Multinational companies (MNCs) have a wide range of financing options when they set up a foreign subsidiary. They can rely on capital transferred from the parent company, but they can also raise local credits. How do multinational firms finance their foreign subsidiaries? To what extent do they rely on local financing and why? Empirical evidence suggests that only part of the subsidiaries is financed internally, with capital from the parent company. Furthermore, multinationals seem to choose a different financing strategy depending on where their foreign subsidiary is located. Kang et al. (2004) report that in industrial countries 29 percent of the financing of subsidiaries come from parents and 42 come from host residents, while in developing countries 45 percent of the financing come from U.S. parents and 34 percent come from host country residents.

In this paper we focus on one particular aspect of a multinational’s financing decision: the credit financing.1 If (at least) part of the financing has to be done through credits, the question arises whether these should be raised locally in the foreign subsidiary’s host country or via the parent company. The aim of our paper is to determine the optimal debt allocation within a multinational corporation. For this purpose we develop a model of multinational borrowing that explicitly considers agency problems in internal capital markets, the existence of bankruptcy costs and the role of creditor rights.