Foreign Project Financing in Segmented Capital Markets: Equity versus Debt
Thomadakis, Stavros, Usmen, Nilufer, Financial Management
It is well known in finance that capital market segmentation may result in a breakdown of capital structure irrelevance propositions. It should, therefore, be generally agreed upon that, under international segmentation of capital markets, an optimal capital structure is possible. Many papers that have dealt with this issue so far (e.g., see Rubinstein , Adler and Dumas , ,  and , Stapleton and Subrahmanyam , Senbet , and Hodder and Senbet ) have admitted certain limitations, such as nonstochastic exchange rates, stochastic independence of exchange rates and cash flows (e.g., Adler and Dumas ), or riskless debt (e.g., Senbet ). They have not directly modeled internationally segmented capital markets in a way that can calrify conditions for optimal international capital structure choices.
In this paper, we propose to show sufficient conditions for the existence of an international capital structure when the capital markets of two countries are not perfectly integrated, and with the simultaneous presence of both exchange and default risks on debt. By an "international capital structure," we mean an optimal combination of equity issued in one market and debt is issued in another. The appearance of international capital structures in this sense is quite frequent in actual corporate decisions. Our sufficient conditions illuminate decision rules for such outcomes in a context of internationally segmented capital markets.
In order to keep the analysis simple and to present only the relevant points, we employ a "state preference" framework for two reasons. First, the model is simple and the conditions for the emergence of an international capital structure are straightforward and relatively intuitive. Second, the state preference result could also be generalized to more specific models (such as the CAPM or representations of contingent claims in the form of options). It also facilitates an easier understanding of the descriptions of segmentation and its consequences. (1)
In spite of its simplicity, our model yields several general economic intuitions. We assume, more specifically, that the two national capital markets are perfect and complete in the sense that pure contingent claims are priced in each one. This assumption is made in order to eliminate all possible causes for relevance of capital structure within each capital market, and to bring into sharp focus the effect of international segmentation. We also assume that the list of contingencies is the same in the two economies, but they are priced differently by each country's investors. Technically, this is feasible in the state preference framework. (2) Imagine two economies that enjoy a high degree of integration through the free movement of goods and services. This would mean that there is substantial commonality of contingencies in the two economies. Yet, if their capital markets are less integrated than their real sectors, the same contingencies will be priced differently in the respective capital narkets. It is easy to think of examples in the world economy or even within the European Economic Community that come close to fitting this general picture. Many national economies are currently more open to the trading of goods and services than to capital movements. They also highly sensitive to contingencies in the larger economies of the world. Yet, several nations retain trading restrictions on foreign financial assets and large groups of investors exhibit clear national preferences in portfolio selection, thus fostering the phenomenon of capital market segmentation.
What emerges from our analysis can be summarized as follows. First, starting with the premise of capital structure irrelevance in each market, we arrive at an optimal international capital structure comprised of equity in one country and debt in another. Let us be more explicit about the essence of the result: segmentation does not always yield an international capital structure. …