Lecture Multinational financial management: Lecture 27 - Dr. Umara Noreen

After completing this chapter, students will be able to: To explain the difference in analyzing cash flows from a subsidiary perspective versus a parent perspective; to explain the various techniques used to optimize cash flows; to explain common complications in optimizing cash flows; and to explain the potential benefits and risks of foreign investments.

International Cash Management 27

Lecture

Chapter Objectives

 To explain the difference in

analyzing cash flows from a subsidiary

perspective versus a parent perspective;

 To explain the various techniques used to

optimize cash flows;

 To explain common complications in

optimizing cash flows; and

 To explain the potential benefits and risks

of foreign investments.

Cash Flow Analysis:

Subsidiary Perspective

• The management of working capital has a

direct influence on the amount and timing

of cash flow.

• Subsidiary expenses – It is difficult to

forecast the payments for international

purchases of raw materials or supplies

because of exchange rate fluctuations,

quotas, sales volume volatility, etc.

• Subsidiary revenue – International sales

may be more volatile than domestic sales

because of exchange rate fluctuations,

business cycles, etc.

• Subsidiary dividend payments – If the

payments and fees (royalties, overhead

charges) for the parent are known and

denominated in the subsidiary’s currency,

forecasting cash flows will be easier.

Cash Flow Analysis:

Subsidiary Perspective

Subsidiary Liquidity Management

• After accounting for all cash outflows and

inflows, the subsidiary must either invest

its excess cash or borrow to cover its

cash deficiencies.

• If the subsidiary has access to lines of

credit and overdraft facilities, it may

maintain adequate liquidity without

substantial cash balances

Cash Flow Analysis:

Subsidiary Perspective

Centralized Cash Management

• While each subsidiary is managing its own

working capital, a centralized cash

management group is needed to monitor,

and possibly manage, the

parent-subsidiary and interparent-subsidiary cash flows

• International cash management can be

segmented into two functions:

¤ optimizing cash flow movements, and

¤ investing excess cash

Cash Flow of the Overall MNC

Fees & Earnings Excess Cash

Fees & Earnings Excess Cash

Interest &/or Principal Loans or Investment

Interest &/or Principal Loans or Investment Subsidiary

Sources

of Debt

holders

Stock-Loans

New Issues Cash Dividends

Repayment

Short-Term Securities

Long-Term Projects

Purchase

Long-Term Investment

Parent

Centralized Cash Management

• The centralized cash management division

of an MNC cannot always accurately

forecast the events that affect parent-

subsidiary or intersubsidiary cash flows.

• It should, however, be ready to react to

any event by considering

¤ any potential adverse impact on cash

flows, and

¤ how to avoid such adverse impacts

Techniques to Optimize

Cash Flows

 Accelerating cash inflows

• The more quickly the cash inflows are

received, the more quickly they can be

invested or used for other purposes.

• Common methods include the

establishment of lockboxes around the

world (to reduce mail float ) and

preauthorized payments (charging a

customer’s bank account directly).

 Minimizing currency conversion costs

• Netting reduces administrative and

transaction costs through the accounting

of all transactions that occur over a period

to determine one net payment.

• A bilateral netting system involves

transactions between two units, while a

multilateral netting system usually

involves more complex interchanges.

Techniques to Optimize

Cash Flows

Intersubsidiary Payments Matrix & Netting Schedule

 Managing blocked funds

• A government may require that funds

remain within the country in order to

create jobs and reduce unemployment.

• An MNC can shift cost-incurring activities

(like R&D) to the host country, adjust the

transfer pricing policy (such that higher

fees have to be paid to the parent), borrow

locally rather than from the parent, etc.

Techniques to Optimize

Cash Flows

 Managing intersubsidiary cash transfers

• A subsidiary with excess funds can

provide financing by paying for its

supplies earlier than is necessary This

technique is called leading

• Alternatively, a subsidiary in need of

funds can be allowed to lag its payments

This technique is called lagging

Techniques to Optimize

Cash Flows

• Source: Adopted from

South-Western/Thomson Learning © 2006

in Optimizing Cash Flows

 Company-related characteristics

¤ When a subsidiary delays its payments to

the other subsidiaries, the other

subsidiaries may be forced to borrow until

the payments arrive

 Government restrictions

¤ Some governments may prohibit the use of

a netting system, or periodically prevent

cash from leaving the country

 Characteristics of banking systems

¤ The abilities of banks to facilitate cash

transfers for MNCs may vary among

countries

¤ The banking systems in different countries

usually differ too

Complications

in Optimizing Cash Flows

Investing Excess Cash

• Excess funds can be invested in domestic

or foreign short-term securities, such as

Eurocurrency deposits, Treasury bills, and

commercial papers.

• Sometimes, foreign short-term securities

have higher interest rates However, firms

must also account for the possible

exchange rate movements.

Short-Term Interest Rates

as of February 2004

Centralized Cash Management

• Centralized cash management allows for

more efficient usage of funds and possibly

higher returns.

• When multiple currencies are involved, a

separate pool may be formed for each

currency Funds can also be invested in

securities that are denominated in the

currencies needed in the future.

Investing Excess Cash

• Given the current online technology,

MNCs should be able to efficiently create a

multinational communications network

among their subsidiaries to ensure that

information about their cash positions is

continually updated.

Investing Excess Cash

Centralized Cash Management

Determining the Effective Yield

• The effective yield on foreign investments

r = (1 + if )(1 + ef ) – 1

where if = the quoted interest rate on the

investment

ef = the % in the spot rate

Investing Excess Cash

• If the foreign currency depreciates over

the investment period, the effective yield

will be less than the interest rate.

Implications of Interest Rate Parity (IRP)

• A foreign currency with a high interest

rate will normally exhibit a forward

discount that reflects the differential

between its interest rate and the investor’s

home interest rate.

• However, short-term foreign investing on

an uncovered basis may still result in a

higher effective yield.

Investing Excess Cash

Use of the Forward Rate as a Forecast

• If IRP exists, the forward rate can be used

as a break-even point to assess the

short-term investment decision.

• The effective yield will be higher than the

domestic yield if the spot rate at maturity

is more than the forward rate at the time

the investment was undertaken.

Investing Excess Cash

Use of the Forward Rate as a Forecast

Use of Exchange Rate Forecasts

• Given an exchange rate forecast, the

expected effective yield of a foreign

investment can be computed, and then

compared with the local investment yield.

• It may be useful to use probability

distributions instead of point estimates, or

to compute the break-even exchange rate

that will equate foreign and local yields.

Investing Excess Cash

Deriving the Value of ef that Equates Foreign

and Domestic Yields

r = (1 + if )(1 + ef ) – 1

ef = (1 + r ) – 1

(1 + if )

• r = 11%, if = 14% breakeven ef = -2.63%.

If the foreign currency depreciates by less

than 2.63%, the foreign currency deposit

Investing Excess Cash

Use of Probability Distributions

Probability Distribution of Effective Yield

Diversifying Cash Across Currencies

• If an MNC is not sure of how exchange

rates will change over time, it may prefer

to diversify its cash among securities that

are denominated in different currencies

• The degree to which such a portfolio will

reduce risk depends on the correlations

among the currencies.

Investing Excess Cash

Use of Dynamic Hedging to Manage Cash

• Dynamic hedging refers to the strategy of

hedging when the currencies held are

expected to depreciate, and not hedging

when they are expected to appreciate.

• The overall performance is dependent on

the firm’s ability to accurately forecast the

direction of exchange rate movements.

Investing Excess Cash