A localized financial structure helps management

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Financial Reporting, Financial Statement Analysis and Valuation
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Chapter 4 / Exercise 4.7
Financial Reporting, Financial Statement Analysis and Valuation
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A localized financial structure helps management evaluate return on equity investment relative to local competitors in the same industry. In economies where interest rates are relatively high because of a scarcity of capital, the high cost of local funds reminds management that return on assets needs to exceed the local price of capital. The main disadvantages of localized financial structures are as follows: An MNE is expected to have a comparative advantage over local firms in overcoming imperfections in national capital markets through better availability of capital and the ability to diversify risk. If each foreign subsidiary of an MNE localizes its financial structure, the resulting consolidated balance sheet might show a financial structure that does not conform to any particular country’s norm. The debt ratio of a foreign subsidiary is only cosmetic, because lenders ultimately look to the parent and its consolidated worldwide cash flow as the source of repayment. In our opinion, a compromise position is possible. Both multinational and domestic firms should try to minimize their overall weighted average cost of capital for a given level of business risk and capital budget, as finance theory suggests. However, if debt is available to a foreign subsidiary at equal cost to that which could be raised elsewhere, after adjusting for foreign exchange risk, then localizing the foreign subsidiary’s financial structure should incur no cost penalty and would also enjoy the advantages listed above. Financing the Foreign Subsidiary In addition to choosing an appropriate financial structure for foreign subsidiaries, financial managers of multinational firms need to choose among alternative sources of funds—internal and external to the multinational—with which to finance foreign subsidiaries. Ideally, the choice among the sources of funds should minimize the cost of external funds after adjusting for foreign exchange risk. The firm should choose internal sources in order to minimize worldwide taxes and political risk, while ensuring that managerial motivation in the foreign subsidiaries is geared toward minimizing the firm’s consolidated worldwide cost of capital, rather than the subsidiary’s cost of capital. Internal Sources of Funding
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Financial Reporting, Financial Statement Analysis and Valuation
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Chapter 4 / Exercise 4.7
Financial Reporting, Financial Statement Analysis and Valuation
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Exhibit 14A.1 provides an overview of the internal sources of financing for foreign subsidiaries. In general, although a minimum amount of equity capital from the parent company is required, multinationals often strive to minimize the amount of equity in foreign subsidiaries in order to limit risks of losing that capital. Equity investment can take the form of either cash or real goods (machinery, equipment, inventory, etc.). While debt is the preferable form of subsidiary financing, access to local host country debt is limited in the early stages of a foreign subsidiary’s life. Without a history of proven operational capability and debt service capability, the foreign subsidiary may need to acquire its debt from the

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