Question

1. An MNC has total assets of $ 100 million and debt of $ 20 million. The firm's cost of pretax debt is 12 percent, and its equity financing cost is 15 percent. The MNC has a corporate tax rate of 20 percent. What is the capital cost of this company?

2. Discuss the pros and cons of an MNC that has a centralized cash manager that handles all investments and loans of all MNC affiliates versus each affiliate that has a local manager that performs the branch's cash management activities. .

3. Compare and contrast the three basic types of taxes that governments apply within their tax jurisdictions.

Answer 1

(1) The cost of capital of the MNC can be calculated with the help of the follwoing formula :

Cost of Capital = (Weight of debt * Cost of debt) + (Weight of equity * Cost of equity)

Or, this formula can be expressed mathematically as:-

K_o = {D / (D +E)} * K_d (1-t) + {E / (E+D)} * K_e

where, K_o = overal cost of capital or the weighted cost of capital

{D / (D+E)} i.e. Total Debt / Total assets (as Total Assets = Debt + Equity)

or, we can say, {D / (D+E)} = weightage of the debt capital

{E / (D+E)} i.e. Total Equity Capital / Total assets

or, we can say, {E / (D+E)} = weightage of the equity capital

K_d = Cost of debt

t = tax rate

K_e = cost of equity

We get the following data from the above given problem,

Before tax cost of debt or K_d = 12% or 0.12

Cost of equity or K_e = 15% or, 0.15

corporate tax rate i.e. t = 20% or 0.20

Total Assets i.e. (D+E) = $100 million

Total Debt or D = $20 million

Total Equity or E = $80 million

Hence, putting the values in the aforementioned formula, we get :-

K_o = {D / (D +E)} * K_d (1-t) + {E / (E+D)} * K_e

Or, K_o = {($20 million/ $100 million) * 0.12 * (1- 0.20)} + {($80 million / $100 million) * 0.15}

Or, K_o = (0.20 * 0.12 * 0.80) + (0.80 * 0.15)

Or, K_o = 0.0192 + 0.12

Or, K_o = 0.1392

Or, K_o = 13.92%

Therefore, the cost of capital of the MNC is = 13.92%

(2)

An MNC, generally, consists of a parent company whose head quarter is located in the home country. Under the parent co. there are a number of subsidiaries or affiliate companies located in a no. of foreign countries dispersed all over the world or in one or more continents. So, the first & foremost difficulty of having a centralized cash management system is that the cash manger has to deal with a number of different foreign currencies & their respective exchange rates while handling the investments & loans of all the affiliates.

An efficient cash budgeting system always helps the company to predict the future cash flows, thus enabling it, to borrow funds at affordable rates & invest the surplus funds at in profitable projects. Thus a centralized cash manager has a better globalized view of the cash management system of the entire MNC & its affiliates. He/she can always monitor the cash inflows & outflows of the different affiliates as well as its different departments. This enables the centralized cash management system to always keep a tab on the shortage & surplus of funds in the different units. Accordingly, the manager can make advanced plans of borrowings at affordable rates & make investments that earn the most attractive ROI after evaluating wide variety of alternatives. The centralized cash manger can pool in all the idle funds lying with the different affiliates & make various short term investments having good yields.

A centralized cash management system can also manage the transaction & the translation exposures of an MNC and its subsidiaries much more efficiently as compared to the local cash managers. Netting is an excellent example of the benefit of centralized cash management system. With the help of netting the currency conversion costs & the processing costs associated with the exchange of funds among the subsidiaries & with the parent co. can be reduced considerably. Thus centralized cash management system helps in the optimum utilization of funds.

A central cash manger will always work keeping in mind the overall corporate profit, whereas the local cash manger would have the tendency to work only for the subsidiary unit profit.
A central cash manager will ensure that the funds are held by the affiliates only for the transaction purposes. Thus it helps to absorb & eliminate the excess cash held for speculative purposes by the affiliates. This would help to reduce the redundant assets, decrease the financing costs & thus improves the MNC’s profitability.

The advantage of having local cash manger for a subsidiary is that he/she becomes well acquainted with the local government & the local banks. As a result, the subsidiary can get loans readily and at discounted rates from the local banks. Also, due to having better knowledge regarding the local economic activities & the govt.’s economic policies, a local cash manager can help the subsidiary to bid more efficiently for the local tenders and ultimately win them.
However, one disadvantage of having local cash manger for every affiliate is that their tendency would be to work only in the interest of that particular affiliate. For example, when an affiliate needs to transfer funds to another affiliate facing cash crunch, it can deliberately delay that loan in order to avail other attractive investment opportunities thus causing financial difficulties for that affiliate.

(3) Any tax system of a country can be subdivided into two types :- Direct taxes & Indirect Taxes.

Direct taxes are those that are directly collected by the govt. from the resident taxpayers in the form income tax, capital gain tax, corporate tax, property tax etc.

Indirect taxes are collected by the govt. from the manufacture & sale of goods & services. For example, goods & srvices tax, Value added tax, customs duty, sales & excise tax, entertaiment tax, gift tax etc.

The 3 basic types of taxes imposed by any goernment are as follows:-

Income Tax - The main source of tax revenue of a govt. comes from the income tax collected in difeerent percentages from the indivduals. businesses & the corporates of any country. This tax is imposed on the income earned by the salaried professionals and the turnover generated by the different sole proprietorship, partnership business firms & the corporates in a financial year. The non resident citizens are also taxed on their earnings when they park their funds with the home country banks.

VAT or Goods & services tax - This tax is imposed by the govt. on the manufacture and sale of every product & services originating in the country. VAT is charged on the every stage of manufacturing, sales and consumption of a product or service & is ultimately borne by the final consumer.

Withholding tax & TDS - TDS or tax deducted at source is an amount of the salary withheld by the employer before paying to the employee and directly transfering it to the govt. Other witholding taxes are imposed on the foreign resident indivduals & corporates having income that falls under the tax jurisdiction of another country. The income earned may be in the form of dividends & interests on the investments, patents, royalties, copyright incomes, capital gains etc.