Assignment on International Financial Management Topic - Capital Structure of Foreign Subsidiary FM-3106 Submitted To Professor.

Amritlal Ghosh DBA-JNSMS Assam University Silchar Submitted By Dhruba Debnath Roll No-43 Sec- A

Contents
1. INTRODUCTION 2. Setting objectives as starting point for the capital structure design 03 2.1 Profit maximization 2.2 Maximization of the company value 3. INTERNATIONAL CAPITAL STRUCTURE 3.1 Foreign subsidiary capital structure 3.2. The Financial Structure of Subsidiaries: Three approaches 3.3 Advantages of localization 4 DESIGN PARAMETERS OF THE CAPITAL STRUCTURE Internal financing foreign subsidiary External financing of foreign subsidiary 5. INTERNATIONAL DEBT MARKET 5.1. Bank loans and syndications 5.2. The International Bond Market 5.3 Absence of regulatory interference 04 03

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6. ENVIRONMENTAL CONDITIONS INFLUENCING THE CAPITAL STRUCTURE 13 6.1 Country-related risks 6.2 Tax laws 6.3 Laws and subsidies 6.4 Interests and influence of other groups 7. COST STRUCTURE MINIMIZING APPROACH TO GLOBAL CAPITAL 15 16 17 18

8. JOINT VENTURES 9. SUMMARY AND CONCLUSION 10. REFERENCES

1. INTRODUCTION A decision concerning the design of the capital structure of foreign subsidiaries should bebased on a uniform concept. Therefore, the essential terms corporate group, subsidiary, capitalstructure, and multinational company should be defined. A corporate group consists of companies that are legally independent and economically dependent. A corporate group is an economic entity. The key feature of the definition of a corporate group is the integrated management of the companies belonging to it. Asubsidiaryis a company within a corporate groupwhich is subordinate to another company in that group. In order to be a subsidiary the amountof equity participation must exceed 50 %.the capital structuredescribes the composition ofthe liabilities side of the balance sheet of a company. The amounts of equity and borrowedcapital as well as the source of funds and the period of maturity for the capital are essentialdeterminants of the capital structure. Multinational companies Own manufacturing and distribution activities in different countries where they supply foreign markets with productsfrom the company and all managerial activities are based on their overall corporate planningthis essay is broken down as follows: the introduction puts the concepts into concrete terms,the second chapter discusses the setting of objectives according to which the capital structureis arranged, and the third chapter describes the design parameters influencing the capital structure. Subsequently the environmental conditions to which subsidiaries are exposed to in foreign countries are discussed. These are finally associated to the design parameters in the fifthchapter, and a possible decision procedureconcerning the choice of the funding is shown. 2 Setting objectives as starting point for the capital structure design 2.1 Profit maximization The capital structure is usually designed under the primacy of the entrepreneurial system of objectives. A goal function often assumed is the maximization of profit. Profit is the result ofrevenue minus costsIt is not possible to influence therevenue in a positive manner by using the capital structure design. Therefore, the principlethat all actions are based upon is the minimization of costs. Concerning the capital structuredesign, the objective ofcapital cost minimizationcan be derived. Besides striving for maximum profit, a company must consider other aspects. This can be carried out by the maximization of profit up to a predetermined risk extent (auxiliary condition).However, when choosing between the different alternatives, attention should be paid to thefact that alternatives entailing higher risks also have a higher profit expectationIt is vital that the company is solvent at all times for its continuous existence. If this is notobserved constantly, the continued existence of the company is jeopardizedThe objective ofsafeguarding liquidityis therefore an important auxiliary conditionwhen striving for profit maximizationThe company objective ofgrowthis a financing driver. For example, growth results in additional financing needs. In a company growing extensively, the equity capital is generally limited and thus the growth is more likely funded by borrowed capital. The growth target isaimed at the realization of higher future profits. Therefore, the growth objective is subordinate to the objective of profit maximization in the long-term review.

2.2 Maximization of the company value Companies are increasingly judged by the extent of maximization of shareholder value. Thevalue of the company can also be influenced by the design of the capital structure. The capitalstructure plays an important role in the discounted cash flow method which is the current prevailing assessment procedure.The discounted cash flow procedure is based on the free cash flow in the future which is discounted using the weighted average cost of capital. The rates of equity capital are higher than those of borrowed funds dueto the expectations of the shareholder. Therefore, the discount rate drops as the use of borrowed capital increases. The value of the company is defined as the sum of the discounted freecash flows for the corresponding periods in the future and the discount rate should be as lowas possible in order to achieve maximized company value. This is the reason why borrowedcapital should be used whenever possible. However, the lenders will increase the rate of returnthey requireif the debtto-equity-ratio exceeds a certain factor. Theproblem in this context is how to find the optimal debt-to-equity-ratio. 2.3 Striving for independence and freedom of disposition The possible influence of external groups on the decisions of a company must be consideredwhen designing the capital structure. It is therefore important for many companies to protecttheir independence and freedom of disposition and decision. In decisions regarding fundingthe additional raising of borrowed capital restricts the freedom of disposition. The borrowingof funds must therefore be limited in order to keep independence from lenders.However, the granting of shares in equity capital to third parties canalso lead to an increase in their exertion of their influence, as the newly admitted shareholdershave the right of co-decision.

3. INTERNATIONAL CAPITAL STRUCTURE

However, while knowledge of the costs and benefits of each individual source of funds is helpful, it is not sufficient to establish an optimal global financial plan. This plan requires consideration not only of the component costs of capital, but also of how the use of one source affects the cost and availability of other sources. A firm that uses too much debt might find the cost of equity (and new-debt) financing prohibitive. The capital structure problem for the multinational enterprise, therefore, is to determine the mix of debt and equity for the parent entity and for all consolidated and unconsolidated subsidiaries that maximizes shareholder wealth. The focus is on the consolidated, worldwide financial structure because suppliers of capital to a multinational firm are assumed to associate the risk of default with the MNCs worldwide debt ratio. This association stems from the view that bankruptcy or other forms of financial distress in an overseas subsidiary can seriously impair the parent companys ability to operate domestically. Any deviations from the MNCs target capital structure will cause adjustments in the mix of debt and equity used to finance future investments. Another factor that may be relevant in establishing a worldwide debt ratio is the Empirical evidence that earnings variability appears to be a decreasing function of foreign source earnings. Because the risk of bankruptcy for a firm is dependent on its total earnings variability, the earnings diversification provided by its foreign operations may enable the multinational firm to leverage it more highly than can a purely domestic corporation, without increasing its default risk.

3.1 FOREIGN SUBSIDIARY CAPITAL STRUCTURE Once a decision has been made regarding the appropriate mix of debt and equity for the entire corporation, questions about individual operations can be raised. How should MNCs arrange the capital structures of their foreign affiliates? And what factors are relevant in making this decision? Specifically, the problem is whether foreign subsidiary capital structures should:Conform to the capital structure of the parent company Reflect the capitalization norms in each foreign county Vary to take advantage of opportunities to minimize the MNCs cost of capital Disregarding public and government relations and legal requirements for the moment, the parent company could finance its foreign affiliates by raising funds in its own country and investing these funds as equity. The overseas operations would then have a zero debt ratio (debt/total assets). Alternatively, the parent could hold only one dollar of share capital in each affiliate and require all to borrow on their own, with or without guarantees; in this case, affiliate debt ratios would approach 100%. Or the parent can itself borrow and relend the monies as intra-corporate advances. Here again, the affiliates debt ratios would be close to 100%, In all these cases, the total amount of borrowing and the debt/equity mix of the consolidated corporation are identical. Thus, the question of an optimal capital structure for a foreign affiliate is completely distinct from the corporations overall debt / equity ratio. Moreover, any accounting rendition of a separate capital structure for the subsidiary is wholly illusory unless the parent is willing to allow its affiliate to default on its debt. As long as the rest of the MNC group has a legal or moral obligation or sound business reasons for preventing the affiliate from defaulting, the individual unit has no independent capital structure Rather; its true debt/equity ratio is equal to that of the consolidated group. Exhibits 12.1 and 12.2 show the stated and the true debt-to-equity ratios for a subsidiary and its parent for four separate cases. In cases I, II, and III, the parent borrows $100 to invest in a foreign subsidiary, in varying portions of debt and equity. In case IV, the subsidiary borrows the $100 directly, from the bank. Depending on what the parent calls its investment, the subsidiarys debt-to-equity ratio can vary from zero to infinity. Despite this variation, the consolidated balance sheet shows a debt-to-equity ratio following the foreign investment of 4:7 regardless of how the investment is financed and what it is called. Exhibit 12.5 shows that the financing mechanism does affect the pattern of returns, whether they are called dividends or interest and principal payments. It also determines the initial recipient of the cash flows. Are the cash flows from the foreign unit paid directly to the outside investor (The bank) or are they first paid to the parent, which then turns around and repays the bank?

3.2. The Financial Structure of Subsidiaries Three approaches:

If the theory that minimizes the cost of capital for a given level of business risk and capital budget is an objective for MNE, then the capital structure of each subsidiary is relevant only to the extent that it affects this overall goal. In other words, an individual subsidiary does not really have an independent cost of capital; therefore its capital structure should NOT be based on an objective of minimizing its cost of capital.

So, should an MNE take differing country debt ratio norms into consideration when determining its desired debt ratio for foreign subsidiaries?

1 2

Conform to the parent company's norm. Conform to the local norm of the country where the subsidiary operates. Vary structure by location to reflect local conditions that generate

Which approach to take depends largely on whether and to what extent the parent company is responsible for the subsidiaries financial structure. When the parent is fully responsible for the subsidiary s obligations the independent financial structures of the subsidiary is irrelevant. It is parents overall financial structure that becomes relevant, when the parent is legally and morally responsible for the subsidiaries debts potential creditors will examine the parents overall financial conditions not the subsidiaries. When however the parent company is willing to let its subsidiary default or parents guarantee its subsidiarys financial obligations becomes difficult to enforce across national borders, the subsidiaries financial structures becomes relevant. in this case, potential creditors will examine the subsidiaries capital conditions closely to access default risk. As a result, the subsidiaries should choose own financial structure to reduce default risk and thus financing costs. In reality ,the parent company cannot let its subsidiary default on its debts without expecting its worldwide operations to be hampered in one way or another .default by a subsidiary can deplete the parents reputational capital, possibly increase its own cost of capital, and certainly make it difficult to undertake future projects in the country where default occurred. An immediate implication of the patents legal and moral obligation to honour its subsidiary s debt is that the parent should monitor its subsidiarys financial conditions closely and make sure that the firms overall financial condition s are not adversely affected by the subsidiaries financial structure . What really matter is the marginal impact that the subsidiaries financial structure may have on the parents worldwide financial structure. The subsidiaries financial structure should be chosen so that the parents overall cost of capital can be minimized. Thus the first approach which calls for the replicating the parents financial structure is not necessarily consistent with minimizing the parents overall cost of capital. Suppose the subsidiary can locally borrow at a subsidised interest rate because the host Govt is eager to attract foreign investments. in this situation, the subsidiary should borrow locally and exploit the lower interest rate, even if the means that the subsidiaries debt ratio will exceed the parents norms. If deemed necessary, the parent can simply lower its own debt ratio. In other words, the distribution of debt between the parent and the subsidiary can be adjusted to take advantages of subsidised loans. Also, in special case where the subsidiary is operating in a country that regulates the financial structure, it would be difficult to replicate the parents norms even if that were desirable. The second approach proposed by Stonehill and Stitzel, calls for adopting the local financing norms. in essence, the approach is based on When in Rome, do as the Romans do. By following the local norms, the firm can reduce the chance of being singled out for criticism. This approach makes sense only when the parent is not responsible for the subsidiaries
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obligations and the subsidiaries has to depend on local financing due to, say, segmentation of financial markets. Otherwise, it does not make much sense. Suppose each foreign subsidiary conforms to the local financing norms, which reflect the host countries cultural, economic, and institutional environments. Then the parents firms worldwide financial structure will be determined strictly in a residual manner .the overall financial structure so determined is not likely to be the optimal one that minimises the parents overall cost of capital. When the host countries norms reflect, the immature nature of local financial markets, a subsidiary of the MNC with ready access to global financial markets should not slavishly follow the local norms. The third approach which appears to be the most reasonable and consistent with the goal of minimizing the firms cost of capital states that it should take the advantages of subsidised loans as much as possible whenever available. It should take the advantages of tax deductions of interest payments by borrowing more heavily than is implied by the parent s norms when the corporate income tax rate is higher in the host country than the home country, unless foreign tax credits are usual. Apart from the tax factor, political risk is another factor that should be considered in choosing the method of financing the subsidiary. Political risk is generally favours local financing over the parents direct financing. The parent company can renounce the subsidiaries local debt in the event that the subsidiaries assets are expropriated. When the subsidiary is financed by local creditors and shareholders, the chance of expropriation itself can be lowered. When a subsidiary is operating in a developing country, financing from such international development agencies as the World Bank willlower political risk.

3.3 Advantages of localization (conforming local debt norms): Reduction in criticisms from local countries
1. Debt ratio is too high: the foreign subsidiary does not have enough economic capital to avoid default. 2. Debt ratio is too low: the foreign subsidiary tries to escape the effect of the local monetary policy.

Improvement in the ability of management to evaluate ROE relative to local competitors

Maintaining similar debt ratio levels with local competitors provides a fair condition for comparison.

Reminding management not to misallocate resources

The high cost of local capital could make the management to be more cautious about the efficiency of allocating resources.

4. Design parameters of the capital structure

Internal Financing of the Foreign Subsidiary

Cash

Equity
Real goods

Funds From Within the Multinational Enterprise (MNE)

Funds from parent company

Debt -- cash loans

Leads & lags on intra-firm payables

Debt -- cash loans

Funds from sister subsidiaries

Leads & lags on intra-firm payables

Subsidiary borrowing with parent guarantee

Funds Generated Internally by the Foreign Subsidiary

Depreciation & non-cash expenses

Retained earnings 16-17

4.1 Equity capital resources Besides the source of the funds, the amount of the equity capital is the key designparameter ofthe capital structure. In order to determine the optimal capital structure, the functional relationship between the debt-to-equity-ratio and equity capital return must be consideredThis so-calledleverage-effectbased on the following reflection: The lenders of borrowed capital are served to an ex tent previously fixed. Interest isearned on the equity capital (E) as residual parameter of the annual net profit before interestNPBI) minus the interest on borrowings (CFK)Therefore, the rate of return on equity is(NPBI - CFK)/E. Thus, if the equity capital is substituted by additional borrowed capital, theequity return increases, if the return on total capital employed is higher than the return on borrowed capital. In this case, a higher return is realized with the borrowed capital than the interest that would be paid. However, if the return on total capital employed is lower than the return on borrowed capital, the equity capital return falls by the substitution of equity capitalwith additional borrowed capital. This case is called leverage-risk or leverage-dangerIn addition to this, an increase of the debt-to-equity-ratio alsoleads to a higher risk for the lenders of the equity capital. Therefore, they will increase the rate of return they require accordingly. The amount of the borrowed capital interest rate is essential for thecredit ratingof the corporate group. The risk for the lender of borrowed capital increases as additional borrowed capitalis raised, because the liable equity capital remains the same with given equity capital, and therelation between equity capital and borrowed capital is getting worse. This leads to a downgrading of the credit rating and therefore to more expensive company funding.The amount of equity capital also determines the level ofliabilityrelated to it. In subsidiariesbelonging to international corporate groups, the
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liability is limited to the equity capital. Somecountries, however, impose legal restrictions that are incorporated into the so-called piercingof the corporate veil. This direct liability of the controlling shareholder means that the corporate group parent must always guarantee for the subsidiary company. In many cases the assumption of the parent companys additional liability is required if loans are granted to the subsidiary. 4.2 Capital maturity The period of maturity is an essential aspect related to funding. In some cases, the liquidity of a company can be threatened if funding does not match maturity. The questions concerning the maturity are similar in both the parent company and the subsidiary. However, the period of maturity of the capital in the subsidiary can be designed more easily as it is possible to limit, for example, the consequences resulting from political or exchange rate risks. Other design parameters such as source of the capital and equity capital stock contain a higher potential for realization of the company objectives. Therefore, the problems of maturity are discussed secondarily when reflecting regarding the capital structure. 4.3 Participation structure Companies try to limit the exertion of influence by third parties and minimize their participation rights by skilful choice of financing instruments. Participation rights are information rights, veto rights, and rights of co-determination in decisions concerning the company. Lenders of borrowed capital only have the right to be informed, while lenders of equity capital have further rights of influence on the companys management. If the subsidiarys equity capital is not fully funded by the corporate group parent, the management must consider the rights of the other lenders. Therefore, in practice 100% participation in subsidiaries is striven for in most cases.

External Financing of the Foreign Subsidiary

Borrowing from sources in parent country
Banks & other financial institutions Security or money markets

Funds External to the Multinational Enterprise (MNE)

Local currency debt

Borrowing from sources outside of parent country

Third-country currency debt

Eurocurrency debt

Individual local shareholders

Local equity
Joint venture partners

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4.2 Geographic capital source There are several possibilities to source theequity capitalThe corporate group can raise theequity capital in the parent companys country from a financing company in a third country or a national holding in the subsidiarys country. It can also be financed in the subsidiarys country by issuing shares or through the participation of shareholders. The sources forborrowed capitalare identical to those for equity capital. The borrowed capital can be raised locally or offshore. The borrowed capital can be borrowed from the companies within the corporate group or from the capital market. The parent company can also makea deposit at a bank and then grant a loan to the subsidiary. In legal terms this would be an external loan, however, for the corporate group it is effectively an internal loan. 5. International Debt Market The international debt market offers the borrower a wide variety of different maturities, repayment structures, and currencies of denomination. The markets and their many different instruments vary by source of funding, pricing structure, maturity, and subordination or linkage to other debt and equity instruments

International Debt Markets & Instruments

Bank Loans & Syndications
(floating-rate, short-to-medium term)

International Bank Loans Eurocredits

Syndicated Credits Euronotes & Euronote Facilities Eurocommercial Paper (ECP)

Euronote Market
(floating-rate, short-to-medium term)

Euro Medium Term Notes (EMTNs)

Eurobond
* straight fixed-rate issue * floating-rate note (FRN) * equity-related issue

International Bond Market

(fixed & floating-rate, medium-to-long term)

Foreign Bond
16-20

5.1. Bank loans and syndications: a) International bank loans They have traditionally been sourced in the Eurocurrency markets. The attractiveness is the narrow interest rate spread in the Eurocurrency load market, i.e. there is a narrow interest rate spread between deposit and loan rates of less than 1%. b) Euro credits The line of credit is an arrangement between a bank and its customers that establishes a maximum loan balance that the bank will permit the borrower to maintain. The borrower can
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draw down on the line of credit at any time, as long as he or she does not exceed the maximum set in the agreement. Euro credits are a type of credit dominated in Eurocurrencies, i.e. the denominated currency is not the lending banks national currency. c) Syndicated credits The syndication of loans has enabled banks to spread the risk of very large loans among a number of banks. Syndication is particularly important for MNEs as they usually need credit in an amount larger than a single banks loan limit. The periodic expense of the syndicated credit is composed of two elements. The actual interest expense of the loan: normally states as a spread in basis points over a variable-rate base such as LIBOR. The commitment fees paid on any unused portions of the credit

d) The Euro note market: It is a collective term used to describe short- to medium-term debt instruments sourced in the Eurocurrency markets. e) Euro notes and Euro note facilities. A major development in international money markets was the establishment of facilities for sales of short-term, negotiable, promissory noteseuro notes. The euro note is a cheaper source of short-term funds than international bank loans, because the notes are placed directly to the investing public, and the securitized and underwritten form helps the establishment of liquid secondary markets (it is a kind of direct financing). However, it needs substantial fees initially for the underwriting services f) Euro-commercial paper (ECP) ECP is a short-term debt obligation of a corporation or bank Its maturities are typically one, three, and six months, and it is sold normally at a discount Over 90% of issues outstanding are denominated in U.S. dollars g)Euro medium-term notes (EMTNs) EMTN is a new entrant to the worlds debt markets, which bridges the gap between Eurocommercial paper and a longer-term and less flexible international bond The EMTNs basic characteristics are similar to those of a bond, with principal, maturity, and coupon rates. The unique characteristics for EMTN The EMTN allows continuous issuance over a period of time, whereas a bond issue is
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essentially sold all at once. For EMTN, to ease the management of coupon payments for continuous issuance, the coupons are paid on set calendar dates regardless of the date of issuance. EMTNs are in smaller denominations, from $2 to $5 million, than the minimum amount needed for international bonds. 5.2. The International Bond Market: The international bond market rivals the international banking market in terms of the quantity and cost of funds provided to international borrowers. International bonds can be classified as Eurobonds and foreign bonds a) Eurobonds Which are underwritten by an international syndicate of banks and other securities firms and are sold exclusively in countries other than the country in whose currency the issue is denominated? For example, a bond issued by a U.S.-based firm and denominated in U.S. dollars, but sold to investors in Europe and Japan, would be a Eurobond.

b) Foreign bonds Which are underwritten by a syndicate composed of members from a single country, sold principally within that country, and denominated in the currency of that country? For example, a bond issued by a firm resident in Sweden, denominated in dollars, and sold in the U.S. by U.S. investment bankers, would be a foreign bond. The international bond has many innovative instruments created by investments bankers, who are free of controls and regulations in domestic capital markets. c) Straight fixed-rate issues: It is like most domestic bonds, with a fixed coupon, a set of payment date, and full principal repayment at maturity. Coupons are normally paid annually, rather than semiannually. d) Floating-rate notes (FRNs) The FRN normally pays a semiannual coupon that is determined using a variable-rate base, e.g. LIBOR plus a spread. It was the new and popular instrument on the international bonds in the early 1980s, since the interest rate is relatively high and unpredictable in that era. e)Equity-related issues. The most recent major addition to the international bond markets is the equity-related issue. The equity-related international bond resembles a straight fixed-rate issue with an additional feature that it is convertible to stock prior to maturity at the specified price per share, e.g. Euro-convertible bond (ECB).
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The borrower is able to issue debt with lower coupon payments due to the added value of the equity conversion feature. f) Unique characteristics of Eurobond markets. 5.3 Absence of regulatory interference Governments in general have less rigorous limitations for securities sold within the county but denominated in foreign currencies. Thus, Eurobond sales fall outside the regulatory domain of any single nation Less stringent disclosure Disclosure requirements in the Eurobond market are much less stringent than those of the SEC for sales within the U.S. Thus, non-U.S. firms often prefer Eurodollar bonds over bonds sold within the U.S., because they do not wish to undergo the costs and the disclosure needed to register with the SEC Favorable tax status Interest paid on Eurobonds is generally not subject to an income withholding tax, i.e. Eurobonds offer tax avoidance This is because Eurobonds are usually issued in bearer form, under which the name of the owner is not on the certificate, and the bearer must cuts an interest coupon to exchange for interest receipt On the contrary, for a registered bond, it is necessary for bond owners to register with the bond's issuer. Since the issuer knows the owner of the bond, it is possible to withhold tax from the interest payment

6. Environmental conditions influencing the capital structure Different settings and environmental constellations apply to the foreign subsidiary in comparison to the German parent company. Political, economic, and currency-related risks vary in theindividual countries. The company is subject to different tax regulations, and laws. Government grants, special interests, and the influence of other groups must be taken into account. 6.1 Country-related risks The term country-related risk summarizes all possible dangers of losses resulting from macroeconomic, political, and cultural situationsAccording to the extentof the country related risk, different action recommendations are made regarding the intensityof the business relationship with the individual country. Thepolitical riskexpresses the danger that a country becomes unwilling to pay for politicalreasons.The political risk is divided into five componentswhich include the risk of condemnation, the disposition risk, thetransfer and conversion risk, the security risk and the fiscal risk. Theeconomic riskdescribes the danger of partial or total insolvency of a country. It is
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determined by several domestic and external economic indicators.As domestic economic indicators also influence a countrys interest rate level, interdependence between the countryrelated risk and the interest rate level exists. In cases where there isa high country-related risk there tends to be a higher interest rate levelThis is mainly the result of the higher inflation and the risk premium for investments incountries with a high risk. Currency risk is the possible loss because of changes in the exchange rate. The currency riskis divided into the three components: currency translation risk, currency transaction risk, andeconomic exchange rate risk. Thecurrency translation riskresults from the danger of thedepreciation of the equity originally paid and later arising equity capital by the surplus retained within a given period by the subsidiary from the parent companys viewpoint. Thecurrency transaction riskresults from the exchange raterisk of individual transactions, e.g. payment of dividends or license fees, when currencies areex changed at the outset or on completion. Theeconomic exchange rate riskdescribes the danger that the competitiveness of a companywill get weaker due to changes in the exchange rate. 6.2 Tax laws The tax burden suffered by the corporate group can be reduced by the choice of the capitalstructure. Therefore, the tax aspects in a sense of the objective of cost minimization are important with regard to the capital structure design. The tax burden must always be assessed fromthe viewpoint of the company as a whole. Thesubsidiarypays different taxes in the country of its seat. Its profit is subject to taxationby corporate income tax. Further income tax is levied in some countries, which is comparableto German trade taxIn some countries taxes on non-income itemsare levied in the form of general capital tax if they are funded by equity capitalConcerning the payment of dividends, in most of the countries taxes arise that are collected at the source, so that in case of the distribution of a dividend a tax deducted atthe source must be withheld by the parent company and paid to the subsidiarys local tax office. In accordance with the principle of residence, The parent Company is subject to taxation inthe country of its corporate seatIf a dividend is distributed, it results in income for the parent company and the taxes must be paid there. In many countries, adouble taxation of corporate profits arising in this manner is stopped by mutual double taxation agreements. The following characteristics must also be observed for a German parentcompany: interest on internal corporate group loans is taxable in the parent company. If theparent company takes up longterm borrowed capital to finance the subsidiary this results inaddition to the trade tax to approximately the order of 50% of the debt interest. It may be worthwhile to establish afinancing companyfor tax purposes. It is typical for afinancing company to be located in a foreign country, to be part of a corporate group, haveeconomic interests in other countries outside the country of corporation, and to executefinancing functions. Afinancing company is utilized if better financing can be guaranteed and/or the extent of the taxburden can be reducedFinancing companies may reduce the taxdeducted at the source (withholding tax) that is to be paid if the country of corporation hasimposed lower withholding tax rates with the country of corporation of the subsidiary thanwould arise should direct payment be made to the German parent.
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6.3 Laws and subsidies Besides the taxation rules, there are laws in some countries that limit the flexibility and thefreedom of decision made by companies. Several countries try to protect their industry by imposing customs barriers or local content regulations. Some countries require, for example, thatat least one local partner is admitted as subsidiary shareholder.They also charge high duties on imports, making them practically impossible. Furthermorelaws may regulate the monetary transactions thus influencing the capital flow of the companies. Normally these restrictions apply to long-term borrowed capital.On the other hand, efforts are also made to get investors within their own country by attractingthem with subsidies and other benefits. Design possibilities may be given depending on thespecifics of the individual case. The requirements of local content influence the real net outputto be created in the country and therefore the extent of investments planned by the subsidiaryand the financing requirement related to them. 6.4 Interests and influence of other groups A company is in the focus of the public and deals withmany interest groups. These can becustomers, suppliers, employees, financial authorities, the government, the public, and lendersof borrowed capital or investors of equity capital. According to the country, it is necessary tocheck which groups there are and how much they can influence the policy of the company.

Leasing and the Tax Reform Act of 1986. As an alternative to increasing the debt of foreign subsidiaries, multinationals could expand their use of leasing. Although leasing an asset is economically equivalent to using borrowed funds to purchase the asset, the international tax consequences differ. Prior to 1986, U.S. multinationals counted virtually all their interest expense as a fully deductible U.S. expense. Under the new law, firms must allocate interest expense on general borrowings to match the location of their assets, even if all the interest is paid in the United States. This allocation has the effect of reducing the amount of interest expense that can be written off against U.S. income. Rental expense, on the other hand, can be allocated to the location of the leased property. Lease payments on equipment located in the United States, therefore, can be fully deducted. At the same time, leasing equipment to be used in the United States, instead of borrowing to finance it, increases reported foreign income (since there is less interest expense to allocate against foreign income). The effect of leasing, therefore, is to increase the allowable foreign tax credit to offset U.S. taxes owed on foreign source income, thereby providing another tax advantage of leasing for firms that Owe U.S. tax on their foreign source income. 7. Cost Minimizing Approach to Global Capital Structure: The cost-minimizing approach to determining foreign affiliate capital structures would be to allow subsidiaries with access to low-cost capital markets to exceed the parent company capitalization norm, while subsidiaries in higher-capital-cost nations would have lower target debt ratios. These costs must be figured on an after-tax basis, taking into account the companys worldwide tax position. A counterargument is that a subsidiarys financial structure should conform to local norms. Then because German and Japanese firms are more highly leveraged than, say, companies in the United States and France, the Japanese and
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German subsidiaries of a U.S. firm should have much higher debt/equity ratios than the U.S. parent or a French subsidiary. The problem with this argument, though, is that it ignores the strong linkage between U.S-based multinationals and the U.S. capital market. Because most of their stock is owned and traded in the United States, it follows that the firms target debt/equity ratios are dependent on U.S. shareholders risk perceptions. Similar arguments hold for multinationals not based in the United States. Furthermore, the level of foreign debt/equity ratios is usually determined by institutional factors that have no bearing on foreign-based multinationals, For example. Japanese and German banks own much of the equity as well as the debt issues of local corporations. Combining the functions of stockholder and lender may reduce the perceived risk of default on loans to captive corporations and increase the desirability of substantial leverage. These institutional considerations would not apply to a wholly owned subsidiary. However, a joint venture with a corporation tied to the local banking system may enable an MNC to lower its local cost of capital by leveraging itselfwithout a proportional increase in risk - to a degree that would be impossible otherwise. The basic hypothesis proposed in this section is that a subsidiarys capital structure is relevant only insofar as it affects the parents consolidated worldwide debt ratio. Nonetheless, some companies have a general policy of every tub on its own bottom. Foreign units are expected to be financially independent following the parents initial investment. The rationale for this policy is to avoid giving management a crutch. By forcing foreign affiliates to stand on their own feet, affiliate managers will presumably be working harder to improve local operations, thereby generating the internal cash flow that will help replace parent financing. Moreover, the local financial institutions will have a greater incentive to monitor the local subsidiarys performance because they can no longer look to the parent company to bail them out if their loans go sour. But companies that expect their subsidiaries to borrow locally had better be prepared to provide enough initial equity capital or subordinated loans. In addition, local suppliers and customers are likely to shy away from a new subsidiary operating on a shoestring if that subsidiary is not receiving financial backing from its parent. The foreign subsidiary may have to show its balance sheet to local trade creditors, distributors, and other stakeholders. Having a balance sheet that shows more equity demonstrates that the unit has greater staying power. It also takes more staff time to manage a highly leveraged subsidiary in counties like Brazil and Mexico where government controls and high inflation make local funds scarce. One treasury manager complained. We spend 75%8O% of managements time trying to figure out how to finance the company. Running around chasing our tails instead of attending to our basic businessgetting production costs lower, sales up, and making the product better.

8. JOINT VENTURES Because many MNCs participate in joint ventures, either by choice or necessity, establishing an appropriate financing mix for this form of investment is an important consideration. The previous assumption that affiliate debt is equivalent to parent debt in terms of its impact on perceived default risk may no longer be valid. In countries such as Japan and Germany, increased leverage will not necessarily lead to increased financial risks, due to the close relationship between the local banks and corporations. Thus, debt raised by a joint venture in Japan, for example, may not be equivalent to parent-raised debt in terms of its impact on default risk. The assessment of the effects of leverage in a joint venture requires a qualitative analysis of the partners ties with the local financial community, particularly with the local banks. Unless the joint venture can be isolated from its partners operations, there are likely to be some significant conflicts associated with this form of ownership. Transfer pricing,
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setting royalty and licensing fees, and allocating production and markets among plants are just some of the areas in which each owner has an incentive to engage in activities that will harm its partners. These conflicts explain why bringing in outside equity investors is generally such an unstable form of external financing. Because of their lack of complete control over a joint ventures decisions and its profits, most MNCs will, at most, guarantee joint venture loans in proportion to their share of ownership. But where the MNC is substantially stronger financially than its partner, the MNC may wind up implicitly guaranteeing its weaker partners share of any joint-venture borrowings, as well as its own. In this case, it makes sense to push for as large an equity base as possible; the weaker partners share of the borrowings is then supported by its larger equity investment. 9. Summary and conclusion The primary emphasis is on taking advantage of distortions resulting from Government intervention in financial markets or from differential national tax law, either of which may cause difference to exit in the risk-adjust after- tax costs of different sources and types funds. Secondly, this framework includes the possibility of reducing various operating risks resulting from political or economic factors. Last, it seeks to determine appropriate parent, of affiliate, and worldwide capital structures- taking into account the unique attributes of being a multinational corporation.

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REFERENCES
Eun, C. S., Resnick, B. G. (2005). International Financial Management 4e, Tata McGrow Hill. Investopedia . com

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