One stylized fact of multinational corporations is that foreign subsidiaries are capitalized with as little equity as possible and with as much intrafirm debt as possible.
a. What are the advantages of internal debt over internal equity in financing a foreign subsidiary?
b. How do the tax rate in the home and the host country affect the decision to use internal debt instead of internal equity?
c. How would you choose the currency denomination of the internal debt?
d. To what extent dos the capital structure (debt versus equity) of the subsidiary really matter? Carefully explain your reasoning. hide problem hide problem
(a) Internal debt reduces the taxes (plus there is no tax on debt, except for interest, but that one can be adjust within the corporation) while internal equity involves retained earnings, which consist of income during the year the company has to pay taxes on that one.
(b) If the tax rate is high in the host country, then it's better to use the internal debt for financing (for the reason described in (a)), whereas if the tax rate is high in the home country, it's better to use the opposite approach.
The solution discusses how tax rates in the home and the host country affect the decision to use internal debt instead of internal equity.