The effectiveness of international diversification of companies from BRIC countries

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The effectiveness of international diversification of companies from BRIC countries

Introduction

In recent years corporate international diversification (CID) has become a widespread growth strategy of companies from both developed and developing countries. Corporate international diversification can take two forms: when a company expands abroad by exporting products or by placing production facilities in the foreign markets. In the paper we use the terms «internationalization», «international diversification» and «cross-border diversification» as synonyms as proposed by Hitt et al. (2006).

During the last two decades the level of CID has been significantly growing. For that reason, its influence on corporate performance has become a topic of interest among researchers. Despite the efforts to introduce a general model, the findings are often contradicting. It happens due to the trade-off between the costs and benefits of international diversification. On the one hand, companies benefit from competitive advantages that are not accessible in the home market. On the other hand, CID brings various risks, transactional costs and agency problems. According to the majority of scholars, the internationalization activities are mainly value-destroying.

When analyzing the performance of companies, considering the degree of internationalization, most researches focus on operating performance measures (operating profit margin, return on assets and equity) and do not account in their analysis for financial effects, which, as argued by Singh and Najadmalayeri (2004), determine companies' access to global capital markets, their capital structure and tax optimization policy. In aggregate it affects the cost of capital. Thus, in most papers the analysis of company's internationalization policy is incomplete. We argue that in order to discover the relationship between international diversification and performance both operational and financial effects should be analyzed concurrently.

In order to resolve this problem we introduce a model of economic profit, or residual income, which is the main contribution of our paper. This measure is considered as a proxy for company's strategic performance, as it accounts for investment risk. The second contribution stems from simultaneous analysis of internationalization strategies of companies' from several developing countries, which, in comparison with developed markets, have not been analyzed before thoroughly.

Among the emerging economies, we focus on BRIC countries. The choice is explained by their significant demographic and economic contribution to the global development and their potential to become the largest and most influential economies in this century, which is proved by the following statistics. According to the World Bank, in the period from 2005 to 2013 the share of BRIC countries' output in the world GDP increased from 10% to 15%. Moreover, BRIC countries contributed to more than 40% of increase in global output during that period. According to the forecast of Goldman Sachs made in 2007, China and India would become the first and the third largest economies by 2050, while Russia and Brazil would occupy the fourth and the sixth positions. Thus, BRIC countries distinguish from other emerging economies, making them a separate object for analysis.

The paper has the following structure. In section two we summarize the approaches and findings of prominent researches, and formulate the hypotheses on their basis. In section three we introduce our model and describe the data. The findings are discussed in section four. Finally, we present the conclusions and make recommendations.

1. Theoretical background and hypotheses

1.1 Research approach

economic cooperation financial relationship

In existing literature, for example in the paper of Hitt et al. (2006), the relationship between international diversification and performance is analyzed in two paradigms. The first one is the event studies approach which focuses on a time window before and after an M&A transaction and analyses the change in company's performance within this time frame. The second method is the accounting studies paradigm which identifies the relationship between degree of internationalization (DOI) of a company and its performance.

In our paper we apply the regression analysis in order to define the relationship between degree of internationalization and performance. The analysis of existing researches allowed to identify the most commonly used proxies for those two indicators as outlined below:

· The most widely used internationalization parameters are separated into two categories - diversification of assets, usually presented by foreign-assets-to-total-assets (FATA) ratio, and diversification of markets, presented by foreign-sales-to-total-sales (FSTS) ratio;

· The discovered performance variables are described in Table 1.

The table presents the summary of existing corporate performance measures and the most prominent papers, in which those measures are applied.

Table 1. Accounting studies by the types of corporate performance measures

Type of measure	Type of corporate performance	Examples of measures	Papers
Current performance measures (disregarding expected performance)	Operational efficiency	Revenue, operating cash flow, operating margin, return on investment (ROS, ROE, ROA, etc.)	Qian and Li (2002), Gugler et al. (2003), Moeller and Schlingemann (2004), Lu and Beamish (2004), Contractor et al. (2007), Bobillo et al. (2010), Rugman and Chang (2010)
	Financial efficiency	WACC and other cost-of-capital related measures	Singh and Nejadmalayeri (2004), Joliet and Hubner (2006)
Measures reflecting expectations	Operational and financial efficiency	Tobin's Q, P/E, market-to-book ratio	Chang and Wang (2007), Rugman and Chang (2010)

As shown in Table 1, there are typically two types of corporate performance indicators:

1. The current company's performance constitutes the first group of measures. Those parameters describe company's efficiency during a certain time period not exceeding one year. However they do not capture expectations about corporate performance in the future. This group is then segmented in two categories: operational and financial efficiency indicators.

2. Future company's performance is considered in the second group of efficiency characteristics. These measures are a combination of accounting parameters and market data.

The first group of measures is criticized for their inability to simultaneously take into account both operational and financial aspects of cross-border diversification. Indeed operational benefits of internationalization should not be outweighed by unfavorable change in the cost of capital. Therefore in order to resolve this problem we implement a new approach of economic profit concept. Since this measure accounts for operational efficiency and the risks resulting from international diversification, presented by the cost of capital, it can be considered as a strategic performance measure. The economic profit or residual income is estimated as follows:

(1)

where RI is the company's residual income, ROCE - return on capital employed, WACC - weighted average cost of capital, CE - capital employed.

In order to estimate the relationship between internationalization and performance, we use the ratio of residual income to capital employed as a proxy for economic profit. Thus, we need to estimate both ROCE and WACC as functions which are dependent on degree of internationalization (DOI) and other explanatory variables.

Using the measures of internationalization and performance listed previously in this section, the researchers obtained different and often contradictory results. Some of them, which were derived when analyzing companies from developing markets, are presented in Table 2.

The table presents the most frequently used combinations of internationalization - performance variables among scholars, as well as the derived relationships.

Table 2. The results of the developing countries analysis

Paper	Sample	Performance variable	DOI variable	Relationship
Thomas (2005)	500 Mexican firms	1994-2001	ROS	FSTS	U-shaped curve
Chen, Tan (2012)	887 Chinese firms	2000-2012	Tobin's Q	FSTS	Linear negative
				RSTS (regional sales to total sales)	U-shaped curve
				RSTS (Intragreater China)	S-shaped curve
Singla, George (2013)	237 Indian firms	2002-2008	ROA, Tobin's Q	FSTS	No relationship
				Composite index (FSTS, FATA, OSTS, scope)	Negative linear
Xiao et al. (2013)	114398 Chinese firms	2001-2007	ROA	FSTS	S-shaped curve

We observe that the analysis of Indian companies by using both operational and financial measures of efficiency, has shown no relationship between internationalization and performance. For Chinese and Mexican companies there is evidence of a non-linear curve shape when using operational performance measures. Among the most interesting conclusions, we should mention the paper of Chen and Tan (2012), where the authors derived different internationalization-performance relationships for each of the three DOI measures.

With a large number of papers presenting contradictory results, a group of researchers decided to meta-analytically integrate empirical data from different studies in order to test, whether the proposition that both international and domestic diversification affect corporate performance, holds for the overall sample. Some of the existing meta-analyses are presented in Table 3.

The table presents internationalization - performance relationships found in selected meta-analysis researches.

Table 3. The meta-analysis results of diversification-performance relationship

Paper	Sample	Explanatory variable	Relationship
Bausch, Pils (2009)	104 studies	Related product diversification	Positive
		Unrelated product diversification	Negative
Pils (2009)	99 studies	Related product diversification	Positive
		Unrelated product diversification	Negative
Carney et al (2011)	141 studies	FSTS, product diversification	Moderating effect
Kirca et al (2011)	111 studies	FSTS	Positive

Among the selected papers, all the authors use a set of performance variables, including both accounting-based and market-based measures. The main difference stems from the explanatory variable.

· Pils (2009), and Bausch and Pils (2009) examine the influence of product diversification on corporate performance. Product diversification is defined as the amount of businesses in which a firm is involved. Both papers found positive relationship between related product diversification and performance, while the influence of unrelated product diversification on performance is negative.

· Carney et al. (2011) use the number of company's affiliates as an explanatory variable, while the amount of exports in total sales and product diversification act as moderators.

· Kirca et al. (2011) found positive relationship between international diversification and performance, with firm-specific assets having a positive moderating impact.

1.2 Hypotheses

Taking existing studies as a basis for our research, we have formulated several hypotheses for a sample of Chinese, Indian, Brazilian and Russian companies.

Hypotheses for operational performance - internationalization relationship

Most of the researches which are dedicated to the analysis of international diversification-performance relationship found a non-linear pattern for a sample of companies from developed markets. Lu and Beamish (2004), Bobillo et al. (2010) identified the S-shaped relationship which is generally the most widely spread finding among researchers. The shape of an S-curve is supported by the following considerations:

1) at the initial stage of cross-border diversification companies are facing internationalization-specific costs, including learning and coordination costs, which outweigh the benefits from increasing sales in the foreign markets. Thus operational performance is deteriorating along the increase in DOI;

2) at a medium level of international diversification companies are able to achieve economies of scale and scope, diversify country-specific risks, get access to cheaper resources and occupy bigger market share. Those benefits exceed transaction costs, which result in performance improvement.

3) at the latest stages of cross-border diversification companies become too complex to be managed and they face a decline in their performance.

This type of a relationship is most commonly derived by researchers on a sample of developed countries. But still some scholars, for example Capar and Kotabe (2003), have come up with a U-shape curve, while Hitt et al. (1997) argue that internationalization-performance relationship is inverse U-shaped. The U-shape curve constitutes only the initial and medium stages of an S-shape curve, while for the inverse U-shape curve only the medium and the latest stages are represented.

Several researches focus on the analysis of emerging markets. Thus, Contractor et al. (2007) on a sample of Indian companies and Chen and Tan (2012) on a sample of Chinese companies found a U-shape relationship between internationalization and performance. The argument is that companies from developing countries at their latest stages of international diversification usually do not become too complex, thus avoiding the decline in their efficiency.

Hypothesis 1.1: The relationship between operational performance, presented by return on capital employed (ROCE) and DOI is U-shaped for companies from BRIC countries.

Lu and Beamish (2004) have shown that the internationalization-performance relationship significantly depends on the amount of intangible assets of a company. They argue that firms deploy their intangible assets to exploit market imperfections in other countries.

Hypothesis 1.2: The share of intangible assets in total assets has a positive impact on operational efficiency of BRIC companies related to internationalization.

As outlined in the introduction, among the emerging economies it is most reasonable to include Chinese, Indian, Brazilian and Russian companies in a single analysis, as BRIC countries are similar from different perspectives.

Hypothesis 1.3: There exists a common model that describes the relationship between operational performance and the level of international diversification, applicable to all BRIC countries.

Hypotheses for financial performance - internationalization relationship

Leverage

As argued by Singh and Nejadmalayeri (2004), companies that expand abroad tend to increase their financial leverage. This finding is explained by debt supply growth on capital markets, resulting from decreasing risks of bankruptcy due to risk diversification of companies that pursue their internationalization strategies. On the other hand some researchers are persuaded that internationalization leads to a reduction in debt supply. Doukas and Pantzalis (2003) propose the following arguments in support of this statement:

a) debt holders face an increase in agency costs due to fast growth of internationalizing companies and their organizational complexity at the latest stages of diversification;

b) debt holders bear more risks as companies are likely to have more intangible assets with further expansion of their foreign activities, thus there might be difficulties with their monetization if the company goes bankrupt.

Since there are different effects which have an opposite influence on the capital structure, we will assume that the relationship between financial leverage and internationalization will be non-linear, however we cannot predict whether it will be positive or negative.

Hypothesis 2.1: The financial leverage of companies from BRIC countries follows a non-linear pattern depending on DOI.

Cost of equity

We can distinguish three factors that explain the influence of cross-border diversification on cost of equity:

a) Change of risk

At the initial stages of internationalization risks for shareholders are generally high due to the new business environment the company has to adapt to, while at the latest stages risks are likely to be diversified. It thus results in non-linear relationship between cost of equity and DOI.

b) Increase of agency costs shareholders

It is argued that monitoring management is becoming more costly the more the more the company internationalizes.

c) Change in capital structure

The factors were discussed when formulating Hypotheses 2.1.

Hypothesis 2.2: Cost of equity grows along the increase in DOI. The relationship may be U-shaped for companies from BRIC countries.

Cost of debt

We identify the following factors that describe the relationship between cost of debt and DOI:

a) Change in debt maturity

Singh and Nejadmalayeri (2004) argue that internationalizing companies raise debt of longer maturity as compared to domestic firms. As a result the cost of debt is higher.

b) Change in effective tax rate

If a company generates profits in countries with different taxation, then it will have a direct impact on the after tax cost of debt.

Hypothesis 2.3: Cost of debt of companies from BRIC countries grows with the expansion of their foreign activities.

2. The methods

2.1 The sample

We have collected the data for 173 companies from BRIC countries. The sample includes 49 Chinese, 41 Indian, 33 Brazilian and 50 Russian firms.

The chosen companies are large public firms that satisfy two requirements. First, they disclose all the information, which is needed in the our research. Second, they have acquired at least one foreign company with the value of more than $10m. The initial sample included companies from 6 industries, as outlined in the SIC standard. However, we analyze only firms, which operate in manufacturing industry. The motivation is to remove operational discrepancies between companies in order to make them comparable.

We collected the data for 2005-2013 time span from Bloomberg database. Descriptive statistics for the dataset is depicted in Appendix 1.

2.2 The Model

First, we estimate ROCE and WACC equations separately on panel data for the years 2005-2013.

The form of the ROCE equation is as follows:

(2)

where X are control variables: company size (measured by logarithm of sales, ln_sales), return on investment (measured by a 3-year average return on equity, roe3), growth (3-year average growth rate of revenues, growth3), assets efficiency (asset_turnover), profitability (EBIT_margin), book value of intangible assets normalized by total amount of assets (intang_to_tot_assets), and year dummy variables.

In order to test the hypothesis 2.1-2.3 we decomposed the WACC equation into three parts: financial leverage, cost of debt and cost of common equity:

(3)

where D states for the amount of debt, E - common equity, CoD - cost of debt, CoCE - cost of equity.

In order to derive the relationship between degree of internationalization and WACC, the following equations have to be estimated:

(4)

(5)

(6)

where dummies refer to the years, which could make it possible to analyze the post-crisis performance of internationalizing companies.

3. Findings

3.1 Testing the ROCE to DOI relationship

On the first step we analyze BRIC countries separately by constructing individual models. In order to define a proper functional form of the ROCE-DOI relationship all the variables have been initially included in equation (2), and then, relying on Akaike and Shwartz information criteria, the list of explanatory parameters was reduced, so that the ultimate model obtained the best fit to the data.

· In order to test the formulated hypothesis 1.1 of non-linear impact of internationalization on performance, we employ the polynomial function components (,,).

· To test hypothesis 1.2 of an influence of intangible assets on ROCE-DOI relationship we use intang_to_tot_assets variable.

When constructing the models we made a number of tests. First, performing a Breusch-Pagan test we discovered and corrected heteroskedasticity for all BRIC countries except Brazil. Second, we performed a Hausman test, which indicated the preference of random effects model over pooled and fixed effects models for all countries except Russia. The interpretation is that only a model for Russian companies experiences the problem of endogeneity. The possible reason is that either one of the explanatory variables is correlated with the unobserved variable or the dependent and explanatory variables have a simultaneous impact on each other. For that reason we need to introduce an instrumental variable, which would be correlated with a parameter causing endogeneity, and at the same time it should not be correlated with the error term. Regarding the list of variables available in our dataset, we do not find it possible to include an instrumental variable in the model in order to run a 2SLS regression.



Figure 1. ROCE-DOI relationship, individual models

The graph presents the change in return on capital employed as compared to the no internationalization case for each level of foreign expansion, when analyzing each of the BRIC countries individually.

Our main findings are as follows:

· In India we find that the ROCE-DOI relationship is inverse U-shaped. At the early stages of internationalization performance increases sharply and reaches its peak at cross-border diversification level of 40%. With further foreign expansion, the return on capital employed declines steadily and reaches the inception point when foreign sales constitute 90% of total sales.

· In Brazil we find evidence of an S-shaped ROCE-DOI relationship. At the early stages of international expansion (with share of foreign sales below 20%), return on capital employed faces a slight decline. However, in a range of 20-60% performance improves significantly, and deteriorates afterwards.

· For Russian companies coefficients before all the polynomial DOI variables are not significant. For that reason ROCE-DOI relationship is almost linear with negative slope. It might be explained by possible irrationality of managerial behavior and high level of corruption specific for Russian business and economic environment.

· In China we find that ROCE-DOI relationship follows an S-shape pattern. At the early stages of internationalization (with share of foreign sales below 30%) cross-border diversification significantly diminishes the return on capital employed. At the later stages of internationalization performance improves, however the returns are still negative.

The significant drop in ROCE of Chinese companies is difficult to explain as, compared to other BRIC countries, China has the largest cumulative average growth rate of GDP over the last ten years, the second highest quality of management and the second lowest level of corruption (see Table 4). Moreover, Chinese export-oriented companies have an advantage over their peers as they are strongly supported by the government. We find evidence in preferential tax policies, reduced cost of debt for the most productive firms due to state's monopoly on large-scale banks and massive deployment of funds aimed to bolster the foreign expansion policy of companies.

The table presents selected macroeconomic characteristics of BRIC countries. GII is a Global Innovation Index, which stands as a proxy for the quality of management. It is co-published by Cornell University, INSEAD and WIPO on a yearly basis. The level of corruption is taken from Transparency International. Higher value of this index indicates lower level of corruption.

Table 4. Macroeconomic comparison of BRIC countries

Variable	China	India	Brazil	Russia
GDP CAGR, 2004-2013	18.9%	11.1%	14.4%	15%
GII	0.98	1.02	0.78	0.7
Corruption	40	36	42	28

Thus, a possible explanation of low performance of Chinese companies could be that some variables in the model are missing. We suppose that those are macroeconomic characteristics as outlined earlier.

At this point we have found evidence that supports hypothesis 1.1 of non-linearity in ROCE-DOI relationship for all BRIC countries except Russia. We can also affirm that hypothesis 1.2 of positive relationship between intangible assets and performance is correct, based on coefficients presented in Appendix 2.

After analyzing BRIC countries independently, on the second step we build a common model aiming to support hypothesis 1.3 that the ROCE-DOI relationship follows the same pattern for companies from BRIC countries, if analyzed together. In order to control for country differences, in addition to a set of standard variables used in individual models, we include the following parameters:

· Lag of GDP growth

As growing GDP is an indicator of a positive business outlook in a country, we expect a company to show better performance than its international peer at the same level of DOI. A lag is used, as a company, when deciding on the level of foreign expansion, relies on last year GDP growth rate.

· Change in local currency rate

If local currency is depreciating, a company will gain more from its exports, thus resulting in a positive impact on return on capital employed.

· Global innovation index

As outlined in table 4, GII is used as a proxy for the quality of management. Comparing two companies at the same level of DOI, the one with a strong management team will be more adaptable to a different economic environment, thus showing better performance.

· Level of corruption

With a high level of corruption in the country, the company will perform better in case a larger amount of its operations is conducted abroad.

· State support

This factor could be critical for the company's performance, however there is no commonly used measure to apply in the model. For that reason, relying on information about sound state support in China, we introduce a dummy variable that equals 1 for Chinese companies and 0 otherwise. We expect to find positive relationship between this variable and return on capital employed.

The common model regression results for ROCE-DOI relationship are presented in Appendix 2.

As with individual models, we performed a Breusch-Pagan test for heteroskedasticity and Hausman test. We derived and corrected heteroskedasticity, and found no evidence of endogeneity. We also found that the impact of macroeconomic parameters on performance is in line with our expectations.

As in case with individual models, we created a single graph that illustrates ROCE-DOI relationship for a sample of companies from all BRIC countries (see figure 2).

Figure 2. ROCE-DOI relationship, common model

The graph presents the change in return on capital employed as compared to the no internationalization case for each level of foreign expansion, when analyzing all the companies from BRIC countries in one model.

We support hypothesis 1.3 by showing that it is possible to build a common model, which describes ROCE-DOI relationship for all BRIC countries. We derive that this relationship follows an S-shaped pattern, thus supporting hypothesis 1.1. Comparing a common model with individual models for each BRIC country, we find that the same relationship holds for India and Russia. However, results are opposite for China and Brazil. Return on capital employed of Brazilian companies deteriorates with an increase in foreign diversification, while Chinese companies show positive returns and outperform their BRIC peers. We believe that this relationship is more reasonable due to macroeconomic considerations mentioned above.

3.2 Testing the WACC to DOI relationship

Following the methodology described in the previous section, we estimate separately the influence of DOI on debt-to-assets ratio (DTA), cost of debt (COD) and cost of equity (COE) for each of the BRIC countries. We also build a common model by including macroeconomic variables in order to take into account country differences.

Debt-to-assets ratio

On the first step, we made the same tests as when analyzing ROCE-DOI relationship. We found heteroskedasticity in all the models and resolved the problem by using White's correction. We performed Hausman test as well, which indicated the preference of random effects model over a fixed effects and pooled models, thus showing absence of endogeneity.

The regression results are presented in Appendix 3. The graph that shows individual relationship between the capital structure and degree of internationalization for companies from each of the BRIC countries is presented in Figure 3.

Figure 3. DTA-DOI relationship

The graphs present the change in debt-to-assets ratio as compared to the no internationalization case for each level of foreign expansion. The graph on the left illustrates the results of individual models analysis. The graph on the right presents the outcome of a common model, which includes all the BRIC countries in a single analysis.

Our main findings are as follows:

· In China we find that at the early stages of internationalization (below 20%) DOI has no significant influence on the company's capital structure. However, with further foreign expansion companies decrease their leverage significantly. This relationship might be explained by the trend among Chinese companies to attract new foreign investors when expanding abroad. Some of those companies go for an IPO in a foreign market even not being present abroad beforehand. Thus, the amount of equity in total capital increases resulting in lower leverage.

· In India the DTA-DOI relationship follows an S-shape pattern. With the level of internationalization below 20%, the amount of debt in total assets decreases, with further increase to the inception point at DOI of 70%.

· In Brazil and Russia the pattern of the DTA-DOI curve is similar with leverage increasing more sharply in Brazil at the later stages of internationalization.

· Finally, we managed to build a common model that is applicable to all BRIC countries. The new curves follow a U-shaped pattern, thus we confirm hypothesis 2.1 of non-collinearity between financial leverage and degree of internationalization. Although the shape of the curve in the common model is different from the one in individual models, for each of the countries we observe the similar trend and percentage change in debt-to-assets ratio.

Cost of equity

Following the same procedure as in financial leverage analysis we start with testing the models and find evidence of endogeneity for a sample of Chinese and Brazilian companies, as well as when analyzing the common model. As stated in the ROCE-DOI section, the possible reason is that either one of the explanatory variables is correlated with the unobserved variable or the dependent and explanatory variables have a simultaneous impact on each other. We suspect that the endogenous variable is debt-to-assets ratio. On the one hand, it determines the cost of equity as it is used when levering the share price beta, which in turn is a component of the CAPM model. On the other hand, if due to specific market conditions the company observes a too high or too low cost of equity in comparison to its cost of debt, then it might decide to change its leverage accordingly.

In order to resolve the endogeneity problem, we run a 2SLS regression by introducing an instrumental variable - asset turnover. We expect it to be correlated with debt-to-assets ratio, as the higher is the productivity of the company's assets, the larger would be its net income, which would likely result in lower leverage. At the same time asset turnover is unlikely to be correlated with the error term and has a non-straight influence on the dependent variable.

Regression results are presented in Appendix 4. The graph that shows individual relationship between cost of equity and degree of internationalization for companies from each of the BRIC countries is presented in Figure 4.

Figure 4. COE-DOI relationship

The graphs present the change in cost of equity as compared to the no internationalization case for each level of foreign expansion. The graph on the left illustrates the results of individual models analysis. The graph on the right presents the outcome of a common model, which includes all the BRIC countries in a single analysis.

Our main findings are as follows:

· In China the COE-DOI relationship follows a U-shape pattern. At the early stages of internationalization (below 30%), cost of equity declines by 2% and then reverts back. If compared to the scenario of no foreign expansion, cost of equity increases when DOI level is above 70%.

· In India the COE-DOI relationship is inverse U-shaped. We find that cost of equity grows until the level of international diversification reaches 60%.

· In Brazil cost of equity drops sharply at the early stages of internationalization (below 20%), and then remains at the same level even with further increase in international activity.

· In Russia the pattern of COE-DOI curve is similar to the one of China, with the only exception that the percentage change in cost of equity is lower. Thus, for all countries except Brazil we find evidence that supports hypothesis 2.2 of non-linear relationship with cost of equity increasing at the later stages of internationalization.

· Comparing to individual models, the common model mostly provides different results: in India we observe a decrease in cost of equity, in Brazil the percentage change is lower and in China cost of equity increases from the first stages of foreign expansion.

· In general, although there are discrepancies between individual and common models, we believe that it is not critical, as the percentage change in cost of equity is low, especially if compared to obtained results from DTA - DOI analysis.

Cost of debt

After performing Hausman test, we found evidence of endogeneity in all the individual models, as well as in common model. We assume that the reason, as with the cost of equity, stems from the inclusion of debt-to-assets ratio in the model. We run a 2SLS regression, but now use the share price beta as an instrumental variable, as we believe it to be a more powerful instrument than asset turnover.



Figure 5. COD-DOI relationship

The graphs present the change in cost of debt as compared to the no internationalization case for each level of foreign expansion. The graph on the left illustrates the results of individual models analysis. The graph on the right presents the outcome of a common model, which includes all the BRIC countries in a single analysis.

Our main findings are as follows:

· In China the COD-DOI relationship follows an inverse U-shape pattern. We find that cost of debt grows until the level of international diversification reaches 60%.

· In India cost of debt grows steadily and increases by nearly 4% at the latest stages of internationalization, if compared to the scenario of no foreign expansion.

· In Brazil we discover an S-shape relationship with cost of debt declining sharply at the early stages of internationalization (below 30%), and remaining at the same level afterwards.

· In Russia the COD-DOI relationship is U-shaped. At the early stages of internationalization (below 20%), cost of equity declines by 1% and then reverts back. When the amount of foreign sales in total sales exceeds 50%, cost of debt becomes higher than in case the company does not expand abroad.

· Finally, building a common model and comparing it to individual models, we find the similar trend in COD-DOI relationship, as well as the similar percentage change in debt-to-assets ratio. We also find evidence that supports hypothesis 2.3 of growing cost of debt for all countries except Brazil. To sum up, we showed that there exists a common model that describes the relationship between cost of debt and the level of international diversification, applicable to all BRIC countries.

Weighted average cost of capital

In order to apply the percentage changes of financial leverage, cost of debt and cost of equity in one model, for each of the three parameters we estimate their mean value on a sample of companies with no foreign operations (see Table 5).

The table presents the mean values of debt-to-assets ratio, cost of equity and cost of debt for companies from each of the BRIC countries that operate only in domestic market.

Table 5. WACC components of companies without foreign activities

Variable	China	India	Brazil	Russia
DTA	22.68%	35.03%	36.12%	19.34%
COE	11.29%	10.32%	12.62%	9.86%
COD	3.4%	5.91%	11.3%	3.22%

Taking these values as a benchmark (point zero on the previous graphs), we add to them the percentage changes resulting from increasing internationalization. Finally, deriving the set of values for each of the three parameters, we insert them in a WACC model (formula 3).

The graph that shows individual relationship between WACC and degree of internationalization for companies from each of the BRIC countries is presented in Figure 6.



Figure 6. WACC-DOI relationship

The graphs present the values of weighted average cost of capital for each level of foreign expansion. The graph on the left illustrates the results of individual models analysis. The graph on the right presents the outcome of a common model, which includes all the BRIC countries in a single analysis.

Our main findings are as follows:

· For Chinese and Russian companies we find that there exists an optimal 20%-40% range of degree of internationalization, where WACC obtains its minimum value.

· In India the WACC-DOI relationship follows an inverse U-shape pattern, meaning that the company has the lowest cost of capital when it does not internationalize.

· In Brazil the finding is opposite to the one in India: companies should expand more in order to minimize their WACC.

· Constructing a common model we do not find evidence of non-linear relationship between weighted average cost of capital and degree of internationalizaion. However, the trend of this relationship, as well as the range of WACC values is similar to individual models.

3.3 Estimation of economic profit

In order to capture both operational and financial aspects of performance we introduce a measure of residual income which is calculated as a difference between return on capital employed and weighted average cost of capital. The graph which illustrates the relationship between residual income and degree of internationalization is presented in Figure 7.

Figure 7. RI-DOI relationship

The graphs present the values of residual income for each level of foreign expansion. The graph on the left illustrates the results of individual models analysis. The graph on the right presents the outcome of a common model, which includes all the BRIC countries in a single analysis.

Our main findings are as follows:

· In China the RI-DOI relationship follows an S-shape pattern. At the earliest stages of internationalization (below 20%) the expansion policy is value-destroying. However, with further international diversification, residual income starts to increase and reaches its peak at DOI of c. 70%.

· In India the RI-DOI relationship is inverse U-shaped. This finding allows us to advise Indian companies to generate 40%-50% of their sales abroad.

· Brazilian companies experience the strongest fluctuations in residual income. Contracting slightly in the beginning, it increases rapidly and reaches its maximum when foreign sales constitute 60% of total sales.

· For Russian companies we derive that internationalization policy is value-destroying since the earliest stages of foreign expansion.

· When building a common model we find that the trend in residual income is close to linear, although there exists a 60%-70% DOI range, which is optimal for Chinese and Indian companies.

To sum up, companies from BRIC countries do not fit in a common model well. However, when analyzed separately it becomes possible to make recommendations which, if applied in practice, might be value-adding.

Conclusions and policy implications

In this paper we propose the approach of residual income in order to define the influence of internationalization level on company's performance. This method captures both operational and financial effects of cross-border diversification, which is the main contribution to scientific literature.

We conduct our research on a sample of companies from BRIC countries, which have never been analyzed simultaneously before. We have constructed a common model on a sample of all companies from BRIC countries, however the relationships are mostly linear, thus in our conclusions we rely on the outcome of individual models.

We have formulated several hypotheses about the influence of degree of cross-border diversification on both operational and financial performance measures, which we empirically confirmed.

First, we found evidence of non-linear relationship between return on capital employed and degree of internationalization for all BRIC countries except Russia. This finding is in line with the majority of researches conducted on a sample of developing countries.

Second, we discovered an S-shaped relationship between debt-to-assets ratio and DOI with a strong negative trend for Chinese companies. Other firms experience mild fluctuations with financial leverage increasing at a certain point.

Third, we found proof of growing cost of equity and cost of debt as a result of expanding foreign activities in all countries except Brazil. The pattern of the curves is non-linear as expected.

Finally, after combining the above relationships in a residual income model, we derived non-linear RI-DOI curve patterns, allowing us to make a number of recommendations. In order to maximize residual income we would advise Chinese companies to generate c. 70% of sales in the foreign markets, for Indian companies the optimal amount would be 40%-50% of sales, for Brazilian companies - c. 60% of sales. We do not find it possible to advise Russian companies, as the model is not reliable due to endogeneity problem, which arouse at the stage of return on capital employed analysis.

As an implication of the paper we can recommend companies to be cautious when making internationalization decisions. At the early stages of diversification companies should expect to face deterioration in performance due to high internationalization costs as compared to benefits. They should also take into account not only operational, but financial effects of internationalization.

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