Newly developed methods of communication transformed the world into highly integrated place, where new global standards and collaborative corporate systems were established. Increased importance to participate in financial and economic transactions had made it relevant for all countries to use such financial theories as Capital structure, Net Present value, and Dividend policy, Leverage and Taxes. However, each country’s unique political and legal structure, cultural ideology and economic circumstances influence the extent to which these theories are used and determine a particular approach for their implementation.
In this paper I will critically discuss the role of culture in finance by examining uncertainty avoidance, individualism and power distance as cultural determinants of leverage and dividend policies. Also, I will demonstrate that each country’s tax system, legal structure and inflation are important factors that determine cross-cultural differences in approach to financial theories introduced above.
First of all, it is important to understand that “cultural values are conceptions of the desirable that guide the way social actors select actions, evaluate people and events, and explain their actions and evaluations (Schwartz, 1999)” (Fidrmuc & Jacob, 2010, p. 322) Therefore, culture determines social ideology, influences and predicts behaviour of people in a particular group including organizational leaders, shareholders, and invertors. As a result, financial organizations operating in different cultures or countries naturally organize their business differently.
Individualism and uncertainty avoidance are important cultural determinants of risk taking and leverage levels in organizations. According to research done by Ramirez and Kwok (2009) managers in individualistic societies such as U. S, Australia and United Kingdom are motivated by self-interest and are hesitant to contribute to collective action unless their own efforts are recognized. Therefore, they value their freedom and are “less willing to render control of their companies or projects to a bank or bondholder” (Ramirez & Kwok, 2009, p. 5).
On the other hand, managers in collectivist societies such as Peru, Indonesia and China “are likely to see debt holders as partners in a common effort towards a common goal” and therefore, they view “monitoring and project screening services provided by banks as feedback on their performance and prospects, and thus, consider them very valuable services” (Ramirez & Kwok, 2009, p. 5). Overall, collectivist societies have trust in cooperating parties such as banks and bondholders, and view additional debt financing as a positive attribute to their business.
Therefore, higher debt-to-equity ratios and leverage should be expected in such cultures. An earlier research conducted by Weber and Hsee (1998), also supports the idea that members of collectivist cultures are greater risk takers than those of individualist cultures. They found that “Chinese respondents were significantly less risk-averse in their pricing than Americans when risk preference was assessed in the traditional expected-utility framework” (Weber & Hsee, 1998, p. 1205).
The reason is that in the culture like China, family or other community members will help their group member who encounters large losses after selecting a risky option, thus acting as a “cushion” for potential losses (Weber & Hsee, 1998, p. 1208). Therefore, the personal effect of an actual loss is greatly reduced and the option is not considered so risky anymore. However, in individualist culture like U. S. “a person making a risky decision will be expected to personally bear the consequences of their decisions” (Weber & Hsee, 1998, p. 208). Therefore, it is less expected that corporations placed in individualist culture would risk using high levels of debt financing and participate in high-risk investments. The studies conducted by Ramirez and Kwok (2009) had shown that uncertainty avoidance is also an important cultural factor that determines organization’s willingness to take risk and use debt financing. “Low uncertainty avoidance ranking indicates that the country is less concerned about ambiguity and the future, and has more tolerance for a variety of opinions.
This is reflected in a society that welcomes rule breaking, more readily accepts change, and takes more and greater risks” (Ramirez & Kwok, 2009, p. 5) On the other hand, “a high uncertainty avoidance culture creates a rule-oriented society that institutes laws, rules, regulations, and controls to reduce the amount of stress that uncertainty creates in individuals” (Ramirez & Kwok, 2009, p. 5). As a result, in high uncertainty avoidance countries such as Portugal, Belgium and Poland corporations would be less willing to take risks and will see debt as an additional risk of bankruptcy (Ramirez & Kwok, 2009).
These corporations will prefer low debt and will try to avoid risky investments. However, corporations in countries like Singapore, Denmark and Hong Kong would be more likely to make unusual and risky investments in order to gain higher returns, and would be more comfortable financing their capital with debt by seeing in it opportunities rather than risks. Overall, both individualism and uncertainty avoidance have negative impact on debt financing and risk taking. High individualist and high uncertainty avoidance cultures would be less willing to take risky options and will try to reduce risk and uncertainty by lowering their debt financing.
Therefore, depending on the cultural ideologies, optimal capital structure of the firms may vary across cultures. Culturally shaped social norms and beliefs also influence the agency relationship and determine acceptable dividend payout strategies across different countries. According to research done by Fidrmuc and Jacob, in individualist societies agency conflicts are more severe, and therefore, “outside shareholders may consider low payouts unacceptable and instead expect higher levels of distribution to discipline the self-interested corporate insiders” (2010, p. 323). Such individualistic countries as U. S. nd Australia would promote personal gains culture by making regular and higher dividend payments. In the high power distance countries, such as Malaysia and Mexico, which easily accept wealth and power differentials, agency conflicts are less relevant. Therefore, “investors have a lower preference for dividends as a disciplining mechanism and find lower dividend payouts culturally more acceptable”. On the other hand, low power distance countries, such as Austria and Denmark, view dividends as a measure of equal distribution of earnings and increase their payouts in order to reduce wealth and power inequality.
Finally, research shows that in high uncertainty avoidance countries, such as Portugal and Belgium, stakeholders put “heavy emphasis on the certainty that dividend payment expectations are met each period. ” However, “investors and insiders may prefer higher retained earnings because they need cash resources to hedge against unforeseen financial distress”. Therefore, in high uncertainty avoidance countries, corporations should be expected to pay regular but much lower dividends. (Fidrmuc & Jacob, 2010, p. 323)
Overall, level of individualism, power distance and uncertainty avoidance determine cultural norms and beliefs that influence agency relationship in corporations and establish culturally shaped dividend policies. “Firms are motivated to pay the culturally acceptable level of dividends as they compete for capital and need to ensure liquidity for their shares (Faccio et al. , 2001; Farinha and Lopez-de-Foronda, 2009). ” (Fidrmuc & Jacob, 2010, p. 323) Therefore, cultural ideology is acting as a socially acceptable regulation policy to guide and maintain financial operations in corporations.
However, legal protection of investors can be another cultural determinant of dividend payouts. For example, according to the research done by Fidrmuc and Jacob (2010) there are five countries such as Brazil, Chile, Greece, Peru and the Philippines that have a legal requirement that a certain fraction of earnings be paid out as dividends. Better legal protection of investors usually exists in cultures that are “naturally afflicted with more severe agency conflicts” (Fidrmuc & Jacob, 2010, p. 323). In low protection countries dividends are usually paid to establish market reputation and attract greater financing.
Therefore, there are legal as well as socially acceptable regulations that determine dividend payout strategies for every country. The tax rates and regulations have a high influence on corporate financing. Since cash flows are measured after tax, corporations have a high incentive to manipulate their net income by choosing advantageous time recognition, and by increasing their debt financing in order to receive higher tax deductions. The size of the tax bill is determined through “laws and regulations in the annual budgets of the federal and provincial governments. Therefore, corporate and individual tax rates vary around the world depending on the “political and financial structure of a particular country”. (Ross, 2010, p. 41) Research conducted by James Hines (2010) demonstrated that countries that have low tax rates and favourable regulatory policies to foreign investors, which he calls “tax havens”, encourage tax avoidance by multinational firms that structure their transactions to reduce taxable incomes and “create incentives for others to funnel portfolio capital flows through tax haven financial affiliates and thereby sidestep local taxes and regulations” (p. 23).
In his research Hines lists 52 “Tax haven” countries that are mostly very small islands such as Cyprus, Hong Kong, Maldives, and Aruba. Due to the large amount of foreign investment, these countries have per capita incomes and rates of economic growth that by far exceed world averages. (Hines, 2010) Therefore, it is obvious that country’s tax laws and regulations have an influential role on the way organizations structure their business operations. In countries such as U. S. where interest is tax deductible, corporations take advantage of increasing their debt financing in order to increase their cash flows. In the global market, however, multi-national corporations shop for lower tax rates and favourable regulations around the world, as well, hoping to improve their cash flows and keep their profits high. Inflation rates that differ depending on the policies and economic activities of the country have a large effect on the cost of financing and future investment returns through interest rates.
According to the article written by Mukherji (2011), “unanticipated inflation negatively affects real returns on securities with fixed cash flows, and it has a stronger influence on longer-term securities, whose cash flows are fixed for longer periods. ”(p. 76) Therefore, in countries that exhibit unexpectedly high inflation, corporations would experience higher discount rates. Thus, the value of investment with fixed interest rates or fixed cash flows will substantially decrease, compare to current prices. This will result in a disadvantage for investors and advantageously effect corporations that borrow in the long run.
Due to high inflation previous bonds would, also, be sold in the market at a discount, therefore, negatively effecting their buyers. Overall, inflation is an important factor that influences corporate financing decisions and outcomes. Therefore, economic activities in a particular country can largely effect corporate decisions. In conclusion, culture by determining social norms and ideology has the power to influence people’s and, thus, corporate decisions. In other words, social culture largely affects corporate culture.
As a result, corporate culture has influence on existing agency relationships, dividend payouts, and debt ratios of the corporation. Also, specific to each country legal rules and regulations, for example those that determine tax rates and dividend policies, have a strong legal effect on corporate operations. As well, each country’s economic structure and activities, such that create inflation, have an effect on the economic circumstances in which corporations operate. Overall, culture has a large effect on corporate financial theories such as Capital structure, Net Present value, and Dividend policy, Leverage and Taxes.