency zones, affecting hence the flow of international investment. The use of an exchange risk premium (or discount) may be justified by some deviations from purchasing power parity as well as international differences in consumption baskets.

The more recent literature in international investments puts the stress on the role of information in financial markets. Information plays also a central role in explaining the decisions to invest abroad. The strong preference for domestic securities exhibited by investors in international markets, despite the known gains from international diversification, still remains an empirical puzzle in financial economics. The fact that investors appear to only invest in their home country, ignoring in general, foreign opportunities are referred to as the "home bias puzzle". The explanations of this bias are based on barriers to international investment such as governmental restrictions on foreign and domestic capital flows, foreign taxes and high transactions costs. These explanations appear in Black (1974) and Stulz (1981).

Other explanations are associated with the existence of national boundaries and for the geographic proximity (See Bellalah-Zhen (2002). Several explanations and references are advanced in Kang and Stulz (1997) and Stulz (1999) for the home bias. One of these explanations relies on the fact that investors do not invest abroad because they do not know they would benefit or do not want to invest. This explanation supports the main ideas in Merton's (1987) model where an investor who knows little about foreign shares does not invest in them.

This paper studies the effect of information costs, diversification of operational cash flows and exchange risk on corporate international investment decisions in a two-country dynamic optimization model taking these factors as environmental factors. …

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