Leverage in an International Setting

The general business environment may differ from one country to another, and these country-specific factors have a significant impact on determining a company’s capital structure. Taxes, regulations, and traditions can explain the different degrees of leverage in the two countries. When an analyst is assessing the capital structure of companies in an international setting, they must consider the maturity structure of debt and the relative use of debt. It is equally important to use country-specific factors that explain the cross-country differences. Three major types of factors may be used to explain differences in capital structure in an international setting:

1. Institutional and legal environment.
2. Financial markets and banking sector.
3. Macroeconomic environment.

1. Institutional and Legal Environment

Taxation, bankruptcy laws, financial legislation, and the quality of enforcement differ from one country to another. Companies operating in countries with efficient legal systems tend to use more long-term debt, while companies with weak legal systems use more short-term debt. Some legal systems based on civil law offer less protection to capital providers than legal systems based on common law. The quality of investors’ legal protection depends on both the enforcement and contents of the contracts and laws.

We expect to see lower financial leverage in countries that have stronger legal systems. In efficient legal systems, research shows that a high level of information asymmetry between managers and outsiders encourages greater use of debt relative to equity since enforcing shareholder rights is much harder than enforcing the debt contract. The presence of auditors and analysts is associated with lower financial leverage, where the presence of analysts is more important in developed countries, and the presence of auditors is more important in emerging markets.

In a situation where dividend income is taxed at a lower rate than interest income, some of the benefits of debt versus equity are reduced because the price at which equity can be sold should reflect an advantage. Accordingly, countries with higher tax rates on dividend income have more debt in their capital structures.

2. Financial Markets and Banking Sector

The activity, size, and liquidity of capital markets are important for corporations’ access to capital. Researchers have found that countries with active and liquid markets tend to use more long-term debt with longer maturity periods which is attributed to the heightened external monitoring by investors in active markets. The banking sectors are the major source of funds in many countries. Countries with civil-law tradition tend to be more bank-based, while countries with common-law tend to be market-based. Because the relationship between bondholders and the company is weaker than that of a bank and a company, banks can efficiently handle information asymmetry.

Research shows that companies that operate in market-based countries have lower financial leverage than those operating in bank-based countries. Institutional investors can also affect the companies’ capital structure choice because some of the institutional investors have a preferred debt maturity which in turn affects the company’s debt maturity structure.

3. Macroeconomic Environment

High inflation hurts both the use of long-maturity debt and the level of debt financing. Companies in higher-inflation countries have lower levels of financial leverage, shorter debt maturity structures, and depend more on equity financing than those in lower-inflation countries. Researchers found that companies in developing countries with high growth rely on equity financing, and growth in the gross domestic product in developed markets is associated with longer debt maturity.

Financial analysts, when analyzing and comparing companies operating in different countries, should consider country-specific factors, and may refer to the following table as a summary:

Question

The factors that most likely explain the capital structure differences between different countries are:

1. Microeconomic environment, financial markets, and banking sector, and institutional and legal environment.
2. Institutional and legal environment, macroeconomic environment, and debt financing.
3. Financial markets and the banking sector, macroeconomic environment, and institutional and legal environment.

Solution

The correct answer is C.

Financial markets and the banking sector, macroeconomic environment, the institutional and legal environment should be considered when comparing capital structures of companies in different countries.

A is incorrect. Microeconomic environment is not considered when comparing the capital structures of companies in different countries.

B is incorrect. Debt financing is not considered when comparing the capital structures of companies in different countries.

Reading 15: capital Structure

LOS 15 (d) Describe international differences in the use of financial leverage, factors that explain these differences, and implications of these differences for investment analysis.