J. of Multi. Fin. Manag.

14 (2004) 153169

Internationalization, capital structure, and cost of capital: evidence from French corporations
Manohar Singh , Ali Nejadmalayeri1
Department of Managerial Sciences, College of Business Administration, University of Nevada-Reno, Mail Stop 028, Reno, NV 89557-0206, USA Received 15 September 2002; accepted 10 July 2003

Abstract The paper examines the relationship between international diversication, nancial structure, and their individual and interactive implications for the combined debt and equity cost of capital for a sample of French corporation. We report that the degree of international diversication positively associates with higher total and long-term debt ratios. Our evidence suggests a non-linear inverted U-shape relationship between the degree of international diversication and short term debt nancing. We also nd that internationally diversied rms support higher level of debt nancing that directly results in reduction of overall cost of capital despite higher equity risk. More signicantly, we nd that even after controlling for the effects of the degree and composition of debt nancing, equity risk, rm size, managerial agency costs, and asset structure, higher degree of international diversication results in lower overallcombined debt and equitycost of capital. 2003 Elsevier B.V. All rights reserved.
JEL classication: G32 Keywords: International diversication; Capital structure; Cost of capital

1. Introduction Despite phenomenal growth in the theory of capital structure there is no unique theoretically predicted relationship between various rm specic business, nancial, and
We would like to thank Ike Mathur, the editor, seminar participants in the 2003 Midwestern Finance Association meetings, and an anonymous referee for helpful comments. Corresponding author. Tel.: +1-775-784-6993x308; fax: +1-775-784-1769. E-mail addresses: msingh@unr.edu (M. Singh), aliala@unr.edu (A. Nejadmalayeri). 1 Tel.: +1-775-784-6993x306; fax: +1-775-784-1769. 1042-444X/$ see front matter 2003 Elsevier B.V. All rights reserved. doi:10.1016/j.muln.2003.07.003

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lifecycle stage characteristics on one hand and composition and degree of nancial leverage and consequent cost of capital on the other. This is particularly so in the case of issues related to multinational corporations (hereafter MNCs) nancial structure choices and the cost of capital implications of those choice. Earlier studies provide a substantial body of empirical evidence (see, e.g. Burgman, 1996; Chen et al., 1997) suggesting that MNCs tend to carry less debt in their capital structure than domestic rms. However, more recent evidence by Mansi and Reeb (2002) suggests that not only MNCs carry more debt than domestic corporations (hereafter DCs), their cost of debt nancing is also lower than that of DCs (Reeb et al., 2001). At present, the debate focuses on resolving the obvious question: why, despite a lower cost of debt nancing, MNCs carry less debt? While there has been extensive work on the issue of relating cost of equity to international diversication, only very recently (Mansi and Reeb, 2002; Reeb et al., 2001) have researchers focused on the relationship between cost of debt capital and international diversication. There has been no work analyzing the overall cost of capital and international diversication link. Extending Reeb et al. (2001), this paper aims at investigating the issue by studying rms overall weighted average cost of capitalin contrast to analyzing individual cost of equity or cost of debtas conditioned by strategy of international diversication and capital structure choices of MNCs and DCs. Our investigation involves two stages. In the rst instance, we relate capital structure to the degree of international diversication. At the second stage, we focus on the overall cost of capital implications of internationalization, controlling for inuences of capital structure choice, which, in turn, is conditioned by international diversication. To the best of our knowledge, this is the rst paper that analyzes the relationship between the overall cost of capital and international diversication strategy. The main contribution of this paper lies in its being the rst in relating MNCs nancial structure to overalldebt and equity combinedcost of capital. Second, this study focuses on French corporations, testing the issue of MNCs capital structure in European setting to see if the paradoxlower MNCs leverage despite lower cost of debtcan be explained more satisfactorily in a different setting. Third, we utilize a more appropriate analytic framework to clearly delineate the role of international diversication, net of the effects of capital structure and equity market risks, in determining corporate cost of capital. Further, we use a system of equations specication that allows for the endogeneity and joint determination of the degree of nancial leverage and the cost of capital. Our ndings suggest that a higher degree of international diversication positively associates with higher total and long-term debt ratios. Further, the results point to a nonlinear inverted U-shape relationship between the degree of international diversication and short term debt nancing. More signicantly, we nd that internationally diversied rms support higher level of debt nancing that directly results in the reduction of overall cost of capital despite higher equity risk levels as proxied by beta. Finally, the evidence indicates that even after controlling for the effects of the degree and composition of debt nancing, equity risk, rm size, managerial agency costs, and asset structure, higher degree of international diversication results in lower overallcombined debt and equitycost of capital.

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The paper is organized as follows. Section 2 outlines the research focus and overviews the relevant theoretical and empirical research. Section 3 describes the sample and the methodology used to analyze the issues. Section 4 offers a discussion of the results. We present the conclusions of the study in Section 5.

2. Research focus 2.1. Overview Reeb et al. (2001) suggest that greater international activity may lead to lower risksdue to diversication benetsfor debt holders, while simultaneously increasing the riskiness of equity capital due to risksexchange rate uctuationsspecic to international operations. Thus, for MNCs, while higher debt nancing may be an appropriate strategy for reducing the cost of debt component of total capital, increased leverage may increase the cost of equity high enough to offset any benets of higher leverage, thereby resulting in a higher overall cost of capital. In addition, given that international diversication may result in changes in the levels of volatility (Bodnar and Wong, 2000) and associated reduction in the value of equity call option, cost of equity is expected to go up and that of debt go down. The net effect of these two tendencies on the total cost of capital will depend on the degree of international diversication and level of debt nancing. However, there is no published research dealing with the impact of international diversication on the overallcombined debt and equitycost of capital. The present paper is the rst in dealing with the interrelationship between geographic diversication, nancial structure strategy, and corporate cost of capital. While addressing the issue of determinants of cost of capital, we must recognize that international diversication acts as a direct inuence on the overall cost of capital through benets related to risk diversication and internal capital markets and costs related to information asymmetries and political and foreign exchange risks involved in international activities. Since capital structure choice determines the overall cost of capital, international diversication, by inuencing choice of capital structure, would also indirectly inuence the overall cost of capital. Therefore, at the second stage, we analyze the relationship between international diversication and cost of capital controlling for the inuence of degree of nancial leverage on cost of capital. We do this by utilizing the system of equations approach, thereby avoiding the estimation problems related to the endogeneity and joint determination of nancing mix and cost of capital. Specically, we addresses the following questions: (a) Are there signicant differences between multinational corporations and domestic corporations with respect to the compositionshort-term versus long-term debtand the degree of nancial leverage? (b) What is the relationship between international diversication and the extent of debt nancing? Is that relationship dependent upon the degree of international diversication? (c) How do international diversication and capital structure strategies individually and interactively determine the overall cost of capital for multinational corporations?

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2.2. Diversication and cost of capital 2.2.1. Diversication and internal capital markets Given the imperfections in the international capital markets, rms undertaking international operations will have to incur additional costs to overcome these barriers. However, it is argued (Kindelberger, 1969; Caves, 1971) that MNCs, by virtue of their ability to internalize the capital market transactions, are able to overcome capital ow barriers consequent market imperfection. The resulting internal capital markets, by providing an opportunity for MNCs to avoid costly external market transactions, help reduce their cost of capital. 2.2.2. Diversication and risk reduction Levy and Sarnat (1970) and Lessard (1973) highlight the risk reduction benets of multinational diversication. Similarly, Agmon and Lessard (1977) indicate that MNCs have greater stability against volatile markets. The reduced variability of earnings is perceived as nancial strength by investors in the rm and thus results in reduced cost of capital. Fatemi (1984), among others, reports that internationally diversied rms have lower systematic risk that would get translated into lower cost of equity capital relative to DCs. 2.2.3. Information asymmetries Burgman (1996) argues that due to institutional, legal, and socio-cultural differences across nations, MNCs may face higher degree of information asymmetries. Further, it is suggested (Lee and Kwok, 1988) that it is more difcult to monitor rms that are globally active than those that are purely domestic. These asymmetries may raise overall cost of capital. In addition, due to the lack of transparency of international operations, there may be higher monitoring costs leading to greater conict of interests between debt holders and shareholders as well as agency conict between managers and shareholders. First, in terms of agency cost of debt, if, as suggested by Lee and Kwok (1988), MNCs have more investment related real options than domestic rms, then in Myers (1977) framework, there will be a more severe underinvestment problem in MNCs compared to DCs. This would lead to higher cost of debt, as lenders will nd MNCs debt relatively less attractive. In addition, due to different risk-return preference of debtholders and shareholders, debtholders may raise their required rate of return to adjust for asset-substitution problem related costs that may be more sever in MNCs due to difculties in monitoring international operations. Secondly, in terms of management-shareholder conict, MNCs managers may face less strict monitoring by shareholders given more severe information asymmetries between MNCs insiders and outsider stakeholders. This may lead to higher cost of equity due to higher bonding and monitoring costs. 2.2.4. Risks unique to internationalization It is argued (Aliber, 1984) that MNCs, operate as they do in foreign economies, may be perceived more negatively by investors in terms of nancial, business, and socio-political risks involved in a foreign economy. Reeb et al. (1998) and He and Ng (1998) suggested that in addition to facing unique political risk exposure, MNCs face a higher risk of foreign exchange exposure that leads to increased variability in their domestic currency denominated

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earnings. These risks, unique to MNCs, may result in higher probability of them experiencing nancial distress thereby raising their overall cost of capital. 2.3. Diversication and capital structure 2.3.1. Coinsurance effect Following Lewellens (1971) argument that product diversication provides a coinsurance thereby enhancing corporate debt capacity, it is reasonable to expect a positive impact on debt capacity for geographically diversied rms. In fact, Heston and Rouwenhorst (1994) provide evidence that diversication across political boundaries reduces risk more than diversifying across industries within one country. In the same vein, Agmon and Lessard (1977) and Fatemi (1984) posit that international diversication reduces the expected cost of bankruptcy and allows for increased debt capacity. Chkir and Cosset (2001) suggest that leverage increases with both international and product diversication, and that a strategy of combined international and product diversication leads to lower threat of bankruptcy risk. However, more recently, Singh et al. (2003) provide evidence that while product diversied rms have higher degree of leverage relative to product focused rm, MNCs support a lower level of debt nancing relative to DCs. 2.3.2. Debt as hedging instrument If, as argued, MNCs face higher exchange rate and political risks compared to DCs, we should expect MNCs to carry more debt to hedge against those risks by borrowing in the local (host) country debt market. Burgman (1996), nding a positive relationship between political and exchange rate risk and leverage, argues in terms of companies using leverage to hedge away these risks. More recently, Kedia and Mozumdar (2002) report strong evidence that rms issue foreign currency debt to hedge their exposure in the underlying currency. 2.3.3. Growth opportunities and the level of corporate debt It is often argued that multinational diversication is motivated by generation of growth opportunities through creation of larger markets. Kim and Lyn (1986) suggest that MNCs often outperform local companies in host countries and have more growth opportunities. In this scenario, MNCs will have lower leverage as the agency costs associated with the debtholderstockholder conict is likely to be a positive function of a rms growth opportunities. Since the degree of underinvestment problem positively associates with growth opportunities (Myers, 1977), MNCshaving better growth opportunitieswill have a tendency to nance their business with equity rather than debt. 2.3.4. Asset structure There is a large body of evidence suggesting that high growth MNCs carry more intangible assets (Ethier, 1996; Ethier and Horn, 1990) compared to low growth domestic rms. Given that it is more difcult for debtholders to monitor rms with greater growth opportunities, and that they would less likely recoverdue to lack of disposable collateral assetstheir investment in case of default, an MNCs debtholders will require higher return on debt, thereby discouraging them from utilizing higher debt nancing.

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2.3.5. Agency cost issues In the managerial agency framework, debt is argued to be a bonding device to contain free cash ow related agency costs that are more severe in mature and low growth rms. Accordingly, the free cash ow hypothesis (Jensen, 1986) suggests an inverse relation between growth opportunities and debt ratios predicting lower leverage for MNCs. In line with these arguments, Burgman (1996) and Fatemi (1988) nd that MNCs have lower debt ratios. Lee and Kwok (1988) report that after controlling for size and industry related factors, MNCs have higher agency costs than DCs and that may explain why MNCs are less leveraged than DCs. In terms of agency costs of debt, Chen et al. (1997) argue that MNCs have higher bankruptcy costs and agency costs of debt. Doukas and Pantzalis (2003) provide evidence that suggests that MNCs face higher agency costs of debt than DCs, hence leading MNCs to seek less long-term debt nancing than DCs.

3. Sample selection and methodology 3.1. Sample selection We focus on French rms for a number of reasons. On the macroeconomic level, unlike other large European economies like Germany and the UK, France recently experienced a transformation from bank-based to market-based system in which the role of banks in corporate debt markets is declining (Schmidt et al., 1999). On the microeconomic level, according to a 1995 report prepared by the European Committee of Central Balance Sheet Ofces, there are two dening characteristics of the French corporate nancial strategy. First, French rms show an overall lower level of debt nancing compared to other European rms. This implies that French corporations may not have risk proles typically observed in studying the diversication-leverage link in the US/UK setting. Second, in France, corporate size does not signicantly seem to differentiate debt-nancing levels in French rms. The implication for our analysis is that the risksinformation asymmetries and nancial distressthat are normally hypothesized to be negatively related to rm size may not behave in the typically hypothesized fashion. Our original source of the set of French rms analyzed in this paper is the country-wise annual list of the best performing companies compiled by Stern Stewart. The Stern Stewart data includes information on the cost of capital and return on capital for the listed companies. We started with 179 rms listed in the 1999 best performing rms list. We trace these rms back for 3 years up to 1996. The nal set includes only those rms that appear in the best performing list consistently for all the 4 years. We then retrieve the annual balance sheet and income statement data for these French companies from the WorldScope database. The nal sample consists of 90 rms that consistently appeared in the Stern Stewart best performing list for 4 years from 1996 to 1999 and also had information available on WorldScope database. Thus, our nal sample has 360 rm year observations. We classify the sample rms as domestic or multinational depending upon the ratio of foreign sales to total sales being less than or equal to 10% or more than 10%, respectively. Table 1 provides basic descriptive statistics of the sample.

M. Singh, A. Nejadmalayeri / J. of Multi. Fin. Manag. 14 (2004) 153169 Table 1 Sample descriptive statistics Variable Size (000) TA COMEQ NETSALE NI Growth (%) SLGR5 INCGR5 Protability (%) PRETAXMR ROA5 ROA ROE5 ROE Leverage (%) DTA STDTA LTDCAP CEQTA5 LTDCAP5 Description Total assets Book value of common equity Net sales Net income Five-year average sales growth Five-year average net income growth Pretax margin; ratio of EBIT to sales Five-year average return on assets Current return on assets Five-year average return on equity Current return on equity The ratio of total debt to total assets The ratio of short-term debt to total assets The ratio of long-term debt to total capital Five-year average of the ratio of common equity to assets Five-year average of the ratio of long-term debt to assets Mean 37853988.70 9457224.60 30898442.40 909755.50 11.00 13.11 6.78 5.20 5.90 10.61 13.87 21.38 0.09 24.46 33.14 25.73 Median 9811786.00 2872350.00 9062661.00 271955.50 8.06 7.10 6.87 4.53 5.18 10.74 13.69 19.59 0.07 22.35 34.20 23.80 S.D.

159

662137.79 868049.54 2624444.90 115511.70 1.88 1.14 0.69 0.24 0.25 0.68 0.71 0.74 0.00 0.94 0.87 0.94

International diversication (%) FATA The ratio of foreign to total assets FINCTINC The ratio of foreign to total income FSLTSL The ratio of foreign to total sales Market performance PRICEBK The ratio of price to book PBVCL5 Five-year average price to book ratio BETA Equity beta CFS Four-year S.D. of cash ow to sales COC Cost of capital

4.74 8.81 39.49 3.74 2.11 0.91 1.24 9.73

0.00 0.00 43.09 2.55 1.73 0.92 0.29 9.70

0.73 1.87 1.53 0.22 0.16 0.03 4.86 0.10

This table reports mean, median, and standard deviation of the variables of interest for all the rms in our sample. All non-ratio amounts are in French Francs.

3.2. Data analysis The data analysis involves using parametric and non-parametric test statistics for identication and quantication of corporate capital structure and cost of capital differentials across internationally diversied rms on the one hand and domestic rms on the other. We also use multivariate random effects panel data regression analysis to investigate the nature and the degree of inuence that international diversication has on the capital structure and cost of capital. We also test for non-linearity of relationship between the degree of international diversication and the extent of debt nancing and the resulting cost of capital. We use the full information maximum likelihood estimation of a seemingly unrelated regressions

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system of equations wherein leverage and cost of capital are specied as endogenous variables. The base models for relating leverage and cost of capital to the degree of international diversication estimated using the OLS technique are specied respectively as DebtRatio = 0 + 1 lsale + 2 ROE5 + 3 SLGR5 + 4 FSLTSL + 5 nppta + 6 inddum + COC = 0 + 1 DebtRatio + 2 lsale + 3 BETA + 4 ATO + 5 FSLTSL + 6 inddum + and, the seemingly unrelated system of equations is: DebtRatio = 0 + 1 lsale + 2 ROE5 + 3 SLGR5 + 4 FSLTSL +5 nppta + 6 inddum + COC = 0 + 1 DebtRatio + 2 lsale + 3 BETA + 4 ATO +5 FSLTSL + 6 inddum + (2) (1)

(3)

where DebtRatio is either of three variables: DTA; proportion of total debt of total assets, STDTA; proportion of short-term debt of total assets, or LTDTA; proportion of long-term debt of total assets. COC is the cost of capital as computed by Stern Stewart. lsale is the log of total sales. ROE5 is the 5-year average of return on equity. SLGR5 is the 5-year average sales growth. BETA is the 5-year average equity beta. ATO is the asset turn-over ratio. FSLTSL is percentage of foreign sales to total sales. The variable nppta is the ratio of net plant, property, and equipment to total assets. Finally, inddum is a vector of six industry dummies each for a two-digit SIC industry classication code to control for industry specic factors.

4. Empirical ndings and discussion of results 4.1. Univariate analysis As is evident from Table 2, the multinational rms have signicantly larger asset base and generate more sales. The results also show that not only MNCs net income is signicantly higher relative to DCs, their protability, as measured by prot margin is also higher. The results pertaining to relative protability in terms of ROA and ROE are ambiguous. The sample MNCs seem to have higher growth opportunities in terms of higher price to book and price to earnings ratios. Our results also show that, as a group, MNCshaving riskier equity and higher level of intangible assetscarry lower levels of long-term and higher level of short-term debt. Despite these signicant differences in asset structure and nancial leverage composition, the two groups have statistically insignicant difference in their costs of capital. Our results do not indicate that MNCs total debt ratio differs signicantly from that of DCs. It is also possible that although across the two groups there are no signicant differences in the capital

M. Singh, A. Nejadmalayeri / J. of Multi. Fin. Manag. 14 (2004) 153169 Table 2 Mean comparison tests: domestic vs. multinational corporations Variable Domestic MNC Parametric P-value of mean equality 0.025 0.092 0.000 0.208 0.119 0.232 0.804 0.740 0.074 0.573 0.616 0.089 0.253 0.450 0.612 0.000 0.023 0.001 0.093 0.833 0.422 0.765 0.906 0.808 0.000 0.069

161

Non-parametric (Kruskal & Wallis) P-value of distribution equality 0.000 0.000 0.000 0.000 0.003 0.026 0.027 0.126 0.153 0.238 0.100 0.735 0.007 0.123 0.444 0.000 0.002 0.000 0.434 0.190 0.023 0.383 0.777 0.768 0.000 0.036

TA (FF000) COMEQ (FF000) NETSALE (FF000) NI (FF000) SLGR5 INCGR5 PRETAXMR ROA5 ROA ROE5 ROE PRICEBK PERATCL5 PBVCL5 COC BETA INTANGTA STDTA LTDTA DTA DCEQ LTDCAP CEQTA5 LTDCAP5 FSLTSL CFS Number of observations

24263170 662301 15282961 612176 7.859 10.904 6.391 5.408 6.822 10.022 14.494 3.257 5.072 1.968 9.813 0.730 0.118 6.80 15.00 21.812 46.379 24.731 33.273 25.709 2.055 0.023 96

42954160 10525840 36709723 1021552 12.271 13.869 6.997 5.183 5.617 11.011 13.502 3.921 25.202 2.169 9.697 0.975 0.153 9.60 11.60 21.356 82.900 23.973 33.514 25.134 52.830 0.009 259

This table compares the means of all variables of interest of domestic and multinational rms. PERATCL5 is the ve-year average PE ratio. PBVCL5 is the ve-year average price-to-book ratio. INTANGTA is the ratio of intangible assets to total assets. LTDTA is the ratio of long-term debt to total assets. DCEQ is the ratio of debt to common equity. All other variables are dened in Table 1.

structure and the cost of capital, within the MNCs group, leverage and cost of capital are functions of the degree of international diversication. In sum, our univariate evidence points to the existence of some signicant differences across MNCs and DCs in rm-specic characteristics that may have bearing on rm capital structure and cost of capital. 4.2. Multivariate analysis 4.2.1. Leverage, cost of capital, and international diversication Initially, we relate a rms degree of international diversication to the degree of debt nancing in a linear regression framework. As shown in Table 3, our pooled linear regression results indicate that, controlling for other factors, international diversication, as measured

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Table 3 Relationship between leverage ratios and international diversication Variable Intercept lsale ROE5 SLGR5 FSLTSL nppta Industry dummy Industry dummy Industry dummy Industry dummy Industry dummy Industry dummy Total debt ratio 15.8061 (1.07) 2.5245 (3.36) 0.1246 (3.20) 0.0248 (2.87) 0.0266 (1.00) 15.8585 (1.98) 5.6120 (0.47) 8.0698 (0.77) 8.3370 (0.79) 0.0370 (0.00) 7.2671 (0.67) 2.8907 (0.27) 343 0.1204 21.51 0.0006 Short-term debt ratio 0.0022 (0.03) 0.0093 (2.12) 0.0005 (1.71) 0.0001 (1.04) 0.0002 (0.95) 0.0479 (1.02) 0.0674 (1.08) 0.0302 (0.55) 0.0550 (1.01) 0.0551 (0.93) 0.0680 (1.22) 0.0664 (1.19) 343 0.0478 11.94 0.0356 Long-term debt ratio 0.1665 (1.49) 0.0160 (2.72) 0.0007 (1.92) 0.0001 (1.79) 0.0001 (0.63) 0.3172 (5.06) 0.0296 (0.34) 0.0537 (0.70) 0.0362 (0.47) 0.0344 (0.41) 0.0384 (0.49) 0.0252 (0.32) 343 0.1630 13.10 0.0225

1 2 3 4 5 6

Number of observations Adj. R2 Hausman (F-test) P-value

This table presents the results for a pooled regression of the following model of debt ratio using a sample of 90 French companies over the period of 19961999: DebtRatio = 0 + 1 lsale + 2 ROE5 + 3 SLGR5 + 4 FSLTSL + 5 nppta + 6 inddum + where DebtRatio is either of three variables: DTA; ratio of total debt to total assets, STDTA; ratio of short-term debt to total assets, or LTDTA; ratio of long-term debt to total assets, lsale is the log of total sales, ROE5 is the 5-year average of return on equity, SLGR5 is the 5-year average sales growth, FSLTSL is the ratio of foreign sales to total sales, nppta is the ratio of plant, property and equipment to total assets, and inddum is a vector of six industry dummies. The t-statistics are in parentheses. Signicance at 10%. Signicance at 5%. Signicance at 1%.

by the ratio of foreign sales to total sales, has no signicant impact on either the degree of total nancial leverage, as measured by the ratio of total debt to total assets, or the short- and long-term debt components. One possible reason for the insignicance of linear coefcients may be that the actual relationship between nancial leverage and international diversication may be non-linear. Other reasons may be that some of the control variables are proxying for international diversication or there are distortions related to simultaneous determination of leverage and cost of capital. Consistent with the previous research, our control variables results indicate that rm size, as measured by log of net sales (lsale), and asset tangibility, as measured by the ratio of net property, plant, and equipment to total assets (nppta), have signicant positive impacts on the total leverage. As noted earlier, our objective is to examine whether international diversication affects cost of capital despite its well-documented impact on leverage and maturity structure. Initially, we relate degree of international diversication to rm cost of capital in a simple linear regression framework. The results reported in Table 4 indicate that after adjusting for the effects of leverage, equity risk, and managerial agency costs (proxied by the inverse of asset turnover ratio, ATO) on the overall cost of capital, international

M. Singh, A. Nejadmalayeri / J. of Multi. Fin. Manag. 14 (2004) 153169 Table 4 Cost of capital and international diversication Variable Intercept DTA STDTA LTDTA lsale BETA ATO FSLTSL Industry dummy Industry dummy Industry dummy Industry dummy Industry dummy Industry dummy Effect of total debt (12.11) 0.0559 (10.76) 0.0624 (1.36) 0.2536 (1.74) 0.6631 (4.07) 0.0061 (2.40) 0.3724 (0.67) 0.2297 (0.49) 0.5007 (1.09) 0.3044 (0.61) 0.1599 (0.34) 0.0377 (0.08) 321 0.3764 10.93 0.0251 12.6002 Effect of short-term debt 12.3103 (10.64)

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Effect of long-term debt 13.1750 (12.14) 0.0573 (8.94) 0.1563 (3.40) 0.2840 (1.87) 0.6185 (3.61) 0.0066 (2.46) 1.0531 (1.84) 0.0668 (0.14) 0.8819 (1.85) 0.1030 (0.20) 0.6038 (1.21) 0.3946 (0.82) 321 0.3207 11.72 0.0164

0.0576 (4.76) 0.1253 (2.37) 0.2375 (1.45) 0.0857 (0.50) 0.0040 (1.40) 0.3951 (0.63) 0.1293 (0.24) 0.4376 (0.84) 0.9897 (1.75) 0.1702 (0.31) 0.2507 (0.48) 321 0.2076 20.73 0.0079

1 2 3 4 5 6

Number of observations Adj. R2 Hausman (F-test) P-value

This table presents the results for a pooled regression of the following model of cost of capital, using a sample of 90 rms for each of the years between 1996 and 1999: COC = 0 + 1 DebtRatio + 2 lsale + 3 BETA + 4 ATO + 5 FSLTSL + 6 inddum + where, COC is the cost of capital, lsale is the log of total sales, DebtRatio is either of three variables: DTA; ratio of total debt to total assets, STDTA; ratio of short-term debt to total assets, or LTDTA; ratio of long-term debt to total assets, BETA is the 5-year average equity beta, ATO is the asset turnover ratio; the ratio of total sales to total assets, a measure of agency cost, FSLTSL is the ratio of foreign sales to total sales, nppta is the ratio of plant, property and equipment to total assets, and inddum is a vector of six industry dummies. The t-statistics are in parentheses. Signicance at 10%. Signicance at 5%. Signicance at 1%.

diversication signicantly (at the 5% level) decreases the cost of capital. This holds true for both the total debt to total asset ratio, as well as, long-term debt to total asset ratio proxies for leverage as control variable. Our results show that for every percentage point increase in the ratio of foreign sales to total sales, the rms cost of capital decreases by 0.0061% and 0.0066%, respectively, controlling for inuence of total debt and long-term debt. In combination with evidence of signicantly higher beta for MNCs relative to DCs (Table 2), these results indicate that despite higher equity risk, international diversication leads to lower total risks and hence lower overall cost of capital. Given that the coefcients of leverage proxies are negative signicant, we can safely conclude that higher leverage does not seem to increase the perceived riskiness of rms. Higher leverage in fact seems to reduce the overall cost of capital. Although this paper does not aim to provide evidence on foreign currency debt issuance by MNCs, our results may be rationalized in terms of sample rms utilizing foreign currency debt as hedging instruments (see Kedia and Mozumdar,

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2002) thereby reducing the overall riskiness and the rm cost of capital despite increasing leverage. In terms of control variable coefcients, we nd that larger rms face lower cost of capital, possibly a reection of nancial strength and lower information asymmetries for these rms. As expected, higher equity risk in terms of beta positively relates to the overall cost of capital. Firms with higher asset turnover ratioreecting lower managerial agency problem in Ang et als (2000) frameworkhave lower cost of capital. Ang et al. (2000) and Singh and Davidson (2003) argue that the asset turnover ratio measures managements ability to employ assets efciently. Our results support this contention. To make sure that our results are not an artifact of our methodological approach adopted or conditional upon a particular denition of our test variables, we perform a number of robustness checks in the next section. 4.2.2. Interlink between leverage and cost of capital Obviously a rms leverage and cost of capital are intertwined. Thus, one cannot accurately examine the impact of international diversication without accounting for such interlinks. Econometrically, the remedy for such problem is to use the seemingly unrelated system of equations model. To examine the impact of international diversication on leverage and cost of capital, we estimate the system of Eq. (3) using the seemingly unrelated regressions method. Using the more robust system-of-equations model we see a signicant change in our results that were reached using the linear regression model. As is shown in Table 5, when we control for the endogeneity between leverage and cost of capital, our results indicate that international diversication now positively affects leverage (signicant at the 10% level). When we decompose total debt into long- and short-term debt, we nd a positive impact of international diversication on long-term leverage. Though barely signicant at 10% level, the results show that rms that are more internationally diversied do use marginally more long-term debt. Our results, however, do not show a signicant relationship between short-term leverage and international diversication when cost of capital is controlled for. The results are consistent with previous research results reported by Reeb et al. (2001) and Mansi and Reeb (2002). In terms of cost of capital and diversication relationship, we nd a signicant capital cost saving effect of international diversication. We argue that the positive association between total and long-term leverage and international diversication may be a result of potential cost of capital savings due to increased usage of total and long term debt by internationally diversied rm. Although, all three types of debt are signicant negative inuence on cost of capital, as noted earlier, international diversication is insignicantly related to degree of short-term debt. When we control for short-term debt in our cost of capital equation, the relationship between international diversication and cost of capital is insignicant. 4.2.3. Nonlinear impact of the degree of international diversication To ensure that this insignicance is not due to imposing a linear function on a nonlinear relationship, we specify our system of equations model allowing for non-linearity in international diversication. A plausible reason for possible non-linearity is as follows. At the initial stages of international diversication, as rms expand abroad, their nancing needs

M. Singh, A. Nejadmalayeri / J. of Multi. Fin. Manag. 14 (2004) 153169 Table 5 System of equations models of cost of capital and leverage Total debt ratio Intercept lsale ROE5 SLGR5 FSLTSL nppta Adj. R2 Short-term debt ratio Intercept lsale ROE5 SLGR5 FSLTSL nppta Adj. R2 Long-term debt ratio Intercept lsale ROE5 SLGR5 FSLTSL nppta Adj. R2 5.5962 (0.77) 1.8992 (4.64) 0.2346 (4.58) 0.0089 (0.56) 0.0398 (1.66) 44.4535 (10.50) 0.4468 0.0813 (1.77) 0.0157 (6.12) 0.0009 (2.72) 0.0001 (1.26) 0.0000 (0.15) 0.0021 (0.08) 0.1690 0.0147 (0.25) 0.0040 (1.19) 0.0014 (3.40) 0.0001 (0.68) 0.0003 (1.43) 0.4499 (13.11) 0.4877 Cost of capital Intercept DTA lsale BETA ATO FSLTSL Adj. R2 Cost of capital Intercept STDTA lsale BETA ATO FSLTSL Adj. R2 Cost of capital Intercept LTDTA lsale BETA ATO FSLTSL Adj. R2

165

12.7743 (11.79) 0.0611 (4.93) 0.0822 (1.20) 0.2913 (1.47) 0.5820 (2.35) 0.0067 (1.91) 0.1533 10.9169 (6.46) 0.1891 (2.12) 0.0876 (0.50) 0.1606 (0.63) 0.0087 (0.03) 0.0046 (1.07) 0.0677 13.3967 (12.14) 0.0630 (4.68) 0.1842 (2.95) 0.3260 (1.61) 0.5375 (2.16) 0.0072 (2.01) 0.1443

This table presents the results for pooled regression of the following system of cost of capital and leverage equations model, using a sample of 90 French companies over the period of 19961999: DebtRatio = 0 + 1 lsale + 2 ROE5 + 3 SLGR5 + 4 FSLTSL + 5 nppta + 6 inddum + COC = 0 + 1 DebtRatio + 2 lsale + 3 BETA + 4 ATO + 5 FSLTSL + 6 inddum + where COC is the cost of capital, lsale is the log of total sales, DebtRatio is either of three variables: DTA; ratio of total debt to total assets, STDTA; ratio of short-term debt to total assets, or LTDTA; ratio of long-term debt to total assets; ROE5 is the 5-year average of return on equity, SLGR5 is the 5-year average sales growth, BETA is the 5-year equity beta, ATO is the asset turnover ratio; the ratio of total sales to total assets, FSLTSL is the ratio of foreign sales to total sales, and nppta is the ratio of plant, property and equipment to total assets. inddum are six industry dummies-not reported. The t-statistics are in parentheses. Signicance at 10%. Signicance at 5%. Signicance at 1%.

can only be met using short term debt as they may nd it difcult to raise long-term debt due to investor perceived higher information asymmetries. Once these rms have established themselves in the host market and the investors feel safe in investing long-term in these MNCs, these rms reduce their dependence on short-term debt and raise long-term debt instead. This logic further implies that as MNCs expand in the host markets they are able to raise more long-term debt yielding a positive relationship between long-term debt and the degree of international diversication.

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Table 6 Non-linear effect of international diversication Total debt ratio Intercept lsale ROE5 SLGR5 FSLTSL fssq nppta Adj. R2 Short term debt ratio Intercept lsale ROE5 SLGR5 FSLTSL fssq nppta Adj. R2 Long-term debt ratio Intercept lsale ROE5 SLGR5 FSLTSL fssq nppta Adj. R2 14.5916 (0.99) 2.3946 (3.17) 0.1254 (3.22) 0.0265 (3.03) 0.1110 (1.53) 0.1040 (1.25) 16.4248 (2.05) 0.0014 0.0260 (0.30) 0.0070 (1.50) 0.0005 (1.74) 0.0001 (1.48) 0.0014 (2.87) 0.0016 (2.69) 0.0505 (1.04) 0.0301 0.1599 (1.43) 0.0153 (2.59) 0.0007 (1.93) 0.0001 (1.86) 0.0002 (0.36) 0.0005 (0.62) 0.3212 (5.14) 0.0426 Cost of capital Intercept lsale DTA BETA ATO FSLTSL fssq Adj. R2 Cost of Capital Intercept lsale STDTA BETA ATO FSLTSL fssq Adj. R2 Cost of capital Intercept lsale LTDTA BETA ATO FSLTSL fssq Adj. R2 12.5799 (12.15) 0.0603 (1.30) 0.0559 (10.74) 0.2615 (1.77) 0.6578 (4.02) 0.0090 (1.06) 0.0038 (0.36) 0.0158 12.7232 (10.19) 0.1501 (2.37) 0.0448 (3.75) 0.1284 (0.73) 0.1143 (0.59) 0.0011 (0.10) 0.0061 (0.46) 0.0037 13.1313 (12.11) 0.1514 (4.66) 0.0575 (2.94) 0.3012 (1.56) 0.6089 (2.15) 0.0130 (0.44) 0.0084 (0.17) 0.0090

This table presents the results for pooled regression of the following models of cost of capital and leverage, accounting for nonlinear impact of international diversication for a sample of 90 French companies over the period of 19961999: DebtRatio = 0 + 1 lsale + 2 ROE5 + 3 SLGR5 + 4 FSLTSL + 5 nppta + 6 fssq + 7 inddum + COC = 0 + 1 DebtRatio + 2 lsale + 3 BETA + 4 ATO + 5 FSLTSL + 6 fssq + 7 inddum + where fssq is the squared ratio of foreign sales to total sales. All other variables are same as Table 5. inddum are six industry dummiesnot reported. The t-statistics are in parentheses. Signicance at 10%. Signicance at 5%. Signicance at 1%.

To control for possible non-linearities, we include square of the ratio of foreign sales to total sales in our original models and re-estimate the system of equations. The results, presented in Table 6, indicate that international diversication only affects short-term leverage non-linearly (signicant at the 1% level) thereby supporting our conjecture. In fact for total and long-term debt the inuence of international diversication seems to be positive.

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4.3. Robustness analyses 4.3.1. Impact of cash ow variability Previous studies (see, e.g. Burgman, 1996) suggest that the variability of multinational rms cash ows can proxy for international risk factors (e.g. exchange risk and political risk). Additionally, both leverage and cost of capital can be signicantly affected by risk management strategies (e.g. exchange risk hedging) that are designed to reduce cash ow volatility. To control for these effects, we include a rms 4-year standard deviation of the ratio of cash ows to total sales in our original model (3) and re-estimate this model. The results, not reported for brevity, indicate that cash ow volatility has signicant and positive relationship with total and long-term leverage ratios. The positive association of higher volatility and debt ratio is consistent with the hedging role of foreign currency debt. Further, as expected, higher cash ow volatility is positively related to the rm cost of capital. 4.3.2. Effect of growth opportunities Literature suggests that internationally diversied rms have richer growth opportunity sets than domestic counterparts. Higher growth opportunities, in turn, may lead to greater agency costs of debt in case of MNCs. Previously, we have used the realized 5-year average sales growth as a proxy for future growth opportunities. We check the robustness of those ndings by utilizing the market-to-book ratio as an alternative proxy for growth opportunities in our original model (3). Our results, not reported for brevity, indicate that the impact on leverage as well as on rm cost of capital of growth opportunities, as proxied by market to book ratio, is statistically insignicant. To insure that market-to-book is a good proxy of agency cost of debt in MNCs as well as domestic rms, we use a censored market-to-book variable. This is equivalent to adding the product of the market-to-book ratio and a dummy variable that equals to 1 when the rm is domestic and zero otherwise. We argue that it is only for the domestic rms that the information embedded in prices reveals the extent to which a rm is subject to debt related agency problems. Given greater informational asymmetries in the case of multinational rms, the market-to-book ratio may not reect the magnitude of agency costs of debt appropriately. Our results indicate that only in the case of domestic rms, there is a negative relationship between growth opportunities and the degree of total and long-term nancial leverage. 4.3.3. Alternative measures of leverage and diversication Previous studies have used different measures of leverage and diversication. To insure that our results are not artifacts of variable choice, we re-estimate our original model (3) by using alternative measures of leverage and diversication. The results, not reported for bervity, show that when we use market value-based measures of leverage, conclusions pertaining to the rm cost of capital and leverage as inuenced by the degree of international diversication are similar to our previously reported ndings. 5. Conclusion The paper focuses on the relationship between international diversication, nancial structure, and their individual and interactive implications for combined debt and equity

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cost of capital for French corporations. We report that international diversication positively associates with higher total and long-term debt ratios. The results are consistent with Reeb et al. (2001) who show that rms with higher internationalization have higher degree of debt nancing. Our evidence suggests a nonlinear inverted U-shape relationship between the degree of international diversication and short term debt nancing. With respect to the main focus of the paper, that is the cost of capital implication of international diversication and nancial structure strategies, we nd that internationally diversied rms support higher level of debt nancing that directly results in reduction of the overall cost of capital despite higher equity risk levels as proxied by beta. The results may reect the phenomenon of MNCs using higher foreign currency denominated debt as a hedging instrument (Kedia and Mozumdar, 2002) thereby not only increasing the proportion of total debt nancing but also reducing the overall cost of capital.

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