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The Pros & Cons of Financial Globalization

October 10, 2010 4 comments
Kofi Annan, the seventh Secretary-General of the United Nations, once stated that “… arguing against globalization is like arguing against the laws of gravity”. “From a historical perspective … globalization is not a new phenomenon” (Schmukler, 2004); though given the technological advancements in the most recent decade or two, globalization has manifested itself in all fields, “flattening the world” (p.51)  as Thomas Friedman called it. Technological advancements facilitated cheaper means of communication and transportation, effectively bridging the distance disparities between nations. From a financials’ industry perspective, this brought good news to both investors and businesses alike; or so it appeared from first glance!

There is no denying the advantages that are brought upon by financial globalization. Due to the interconnectedness of the world markets, a given country’s market will gain a “deeper degree of financial integration” (Schmukler, 2004). This translates to further market stability and regulation, strengthening investors’ trust in a given country’s market. Thus, businesses seeking to raise funds, will have a larger pool of investors to chose from. Due to the access of a larger pool of investors, “increased competitiveness” (Moldovan, 2010) will drive down the cost of funds for businesses. So not only will businesses have access to more funds, but the cost of raising the funds will be lower. From a global perspective, this will lead to “better allocation of capital” (Moldovan, 2010). From a specific business perspective, this may lead to businesses raising their required capital at the very least; it might even accelerate the business’s growth plans and funding requirements. This is most notable in low income countries, where a study conducted by the International Monetary Fund shows that private flows have “grown more than fourfold since the 1980s” (Dorsey, 2008).

 

 

 

 

 

 

 

(Dorsey, 2008)

 

 

Financial globalization also bares benefits to investors.  For example, it does promote for a “better financial infrastructure” (Schmukler, 2004). As a result, lenders and borrowers operate in a financial system that is more “transparent, competitive, and efficient” (Schmukler, 2004). This leads, from the investor’s perspective, to more trust in the financial system. It also enables the investor to make varied investments; allowing for the spreading of risk via  diversification.

But just like falling to the ground due to gravity, globalization has its dark side. Kofi Annon continued elsewhere to say that although “… globalization is a fact of life … we have underestimated its fragility”.

As the financial markets of the world become ever connected due to globalization, if a problem occurred in one part of the globe, it would “cascade [and echo] uncontrollably” (Beinhocker et al., 2009) in other corners of the world. The latest of such crises is the housing bubble burst in the United States. Therefore, the risk of financial globalization is market disturbance due to factors beyond that of the domestic market. What this may mean for businesses seeking capital at such times, is that it will not find any; or if it does, it will be at a very high cost. This will always be true, even in the case if a given country’s government takes necessary precautionary measures to support its financial market in times of needs

For example, Saudi Arabia has been preparing its yearly budget with the assumption that the price of the oil barrel is USD 40; though in reality, the oil barrel was being sold for over USD 100.  This created a lot of surplus for the Saudi government. When the housing bubble burst in end of 2008, the Saudi government tried to inject a lot of liquidity in its market. And although, Saudi Arabia was able to recover much quicker than other countries, the truth of the matter is that liquidity dried up in the country, and businesses seeking capital at that time, had to pay a higher premium to obtain it.

One benefit that was cited in regards to financial globalization is that capital, on a global scale, is distributed in the most efficient manner. But this same benefit may be viewed in a negative light by some business owners whom are seeking capital, due to the emerging trend of “imbalances in trade and financial flows” (Wyss, 2009). To such business owners, financial globalization dried up their pool of potential investors; or increased substantially their cost of capital.

Looking at things from an investor’s point of view, it can be argued that globalization of financial markets aid in spreading their risk via diversification, but when a crisis does occur, no financial market or industry is shielded. Thus, the spreading of risk efforts would be dampened due to globalization of financial markets. Sort of a double edge sword.

Another aspect that must be analyzed, from an investor’s point of view, is that due to the globalization of financial markets, capital is allocated in the most efficient manner; irrespective of other non profit oriented criteria. Rarely is a criterion such as the likes of morality, humanitarianism and environmentalism are incorporated in the definition of efficiency. Thus globalization of financial markets will penalize investors who don’t regard profits as their only priority.

— Youssef Aboul-Naja

Capital Structure: Optimal Composition

March 7, 2010 Leave a comment

The Bigger Picture:

To start our discussion on how do companies decide on their composition of capital structure, it would be beneficial to take a step backwards, and glance at the bigger picture; prior to jumping into the details. Any company is brought into existence to increase the wealth of its owners; the shareholders. The company does so by generating economic returns through the process of taking “financial capital and [converting it] into assets…[to fulfill] customer needs” (Groth and Anderson, 1997). The financial capital utilized by the company, which becomes its assets, comes from shareholders’ funds (equity) and debt. It is the different percentage claims of the financiers (shareholders and debtors) that make up the capital structure of a company.

As companies are established to increase shareholder’s wealth, managers want to put in place a capital structure to achieve just that. Thus an “efficient mixture of capital reduces the price of capital … [and in doing so] increases net economic returns which, ultimately, increases firm value” (Groth and Anderson, 1997).

But reducing the price of capital is not the only task a company faces as it increase the wealth of its shareholders. A company face other variables such as:

-> Government taxes on the revenue it generates
-> Indirect bankruptcy claim costs, rendered through “higher interest rates” (Ross et al., 2008, p. 463), should the company default on its debts.
So, in selecting a capital structure, taxes and bankruptcy claims must also be taken into consideration; along with reduction of capital costs. Given such qualitative framework, the following questions arise: Is there an optimal capital structure for companies? Is a company’s capital structure a result of its operating context, or underlying principles?
In Principle:

Each company does have an optimal capital structure; and such structure is a result of underlying principles.

As stated briefly, four parties have claims over a company’s earnings: the shareholders (equity), the bondholders (which shall represent the debt portion), the government (taxes), and bankruptcy claims (indirect costs). As companies cannot influence directly the claims of the latter two [taxes and bankruptcy claims], it must do so by optimizing the debt-to-equity mix. “Stockholders choose the debt level to maximize the value of their equity taking into account the cost of default” (Harris and Raviv, 1990).

Modigliani-Miller (1958) have proved that the “value of [a] firm is completely independent of [its] capital structure” in the absence of taxes and bankruptcy costs. It was later demonstrated that “high leverage capital structures” (Miller, 1988) reduce corporate income taxes, as accounting principles require interest expense to be subtracted from earnings prior to tax calculation. With higher leverage [debt] capital structure, more money ‘in theory’ finds its way to shareholders/bondholders; since less of it goes to taxes. But one side effect of increased leverage is the increased risk of bankruptcy. Thus as a company’s leverage increases, so does its bankruptcy claims costs; which is reflected through increased interest rates on debts. With the increase of bankruptcy claims due to higher leverage, less money finds its way to shareholders/bondholders.

So in principal, the optimal capital structure of a company is when the tax shelter gains minus the bankruptcy claims costs is maximized. This should bring about the most wealth to the shareholder’s of the company. Effectively, “the use of the right amount of debt lowers the companies weighted cost of capital” (Groth and Anderson, 1997).

In Reality:

Though the above explanation of how to decide on an optimal capital structure makes perfect sense, it is all academia. “No equation exists to determine the optimal capital structure for a company” (Groth and Anderson, 1997). The actual market environment is much more complex to capture in mathematical formulas. Some factors that make it difficult to arrive to an optimal capital structure include (the list is not exhaustive):

-> “Investors’ receptivity to debt” (Milken, 2009): This is mainly influenced by the current market conditions.
-> A culture’s acceptability of debt: Culture plays a big role in “influences our values, which in turn affects our attitudes, and then behavior” (Chui et al., 2002).
-> Country factors: “Aggarwal (1981) [analyzed the] 500 largest European firms” (Chui et al., 2002) and concluded that country factors play a role when companies decide on their capital structure.
-> Free cash flow problem: Whereby if a company generates a lot of cash flows from the optimal capital structure, it would “waste it rather than pay it out to investors” (Myers, 1993) considering that a conflict of interest would be present between management and shareholders.
-> Deviation from industry norm issues: If a company structures its capital in a way where it deviates substantially from its industry norm, it might be frowned upon by lenders, making it difficult for the company to attain debt-financing.

Closing Notes:
Given the complexities of capturing all the variables that effect the optimal capital structure formula, then the capital structure composition is left to an educated guess at best: industry standards, operating context of the firm, stakeholder’s preference, etc. But as companies experiment with various capital structures, they would be inching ever closer or further to the optimal point. One statement that rings true, regardless of capital structure composition, is “it doesn’t matter whether a company is big or small. Capital structure matters. It always has and always will” (Milken, 2009).
~ Youssef Aboul-Naja