Multinational Company is the company that has their branches operates in different countries like for example in North Europe, South Europe, North America, Latin America and Asia-Pacific. Multinational Company can engaged in wide range of specialty. It can be processing materials, sealing, bonding, damping reinforcing, protecting load bearing structures etc. Normally, Multinational Company will be divided into two business division, which is construction and industry division.
The ability of the corporation to perform well in the market is depends on the efficiency of its capital structure (5). In general, the capital structure of the company may classify into debt and equity. Most of the companies have mix capital structure which mean the mixture of long-term or short-term debt and equity.
When the multinational corporation will like to expand their business or invest in new project, the management will need to make decision either to get fund from internal sources, debt financing or equity financing. Most of the companies may use internal source (retain profit) to reinvest in the new project in the first place. Although it may increase value of the company, but using internal sources may reduce the return to the shareholders (6).
Anyway, if the retained profit is not enough to reinvest in new project, the management may look forward to take debt to raise the capital. This is because debt financing can help the company to reduce the cost of capital, tax saving, reduce the risk of company, maintain the ownership of the company and increase the company value. But anyway, there is also case where debt may increase until certain level of proportion that may reduce the value of company. This may cause cost of capital increase. But anyway, the level proportion of the debt in capital structure is different across industries and the availability of market that the company is operated.
If the capitals are still not enough for new project or when the company has higher gearing, the management may choose to use equity financing to source for capital. The company may issue new share to offer to the existing investor to raise the capital.
No matter which sources of capital, before the management makes any decision in capital sourcing, the management has to carefully evaluate the advantages and disadvantages of different sources, the most important is they must consider about the optimum capital structure and make sure the finance sources are secure with least cost of capital and be able to maximize the value of corporation.
Cost of Finance
Nowadays, a lot of Multinational Corporation use debt financing to raise capital for their business. This is because the interest rate of debt financing is cheaper than equity. Furthermore, it is safer and secure for lender.
There are two types of debt which is short-term debt and long-term debt. Short-term debt normally is when the company required capital in the case of emergency or in short time. The interest rate of short-term debt is cheaper because it has lower risk to lender. Anyway, it also depends on the amount the debt. The interest rate for long-term debt is higher as the long term debt has higher risk to lender and involved longer period for payback. During this payback period, a lot of things may happen. The higher interest rate is for the secure of the lender.
Another reason for increase of the debt financing is because the debt financing are more secure compare to equity financing. This is because the interest for lender has to be paid before the dividends to shareholder in the case of liquidation. This mean if the company event liquidation, the debt finance investor will be paid off before the equity investor. From the view points of lenders, the debt is safer investment compare to equity investor. Therefore it also require lower rate of return on equity investors (9).
Furthermore, the debt interest payment is also the corporate tax deductable making even cheaper tax paying by the company. As for this purpose, a lot of companies tried to maximize the debt financing to save the tax rate.
Collateral Value of Assets
Most of the multinational corporations raise their capital for the purpose of market expansion, new project, research and development (R&D) and for marketing purpose. To apply for the loan, most of the lender will likely to have pledged assets as security to provide loan to the company. The company needs to use their company’s assets as collateral to apply for the loan. The securities assets own by the multinational corporation are consideration factor of the amount of debt financing (7).
Furthermore, the interest rate for those loans with and without collateral will be different. The loan with collateral has lower interest rate compare to the loan without collateral. This is because if the company event liquidity, the debt investor can take the company’s assets as payment to the debt, the lender will feel more secure with the pledge. Therefore, corporations normally take the high valuable asset such as land and building as collateral for debt to financial institution.
For example, If Intel Company wants to open new factory in Malaysia, Intel can take the dead title of the factory’s land as pledge to bank and apply for the lower interest rate. On the other hand, if the land is not own by Intel, but is rent, then Intel may not has the dead title of the land as a pledge to financial institution. In this case, they will face higher interest rate compare to the previous situation. Normally, if the companies don’t have assets as pledge to apply for loan, and they will consider raising fund by equity financing. This is because the company may face higher cost and lost profitability over the company in the future if by debt financing which has higher interest rate.
Current Market Economic
The economic situation of the market may also influence the decision of management whether to raise fund through debt or equity finance. When there is economic struggling, the financial institutions normally will limit the assessments of loan by increasing the interest rate. This is because a lot of companies may face internal financial problem which are unable for them to pay back the principal and interest of debt. The companies also may face higher risk of bankruptcy. As a result, the financial institutes will limit the loan assessment because they afraid the company are unable to pay back the debt.
Anyway, if the corporations really need to raise fund for their company, they may consider getting loan from government especially during economic recession. Normally, local government will provide loan to help the growth of local economic during recession. For the corporation side, it is more secure as government loan is safer then financial institution as the interest rate from government loan is lower than market interest rate. This may help the company to reduce the cost of financing.
During boom economic, most of the corporation will raise their fund through debt financing although the interest rate is high. At this moment, the loan from financial institution is easy to assess but the interest rate is higher. Anyway, to enable to compete with other competitors during boom economic, the corporation may need fund faster, as a result they will apply loan from the financial institution to raise the fund faster. They are unable to wait for the equity fund as it takes longer time to raise the capital. Time is like money, wasting of time will affected the lost of competitive advantages. Anyway, the corporation may face higher capital cost as the interest rate from financial institution is increase.
The Company Current Gearing Level
The company gearing has the both positive and negative effect on the capital structure decision. Gearing is measurement of financial leverage, demonstrating the degree to which a firm’s activities are funded by owner’s funds versus creditor’s funds. Those corporations with high debt gearing have to face higher interest from financial institution and it may affect company’s current profitability.
Companies with a lot of debt or high debt gearing may have risk of unable to pay back the interest and principal of debt. This will affect the reputation of companies. The corporation with high gearing may affect the confidence of shareholder to the company. Shareholder may assume that their investment to company are not returnable, at the end they may withdraw their capital investment from the company if the company gearing continue to increase.
The amount of debt is measure by capital gearing ratio and the company must ensure that the company’s gearing does not reach higher point. The ratio of the debt is depending on how much the symmetries information on the capacity of the self funds and on the various constraints which the company meets in the access to the various sources of financing.
Dilution of the Ownership
Dilution of ownership is another source of capital. Dilution of ownership may appear to benefit to the company. The offering of additional shares may in fact be a sign that the company is preparing to experience a period of rapid growth. In this case, the market price of each unit stock has chance to increase significantly. As a result, the shareholders have the chance to acquire additional shares and may soon see the overall worth of their investment in the company increase substantially.
Anyway, before a company makes decision to initiate dilution of ownership, they will do it with careful consideration. This is because this method may not beneficial to shareholders as it may reduce the value of each individual’s share when the company chooses to issue additional shares for purchase. In addition, by selling out new share to new investor, it also means that the competitor may have chance to acquisition for company share.
Debt financing does not involve diluted of ownership. The debt investor may not have power to control the company as long as the interest and principal is paid on time. The management just needs to focus on profitability of the company to cover the interest and principal of the debt (2).
Earnings per share will dilute by issue new share
Issuing equity share is one of the major resources of corporation to raise the capital. Large issue of the new share may dilute the earning per share for every shareholder if the investment is not generating the profit immediate. The existing shareholder will reduce earning per share by sharing the profit with the new shareholder. When the total quantity share increases the profit still remains same this will reduce the return for individual shareholder. If the management could not maximize the existing shareholder wealth, it may influence the confidence of the investor. As a result, a lot of investors may pull out their capital and may cause the value of company drop.
Covenant with the debt investors
Before a company wants to extend the debt to expand their business, they need to evaluate the company covenant with debt investor. Normally, the debt investor may have terms and conditions for the company before they release the loan to the company. The debt investor only will issue the loan to the company until a certain ratio of equity.
If the company already reach the debt ratio set by the debt investor requirement. The company is unable to practice debt financing. Anyway, it is possible for the company to use issuing share to get the fund and pay back the debt to reduce the debt ratio. Another important issue is reducing the debt ratio is good to help company reduce the risk bankruptcy.
From time to time, company will try to increase their capital to enable for them to expand their business and to be more competitive advantage. There are two sources of capital for multinational company, they may either raise the capital by debt or equity financing. Anyway, before the company makes any decision, they need to evaluate the advantages and disadvantages both sources.
Under current economic circumstances, it is recommended that multinational company to raise capital by using debt financing. In the current economic recovery situation, the interest rate offer by the financial institution is low compare to equity financing. This is because the markets are reducing expanding and a lot of companies are not dare to take extra risk to expend their business. From here the multinational company can take the advantage of low interest rate to expand their business by debt financing.
Multinational company may choose to use long-term debt with fixed floating rate. This is because if the economic recovery, the company still enjoying the low rate interest for the debt and earn extra profit. By the way, long-term loan with fixed interest rate may also ease the financial controller to control the cost of interest (9). Fixed interest rate provides certainty to management about the rate that they need to pay back to financial institution.
From the view of most investors, they may feel that they are having lower risk if they provide loan compare to be equity investor. This is because the shareholder’s equity financing may have risk of liquidity as they are not the first party to be paid off in the event of liquidation. Anyway, if they are lenders, then in the event of liquidation, they are the first party to get paid.
In this competitive market, it is important for the company to move fast to enable to take advantages as market leader especially for multinational company where they have a lot of branches at different countries. They must make sure that their branches in different country are able to have competitive advantages to maximize the earning in the market. As a result, it is important for the multinational company to move fast to raise fund to expand their business. To enable for them to raise fund in faster way, it is recommended to have debt financing. For example Sika Corporation, they have branches in worldwide, they can apply loan from different countries which has cheaper interest rate to expand their business and take advantage of acquisition compare to competitors.
By the way, debt financing also may help the management to focus only in their daily operational or the production line rather than wasting time looking for the new investors to invest. This can help the management continue focusing on the growth and profitability of company. Debt financing also can give the pressure to the management to make sure the company always has profitability to pay back the principal and the interest of the debt.
Another advantage of debt financing is that, it can make sure no dilution of ownership. This can protect the right of existing ownership. Debt investors have no right to control the operation of the company. It may also prevent the ownership of company from exquisite by the competitors. On other hand, if the company applies equity financing, they have to issue new share to the public, there is risk of changes of new management. This is because the new shareholders may take over the management of the company as they have the power of voting in the company. As a result they may face internal problem with the changes of company’s policy, objectives, goals and direction. In addition, the debt equity can prevent of the information asymmetric inside and outside the company.
Debt financing may also help company to save cost as it does not involve many parties in the transaction. The transaction only involves the company itself and the debt investor. If the company using the equity financing, the transaction cost may be higher as it involve a lot of paper work and administrative cost to issue additional share.
Beside transaction and administration cost, debt financing may also help company in tax saving. Debt ratio has positive relationship with the taxation rates, interest will be deducted along with increase in tax rate. This is because the interest payment is deductable in finance expenses before calculation of income tax. Thus, it may decrease the cost of capital (4). Furthermore, if the equity financing, the dividend paid to shareholder is not deductable in the tax. This may deduce the company value by increasing the taxation.
Justifying the Recommendation
In the newly modified theory by Modigliani and Miller (MM) (1963) on corporate debt in recognition of corporate taxes, it showed that the interest payments made to lenders are deductable from corporate income before calculation of company taxes. They showed that the tax regimes permit companies to offset the interest paid against taxable profit. This tax shield allows firms to pay lower taxes than they should compare to their own capital (3). For example, if the corporate tax is 20%, then every dollar paid in interest payment, 20 cents in corporate taxes is avoided. Tax shield from the debt financing has lead to a lot of multinational company try maximize their capital by debt financing. This effect also help in capital cost saving.
Anyway, in the issue of tax saving, the corporation needs to determine the interaction of both corporate and personal taxes to determine the optimal level of corporate debt. A lot of studies have found that if the firm have relatively high marginal tax burdens, they are more likely to use debt financing to take advantages of tax shield.
Another reason for managers issue debt financing is because of the “pecking order” model (Poulsen, 2008). In the “pecking order” model, it is stated that it is difficult for the public to have true value of the corporation. There may be asymmetric information about the value of the corporation. It is belief that the equity financing may subject to the asymmetric information problem. Since the potential investors are unable to adequately evaluate the value of stock, it would generally undervalue the price of stock. Rather than sell the stock in cheaper price, therefore, a lot of multinational corporation’s managers prefer debt financing (Poulsen, 2008).
Another important consideration is the regularities of the country. According to Raghuram Rajan and Luigi Zingales (1995), the tax level in country and enforcement of bankruptcy law are also the major factors to determine the source of capital. If the firms are corporate in the countries with strong legal systems, then it is more secure using external financing or long-term debt.
According to Hsien the Multinational Company represented the sales ratio less than 50% is considering the low internationalization. Where by the low internationalization Multinational Company there are exists significant industry effect on Return on Asset and the firm size, profitability and growth are the significant determinants of Multinational Company leverage decision during the pre-Asian financial crisis period.
Now values of corporation rise as debt is substituted equity in the capital structure because of the tax saving. The Weighted Average Cost of Capital (WACC) declined with any increment of debt as long as the company has the taxable profits. This parameter can be used to its logical extreme that is almost entirely composed by the company's capital to its minimum of debt and the company's value, at its highest amount of WACC.(anord)
When the company use debt can reduce the volatility in return which the same level of gearing, this is because the company can lower the cost debt while lower increasing in total equity level.
MM theory recommended that the company should take the debt of equity as much as possible this is because the company gearing will increase the market value of the company. It will directly reflect by WACC and benefiting ordinary shareholder.
If the MM theory views are acceptable, the introductions of taxation suggest that the higher the level of taxation, the lower the combination cost of the capital. The important of the company’s financial strategy is to make sure the company use the higher the level of the company gearing to increase the value of the company. The logical conclusion is that companies should choose a 99.9% gearing level.
In the MM theory, it stated that the combination of renewed traditional theory and some new concepts dealing with financial distress costs (or bankruptcy costs) and agency conflicts added both rigorous new theory and empirical tests to support the traditional view of an optimal capital structure which was not 100 percent debt. It was argued that as firm leverage increase the probability of bankruptcy also increase and if the cost of bankruptcy is significant then a firm value will fall when the marginal increase in the expected value of financial distress costs is greater than the increase in the expected value of the tax benefit from debt. The overall cost of financing will rise beyond some optimum leverage proportion and the firm’s value will fall.
Using debt is cost effective but in the other hand the debt cannot be maximized for the financing structure. This is because the debt may have some limitation for using debt as in financing structure. If the MM theory ignored the bankruptcy risk, the company cannot maximize the gearing of the company. The company gearing too high the company may face the risk of bankruptcy and the costs of debt will increase this is because the debt investor may bear the high risk loan of liquidity problem.
In the theoretical capital structure determinants (collateral value of asset, company gearing, current economic, tax saving effect, dilution of ownership and the dilution of the earning per share) are still in the argument as how important these factors in determination of Multinational Company financing structure. A lot of multinational companies raise their capital through debt financing, as from the view point of company the debt financing is cheaper and safer compare to other sources of financing.
The liquidity risk may affect the structure of the company. Certain industry internationalization will have high leverage but some may reverse. Thereby some of the industry financing structure are affected by firm-specific financial ratio, including the collateral value of tangible assets, current ratio, sales volume and etc. the collateral of the value of asset is an important to determine the manufacturing company.
Rajan, Raghuram, and Luigi Zingales. (December 1995) “What Do We Know About Capital structure? Some Evidence from International Data.” Journal of Finance 50. 1421 – 1460
Poulsen, A. (2008) Corporate Financial Structure. The Concise Encyclopedia Economics. Available at: http://www.econlib.org/library /Enc/CorporateFinancialStructure.html. [accessed 1 April 2010]
Muhammad Mahmud, Gobind M. H., Rajar A. W. and Farooqi W. (2009) Economic Factors Influencing Corporate Capital Structure in Three Asian Countries: Evidence from Japan, Malaysia and Pakistan. Indus Journal of Management & Social Sciences, 3(1): 9-17. Available at: http://mpra.ub.uni-muenchen.de/15503/ [accessed 1 April 2009]