Debt can be a double-edged sword, depending upon the interest rates and the retu

Question

Debt can be a double-edged sword, depending upon the interest rates and the return on the investment. Debt is generally part of a company's financial structure. The upcoming discussion topic is about the financial structures of MNEs.

Please respond to all of the following prompts:

List and explain four variables of the optimal financial structure of the MNE.

In your opinion, which one is the most important key to an optimal financial structure?

State and explain various methods of financing that can be used for foreign subsidiaries.

Explanation / Answer

Answer Yes it is perfectly right that Debt can be a double - edged sword, because if the cost of debt ( interest cost ) is more than the return from investment ( return on money which is raised through issue of debt ) then it can cause a harmful effect on the financial statement of the company.

The four variable of the optimal financial structure of the MNE are

1) The availability of capital

2) Diversification of cash flows

3) Foreign exchange risk

4) Meeting the expectations of the investor

According to my opinion meeting the expectation of the investors (4) is the most important key to an optimal financial structure because if investors of the entity are not happy then chances of shutting down the business is always present in the entity.

Various methods of financing that can be used for foreign subsidiaries are

Issue of Shares

It is the most important method. The liability of shareholders is limited to the face value of shares, and they are also easily transferable. A private company cannot invite the general public to subscribe for its share capital and its shares are also not freely transferable. But for public limited companies there are no such restrictions. There are two types of shares :-

Issue of Debentures

Companies generally have powers to borrow and raise loans by issuing debentures. The rate of interest payable on debentures is fixed at the time of issue and are recovered by a charge on the property or assets of the company, which provide the necessary security for payment. The company is liable to pay interest even if there are no profits. Debentures are mostly issued to finance the long-term requirements of business and do not carry any voting rights.

Loans from Financial Institutions

Long-term and medium-term loans can be secured by companies from financial institutions like the Industrial Finance Corporation of India, Industrial Credit and Investment Corporation of India (ICICI) , State level Industrial Development Corporations, etc. These financial institutions grant loans for a maximum period of 25 years against approved schemes or projects. Loans agreed to be sanctioned must be covered by securities by way of mortgage of the company's property or assignment of stocks, shares, gold, etc.

Loans from Commercial Banks

Medium-term loans can be raised by companies from commercial banks against the security of properties and assets. Funds required for modernisation and renovation of assets can be borrowed from banks. This method of financing does not require any legal formality except that of creating a mortgage on the assets.

Public Deposits

Companies often raise funds by inviting their shareholders, employees and the general public to deposit their savings with the company. The Companies Act permits such deposits to be received for a period up to 3 years at a time. Public deposits can be raised by companies to meet their medium-term as well as short-term financial needs. The increasing popularity of public deposits is due to :-

Reinvestment of Profits

Profitable companies do not generally distribute the whole amount of profits as dividend but, transfer certain proportion to reserves. This may be regarded as reinvestment of profits or ploughing back of profits. As these retained profits actually belong to the shareholders of the company, these are treated as a part of ownership capital. Retention of profits is a sort of self financing of business. The reserves built up over the years by ploughing back of profits may be utilised by the company for the following purposes :-

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