Academic journal article Management International Review

Capital Structure of Foreign Direct Investments: A Transaction Cost Analysis

Academic journal article Management International Review

Capital Structure of Foreign Direct Investments: A Transaction Cost Analysis

Article excerpt

1 Introduction

Although the hallmark of foreign direct investment (FDI) is that a company holds a sizeable share of equity in a business registered in another country, much of the capital employed in such a business will not be equity; it will be borrowed, either from external creditors (typically local sources) or in the form of intra-corporate loans. (1) According to the World Investment Report (UNCTAD 2013) 11% of the total FDI income over the period 2005-2011 was interest paid on debt between parent companies and subsidiaries or between subsidiaries of multinational enterprises (MNE). Non-parent debt represented about 80% of the debt of US MNE subsidiaries (Desai et al. 2004). What determines the capital structure decisions that MNE make for their FDI? In this theoretical paper, we take a transaction cost theory (TCT) perspective on FDI capital structure.

Companies make FDIs to ensure control over business activities that are most efficiently conducted abroad. Control is achieved by means of establishing an equity-based link (typically, a 10% equity share is required for the investment to qualify as an FDI) to a business entity--a foreign subsidiary--in another country.

According to transaction cost/internalization theory FDIs are made when internal governance (the firm) is considered as superior to external governance (markets and contracts) as a way of carrying out international business (IB) activities, due to (comparatively) inefficient or even missing markets (Buckley and Casson 1976; Hennart 1982; Rugman 1986; Teece 1986; Williamson 1981). An extensive empirical literature has largely corroborated the arguments that specific assets (referring to a lower value of the assets in alternative uses), knowledge (which is often tacit and hence difficult to transfer across organizational boundaries), and reputation assets (which are vulnerable to free-riding), lead companies to choose FDI over non-equity alternatives such as licensing; for an overview, see Zhao et al. (2004). (2)

Although Buckley and Casson (1976) also mentioned internalization of financial markets, the financial aspects of MNEs have received much less attention from the perspective of transaction cost and internalization theory. With an early proponent in Rugman (1980), such research has tended to focus on benefits from operating internal capital markets (e.g., Aulakh and Mudambi 2005; Nguyen and Rugman 2014). In particular, despite the increased focus on subsidiaries in IB research (Rugman et al. 2011) no study so far has considered to what extent transaction cost factors may explain subsidiary capital structure. (3) MNE subsidiary capital structure has so far been the domain of financial economists demonstrating that the benefits of internal capital markets (Gertner et al. 1994) are augmented in the international context, where MNEs use capital structure strategically to overcome the limitations of host country capital markets, to mitigate political risk, and to reduce the MNE's overall tax burden (e.g., Buettner et al. 2009; Desai et al. 2004).

However, there are good reasons to also consider subsidiary capital structure from a governance perspective. Although internalization of capital markets may reduce transaction costs compared to external markets, the fundamental factors driving transaction costs such as asset specificity, bounded rationality and uncertainty (Williamson 1975) do not disappear. Moreover, internalization can lead to new types of costs such as blunted incentives and intra-MNE rent-seeking. Hence, headquarters (HQ) can improve the functioning of internal capital markets by appropriate choices for internal governance.

Our key argument in this paper is that the use of debt in a subsidiary's capital structure, represents a partial reintroduction of market mechanisms inside the boundaries of a MNE, that can help strengthen subsidiary incentives and limit influence activities and rent-seeking. …

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