Managing The Internal Capital Markets Of Multinational Corporations Flashcards
What are some of the financial flows between the parent firm and an affiliate?
Dividends
Fees, royalties, corporate overhead costs
Interest and principal payments
Equity investments
Loans and credit on goods and services
What are some of the real flows between the parent firm and an affiliate?
Capital goods
Technology
Management
Intermediate/Finished goods
Technology/Market intelligence
What are some of the decision variables between a parent firm and an affiliate?
Dividends
Transfer prices
Leads and lags
Fees and royalties
Debt vs Equity
What are the exceptions to the similar links between two affiliates that an affiliate with the parent firm?
Equity investment and dividends
What are the factors that enhance the value of internal financing transactions?
- Formal Barriers to International Transactions
- Informal Barriers to International Transactions
- Imperfections in Domestic Capital Markets
What are some of the examples of formal barriers to international transactions?
- Quantitative restrictions (exchange controls) and direct taxes on international movements of funds.
- Differential taxation of income streams according to nationality and global tax situation of the owners.
- Restrictions by nationality of investors and/or investments on access to domestic capital markets.
What are some of the examples of informal barriers to international transactions?
- Costs of obtaining information.
- Difficulty of enforcing contracts across national boundaries.
- Transaction costs.
- Traditional investment patterns.
What are some examples of imperfections in domestic capital markets?
- Ceiling on interest rates.
- Mandatory credit allocations.
- Limited legal and institutional protection for minority shareholders.
Why are the restrictions that enhance the value of internal financing transactions imposed?
The restrictions are imposed to allow nations to maintain artificial high values for their respective currencies.
What are the types of arbitrage opportunities presented by the ability to transfer funds and reallocate profits internally?
Tax arbitrage
Financial market arbitrage
Regulatory system arbitrage
Why is there tax arbitrage?
MNCs can reduce their global tax burden by shifting profits from units located in high-tax nations to those in lower-tax nations. Or they may shift profits from units in a taxpaying position to those with tax losses.
Why is there financial market arbitrage?
By transferring funds among units, MNCs may be able to circumvent exchange controls, earn higher risk-adjusted yields on excess funds, reduce their risk-adjust cost of borrowed funds, and tap previously unavailable capital resources.
Why is there regulatory system arbitrage?
When subsidiary profits are a function of government regulations (e.g., when a government agency sets allowable prices on firm’s goods) or union pressure, rather than the marketplace, the ability to disguise true profitability by reallocating profits among units may give the multinational firm a negotiating advantage
What is a highly favoured means of shifting liquidity among affiliates?
Acceleration or delaying the payment of inter-affiliate accounts by modifying the credit terms extended by one unit to another.
What does the value of leading and lagging depend on?
The value of leading and lagging depends on the opportunity cost of funds to both the paying unit and the recipient.
What are the advantages of shifting liquidity (leading and lagging)?
- No formal note of indebtedness is needed, and the amount of credit can be adjusted up or down by shortening or lengthening the returns on the accounts. Governments do not always allow such freedom on loans.
- Governments are less likely to interfere with payments on intercompany accounts than on direct loans.
- Section 482 allows intercompany accounts up to six months to be interest free. In contrast, interest must be charged on all intercompany loans. The ability to set a zero-interest rate is valuable if the host government does not allow interest payments on parent company loans to be tax deductible or if there are withholding taxes on interest payments.
When are intercompany loans more valuable to the firm than arm’s-length transactions?
At least one of the following market distortion exists:
1. Credit rationing (because of a ceiling on local interest rates);
2. Currency controls;
3. Differential tax rates among countries.
What is a back-to-back loan?
The parent company deposit funds with a bank in country A that in turn lends the money to a subsidiary in country B.
What are the advantages of back-to-back loans?
- Certain countries apply different withholding tax rates to interest paid to a foreign parent and interest paid to a financial institution. A cost saving in the form of lower taxes may be available with a back-to-back loan.
- If currency controls are imposed, the government usually will permit the local subsidiary to honor the amortization schedule of a loan from a major multinational bank; to stop payment would hurt the nation’s credit rating. Conversely, local monetary authorities would have far fewer reservations about not authorizing the repayment of an intercompany loan. In general, back-to-back financing provides better protection than does a parent loan against expropriation and/or exchange controls.
What are parallel loans?
Parallel loans are a method of effectively repatriating blocked funds (at least for the term of the arrangement), circumventing exchange control restrictions, avoiding a premium exchange rate for investments abroad, financing foreign affiliates without incurring additional exchange risk.
How is the difference between the rates of interest on the two loans (parallel loans) determined?
In theory, by the cost of funds in each country and anticipated changes in currency values.
What is the most important means of transferring funds from foreign affiliates to the parent firm?
Dividends. They typically account for more than 50% of all remittances to US firms.
What are the factors than MNCs consider when deciding on dividend payments by their affiliates?
- Taxes;
- Financial Statements Effects;
- Exchange risk;
- Currency controls;
- Financing requirements;
- Availability and cost of funds;
- Parent’s dividend payout ratio.
What is a major consideration behind the dividends decision?
A major consideration behind the dividends decision is the effective tax rate on payments from different affiliates. By varying payout ratios among its foreign subsidiaries, the corporation can reduce its total tax burden.
How can the corporation reduce its total tax burden?
By varying payout ratios among its foreign subsidiaries.
Once the firm has decided on the amount of dividends to remit from overseas, how can it reduce its tax bill?
Once the firm has decided on the amount of dividends to remit from overseas, it can then reduce its tax bill by withdrawing funds from those locations with the lowest transfer costs.
What do dividend payments lead to?
Dividend payments lead to liquidity shifts. The value of moving these funds depends on the different opportunity costs of money among the various units of the corporation.
True or false: an affiliate that must borrow funds will usually have a lower opportunity cost than a unit with excess cash available.
False
How can a parent firm (everything else constant)
increase its value by exploiting yield differences among its affiliates?
Setting relatively high payout ratios for subsidiaries with relatively low opportunity costs of funds, while requiring smaller dividend payout ratios from units with relative high borrowing costs or favorable investment opportunities.
What is the impact of exchange controls on dividends?
Generally, exchange controls limit the size of dividend remittance, either in absolute terms or as a percentage of earnings, equity, or registered capital.
How do many firms reduce the danger of exchange controls limiting the size of dividend remittance?
Many firms try to reduce the danger of such interference by maintaining a record of consistent dividends. Dividends are paid annually, regardless of whether they are justified by financial, tax considerations and exchange rate. This to demonstrate a continuing policy to the local government and the central bank.
Why do MNCs generally prefer to invest in the form of loans rather than equity?
- A firm typically has wider latitude to repatriate funds in the form of interest and loan repayments than dividends or reductions in equity, because the latter fund flows are usually more closely controlled by governments.
- The possibility of reducing taxes through new interest tax shields.
True or false: firms have complete control in choosing their debt-to-equity ratios abroad.
False, this subject is frequently open for negotiations with the host governments. Dividends and local borrowings often are restricted to a fixed percentage of equity.
Explain what the Global Capital Asset Pricing Model is and when it should be
used.
The Global Capital Asset Pricing uses a global index like MSCI, World Portfolio or Morgan Stanley Capital International to compute the equity beta and the market risk premium.The recommendation is to use the Global CAPM if the economy where the project will be implemented (firm operates) and the economy where the Parent firm is located are globally integrated.
When should you use the global CAPM?
The recommendation is to use the Global CAPM if the economy where the project will be implemented (firm operates) and the economy where the Parent firm is located are globally integrated.
Explain how is it that a back-to-back loan can help a MNC with the possibility of currency controls/blocked funds.
If currency controls are imposed, the government usually will permit the local subsidiary to honor the amortization schedule of a loan from a major multinational bank; to stop payment would hurt the nation’s credit rating. Conversely, local monetary authorities would have far fewer reservations about not authorizing the repayment of an intercompany loan.
Explain what should be capital structure used in the WACC’s formula to evaluate projects made abroad through a subsidiary (in different countries).
Assuming that the parent firm is in the last instance the responsible to make the debt payments for the multinational corporation, then the capital structure that should be used is the one for the MNC, i.e., one should use D/V, E/V and D/E for the consolidated firm. When a parent firm decides to fund the subsidiary, the choice of using debt or equity is just a choice of which channel to use, as it does not change the consolidated capital structure.
“Firms with the same business risk and D/E ratio have the same equity cost of capital.”
False
Explain what the problem is of adding a country risk-premium in the equity cost of capital for the evaluation of a foreign project.
A foreign country risk premium is computed as the difference between the interest rate on the U.S. dollar denominated debt issued by the foreign government and the rate on U.S. government debt of the same maturity. This difference is then added to the equity cost of capital. The problem is that this measures the liquidity premium and default probability, not systematic risk. Liquidity and default risks do not enter in the equity cost of capital. Country risk premiums should be added to the cost of debt, not the cost of equity.
