Managing Finance In An Internal Capital Market

Anyone who would have read the finance news about fifty years ago would have noted that there were no CFOs. The finance of a company was done by controllers. But with the growth of external markets and companies going international, the demands of the position become prominent and complex. The finance function of a firm required better performance and more disclosures. With the birth of internal capital markets in multinational firms, the finance department has become even more strategic.  This write-up puts the limelight on two issues:

  • How to manage risk globally?
  • How to finance in the internal capital market?

When a company has operations all over the world, the risk management choices broaden massively. Let’s take an example of a US firm that has a European subsidiary. It buys all the components for its product locally, but the final product is sold in Japan. This process creates two situations – a short position in Euro and a long position in Yen. In simple words, if the value of Yen appreciates, then the operations of the firm become stronger. But if Euro appreciates, then the firm has a weaker position.

How does the company offset this exposure? Instead of using the financial market, the company can counterbalance the exposure in some other part of the conglomerate. They can even make the parent company borrow in Yen which will nullify any Yen asset by the Yen liability. This was just a simple example; there are many other ways risks can be managed using the global market of an MNC instead of only one.

Now we move onto financing in the internal capital market. Because the operations of a firm will differ from location to location and there will be institutional variation, there is immense scope when it comes to money matters. One such example is borrowing in a country that has high tax rates and using the excess cash to fund operations in regions that have low tax rates. This method can be used by a CFO to reduce the overall tax bill of the company because interest is tax deductible.

The tax difference can also be exploited by a finance head by carefully timing the flow of profits from subsidiary to parent and vice versa. Tax is not the only way of financing a firm. The rights of a creditor differ all over the world which means the borrowing cost can vary. This disparity can be used by a company to borrow either in the homeland or foreign jurisdiction and then lend the money to other auxiliaries.

Just because there are endless ways to financing thanks to global operations, doesn’t mean the CFO should heedlessly follow them. There are downsides to every strategy like heaping debt on the manager of a particular subsidiary can fog their profit levels. This, in turn, can change how that subsidiary is seen by the entire organization. It can even put a boundary around the professional opportunities of the auxiliary and thus its performance.

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