Financial management of multinational corporations

1. Meaning

A multinational corporation (MNC) has its headquarters in one country (the home or parent country) and operates through branches, subsidiaries or joint ventures in others (host countries). Its financial management covers the same three decisions — investment, financing and dividend — but each is complicated by more than one currency, government, tax system and capital market.

2. Factors peculiar to multinationals

1. Foreign exchange risk. Transaction exposure (a receivable in dollars worth fewer rupees when collected), translation exposure (accounting gains and losses on consolidating foreign subsidiaries), and economic exposure (the effect of rate changes on future cash flows and competitiveness). Hedged by forwards, futures, options, swaps, and by matching assets and liabilities in the same currency.
2. Political (country) risk: expropriation, nationalisation, war, sudden changes in law or tax.
3. Exchange controls and blocked funds: host countries may limit remittance of profits or capital. In India, cross-border flows are governed by the Foreign Exchange Management Act, 1999; Indian investment abroad by the Foreign Exchange Management (Overseas Investment) Rules, 2022, and borrowing abroad by RBI’s external commercial borrowing framework.
4. Different tax systems: double taxation, relieved by Double Taxation Avoidance Agreements; withholding tax on dividends and interest remitted.
5. Transfer pricing: prices for goods and services between units in different countries; tax authorities insist on the arm’s length price.
6. Access to international capital markets: ADRs, GDRs, foreign currency convertible bonds, euro-bonds, syndicated loans; a wider choice of funds at lower cost.
7. Different accounting standards, inflation rates, interest rates and cultures.

3. Decision areas

• where to invest (foreign direct investment, location of plants);
• how to finance the parent and each subsidiary, in which currency and market;
• how to manage working capital and cash across countries;
• how much each subsidiary remits and in what form (dividend, royalty, fee, interest);
• how to measure and control the performance of foreign units;
• how to manage exchange and political risk.

4. Working capital management in MNCs

• Centralised cash management: a regional or global treasury pools surplus cash of all units and lends it to those in deficit, cutting idle balances and borrowing.
• Multilateral netting: inter-unit payables and receivables are set off and only net amounts transferred, saving conversion and transfer costs.
• Leading and lagging: paying early (lead) in a currency expected to rise, late (lag) in one expected to fall.
• Re-invoicing centres and transfer pricing to move funds out of countries with blocked funds or high taxes (within arm’s length rules).
• Inventory: stockpiling imported materials where devaluation or import restrictions are feared; receivables: choice of invoicing currency, export credit insurance (in India, ECGC) and forfaiting.

5. Management accounting

Budgets and performance reports must choose a currency: local currency (judging the manager on what he controls) or parent currency (judging the investment as the parent sees it). The usual answer is to set budgets and measure results at the same projected exchange rate, so that the manager is not blamed for rate changes. Transfer prices distort reported profits and must be adjusted for evaluation.

6. Capital budgeting

A project may be good for the subsidiary but not for the parent, because only cash that can be remitted adds to the parent’s wealth. The parent’s view therefore uses: cash flows remittable to the parent, after host and home taxes and withholding tax; expected exchange rates; and a discount rate adjusted for country risk.

Example. An Indian company invests $10,00,000 in a US unit. Remittable inflows $4,50,000 a year for 3 years. Assumed rates: spot Rs. 80, then Rs. 80, 82 and 84 per dollar. Parent’s required return 12%.

The falling rupee raises the rupee value of later inflows; a rising rupee would cut it. A sensitivity test on the exchange rate is part of the answer.

7. Capital structure of MNCs

• Access to many markets lowers the cost of capital and allows a higher debt ratio; international diversification of cash flows lowers risk.
• The subsidiary’s structure may follow the parent, follow local norms, or vary to take advantage of cheap local finance and tax rules.
• Borrowing in the host currency hedges exchange risk (assets and debts in the same currency) and political risk (local lenders have a stake in the unit’s survival).
• Interest is tax-deductible in the host country, so subsidiaries are often financed by parent loans rather than equity; many countries, India included, limit the deduction of interest paid to associated non-residents (thin-capitalisation rules).
• Exchange controls, withholding taxes and the depth of local markets limit the choice.

8. Dividend policies

The subsidiary’s dividend is the parent’s main return. Factors: the tax on remittance (withholding tax, home-country tax and foreign tax credit), exchange controls and expected currency movements (remit before a devaluation), the subsidiary’s own funding needs, the parent’s need for funds to pay its shareholders, and joint-venture partners. Funds may also be moved as royalties, management fees, interest or transfer prices, which may be taxed differently. Many MNCs set a target payout for each subsidiary so that remittances are regular and acceptable to host governments.

How this is examined

For a 6-mark note on “financial management of MNCs”, give section 1, the factors in section 2 and the decision areas. For “capital structure of MNCs” or “MNC working capital”, write sections 7 or 4 in full with two factors from section 2. A case study, if set, is answered with the parent’s-view capital budgeting in section 6.