“Multinational firms have several alternatives to finance their foreign affiliates; to raise the equity capital or to borrow; to raise the money in United States or in the local market; and which currency is going to be used” (Demirguc-Kunt, Asli, Vojislav, M. , 1999) In reality, however it is often complicated for foreign affiliates to raise the equity capital in the local market, therefore they would rely on borrowing there.In addition, many subsidiaries rely their financing on their parent companies. Therefore, this report will focus on the following three alternatives which are internal financing, borrowing from the parent company and borrowing from the local banks.
“Since interest payments to lenders are tax deductible from taxable income, while dividend payments to shareholders are not, tax systems typically encourage the use of debt rather than equity finance” (Aggarwal, R. , Kyaw, N. A. , 2004)If the internal capital market is efficient, tax considerations determines whether the foreign affiliates chooses vertical FDI or borrowing. When the parent company borrows in the home country, it is appropriate for it to allocate the money to the foreign affiliate by lending. “Further, when the tax rate in the home country is higher than in the foreign affiliate, the firm should retain the profit of the affiliate, and should refrain it from paying dividend to the parent company” (Yonezawa, Y. , Yamaguchi, H., Yamamoto, T.
, Nambu, T. , 2006).When the parent company borrow and lends the money to the foreign affiliate, the payment and receipt of interest cancel out each other, and the tax burden for the parent company would not be increased.
“By borrowing, the affiliate enjoys tax shelter up to the amount of interest payment, as long as it makes profit. This increases the retained earnings of the foreign affiliate compared to the case of vertical FDI” (Yonezawa, Y. , Yamaguchi, H. , Yamamoto, T. , Nambu, T. , 2006)”Efficient allocation of capital should follow two steps as follows; first, the multinational firms seek for financing of the foreign affiliate in the home country.
Assuming the cost of capital is lower in the home country compared to the host country both cases of vertical FDI and bank borrowing” (Aggarwal, R. , Kyaw, N. A. , 2004). Borrowing from the parent company is more significant when the local capital market is less developed. Second, the multinational firm should choose which subsidiaries in different country acquire the capital.Assuming the firm has two subsidiaries situated in two different countries, and both of the subsidiaries need to raise money for capital investment projects at the same time, and the local cost of capital is different from each other, as one is higher and the other one is lower. “If the affiliate must rely at least partially on external sources of capital, the multinational firm would naturally choose to borrow less in the country that has higher cost of capital”(Aggarwal, R.
, Kyaw, N. A. , 2004).That is why, it is appropriate to fund the money from internal borrowing to the affiliates in the country that has higher cost of capital. More formally, the other affiliate situated in a country that has lower cost of capital should rely on the money need on external borrowing. In another word, the affiliate located in country that has higher cost of capital should finance by internal borrowing as much as possible, and then the rest on the external sources available. Most firms need to allocate the limited fund to the necessary purpose efficiently as a whole.
For example, a multinational firm which finds that its foreign affiliates encounter the difficulty in financing in the local market, would allocate the necessary money to the affiliates by using its own borrowing capacity or internal cash holding. Such mechanism often called the internal capital market is particularly important in the operation of multinational firms. “Firms leverage ratios relates to total debts to total assets” (Godfrey, J.
M. , 2006). This type of ratio provides information on how much the business is depending on the debt financing.A high leverage ratio indicates that the firm is highly dependent on debt financing which is associated with high risk. “Debt to equity ratio is a measure of a company’s financial leverage calculated by dividing its total liabilities by shareholders equity” (Godfrey, J.
M. , 2006). It indicates what proportion of equity and debt the company is using to finance its assets. A high debt to equity ratio generally means that a company has been aggressive in financing its growth with debt.
Capital structure choice is an important strategic decision for all companies.In this report, results shows that host country tax rate affect the affiliate use of debt in its capital structure. Dell Inc.
take advantage of higher tax rates in US by holding high debt levels in its affiliates. This tax effect is most significantly reflected in the determinants of the total debt ratio of Dell Inc. ‘s affiliates. “Higher tax rates increases the use of debt from all the sources, with borrowing from parent firms exhibiting greater responsiveness to tax rate differences than borrowing from external sources” (Desai, M. A.
, Foley, C. F. , Hines Jr. J. R. , 2003).