Remission of funds
Certain costs to the subsidiary may in reality be revenues to the parent company.
For example, royalties, supervisory fees and purchases of components from the parent company are costs to the project, but result in revenues to the parent.
The normal methods of returning funds to the parent company are:
Transfer prices; and
Loan interest and principal
It is important to note that some of these items may be locally tax-deductible for the subsidiary but taxable in the hands of the parent.
Overcoming exchange controls – block remittances
Block funds are funds in overseas bank accounts subject to exchange controls, such that restrictions are placed on remitting the funds out of the country.
They mainly aim to circumvent restrictions on dividends payments out of the account by reclassifying the payment as something else:
The parent company can impose a charge on subsidiary for the general management services provided each year.
The fees would normally be based on the number of management hours committed by the parent on the subsidiary’s activities.
The parent company can charge the subsidiary royalties for patent, trade names or know-how.
Royalties may be paid as a fixed amount per year or varying with the volume of output.
The parent can charge artificially higher prices for goods or services supplied to the subsidiary as a means of drawing cash out.
This method is often prohibited by the foreign tax authorities.
Exchange rate risk
Changes in exchange rates can cause considerable variation in the amount of funds received by the parent company.
In theory this risk could be taken into account in calculating the project’s NPV, either by altering the discount rate or by altering the cash flows in line with forecast exchange rates.
Virtually all authorities recommend the latter course, as no reliable method is available for adjusting discount rates to allow for exchange risk.
This relates to the possibility that the NPV of the project may be affected by host country government actions.
These actions can include:
Expropriation of assets (with or without compensation!);
Blockage of the repatriation of profits;
Suspension of local currency convertibility;
Requirements to employ minimum levels of local workers or gradually to pass ownership to local investors.
The effect of these actions is almost impossible to quantify in NPV terms, but their possible occurrence must be considered when evaluating new investments.
High levels of political risk will usually discourage investment altogether, but in the past certain multinational enterprises have used various techniques to limit their risk exposure and proceed to invest.
These techniques include the following:
Structuring the investment in such a way that it becomes an unattractive target for government action.
For example, overseas investors might ensure that manufacturing plants in risk-prone countries are reliant on imports of components from other parts of the group, or that the majority of the technical “know-how” is retained by the parent company.
These actions would make expropriation of the plant far less attractive.
Borrowing locally so that in the event of expropriation without compensation, the enterprise can offset its losses by defaulting on local loans.
Prior negotiations with host governments over details of profit repatriation, taxation, etc, to ensure no problems will arise. Changes in government, however, can invalidate these agreements.
Attempting to be “good citizens” of the host country so as to reduce the benefits of expropriation for the host government.
These actions might include employing large numbers of local workers, using local suppliers, and reinvesting profits earned in the host country.
Economic risk is the risk that arises from changes in economic policies or conditions in the host country that affect the macroeconomic environment in which a multinational company operates.
Examples of economic risk include:
Government spending policy.
Economic growth or recession.
International trading conditions.
Currency inconvertibility for a limited time.
Fiscal risk is the risk that the host country may increase taxes or changes the tax policies after the investment in the host country is undertaken.
Examples of fiscal risk include:
An increase in corporate tax rate.
Cancellation of capital allowances for new investment.
Changes in tax law relating to allowable and disallowable tax expenses.
Imposition of excise duties on imported goods or services.
Imposition of indirect taxes.
Regulatory risk is a risk that arises from changes in the legal and regulatory environment which determines the operation of a company.
Health and safety laws.
Financing overseas projects
The chief sources of long-term finance are the following:
The subsidiary is likely to be 100% owned by the parent company.
However, in some countries it is necessary for nationals to hold a stake, sometimes even a majority of the ordinary shares on issue.
Eurocurrency loan is a loan by a bank to a company denominated in a currency of a country other than that in which they are based.
For example, a UK company may require a loan in dollars which it can acquire from a UK bank operating in the Eurocurrency market. This is called Eurodollar loan.
The usual approach taken is to match the assets of the subsidiary as far as possible with a loan in the local currency.
This has the advantage of reducing exposure to currency risk.
However, this reduced risk must be weighed against the interest rate paid on the loan.
A loan in the local currency may carry a higher interest rate, and it may be preferable, for example, to arrange a Eurocurrency loan in a major currency which is highly correlated with the currency of the overseas operations.
Finance may be available from the UK, the overseas government, or an international body, such as the World Bank.
Financing by intercompany account is useful in a situation where it is difficult to get funds out of the foreign country by way of dividends. This is further discussed below.
Syndicated Loan Market
Syndicated loan market developed from the short-term eurocurrency market. A syndicate of banks is brought together by a lead bank to provide medium-to long-term currency loans to large multinational companies.
These loans may run to the equivalent of hundreds of millions of pounds. By arranging a syndicate of banks to provide the loan, the lead bank reduces its risk exposure.
Eurobond are bonds sold outside the jurisdiction of the country in whose currency the bond is denominated.
Eurobond is a bond issued in more than one country simultaneously, usually through a syndicate of international banks, denominated in a currency other than the national currency of the issuer.
They are long-term loans, usually between 3 to 20 years and may be fixed or floating interest rate bonds
An investor subscribing to such a bond issue will be concerned about the following factors:
● return on the investment.
These are equity sold simultaneously in a number of stock markets. They are designed to appeal to institutional investors in a number of countries. The shares will be listed and so can be traded in each of these countries.
The reasons why a company might make such an issue rather than an issue in just its own domestic markets include:
larger issues will be possible than if the issue is limited to just one market;
wider distribution of shareholders;
to become better known internationally;
queuing procedures which exist in some national markets may be avoided.