Multinational Financial Policy and the Cost of Capital: The Many Roads Home

The previous literature on multinational financial policy has, for the most part, been restricted to the choice between dividend distributions to the parent and further real investment in the foreign affiliate. We argue that investment in financial assets such as the debt and equity of related affiliates or Eurodollar deposits, for example, offer multinationals attractive alternatives to dividend repatriation. We present theoretical models that illustrate how investment and financial incentives change when the possibility of investing in financial assets is added to the analysis. Our models depart from previous work in several important ways. We drop the standard arbitrage condition in which equity and debt are perfect substitutes from the viewpoint of the firm and instead impose a worldwide financial constraint consistent with a rising cost of debt finance. In our models, parents can borrow against financial assets held abroad and may allocate debt across locations to achieve the lowest cost of capital at home and abroad. We also consider the implications of models in which affiliates can invest in related affiliates in other foreign countries. We use firm level balance sheet data from controlled foreign corporations (CFCs) available in the Treasury tax files to test the implications of our models. Our regression results confirm the importance of tax considerations in explaining CFC holdings of financial assets. We also find that CFCs with more debt distribute more dividends. This provides evidence that greater dividend distributions do not necessarily imply lower real investment by CFCs.