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Capital Structure of Foreign Direct Investments: A Transaction Cost Analysis

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Abstract

Transaction cost theory (TCT) plays a major role in theorizing about the boundaries of the multinational enterprise (MNE), and is increasingly being applied to intra-MNE governance. We apply TCT to capital structure decisions for MNE subsidiaries. According to TCT, equity and debt are not just financial instruments, but alternative governance structures. Equity is useful for projects involving specific assets that do not serve well as collateral, and for knowledge intensive activities where information asymmetry and public good issues make external financing more costly. We study under what conditions MNE headquarters may wish to partially re-introduce market mechanisms inside the MNE through the use of external or internal debt to finance subsidiaries. This can allow economizing on governance costs and strengthen subsidiary manager incentives, but may be inappropriate if subsidiary assets are MNE-specific or subsidiary-specific. Empirically testable propositions are developed.

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Notes

  1. Some capital might be retained earnings (Lundan 2009), added to equity in FDI statistics (OECD 2008).

  2. An adjacent and similarly voluminous line of research has looked into whether companies choose full or partial ownership of the foreign entity (Buckley and Casson 1996), i.e., whether the entity is a wholly-owned subsidiary or a joint venture. While companies sometimes have good reasons for keeping some degree of control over given assets and activities, they also recognize that very tight control by means of complete ownership is not always required and may imply foregoing the potential benefits of teaming up with others (Benito 1996; Garcia-Canal et al. 2002; Gomes-Casseres 1989; Hennart 1988b). Again, there is ample empirical evidence for the role of transaction cost factors in shaping the ownership structure decision (Brouthers and Hennart 2007).

  3. Hennart (1994) studied the choice between mediated and non-intermediated equity or debt for international financial transfers, but did not consider capital structure once an equity link has been established. Nguyen and Rugman (2014) studied capital structure as an explanatory variable for subsidiary performance.

  4. A third relevant characteristic of transactions according to TCT, their magnitude (volume and frequency) is not discussed in Williamson (1988) and is omitted also in our discussion.

  5. Continuous intervention by top management in the affairs of a large and complex system of subsidiaries will strain their resources. Hence, MNEs typically re-organize into a multi-divisional form (M-form) as their size and complexity increases (Stopford and Wells 1972; Wolf and Egelhoff 2002). As pointed out by Williamson (1975), the M-form’s effectiveness is due to both the introduction of internal markets for allocation of corporate resources (such as capital), and the economizing on managerial attention and resources from using simpler, uniform decision rules, such as return on capital invested.

  6. We thank an anonymous Reviewer for making this point.

  7. Some evidence of sequential decisions exists in previous literature. Gatignon and Anderson (1988) find MNEs first make a dichotomous choice between integration and shared ownership. If integration is ruled out, the firm turns to the choice between non-integrated options. Ruiz-Moreno et al. (2007) also find evidence of a two-stage process in FDI decisions, arguing bounded rationality limits MNEs’ ability to make all decisions simultaneously.

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Acknowledgements

We thank the Editor Joachim Wolf, the anonymous MIR reviewer, Ulf Andersson, Sjoerd Beugelsdijk, Mark Casson, Jean-Francois Hennart, Elena Kosmopoulou, Alessandra Luzzi, Ieva Martinkenaite, Jakob Müllner, Lilach Nachum, Charles Snow, Øystein Strøm, and participants at a BI Norwegian Business School seminar for valuable comments and suggestions. Earlier versions have been presented at the 2012 EIBA Annual Conference (Brighton, UK), the 2013 Nordic Corporate Governance Network Workshop (Oslo, Norway), the 2013 Reading-UNCTAD International Business Conference (Henley Business School, Reading, UK), and at BI Norwegian Business School in 2014.

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  1. Alliance Manchester Business School, Manchester, UK

    Asmund Rygh

  2. BI Norwegian Business School, Oslo, Norway

    Gabriel R. G. Benito

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Rygh, A., Benito, G.R.G. Capital Structure of Foreign Direct Investments: A Transaction Cost Analysis. Manag Int Rev 58, 389–411 (2018). https://doi.org/10.1007/s11575-017-0335-x

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