CORPORATE FINANCE II: INTERNATIONAL FINANCE

OUTLINE

• INTERNATIONAL PORTFOLIO DIVERSIFICATION: HOME BIAS
• THE INTERNATIONAL TAX SYSTEM AND CORPORATE FINANCE
• COMPARATIVE CORPORATE FINANCE
• SUMMARY

THEORY VS. REALITY

• CAPM theory predicts
  • agents have an incentive to globally diversify their stock holdings.
  • Investors around the world hold the same globally diversified portfolio.
  • Even more complicated models than the CAPM predict global portfolio diversification.
• What do we see in the real world?
  • The empirical evidence shows that actual investors have a home bias-residents of Country H are more likely to hold shares of Country H.

HOME BIAS IS HUGE!

Portfolio weight of investors in:

	US	Japan	UK
US	0.938	0.131	0.059
Japan	0.031	0.981	0.048
UK	0.011	0.002	0.820
France	0.005	0.001	0.032
Germany	0.005	0.035	0.001
Canada	0.010	0.001	0.006

December, 1989 portfolio holdings. French and Poterba, (1991)

EXPLANATION?: INVESTOR PROTECTION

• Poor investor protection can lead to home bias (Dahlquist et al., 2003)
• In countries with poor investor protection, companies are controlled by the insider shareholder blocks
• In addition to stock returns, insiders reap private control benefits that depend on holding large share blocks
• Outside shareholders suffer from insider diversion.
• This may explain both:
  • Shareholders in countries with poor corporate governance holding home shares more heavily.
  • The low weight of these countries in US investors' portfolios.

EXPLANATION?: SOPHISTICATION

• Goetzmann and Kumar (2004) examine individual portfolios between 1991-1996 and find that the least diversified investors earned 2.4% less than the most diversified investors.
• They find that better diversified portfolios are held by: older, wealthier, more experienced and financially sophisticated investors.
• Investors whose trading decisions are consistent with stronger behavioural biases exhibit greater under-diversification.
• Investors who overweight certain specific industries or stock characteristics such as volatility and skewness are less diversified.

EXPLANATION?: TRANSACTIONS COSTS AND CAPITAL CONTROLS

• Transaction costs and capital controls: In the early 1980s explicit barriers to foreign capital flows were common
• There were barriers to both outward flows (outward capital controls) and to inward flows (to prevent hot money or to protect domestic firms).
• Controls over investing in certain 'strategic industries'.
• Transaction costs such as banking fees and foreign exchange costs may lead to a reduction in foreign assets.

EXPLANATION?: ASYMMETRIC INFORMATION

• Asymmetric information: investor know more about home market stocks
• Brennan et al. (2005) present a model with noisy expectations with private and public signals - foreign investors get noisier signals. Perceptions about the variability of future returns depend on the informational disadvantage.
• Cultural differences matter: information is more asymmetric for investors who are not fluent in the language or whose cultural norms are different.

TAXATION AND MULTINATIONAL CORPORATIONS

• Multinational firms (MNCs) operate in many tax jurisdictions
• Different jurisdictions have different tax rates and rules
• These differences generate opportunities for tax avoidance

CORPORATE TAX AVOIDANCE

• There are many ways MNCs can arbitrage the differences between national tax regimes
  • Corporate Inversions
  • Inter corporate loans, etc
• We will focus on remittances, royalties, and transfer prices
• Tax avoidance by MNCs is ubiquitous

THE INTERNATIONAL TAX SYSTEM IS ANOTHER DRIVER OF INTERNATIONAL CAPITAL FLOWS

The current international corporation tax system is based on the OECD Model tax convention.

It is the main source of bilateral tax treaties; over 3,000 in total.

The 1920s compromise of allocation of rights to tax international business income:

• Active income is taxed in the source country. (Art.7)
• Passive income is taxed in the residence country. These are:
  • Interest (Article 11)
  • Royalties (Article 12)

THE MODERN MULTINATIONAL COMPANY

WHERE ARE SOURCE AND RESIDENCE?

ACTIVE VS PASSIVE INCOME I: FINANCE FOREIGN INVESTMENT BY NEW EQUITY

Active income is taxed in S. Typically, dividends are not taxed in R (treaties may allow this).

ACTIVE VS PASSIVE INCOME II: FINANCE FOREIGN INVESTMENT BY DEBT

Passive income is taxed in R.

ACTIVE VS PASSIVE INCOME III: TAX PLANNING 101

H is a tax haven subsidiary (with a zero tax rate). MNC does not pay tax in S, H, or R.

ACTIVE VS PASSIVE INCOME IV: ROYALTIES

Company in R undertakes R&D, develops intangible asset, then transfers it to H. The asset is used in S, which pays royalty to H. MNC does not pay tax in S, H, or R.

TRANSFER PRICING

Transfers within the MNE must be priced for allocation of both active and passive income.

Arm's length price is price which two independent firms would use. Can you think of any issues with this concept?

There are conceptual and practical difficulties with arm's length pricing BUT the existing system does need some means of pricing transfers

WHY DO FIRM FINANCIAL POLICIES DIFFER AROUND THE WORLD?

LAW AND FINANCE

• Corporate capital structures around the world also vary dramatically
• Corporate leverage and reliance on debt financing seems to depend on the legal jurisdiction in which the firm operates

SOURCES OF EXTERNAL FINANCING ACROSS COUNTRIES

Composition of External Financing	External Financing as a Fraction of Total Financing	Net Debt Issuance	Net Equity Issuance
United States	0.23	1.34	-0.34
Japan	0.56	0.85	0.15
Germany	0.33	0.87	0.13
France	0.35	0.39	0.61
Italy	0.33	0.65	0.35
United Kingdom	0.49	0.72	0.28
Canada	0.42	0.72	0.28

OBSERVATIONS

• The French and UK economies are quite similar with respect to most metrics
• However, as the table shows, UK companies are much more reliant on debt financing
• US companies seem to be much less dependent on external finance than firms in other OECD countries
• Why such large cross sectional differences?
• Most finance researchers argue that the dependence of capital structure on jurisdiction results from differences in creditor rights

CREDITOR RIGHTS

• Creditor rights: the ability of creditors to enforce repayment of debt claims
• Creditor rights can be divided into three categories:
  • Capitalization requirements
  • Restrictions on distributions to shareholders
  • Rights of creditors in insolvency proceedings
• Over 300 jurisdictions around world; each of these jurisdictions specifies creditor rights
• Their specifications vary considerably
• Why?

CAPITALIZATION REQUIREMENTS

• Capitalization requirements regulate the amount of paid in capital (i.e. funds provided by stock holders) required to establish a limited liability company.
• More capital implies, ceteris paribus, more assets that can be used to satisfy debt obligations
• Some legal systems,
  • impose stringent capitalization requirement (e.g., German legal system)
  • others (e.g. UK and US legal systems) impose lax requirements

RESTRICTIONS ON DISTRIBUTIONS

• One way for shareholder to elide their obligations to creditor is to simply payout the firms cash flows to shareholders (dividends, share repurchases) before satisfying creditors
• Legal systems impose restrictions on distributions:
  • Prohibit share repurchases (German system before 1998)
  • limits maximum amount of accumulated net profit that can be distributed (French legal system)
  • rules against disguised dividends (e.g., paying a "fee" to shareholder for managing the firm) (French legal system)

INSOLVENCY RIGHTS

• The insolvency rights of creditors determine the actions that creditors can take in event of insolvency
• Types of insolvency
  • Balance sheet insolvency: Book assets worth less than liabilities to creditors
  • Commercial insolvency: Firm is unable to make current payments to creditors

INSOLVENCY RIGHTS: BANKRUPTCY

• All legal systems provide for systems for reorganizing or liquidating insolvent firms.
• The name for these systems varies
• We will call such reorganization systems "bankruptcy systems"
• bankruptcy systems specify
  • some sort of moratorium on legal actions against the firm by creditors
  • Designate an administrator of the bankrupt firm's assets
  • Specify a scope of action for the administrator
  • A trigger rule for bankruptcy

INSOLVENCY RIGHTS: HOW STRICT IS MORATORIUM

• How extensive is the moratorium on creditor legal actions during court reorganisation?
  • Automatic stay of virtually all creditor legal action for a significant period of time (e.g., U. S. system and Mexican system)
  • Limited stay of creditor legal action, does not block all actions by secured debtholders, (e.g., winding up in U. K. system).
  • Complete stay but only for a short period (German System).

INSOLVENCY RIGHTS: WHO CONTROLS THE ADMINISTRATION BANKRUPT FIRM?

• Shareholders: who are termed the "debtor in possession" : U.S. system
• Creditors: German, French, Scandinavian systems
• A specific creditor, the floating charge holder: UK system
• The bankruptcy judge (France).

INSOLVENCY RIGHTS: WHO PULLS THE BANKRUPTCY TRIGGER?

• Voluntary action of shareholders; few restrictions to prevent bankruptcy (U.S. system)
• Forced by creditors- based on inability to satisfy creditors or meet financial ratios (German and U.K. systems)

A SIMPLE EXAMPLE FROM HARRIS AND RAVIV (1995)

• A penniless, wealth-maximising debtor has access to a positive NPV project which requires and investment of K dollars.
• The project makes payoffs at two dates-1 and 2.
• The debtor can appropriate all cash flows from the project.
• The debtor can give creditor the right to liquidate the firm assets at date 1 if promised payments are not made.
• Partial liquidation is possible
• Liquidation is inefficient

CASH FLOWS AND STATES

• Two states of the world are possible: $s=1$ and $s=2$
• The states are equally likely
• The revenues, R, from future operation and liquidation, L, vary with the state of the world.
• States of the world and cash flows are observable but not verifiable
• Because state of the world are not verifiable contracts cannot be written on cash flows or states of the world
• Payments by the debtor to creditors are enforced by creditor's enforcement rights when the debtor defaults.

PARAMETERS

	$s=1$	$s=2$
$R_1$	100	40
$R_2$	200	200
L	100	50
$\alpha = R_2/L$	2	4

INTRODUCING CREDITOR RIGHTS

• If the debtor refuses to pay contracted debt payments, the firm enters insolvency
• What happens after that depends on the insolvency system
• To keep thinks simple we compare to extreme systems
  • Creditor-preferred insolvency: All bargaining power is allocated to the creditor (Corresponds roughly to UK floating charge and receivership system)
  • Debtor-preferred insolvency: All bargaining power is allocated to the debtor (Corresponds roughly with US Chapter 11 reorganization)

CREDITOR PREFERRED DEBT

• Debtor borrows debt with a face value of F.
• Debt is due at date 1
• If the debtor repudiates his debt payments, the creditor has the right to make a first-and-final offer to the debtor
• If the debtor rejects the creditor's offer, the project is liquidated.
• If the debtor accepts the creditor's offer, the creditor is paid the offered amount.

ANALYSIS

• How much will the creditor demand? The most the debtor will pay is determined by the debtor's costs and benefits of repaying
• In state 2, every dollar the borrower pays out of current cash flows costs the borrower one dollar. every dollar of liquidation of the project at date 1 costs the borrower 4 dollars (lost date 2 revenue). So maximal creditor demand the borrower will accept is given by $40+4(d-40)=200$. So the largest offer the debtor will accept in state 2 is $d=80$
• In state 1 the maximal creditor demand the borrower will accept is given by $100+2(d-100)=200$. So the largest offer the debtor will accept in state 1 is $d=150$
• The creditor knows that the debtor will only repudiate if the repudiation offer is less than the face value of debt. Thus, the expected payoff on a debt contract with creditor-preferred debt is

$$ (\frac{1}{2})\min[d_1,F] + (\frac{1}{2})\min[d_2,F] = (\frac{1}{2})\min[150,F] + (\frac{1}{2})\min[80,F] $$

DEBTOR-PREFERRED DEBT

• If the debtor repudiates his debt, the debtor has the right to make a first-and-final offer to the creditor
• If the creditor rejects the debtor's offer, the project is liquidated.
• If the creditor accepts the debtor's offer, the creditor is paid the offer.

ANALYSIS

• How little will the creditor be willing to accept? The least the creditor will accept is determined by the creditor's costs and benefits of repaying
• The smallest payment the creditor will accept is the liquidation value of the assets. Thus, $d_1=100$ and $d_2=50$.
• The creditor knows that the debtor will only repudiate if the repudiation payment is less than the face value of debt. Thus, the expected payoff on a debt contract with debtor-preferred debt is

$$ (\frac{1}{2})\min[d_1,F] + (\frac{1}{2})\min[d_2,F] = (\frac{1}{2})\min[100,F] + (\frac{1}{2})\min[50,F] $$

CREDITOR OR DEBTOR PREFERRED DEBT?: $K=75$

If debt is creditor preferred, competitive financial markets imply that

$$ (\frac{1}{2})\min[150,F] + (\frac{1}{2})\min[80,F] = 75 $$

so $F=75$. The debtor pays the face value of debt in both states as he is even worse off if he tries to renegotiate.

• In state 1, the debtor pays 75 face value out of current cash flow
• In state 2, the debtor will pay 40 of the 75 out of current cash flow and will have to raise $75-40=35$ through liquidation, this costs $\alpha_2 \times 35 = 140$

DEBTOR PREFERRED

If debt is debtor-preferred, competitive financial markets imply that

$$ (\frac{1}{2})\min[100,F] + (\frac{1}{2})\min[50,F] = 75 $$

so $F=100$. The debtor pays the face value of debt only in state 1. In state 2, he repudiates his debt and renegotiates the 100 promised payment down to 50.

• In state 1, the debtor pays 100 face value out of current cash flow
• In state 2, the debtor will pay 40 of the 50 payment out of current cash flow and will have to raise $50-40=10$ through liquidation, this costs $\alpha_2 \times 10 = 40$

CREDITOR PREFERRED DEBT?: $K=80$

If debt is creditor preferred, competitive financial markets imply that

$$ (\frac{1}{2})\min[150,F] + (\frac{1}{2})\min[80,F] = 80 $$

so $F=80$. The debtor pays the face value of debt in both states as his payoff is not higher if he renegotiates.

• In state 1, the debtor pays 80 face value out of current cash flow
• In state 2, the debtor will pay 40 of the 80 out of current cash flow and will have to raise $80-40=40$ through liquidation, this costs $\alpha_2 \times 40 = 160$.

DEBTOR PREFERRED DEBT AND CAPITAL RAISING: $K=80$

If debt is debtor preferred, competitive financial markets imply that

$$ (\frac{1}{2})\min[100,F] + (\frac{1}{2})\min[50,F] = 80 $$

• There is no solution to this equation,
• There is no level of promised payment that extracts 80 from the debtor.
• Thus, the (positive NPV) project cannot be funded with debtor-preferred debt.

TAKE AWAY

• Allocation of bargaining powers between the debt and creditor affects
  • Credit default spread on on debt contracts
  • Borrowing capacity of firms
  • Economic efficiency of insolvency systems
• Jurisdictions vary significantly with respect to how bargaining power is allocated between debtors and creditors.

SUMMARY: I

• There are gains from international diversification for risk averse investors in an environment where the fluctuations in returns in international markets are not perfectly correlated.
• Despite the theoretical justification for international portfolio diversification, there is home bias in security holdings.
• There several explanations for home bias
• Home bias is declining

SUMMARY: II

• Variations in tax regimes, generate opportunities for firms to engage in tax arbitrage, through incorporating in tax havens, manipulating transfer prices, etc.
• To the extent that these tax arbitrage activities affect firms real operations, tax arbitrage leads leads to economic inefficiencies.
• Competitions between jurisdictions to attract corporations through corporate tax policies can thus reduce aggregate welfare

SUMMARY: III

• Multinationals' capital structure policy is affected by the legal environment in which they operate
• For capital structure, the key component of the legal environment is creditor rights
• Creditor rights vary across legal jurisdictions
• This variation enables NMCs, who operated in many legal jurisdictions, to engage in legal-system arbitrage
• E.g., borrowing in jurisdictions featuring strong creditor protections and well developed debt markets to fund in investment in weak-creditor-rights subsidiary jurisdictions