3.2 Institutions, Markets and External Borrowing Conditions 6
3.3 Internal Capital Markets 6
4.0 Financial Data and Ratio Analysis 7
4.1 Firms Leverage Ratio 8
4.2 Return on Equity Ratio 8
4.3 Debt to Equity Ratio 8
5.0 Conclusion 9
References
- Introduction
“Capital structure choice of foreign affiliates is particularly important for multinationals because the capital markets differ among countries with respect to the degree of development” Desai, Foley and Hines (2003). A multinational firm should maximize its consolidated firm value under such difference. “In particular, it should raise necessary capital in a country where capital cost is low, and optimally allocate the fund to the firms that provide it with the highest value” (Harris, M., Artur, R., 1991). To do so, the multinational should centralise their financing decisions, with creating and maintaining well-functioning capital markets. Desai (2000) examines the effect of tax structure difference and legal regimes on the capital structure choice and interest costs of the affiliates of U.S. multinationals. As an extension of Desai (2000), Desai, Foley and Hines (2003) further analyse the determinants of capital structures for foreign affiliates of U.S. multinationals using affiliate-level data.
1.1 Company Background
Dell Inc. manufactures sells and services personal computers. The company markets its computers directly to its customers and builds computers after receiving a customer order. This build-to-order model enables Dell to have much smaller investment in working capital than its competitors. It also enables Dell to more fully enjoy the benefits of reduction in component prices and to introduce new products more quickly. Dell has grown quickly and has been able to finance that growth internally by its efficient use of working capital and its profitability.
Dell Inc. and its subsidiaries engage in the design, development, manufacture, marketing, sale and support of various computer systems and services to customers worldwide. The company sells its product directly to large corporate, government, healthcare, and education accounts as well as small-to-medium businesses and individual customers. Dell operates principally in United States, Europe, Middle East and Africa, and Asia Pacific-Japan. The company was founded in 1984 and is headquartered in Round Rock, Texas.
1.2 Aim
The aim of the report is to analyse the determinants of foreign affiliates of United States multinational firms, thereby obtaining evidence of the workings of their internal capital markets.
1.3 Purpose
The purpose of the report is to offer evidence of the tax and capital market determinants of capital structure and also to illustrate factors influencing the choice between external and internal finance.
1.4 Scope
The report will concentrate on the effect on total affiliate leverage of tax incentives, and evaluates the determinants of borrowing from external sources and borrowing from parent companies.
- Capital Structure Options
“Multinational firms have several alternatives to finance their foreign affiliates; to raise the equity capital or to borrow; to raise the money in United States or in the local market; and which currency is going to be used” (Demirguc-Kunt, Asli, Vojislav, M., 1999) In reality, however it is often complicated for foreign affiliates to raise the equity capital in the local market, therefore they would rely on borrowing there. In addition, many subsidiaries rely their financing on their parent companies. Therefore, this report will focus on the following three alternatives which are internal financing, borrowing from the parent company and borrowing from the local banks
- The Determinants
3.1 Taxes and Capital Structure
“Since interest payments to lenders are tax deductible from taxable income, while dividend payments to shareholders are not, tax systems typically encourage the use of debt rather than equity finance” (Aggarwal, R., Kyaw, N. A., 2004)
If the internal capital market is efficient, tax considerations determines whether the foreign affiliates chooses vertical FDI or borrowing. When the parent company borrows in the home country, it is appropriate for it to allocate the money to the foreign affiliate by lending. “Further, when the tax rate in the home country is higher than in the foreign affiliate, the firm should retain the profit of the affiliate, and should refrain it from paying dividend to the parent company” (Yonezawa, Y., Yamaguchi, H., Yamamoto, T., Nambu, T., 2006).
When the parent company borrow and lends the money to the foreign affiliate, the payment and receipt of interest cancel out each other, and the tax burden for the parent company would not be increased. “By borrowing, the affiliate enjoys tax shelter up to the amount of interest payment, as long as it makes profit. This increases the retained earnings of the foreign affiliate compared to the case of vertical FDI” (Yonezawa, Y., Yamaguchi, H., Yamamoto, T., Nambu, T., 2006)
3.2 Institutions, Markets and External Borrowing Conditions
“Efficient allocation of capital should follow two steps as follows; first, the multinational firms seek for financing of the foreign affiliate in the home country. Assuming the cost of capital is lower in the home country compared to the host country both cases of vertical FDI and bank borrowing” (Aggarwal, R., Kyaw, N. A., 2004). Borrowing from the parent company is more significant when the local capital market is less developed. Second, the multinational firm should choose which subsidiaries in different country acquire the capital. Assuming the firm has two subsidiaries situated in two different countries, and both of the subsidiaries need to raise money for capital investment projects at the same time, and the local cost of capital is different from each other, as one is higher and the other one is lower. “If the affiliate must rely at least partially on external sources of capital, the multinational firm would naturally choose to borrow less in the country that has higher cost of capital”(Aggarwal, R., Kyaw, N. A., 2004). That is why, it is appropriate to fund the money from internal borrowing to the affiliates in the country that has higher cost of capital. More formally, the other affiliate situated in a country that has lower cost of capital should rely on the money need on external borrowing. In another word, the affiliate located in country that has higher cost of capital should finance by internal borrowing as much as possible, and then the rest on the external sources available.
3.3 Internal Capital Markets
Most firms need to allocate the limited fund to the necessary purpose efficiently as a whole. For example, a multinational firm which finds that its foreign affiliates encounter the difficulty in financing in the local market, would allocate the necessary money to the affiliates by using its own borrowing capacity or internal cash holding. Such mechanism often called the internal capital market is particularly important in the operation of multinational firms.
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4.0 Dell Inc Financial Data and Ratio Analysis
Source: Dell Inc. Financial Data
Based on the data collected, it can be concluded that Dell Inc. increases the use of debt when the tax rate is high.
4.1 Firms Leverage Ratio
“Firms leverage ratios relates to total debts to total assets” (Godfrey, J. M., 2006). This type of ratio provides information on how much the business is depending on the debt financing. A high leverage ratio indicates that the firm is highly dependent on debt financing which is associated with high risk.
4.2 Returns on Equity Ratio
“Return on equity ratio is a measure of a corporation’s profitability that reveals how much a company generates with the money shareholders have invested” (Godfrey, J. M., 2006).
4.3 Debt to Equity Ratio
“Debt to equity ratio is a measure of a company’s financial leverage calculated by dividing its total liabilities by shareholders equity” (Godfrey, J. M., 2006). It indicates what proportion of equity and debt the company is using to finance its assets. A high debt to equity ratio generally means that a company has been aggressive in financing its growth with debt.
5.0 Conclusion
Capital structure choice is an important strategic decision for all companies. In this report, results shows that host country tax rate affect the affiliate use of debt in its capital structure. Dell Inc. take advantage of higher tax rates in US by holding high debt levels in its affiliates. This tax effect is most significantly reflected in the determinants of the total debt ratio of Dell Inc.’s affiliates. “Higher tax rates increases the use of debt from all the sources, with borrowing from parent firms exhibiting greater responsiveness to tax rate differences than borrowing from external sources” (Desai, M. A., Foley, C. F., Hines Jr. J. R., 2003).
References
Aggarwal, R., Kyaw, N. A., (2004), “Internal Capital Markets and Capital Structure Choices of U.S. Multinationals’ Affiliates,” Working Paper, Hagan School of Business
Dell Inc, (2007), Annual Report 2005, Viewed 7th April 2007, <www.dell.com/downloads/global/corporate/annual/2005_Annual.pdf>
Dell Inc, (2007), Annual Report 2004, Viewed 7th April 2007, <www.dell.com/downloads/global/corporate/annual/2004_Annual.pdf>
Dell Inc, (2007), Annual Report 2003, Viewed 7th April 2007, <www.dell.com/downloads/global/corporate/annual/2003_Annual.pdf>
Demirguc-Kunt, Asli, Vojislav, M., (1999), “Institutions, Financial Markets, and Firm Debt Maturity,” Journal of Financial Economics, pp. 295-336
Desai, M., (2000), “A Multinational Perspective on Capital Structure Choice and Internal Capital Markets,” Working Paper, Harvard University
Desai, M. A., Foley, C. F., Hines Jr. J. R., (2003), “A multinational Perspective on Capital Structure Choice and Internal Capital Markets,” The Journal of Finance, vol LIX, no 6, pp. 1-32
Eliteman, D., Stonehill, A., Moffett, M., (2000), “Multinational Business Finance,” 10th edn, Pearson & Addison Wesley, New York
Godfrey, J. M., (2006), “Accounting Theory,” 6th edn, John Wiley & Sons, Milton, Queensland
Harris, M., Artur, R., (1991), “The Theory of Capital Structure,” Journal of Finance, no 46, vol 1, pp. 297-356
Yonezawa, Y., Yamaguchi, H., Yamamoto, T., Nambu, T., (2006), “Capital Structure Choice of the Foreign Affiliates of Japanese Multinational Firms: Characteristics and Problems,” Working Paper, Japan Center for Economic Research
