Final answer:
The parent company must consider adjusting its subsidiary's capital structure and dividend policy, potentially increasing equity or retaining earnings to comply with the foreign country's thin capitalization rules. Countries aim to manage the risk of volatile foreign capital flows, fostering long-term investment over short-term speculation. Issuing stock can raise capital without debt but involves regulatory compliance and strategic profit reinvestment decisions.
Step-by-step explanation:
If a subsidiary is not meeting the thin capitalization rules of a foreign country, the parent company may need to adjust the capital structure and dividend policy of its subsidiary. The company could increase equity funding either through retaining more earnings (and consequently reducing dividend payouts) or by issuing new stock. This would help in adjusting the debt-to-equity ratio that is under scrutiny due to thin capitalization rules. Additionally, the company should also focus on long-term financial sustainability, as abrupt changes in foreign financial capital flows can have significant impacts on both the subsidiary and the parent company's financial health.
Countries are aware of such risks and take steps like holding foreign exchange reserves and regulating domestic banks to prevent imprudent lending. Yet, measures to control or reduce foreign capital flows remain controversial. These steps aim to prevent economic disturbances driven by short-term speculative capital, ensuring instead that only medium- to long-term investment capital flows into the country.
For the firm issuing stock, it should be noted that this increases visibility in the financial markets and allows for the raising of financial capital without increasing debt levels. However, this comes with increased costs and regulatory compliance requirements. Ultimately, the board of directors and shareholders will need to decide whether to issue stock, how to set dividend policies, and how to reinvest profits for the company’s growth in accordance with regulatory environments and strategic financial planning.