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SOURCES OF INTERNATIONAL INVESTMENT CAPITAL

Having identified such profitable opportunities firm must secure sufficient capital to them from external or internal sources to minimize the worldwide cost of its capital while also minimizing its foreign-exchange risk, political risk and global tax burden.

i)             External Sources Of Investment Capital

When raising external financing for their investment projects internal businesses may choose from a rich source of debt and equity alternatives. International firms also have many opportunities to borrow funds internationally on either a short or long-term basis. Securities firms and investment banks are continually developing innovative financing techniques to reduce the costs of borrowing for their MNC clients or to exploit gaps in national financial regulations.

A particularly important facet of the international capital market is the swap market in which two firms can exchange their financial obligations. Swaps are undertaken to change the cost and nature of a firm’s interest obligations or to change the currency in which its debt is denominated. A swap may be arranged between two firms that have differing currency preferences. International banks play a key role in the currency swap market. Most international banks engage in currency swap with corporate clients on an ongoing basis.

ii)            Internal Sources Of Investment Capital

Another source of investment capital for international businesses is the cash flows generated internally. Subject  to legal constraints the parent firm may use the cash flow generated by any subsidiary to fund the investment projects of any member of the corporate family. The corporate parent may access the cash flow directly via the subsidiary’s dividend payments to parent. The parent then can channel those funds those to another subsidiary through either a loan or additional equity investment in that subsidiary. Figure 1 summarizes the various internal sources of capital available to the parent and its subsidiaries.

Figure 1

Two legal constrains may affect the parent’s ability to shift funds among its subsidiaries. First if the subsidiary is not wholly owned by the parent the parent must respect the rights of the subsidiary ‘s other shareholders. Any intracorporate transfers of fund must be done on a fair-market basis. This ensures that the parent does not siphon off the subsidiary’s profits through self-dealing thereby harming the other shareholders interest. If the subsidiary is wholly owned transfers of funds do not raise this issue. Second some countries impose restriction on the repatriation of profit  thus blocking their intracorporate transfer.

Strategic Use Of Transfer Pricing

A transfer price is the paid for goods and services involved in intracorporate transaction between a subsidiary and other branches of the corporate family. In practice transfer prices are calculated in one of two way :

i)             Market-based method

The market-based method utilizes prices determined in the open market to market to transfer goods between units of the same corporate parent  and has two main benefits. First reduces conflict between the two units over the appropriate price. The higher the price charged in the intracorporate transfer the better the selling subsidiary’s performance appears and the poorer the buying subsidiary’s performance appears. Second the market-based approach promotes the MNC’s overall profitability by encouraging the efficiency of the selling unit. Motivated by the prospects of bonuses and lucrative promotions unit managers have every incentive to improve the efficiency and profitability of their operations.

ii)            Nonmarket-based method

Prices may be set by negotiations between the buying and selling units or on the basis of cost-based rules of thumb such as production cost plus a fixed markup. Some service of corporate parent may be assessed as a percentage of the subsidiary’s sales such as charges for general corporate overhead and administrative services or for the right to use technology o intellectual property owned by the parent. One disadvantages is that managers of the buying and selling units may waste and energy arguing over the appropriate transfer price because it will affect their reported profits even though it will have no overall impact on their parent’s consolidated before-tax income. Also reduce the selling unit’s efficiency. However strategic use of nonmarket-based transfer prices may benefit an international business as table 2. Creative rearranging of intracorporate prices may allow the parent to lower its overall tax bill.

Table 2

The firm can raise the transfer prices charged to the subsidiary in the high-tax country and lower those charged to the subsidiary in the low-tax country, thereby reducing the firm’s overall tax burden.

TAX HAVENS

The ability of multinational corporations to lower their tax burden by the strategic use of transfer prices is facilitated by the existence of tax havens countries that impose little or no corporate income taxes. By manipulating payments such as transfer prices, dividends, interest, royalties and capital gains between its various subsidiaries an MNC’s may divert income from subsidiaries in high-tax countries to the subsidiary operating in the tax haven. By booking its profits in the tax haven subsidiary the MNC escape the clutches of revenue agents in other countries. Being a ta haven can create a thriving economy. A common approach is to use an arm’s length test whereby government officials attempt to determine the price that two unrelated firms operating at arm’s length would have agreed on. In many cases however an appropriate arm’s length price is difficult to establish leading to conflict between international businesses and tax authorities.