Academic journal article Journal of Financial Management & Analysis

Comparative Relationship between Cost of Equity Capital and Leverage in Matched Sets of Multinational Corporations and U.S. Domestic Firms*

Academic journal article Journal of Financial Management & Analysis

Comparative Relationship between Cost of Equity Capital and Leverage in Matched Sets of Multinational Corporations and U.S. Domestic Firms*

Article excerpt

(ProQuest: ... denotes formula omitted.)


This research study deals with an interesting, yet little explored, comparative relationship between cost of equity capital and leverage in matched sets of MNCs and U.S. domestic firms. It is generally accepted that, as leverage increases pre-tax overall cost of capital declines up to a moderate level of debt although due more to market imperfections rather than the tax effect factor alone.1 Only on crossing a certain threshold level of debt, where pretax marginal cost of borrowing exceeds the cost of capital, does a major difference of opinion come about between the two schools of thought.

The traditional view holds that once the leverage becomes unacceptable to the debt markets because of increased risk, the overall cost of capital is forced to rise with the rising cost of incremental debt. This phenomenon leaves behind in its wake an optimal leverage, defined in terms of a point or as a range. Modigliani and Miller,2 on the other hand, place their faith in the over-all cost of capital remaining constant. They believe the rise in debt to be accompanied by a falling cost of equity capital due to the action of arbitrage operators.

The present research was motivated by a desire to examine the hypothesized comparative differences in the cost of equity capital and leverage space between domestic and multinational firms due to transnational financing opportunities, exchange-rate risks, varying levels of debt capacity and inflation, different taxation policies and accounting practices, diversification services for investors, operating economies and organizational differences, capital repatriation restrictions, segmented capital markets, etc. The analysis is carried out for a set of U.S. Multinational Corporations (MNCs) and domestic firms matched on leverage in a cross-sectional as well as time-series framework. In a comparative analysis a lower cost of equity capital curve for the MNCs would probably indicate lower operating risks and costs which can translate into a higher profitability potential. However, a situation of intersecting cost of equity capital curves is certainly not being ruled out. This would indicate carrying degrees of benefits for the MNCs vis-a-vis the U.S. domestic firms.

Research Issues and Data Collection

The research issues involved in the empirical test carried out on the data collected for MNCs and U.S. domestic firms concern the following:

* the relative positioning of the cost of equity capital curves when matched on leverage;

* the hypothesized difference in the regression coefficient of the cost of equity capital models used for the two groups of firms; and finally

* a test of stability in the time-series framework of the cross-sectional results obtained earlier (Table 1).

In a comparative framework, as used here to study the cost of equity capital differences in MNCs and U.S. domestic firms, the criterion of distinctly identifying the two independent groups assumes greater importance. Once definition of a MNC explicitly recognizes that a corporation operating in more than one country would be in a position to take advantage of its access to more than one capital market. This helps in delineating the MNCs from domestic firms which operate in one country alone. Furthermore, concentrating only on the larger industrial concerns, with actively traded stocks, as necessitated for the identifiable impact on the price per share, the likelihood of a shrunken sample size for U.S. domestic firms did not go unnoticed. If obtained with adequate randomization, a sample size of 30 to 35 would work out to be adequate for empirical testing. Keeping this in mind, it was decided to compile a list of 37 domestic companies, from across the industries, which were publicly held and had published data available.

The Safety margin in the number of companies looked at was meant to accommodate the foreseeable possibility of firms dropping out of the sample in a particular year due to various reasons. …

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