Posted: February 13th, 2022

The Upstream-Downstream Hypothesis And Corporate International Diversification Theory

ABSTRACT
The examine of multinationals has acquired a lot consideration in literature. Actually, it has change into a topic of controversy among the many students. On the one hand, some researchers together with Reeb & Mansi (2001), Chkir & Cosset (1999) and Chen et al. (1997) level out to the diversification advantages to multinationals because of danger discount inherent in operations inside imperfectly correlated markets. Whereas then again, the newer analysis by Reeb, Kwok & Baek (1998) and Bartove, Bodnar & Kaul (1996) notes a constructive relationship between internationalization and excessive debtholder monitoring prices.Towards this backdrop, this Assessment counsel another upstream-downstream speculation whereby the general impact of internationalization on the danger and leverage of multinationals depends in the marketplace circumstances of the host and goal nation. The paper examines the idea that multinationals ought to have decrease danger and better leverage than non-multinationals and explains the distinction between this idea and the upstream-downstream speculation. Additionally included on this Assessment, is an evidence for the documented puzzle that multinationals are inclined to have decrease ranges of long-term debt however extra use of short-term debt than non-multinational companies.
INTRODUCTION

The examine of multinationals has acquired a lot consideration in literature. Over the previous few a long time, it has change into a topic of controversy among the many students. It has generated extra warmth than gentle with some suggesting diversification advantages to multinationals, whereas others level out to the constructive relation between a agency danger and internationalization. Towards this backdrop, we advise another upstream-downstream speculation whereby the general impact of internationalization on the danger and leverage of multinationals depends in the marketplace circumstances of the host and goal nation.
Earlier researchers together with Reeb, Mansi & Alee (2001), Chkir & Cosset (2001) and Chen et al. (1997) discovered a constructive relationship between internationalization and debt ratio because of danger discount inherent in operations inside imperfectly correlated markets. Quite the opposite, Burgman (1996) and Lee & kwok (1988) demonstrated a destructive relationship between internationalization and debt ratio that outcomes from elevated dangers because of company prices, and political and trade charge dangers.
Equally, whereas the findings obtained from Preliminary analysis by Hughes, Logue & Sweeny (1975) are per the diversification advantages, the newer analysis by Reeb, Kwok & Baek (1998) and Bartove, Bodnar & Kaul (1996) discovered a constructive affiliation between the danger of a agency and internationalization. Moreover, whereas specializing in leverage, Burgman (1996) famous that internalization could lead to greater debtholder monitoring prices and thus considerably decreasing the degrees of leverage. In keeping with larger company prices, Lee & Kwok (1988) and Chen et al. (1997) discovered that the home companies would typically are inclined to have considerably greater debt ratios relative to the MNCs. Clearly, from what may be discerned, the examine of internationalization of companies has change into a controversial difficulty amongst students.
This Assessment is thus an try and make clear the above by exploring on each worldwide diversification advantages and the upstream downstream speculation. We start out Assessment by analyzing the upstream and downstream speculation
UPSTREAM-DOWNSTREAM HYPOTHESIS
Kwok & Reeb (2000) argue that there’s a rise in danger and a discount in debt utilization when companies from steady economies make investments internationally (downstream). Conversely, the danger is decreased and debt utilization elevated when companies from weaker economies make investments internationally (upstream). It subsequently follows that the general impact of internationalization on agency’s leverage and danger depends on the traits of the house and goal financial system.
The companies’ behaviour in direction of worldwide exercise or reasonably the general impact of internalization on companies leverage and danger depends upon whether or not the agency is transferring upstream or downstream (Kwok & Reeb 2000). For instance, for multinationals primarily based in the USA (which is among the many most steady economies on the planet), their abroad growth are inclined to exacerbate danger. This enhance in danger is probably not completely offset by the danger discount because of worldwide diversification and thus leading to a downward adjustment of the companies’ leverage.
On the converse, for companies within the rising economies, funding internationally within the developed economies results in a discount in company danger and subsequently an upward adjustment of leverage.
INTERNATIONALIZATION AND SYSTEMATIC RISK
The upstream downstream argument may be prolonged to the systematic danger space. Multinationals, by definition, have their operations diversified into numerous nations. The systematic danger of an ith operation can subsequently be outlined as ?i (Reeb, Mansi & Allee 2001).
?i = (?im ?i)/ ?m
The place ?im represents the correlation between the market return and agency’s return
?i represents the agency’s return normal deviation
?m refers back to the market return’s normal deviation
An ith operation is thus influenced by the character of the enterprise operation and the financial system of the nation the place the operation takes place (Reeb, D.M., S.A. Mansi and J.M. Allee, 2001). Take for instance a challenge that’s situated in a extra risky rising financial system. This challenge would are inclined to have the next worth of whole danger, ?i. Until there may be an offset of the excessive normal deviation by a decrease correlation coefficient ?im, the systematic danger ?i’d be greater.
On the converse a challenge that’s situated in a extra steady financial system are inclined to have a decrease worth of its whole danger, ?i. Equally, until there’s a considerably greater worth of correlation environment friendly ?im, the systematic danger ?i are usually decrease.
For any multinational, its general systematic danger is solely the weighted common of the betas (?i) of all its enterprise operations inside the numerous nations (Reeb, Mansi & Allee, 2001).
?mnc = ? Wi ?i
The place Wi represents a fraction of the whole capital invested by the MNC within the ith nation’s operation.
Subsequently, for a agency that’s headquartered in a extra steady financial system, growth of its operations right into a much less steady market would enhance the general beta (?mnc) of the agency, because of doubtlessly larger environmental danger for the brand new operation (Reeb, Mansi & Allee, 2001). Conversely, when a agency that’s headquartered in an rising financial system expands its direct investments right into a developed financial system, its general beta could lower.
The means to arbitrage markets could as effectively differ because of the financial variations of the house and goal economies (Reeb & Kwok 2000). Take for instance, the shift of earnings. The means to have the earnings shifted amongst totally different tax regimes is determined by the diploma of sophistication of the host and goal authorities (Reeb & Kwok 2000). Corporations which can be primarily based in economies that are extra developed and with larger assets, are inclined to have fewer alternatives for shifting their earnings (Reeb & Kwok 2000).
In distinction, companies which can be primarily based within the risky rising economies are inclined to have totally different alternatives to arbitrage labour and capital markets (Reeb & Kwok 2000). That’s, companies which can be transferring upstream have extra alternatives to rent workers with totally different units of abilities and expertise than these which can be transferring downstream. This means that companies’ behaviour in direction of worldwide exercise varies with the traits of the house and goal market. Subsequently, the general impact of internationalization on the companies danger and leverage is determined by whether or not the agency is transferring upstream or downstream.
INTERNATIONALIZATION AND LEVERAGE
Aligning with the above, the affiliation between internationalization and agency danger suggests a leverage impact as effectively. Conventional capital construction idea posits that as agency danger will increase the debt utilization decreases (Reeb & Kwok 2000). Therefore, for companies which can be primarily based within the extra risky rising economies, their abroad growth could result in extra debt utilization, as they could achieve entry to debt that was not beforehand obtainable. The converse can be true.
This view of the leverage facet of upstream-downstream speculation suggests a destructive affiliation between leverage and internationalization for companies primarily based within the extra developed economies and vice versa (Reeb & Kwok 2000). That’s, companies which can be transferring upstream are inclined to have a constructive relationship between the companies leverage and internationalization whereas these transferring downstream are inclined to have a destructive affiliation. This means that the general impact of internationalization on the leverage of multinationals is equally depending on the house and goal market circumstances.
This subsequent part will discover on the company diversification idea and the impact of company prices and inside capital markets on the companies’ leverage. Specifically, the company conflicts and effectivity of inside capital markets might be utilized in offering an evidence as to why multinationals are inclined to have decrease ranges of long-term debt however extra use of short-term debt than non-multinational companies.
CORPORATE INTERNATIONAL DIVERSIFICATION
The company worldwide diversification idea posits that multinationals ought to have decrease danger and better monetary leverage than the home companies (Doukas & Pantzalis 2001). One of many major cause as to why companies wouldn’t take 100% debt of their capital construction is due to the danger of insolvency (Doukas & Pantzalis 2001). Provided that this danger just isn’t linear however will increase with greater debt ranges, companies can thus restrict their leverage to be able to keep away from incurring chapter prices.
There are a selection of enterprise dangers in addition to alternatives that stem from company worldwide diversification. Enterprise danger which is often measured by the volatility of the working web earnings refers the price of monetary misery or reasonably chapter price (Doukas & Pantzalis 2001). Each the home and multinational companies are additionally confronted with trade charge danger. That’s, the danger that fluctuations in currencies will have an effect on the demand and provide, worth and value traits of the company.
There may be additionally the danger of upper company prices which faces multinational companies. MNCs face greater company prices because of auditing prices, monitoring prices, totally different accounting programs, totally different authorized programs, sovereignty uncertainties, language variations, labour market and capital imperfections in addition to the totally different asset buildings (Doukas & Pantzalis 2001). Company prices are identified to have a big influence on the optimum debt degree as might be mentioned under (Doukas & Pantzalis 2001).
Political dangers come up from political occasions that will have antagonistic results on the financial wellbeing of the agency. For instance, potential conflicts could come up between the objectives of the federal government and people of the international companies. That is particularly the case with international direct funding, given their impact on the host financial system.
Among the many advantages put forth by students is the view that by worldwide diversification, companies are in a position to enhance on their debt capability and scale back their chapter prices (Doukas & Pantzalis 2001). It has been argued that dangers are decreased by portfolio results because of the imperfect correlation of international money flows. On this regard, Fatemi (1984) and Agmon & Lessard (1977) level out that diversification advantages scale back the chapter prices and enhance the debt utilization by multinationals.
AGENCY COSTS AND FINANCIAL STRUCTURE OF MULTINATIONALS
The documented puzzle that multinationals are inclined to have decrease ranges of long-term debt however extra use of short-term debt than non-multinational companies warrants an evidence. There are various causes as to why one would count on multinationals to have totally different leverage ratios relative to the home companies. First, given the worldwide nature of their operations, MNCs are anticipated to have entry to extra capital sources not like the home companies (Doukas & Pantzalis 2001). Subsequently, they’ll increase extra capital through international debt financing and at extra beneficial phrases than the home companies (Doukas & Pantzalis 2001).
Contemplate, for instance, the case of multinationals which have subsidiaries in nations with totally different tax charges. These multinationals can profit quite a bit by borrowing by international associates uncovered to excessive tax charges, therefore growing their tax shields (Butler 1999). It subsequently follows that because of entry to exterior sources of financing, these multinationals ought to typically have greater debt ratios than the home companies (Butler 1999).
One more reason as to why Multinationals ought to exhibit greater debt ratios than non-multinational companies is that the international debt can be utilized as a hedging instrument in opposition to the danger of international trade (Butler 1999). Provided that multinationals have greater ranges of international trade publicity compared to the home companies, they’re thus anticipated to make larger use of debt financing than the native companies (Butler 1999). Moreover, since multinationals are topic to political and trade charge danger exposures, it’s anticipated that these multinationals ought to have greater general debt ratios relative to the native companies (Butler 1999).
Thirdly, because of industrial and geographical diversification of operations of MNCs, they’re anticipated to have decrease enterprise and monetary danger than the home companies (Doukas & Pantzalis 2001). This has the influence of decreasing the price of debt and subsequently growing leverage. This means that the leverage of multinationals ought to have a constructive relation with international involvement whereas monetary misery ought to have a destructive and larger bearing on DMCs’ leverage (Doukas & Pantzalis 2001).
Nevertheless, whereas hedging, monetary misery, liquidity and working concerns indicate that multinationals usually tend to have larger leverage than the home companies, findings from empirical research present that these multinationals have as a substitute decrease long-term leverage relative to the home companies (Doukas & Pantzalis 2001).
Three potential explanations may be given for this discovering. These embody: (Doukas & Pantzalis 2001)
Efficiencies of inside capital markets
Company prices of debt
Authorized and institutional variations throughout counties the place multinationals function.
INTERNAL CAPITAL MARKETS
Since MNCs have quite a few divisions working throughout nations, they have a tendency to create in depth inside capital markets which can present cheaper financing relative to the exterior markets (Doukas & Pantzalis 2001). Therefore, the place the interior capital market is environment friendly, MNCs are inclined to rely extra on inside financing than the exterior one. Consequently, they have a tendency to have decrease leverage than the home companies. Consequently, a non-positive relation between the companies leverage and its international operations can emerge when inside capital markets bypass exterior capital market informational asymmetries (Doukas & Pantzalis 2001).
In a latest examine, Matsusaka & Nanda (1997) and Scharfstein & Stein (1997) examined the improved capital allocation in inside capital markets and the related company prices for companies that had diversified their operations. They discovered that diversified companies might use inside capital markets in funding worthwhile initiatives, which might not be financed in exterior capital markets because of company prices and knowledge asymmetries.
This means that the exterior debt financing want for multinationals may be attenuated and that the low ranges of leverage for Multinationals ought to mirror the strengths of inside capital markets (Doukas & Pantzalis 2001). This view definitely signifies a destructive relation between industrial diversification and the leverage of multinationals. That’s, MNCs debt ratios ought to exhibit a destructive and extra pronounced affiliation with industrial diversification than the home companies.
AGENCY COSTS OF DEBT
The company price of debt impact on leverage of multinationals arises from their industrial diversification. Since their operations are geographically dispersed, the price of gathering and processing data is usually extra pricey for MNCs than the home companies (Doukas & Pantzalis 2001). Subsequently, multinationals are anticipated to have extra inherent company issues between the debtholders and shareholders because of their various geographic construction.
It subsequently follows that bondholders would require greater curiosity cost on loans to companies which have larger monitoring prices and are extra vulnerable to uneven data issues (Doukas & Pantzalis 2001). This means that companies which have diversified their operations usually tend to have their debt ratios decrease than home companies. Additional, companies with larger international involvement are anticipated to have a destructive and extra pronounced relation between the companies leverage and company prices of debt, than the home companies (Doukas & Pantzalis 2001).
A number of authors have advised that, not like the home companies, multinationals are more likely to Help extra debt of their capital buildings. Burgman (1999), nevertheless, contests this declare and actually argues that multinationals have, within the precise sense, much less debt of their capital construction. He addresses whether or not elements such because the political and trade charge danger and the company prices can clarify this phenomenon. The findings of his examine present that multinationals are inclined to have greater company prices and that diversifying their operations doesn’t decrease their earnings volatility.
CONCLUSION
Clearly, there are inherent enterprise dangers as effectively alternatives that stem from company diversification. Whereas we don’t ignore the cross-border advantages of company diversification, we advise that the general impact of internationalization on the companies danger and leverage may be predicted by an upstream-downstream speculation.
REFERENCE
Agmon, T. and D. Lessard, 1977. “Investor recognition of company worldwide diversification”. Journal of Finance, 32:1049-55.
Bartov, E., G. Bodnar, and A. Kaul, 1996.“Change charge variability and the riskiness of US multinational companies: Proof from the breakdown of Bretton Woods”. Journal of Monetary Economics, 42: 105-132.
Burgman, T. A., 1996. “An empirical examination of multinational company capital construction” Journal of International Enterprise Research, Vol 30, pp. 553-570.
Butler, Ok.C., 1999, Multinational Finance, 2nd version, Cincinnati, OH: South-Western Faculty Publishing
Chen, C.J. P., C.S. Cheng, H. J. Agnes, and Ok. Jawon, 1997. “An investigation of the connection between worldwide actions and capital construction” Journal of International Enterprise Research, p. 563-577.
Chkir, I.E. and J.C. Cosset, 2001. “Diversification technique and capital construction of multinational companies”. Journal of Multinational Monetary Administration 11, 17–37.
Doukas, J.A. and C. Pantzalis, 2001. Geographic diversification and company prices of debt of multinational companies. Outdated Dominion College. http://papers.ssrn.com/summary=282850 accessed on 30th December 2011
Fatemi, A. 1984. “Shareholders Advantages from Corporate International Diversification”, Journal of Finance Vol. 39 No.5.
Hughes, L., D. Logue, and R. Sweeney, 1975. “Corporate worldwide diversification and market assigned measures of danger and diversification”. Journal of Monetary and Quantitative Assessment, 10:627-37.
Kwok, C. Y. Chuck and D. Reeb, 2000.” Internationalization and Agency Danger: An Upstream-Downstream Hypothesis”, Journal of International Enterprise Research, 31, four; 611-629.
Lee, Ok., and C.Y. Kwok, 1988. “Multinational companies vs. home companies: International environmental elements and determinants of capital construction”. Journal of International Enterprise Research, vol 19, pp. 195-217.
Matsusaka. J, and V. Nanda, 1997, Inner capital markets and company refocusing, Working Paper, College of Southern California.
Reeb, D.M. and C. Kwok and H. Y. Baek, 1998. “Systematic Danger of the Multinational Company”, Journal of International Enterprise Research, Second Quarter.
Reeb, D.M., S.A. Mansi and J.M. Allee, 2001. “Agency internationalization and the price of debt financing: proof from non-provisional publicly traded debt”. Journal of Monetary and Quantitative Assessment 36, 395–414.Chkir & Cosset (1999)
Scharfstein, D.S, 1997, The darkish facet of inside capital market II, Working Paper, MIT press.

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