A Multinational Perspective on Capital Structure Choice and Internal Capital Markets

Abstract

This paper examines the impact of local tax rates and capital market conditions on the level and composition of borrowing by foreign affiliates of American multinational corporations. The evidence indicates that 10 percent higher local tax rates are associated with 2.8 percent higher debt/asset ratios of American-owned affiliates, and that borrowing from related parties is particularly sensitive to tax rates. Borrowing by American affiliates responds to local inflation and political risks, and is more costly in countries with underdeveloped capital markets and those providing weak legal protections for creditors. Affiliates in environments where external borrowing is costly borrow less from unrelated parties: one percent higher interest rates are associated with 1.4 to 2.0 percent less external debt as a fraction of assets. Instrumental variables analysis reveals that affiliates substitute loans from parent companies for between half and three quarters of the reduced borrowing from unrelated parties stemming from adverse local capital market conditions. These patterns suggest that multinational firms are able to structure their finances in response to tax and capital market conditions, thereby creating opportunities not available to many of their local competitors. IntroductionTo what extent does corporate borrowing increase due to the tax deductibility of interest expenses and decline in response to costs imposed by capital market underdevelopment or unfavorable legal systems? Do firms use internal capital markets to substitute for external finance when the latter is costly, and if so, how extensive is such substitution? Empirical attempts to answer these fundamental questions face significant challenges. Limited variation in tax incentives within countries makes it difficult to identify the effects of taxes, and detailed information on the workings of internal capital markets is scarce. Recent efforts using cross-country samples exploit the rich variation that international comparisons offer, but frequently face problems associated with nonstandardized measurement across countries and limited statistical power due to small sample sizes.Cross-country studies of capital structure commonly ignore the many wrinkles associated with multinational firms. These firms face differing tax incentives and legal regimes around the world, making it possible to identify the impact of these factors on financing choices. Analysis of the behavior of multinational firms promises clean estimates of the sensitivity of capital structure choice to tax incentives, an understanding of the mechanisms by which weak capital markets alter financing choices, and insight into the ways in which internal capital markets can facilitate tax minimization and provide an alternate financing source when external financing is most costly.This paper analyzes determinants of the capital structures of foreign affiliates of U.S.multinational firms. The use of confidential affiliate-level data makes it possible to distinguish the behavior of fore...

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