financial choice for an mnc and its foreign affiliates
Answers
pre-tax cost of debt, the post-tax cost of debt is lower in the country with the higher tax rate. MNC affiliates in countries such as Japan and Italy, with high corporate taxes are more highly geared than those in tax havens such as Bermuda and Barbados.
Factor # 2. Carry Forward of Losses:
The tax shield on debt reduces tax liability, and increases post tax profitability. But this is an attraction only when the company has pre-tax profits. If it has pre-tax profits, any brought forward losses from the earlier years can be set off against profits so that its tax liability is zero. In such a case, the tax deductibility of interest on debt becomes irrelevant. So an MNC affiliate with carry forward losses may not select debt financing.
Factor # 3. Protection of Creditor Rights
In countries that do not have laws that protect creditors’ rights, or where such laws exist but enforcement is poor, lenders face difficulties when principal is not repaid. Since non-performing assets are likely to be high, lenders build this into the cost of debt. So, interest rates on debt are likely to be higher, since default risk is factored into the price of the loan. The differential between the cost of debt and cost of equity narrows down, and borrowers are deterred from debt.
Tough laws and rigorous enforcement create a conducive climate in which lending and borrowing can take place. The World Bank publishes a ‘strength of legal rights’ index (SLRI), on a scale of 1 to 10. A rating of ‘1’ implies poorly designed and weak laws and a rating of ’10’ implies well designed, strong laws. In 2009 (the latest year for which SLRI was available), among the BRIC countries, India’s SLRI score was 8. China scored 6, and Brazil and Russia scored 3, Strong creditor protection laws and effective enforcement of laws provide incentives to lending. In countries with strong legal protection for creditors, MNC affiliates tend to use more debt in their capital structure.
Factor # 4. Level of Development of Local Debt Markets:
An affiliate’s ability to raise debt in the host country depends on the availability and willingness of investors (institutional and retail) to subscribe to debt. Institutional investors are circumscribed by their internal investment guidelines that prevent them from investing in below investment grade debt. Many emerging markets have underdeveloped debt markets that run a poor second to equity markets, in terms of issue volumes, investor interest, trading and liquidity, the number of domestic institutional investors, and the absence of credit rating of debt instruments.
Factor # 5. Access to Inter-Affiliate Loans
An affiliate can choose between borrowing money from the capital market (external borrowing), or from within the group—either the parent MNC or other affiliates (internal borrowing). That is, it can substitute internal borrowing for external borrowing. It will choose internal borrowing (from the parent or from another affiliate) when external borrowing is unavailable, inadequate or more expensive. Since the parent MNC can structure the capital for the entire group of affiliates, the parent may draw borrowing from affiliates in countries with strong creditor rights, deep capital markets, and higher tax regimes.
Factor # 6. FDI Restrictions:
FDI ceilings vary between countries and within a country; they can vary from sector to sector, as well as over time. Some countries impose rules specifying that a certain percentage (say 40%) of the project cost must be raised by an MNC affiliate from local capital markets. FDI ceilings specify the maximum equity holding in local companies, and also the type of debt that forms part of FDI.
Factor # 7. Thin Capitalization Rules:
Since interest is a tax-deductible expense, MNCs ask affiliates in countries with high tax rates to lend to affiliates in low tax locations. MNCs raise more debt in high tax countries so that these countries stand to lose tax revenues. To protect themselves against these practices, many countries impose restrictions on the capital structure choices of MNCs, so as to limit the interest paid on excess leverage. The restrictions are called thin capitalization rules (or earning stripping rules).
Factor # 8. Trends in Currency Movements:
Exchange rate fluctuations cause uncertainty in future cash flows, and influence the effective cost of borrowing.