Course Green Sheet
Translation Methods
Currency of Accounts | Functional Currrency | Translation Method |
---|---|---|
parent country's | parent country's | not required |
local currency | local currency | Current Rate |
local currency | parent country's | Temporal |
local currency | another country's | To functional currency by Temporal from functional to parent country's by Current Rate |
Type of Affliate |
---|
integrated foreign entity |
self-sustaining foreign entity |
The cost of capital from the different sources may differ because of differences in the perceived risk associated with the different securities, but it also may differ because of the nature of the tax system. Interest paid on debt is deductible in the computation of profit taxes by the dividends paid to equity holders is not. This means that if the profit tax rate is T and the interest rate on debt is rd then the cost of capital from debt is:
The cost of capital from equity is not affected by the profit tax rate but it is more complicated conceptually than the cost of capital from debt. suppose a corporation is growing at a rate of g and hence the dividends per share, which are now D1, is also growing at a rate of g. If r is the discount rate, called the capitalization rate for the stock, that the market places on future dividends for this corporation Then the price P of the stock would be:
The term D1/P is called the yield rate for the stock. So the cost of capital from equity is the yield rate plus the growth rate.
The above analysis is for a corporation which is expected to grow at a constant rate forever. If that is not the case there is still a discount rate (capitalization rate) that equates the present value of expected future dividends and the market price, but it would be much more difficult to compute and there would not be any simple formula for it.
An alternative approach to computing the cost of capital from equity is to use the formula derived in the Capital Asset Pricing Model (CAPM). According to the CAPM the required rate of return on equity is
where rf is the riskfree interest rate,
rm is the rate of return on the market
portfolio and is the beta (or
volatility coefficient) for the common stock.
The for the common stock can be represented as:
The significant impact of capital market segmentation is that the the cost of capital from a segmented market may be influenced by the amount of capital drawn from that source. This results in the marginal cost of capital from that source being different (greater) than the average cost of capital from that source. For example, consider borrowing from banks in which the interest rate depends upon the total amount of borrowing. The marginal cost of capital is then the increase in interest payment per unit increase in borrowing. The marginal cost of capital is computed by considering the difference in the interest payment between two levels of borrowing and value applies at the level of borrowing which is the average of the two levels used in the computation. For example, in the following table when the level of borrowing increases from $1.0 million to $2.0 million the annual interest payment increases from $65,000 to $140,000, an increase of $75,000. When this increase of $75,000 is divided by the increase in borrowing of $1.0 million the result is 0.075 or 7.55. This is the marginal cost of capital at a level of borrowing equal to (1.0+2.0)/2 = $1.5 million.
Amount of Borrowing ($ million) | Interest Rate | Interest Payment | Marginal Cost of Capital |
---|---|---|---|
0 | 6.0% | 0 | |
0.5 | 6.5% | ||
1.0 | 6.5% | 65,000 | |
1.5 | 7.5% | ||
2.0 | 7.0% | 140,000 | |
2.5 | 8.5% | ||
3.0 | 7.5% | 225,000 | |
3.5 | 9.5% | ||
4.00 | 8.0% | 320,000 | |
4.5 | 10.5% | ||
5.0 | 8.5% | 425,000 | |
5.5 | 11.5% | ||
6.0 | 9.0% | 540,00 |
The optimal financing of capital is the allocation amount the various sources that makes the total cost of capital a minimum. The rule for achieving such a minimum is to make the marginal costs of captial equal. The interest rate paid is the average cost of capital rather than the marginal cost of capital. The relevant figure is the marginal cost of capital rather than the interest rate paid. If there are two sources of capital then the amount obtained from each source should be such that the marginal costs of capital are equal.
To illustrate the principle, suppose that in addition to the above source of capital from bank borrowing capital can be raised by selling bonds but that the interest rate that must be paid depends upon the size of the bond issue, such as in the following table.
Amount of Bond Issue ($ million) | Interest Rate | Interest Payment | Marginal Cost of Capital |
---|---|---|---|
0 | 8.0% | 0 | |
0.5 | 8.25% | ||
1.0 | 8.25% | 82,500 | |
1.5 | 8.75% | ||
2.0 | 8.5% | 170,000 | |
2.5 | 9.25% | ||
3.0 | 8.75% | 262,500 | |
3.5 | 9.75% | ||
4.00 | 9.0% | 360,000 | |
4.5 | 10.25% | ||
5.0 | 9.25% | 462.500 | |
5.5 | 10.75% | ||
6.0 | 9.5% | 570,00 |
The relationship between the marginal cost of capital and the amount of capital raised indicate that if the amount of capital to be raised is less than or equal to $2.0 all of it will be raised by bank borrowing. But above $2 million it is worthwhile to use both sources.
Minimizing the total cost of capital is equivalent to minimizing the weighted average cost of capital (W.A.C.C.), which is the usual criterion for establishing the optimal financial structure. But focusing on the W.A.C.C. hides the role of the marginal costs of capital in achieving an optimal financial structure.
The equivalence of minimizing WACC with minimizing the total capital costs is established as follows: (in this rd is the cost of capital from debt and re is the cost of capital from equity)
Arbitrage Based on Ownership of Foreign Subsidiaries: The Shaklee Case
Objectives for Foreign Investment
Knickbocker proposed an interesting theory of why a country's firms may invest in foreign countries. The foreign sales for firm's which have economies of scale may help them reach level's of production where the marginal cost is lower and thus help them compete in their domestic markets. Thus a firm that declined to seek foreign markets may find that it has a cost disadvantage in competition with another domestic firm that has enhanced its production levels with foreign sales.
The Effective Tax Rate When More Than One Jurisdiction Levies Taxes
Let t1 and t2 be the tax rates imposed upon an income Y and let T1 and T2 be the amount of taxes collected.
If there is no provision for deductibility of taxes paid to the other jurisdiction then the total taxes paid, T, is given by:
Now consider the case in which Jurisdiction 1 gives a deduction from taxable income for taxes paid to Jurisdiction 2. This is the case with Federal and State income taxes. The U.S. gives a deduction from taxable income for state income taxes paid, but states generally do not give a tax deduction for Federal income taxes paid.
In this case T2 = t2Y and T1 = t1(Y - T2)
Thus
Thus in this case the effective total tax rate is (1-t2)t1+t2.
Instead of Jurisdiction 1 giving a deduction for taxes paid to Jurisdiction 2 it could give a tax credit. This means that Jurisdiction 1 reduces its tax bill by the amount of the taxes paid to Jurisdiction 2. Thus the tax owed to Jurisdiction 1 is equal to t1Y - T2 so the total tax paid is t1Y - T2 + T2 = t1Y. This presumes that the tax rate in Jurisdiction 1 is greater than that in Jurisdiction 2. If that is not the case then clearly Jurisdiction 1 is not going to pay the tax payer the differences between the tax owed in Jurisdiction 2 and Jurisdiction 1. Thus, in the case of tax credits the effective overall tax rate is the maximum of the two tax rates; i.e., t = Max{t1, t2}
Let us now go back to tax deductions and consider the case when each jurisdiction give a tax deduction for tax paid to the other jurisdiction. In this case,
The Income Tax of Colorado, at least at one time, had a deduction for Federal income tax paid and taxpayers had to use set of tables to determine their taxes.
If two jurisdictions attempted to give a tax credit for tax paid to the other jurisdiction they would find that, in general, the tax burdens cannot be determined. The equations to be satisfied cannot, in general, be satified. These equations are:
The above relationships can be summarized as follows:
Effective Total Tax Rate | |
---|---|
No deductibililty No tax credit |
t1 + t2 |
Deductibililty of T2 for T1 | t1(1-t2) + t2 |
Tax credit of T2 for T1 | Maximum of t1 and t2 |
Effective Total Tax Rate | |
---|---|
No deductibililty No tax credit |
50% |
Deductibililty of T2 for T1 | 46 % |
Deductibililty of T1 for T2 | 46 % |
Tax credit of T2 for T1 | 40 % |
Tax credit of T1 for T2 | 40 % |
Mutual Deductibililty | 43.75 % |
Mutual Tax Credit | Not Determinate |
Example: A Vertically Integrated Chair Manufacturing
and Retailing Operation
Let PR be the retail price of a chair, PWh the wholesale price of that chair PM the price of the raw materials for that chair. The profit the selling of the chair is PR-PWh, whereas the profit on manufacturing the chair is PWh-PM and let say the profit on producing the materials that go into the chair is PM-CM . If the material production, manufacturing and retailing of the chairs take place in different tax jurisdictions and these jurisdictions have different effective profit tax rates then the pricing of the intermediate products will affect the total taxes paid and hence the profitability of chair production.
If the sales are given then the analysis can be carried out in terms of the revenue, cost and profit per chair. The data can be assembled in the form of the following table:
Materials Production | Chair Manufacturing | Retail Sales |
|
---|---|---|---|
Revenue | pM | pWh | pR |
Cost | cM | pM+cWh | cR+pWh |
Operating Surplus (taxable profit) |
pM-cM | pWh-pM-cWh | pR-cR-pWh |
Tax | tM | tWh | tR |
The retail price pR is given by the market and the average fixed costs are also given.
The after-tax profit is just one minus the relevant tax rate times the operating surplus. The relevant tax rates are the effective tax rates taking into account the deductibilities and tax credit allowances for taxes paid to other jusrisdictions.
The minimization of overall taxes involves setting the transfer prices, pM and pWh, so as to have all of the profit appear in the jurisdiction with the lowest effective tax rate. This means that the taxable profits in the other jurisdictions should be zero. Suppose the lowest effective tax rate is in the jurisdiction where the manufacturing takes place. One generally would not set pM to zero because that would create a loss in the materials production which would not be utilized and would result in the profit in the manufacturing jurisdiction being more than the total profits for the entire chair production operation and thus would result in excess taxes. Likewise pM would generally not be set equal to pR because then the average fixed costs in retailing would not be covered and a loss in retailing would be incurred. Of course, if losses in retailing or material production could offset taxes on profits for other operations in those jurisdiction then that would enter into the choice of transfer prices.
In the absence of other operations in the other jurisdictions then when the tax rate is lowest in the manufacturing jurisdiction:
Time | Cash Flow | Discount Factor | Present Value |
---|---|---|---|
0 | -C0 (initial cost) | 1.000 | -C0 |
1 | CF1 | 1/(1+R) | CF1/(1+R) |
.. | .......... | ..... | ........ |
N | CFN (including salvage value) |
1/(1+R)N | CFN/(1+R)N |
Net Present Value | NPV |
The discount rate R is based upon the cost of capital to the firm and a risk premium for the project. If the NPV is positive then the project is worthwhile.
The tax treatment of these various compensations may be different and thus it is not usually advisable to lump them all together into a bundle called dividends. The separation of these various payments is called unbundling.
There are other financial transactions between the subsidiary and the parent company that could be used to disguise a payment for the return on an investment. For example, affliates often purchase raw materials and/or services from the parent. The pricing of these goods and services may serve to transfer profits from the subsidiary to the parent. This would be a case of the use of transfer pricing for purposes other than to reduce taxes.
Loans from the parent company may also carry an interest charge above the cost of debt capital that serves to transfer profits to the parent. The subsidiary could also make loans to the parent, perhaps at below-cost interest rates, would be an effective way of transfering funds from the subsidiary to the parent.
Lastly the leading or lagging of payments for transactions between the subsidiary and the parent may serve to transfer profits temporarily between the subsidiary and the parent. For example, if the subsidiary buys supplies from the parent and pays for them in advance this serves as a loan from the subsidiary to the parent. If the subsidiary sells supplies to the parent and the payments are delayed (lagged) then this also serves as a loan from the subsidiary to the parent.
If a country's regulations on the transfer of capital prohibits loans from a subsidiary to a parent company but allows the transfer of funds to financial intermediaries then a fronting loan may be used to achieve a transfer of capital from the subsidiary to the parent. The subsidiary deposits funds in a bank which serves as collateral for a loan to the parent company. The interest on the parent company's loan is offset, at least in part, by the interest received on the subsidary's deposit.