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1. SOURCE OF FINANCING
If the firm is going to seek external financing for a project, it will want to borrow
funds from the lowest cost source of capital available. As we have just seen ,firms
increasingly are turning to the global capital market to finance their investments. The cost
of capital is typically lower in the global capitalmarket, by virtue of its size and liquidity,
than in many domestic capital markets, particularly those that are small and relatively
illiquid. Thus, for example, a U.S firm making an investment in Denmark may finance
the investment by borrowing through the London based eurobond market rather than the
Danish capital market.
However, despite the trends towards deregulation of financial services, in some cases
host-country government restrictions may rule out this option. The governments of some
countries require, or at least prefer, foreign multinationals to finance projects in their
country by local debt financing or local sales of equity. In countries where liquidity in
limited, this raises the cost of capital used to finance a project. Thus, in capital budgeting
decisions, the discount rate must be adjusted upward to reflect this. However, this is not
the only possibility. In Chapter 8, we saw that some governments court foreign
investment by offering foreign firms low-interest loans, lowering the cost of capital.
Accordingly, in capital budgeting decisions, the discount rate should be revised
downward in such cases.
In addition to the impact of host-government policies on the cost of capital and financing
decisions, the firm may wish to consider local debt financing for investments in countries
where the local currency is expectedto depreciate on the foreign exchange market. The
amount of local currency required to meet interest payments and retire principal on local
debt obligations is not affected when a country’s currency depreciates. However, if
foreign debt obligations must be served, the amount of local currency required to do this
will increase as the currency depreciates, and this effectively raises the cost of capital.
Thus, although the initial cost of capital may be greater with local borrowing ,it may be
better to borrow locally if the local currency is expected to depreciate on the foreign
exchange market.
FINANCIAL STRUCTURE
There is a difference in the financial structures of firms based in different countries. By
financial structure we mean the mix of debt and equity used to finance a business. For
example, Japanese firms rely far more on debt financing than do most U.S. firms. One
study of firms in 23 countries found that debt to equity ratios varied from a low of 0.34 in
Singapore to a high of 0.76 in Italy. The average ratio in the United States was 0.55. It
was also 0.55 in the United Kingdom, and 0.62 in Germany. Another study of more than
4,000 firms in five countries found that the ratio of long-term debt to assets was 0.185 in

2. the United States, 0.155 in Japan, 0.98 in the United Kingdom, 0.88 in Germany, and
0.145 in France ,suggesting again that reliance on debt financing varies from country to
country.
It is not clear why the financial structure of firms varies so much across countries. One
possible explanation is that different tax regimes determine the relative attractiveness of
debt andequity in a country. However, according to empirical research, country
differences in financialstructure do not seem related in any systematic way to country
differences in tax structure.Another possibility is that these country differences may
reflect cultural norms. This explanation may be valid, although the mechanism by which
culture influences capitalstructure has not yet been explained.
The interesting question for the international business is whether it should conform to
local capital structure norms. Should a U.S. firm investing in Italy adopt the higher debt
ratio typical of Italian firms for its Italian subsidiary, or should it stick wit its more
conservative practice? There are few good arguments for conforming to local norms. One
advantage claimed for conforming to host-country debt norms is that management can
more easily evaluate its return on equity relative to local competitors in the same
industry. However, this seems a weak rationale for what is an important decision.
Another point often made is that conforming to higher host-country debt norms can
improve the image of foreignaffiliates that have been operating with too little debt and
thus appear insensitive to local monetary policy. Just how important this point is,
however, has not been established. The best recommendation is that an international
business should adopt a financial structure for each foreign affiliate that minimizes its
cost of capital, irrespective of whether that structure is consistent with local practice.
Global Money Management : The Efficiency Objective
Money management decisions attempt to manage the firm’s global cash resources – its
working capital - most efficiently. This involves minimizing cash balances and reducing
transaction costs.
MINIMIZING CASH BALANCES
For any given period, a firm must hold certain cash balances. This is necessary
for serving any accounts and notes payable during that period and as a contingency
against unexpected demands on cash. The firm does not sit on its cash reserves.
It typically invests them in money market accounts so it can earn interest on them.
However, it must be able to withdraw its money from those accounts freely. Such
accounts typically offer a relatively low rate of interest. In contrast, thefirm could earn a
higher rate of interest if it could invest its cash resources in longer-term financial
instruments (e.g., six-month certificates of deposit). The problem with longer-term
instruments, however, is that the firm cannot withdraw its money before the instruments
mature without suffering a financial penalty.

3. Thus, the firm faces a dilemma. If it invests its cash balances in money market accounts
(or the equivalent), it will have unlimited liquidity but earn a relatively low rate of
interest. If it invests its cash in longer-term financial instruments (certificates of deposit,
bonds, etc.), it will earn a higher rate of interest, but liquidity will be limited. In an ideal
world, the firm would have minimal liquid cash balances. We will see later in the chapter
that by managing its total global cash reserves through a centralized depository (as
opposed to letting each affiliate manage its own cash reserves), an international business
can reduce the amount of funds it must hold in liquid accounts and thereby increase its
rate of return on its cash reserves.
REDUCING TRANSACTION COSTS
Transaction costs are the cost of exchange. Every time a firm changes cash from one
currency into another currency it must bear a transaction cost—the commission fee it
pays to foreign exchange dealers for performing the transaction. Most banks also charge a
transfer fee for moving cash from one location to another; this is another transaction cost.
The commission and transfer fees arising from intrafirm transactions can be substantial;
according to the United Nations, 40 percent of international trade involves transactions
between the subsidiaries of transaction corporations. As we will see later in the chapter,
multilateral netting can reduce the number of transactions between the firm's subsidiaries,
thereby reducing the total transaction costs arising from foreign exchange dealings and
transfer fees.