International Financial Management 9

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Chapter 9

International Cash Management

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Objectives

This chapter emphasizes the decisions

involved in management of cash by an

MNC. The additional opportunities and

risks of cash management for an MNC

versus a domestic firm should be stressed.

The specific objectives are:

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Objectives

• to explain the difference between a subsidiary perspective and a parent perspective in analyzing cash flows;• 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.

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Cash Flow Analysis:Subsidiary Perspective

• The management of working capital has a

direct influence on the amount and timing

of cash flow :– inventory management– accounts receivable management– cash management

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Subsidiary Expenses• International purchases of raw materials or supplies are more likely to be difficult to manage because of exchange rate fluctuations,

quotas, etc. a larger inventory is thus required by MNC compared with domestic firms.• If the sales volume is highly volatile, larger cash balances may need to be maintained in order to cover unexpected demands.

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Subsidiary Revenue

• International sales are more likely to be

volatile because of exchange rate

fluctuations, business cycles, etc.

• Looser credit standards may increase

sales (accounts receivable), though often

at the expense of slower cash inflows.

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Subsidiary Dividend Payments

• Forecasting cash flows will be easier if the dividend payments and fees (royalties and overhead charges) to be sent to the parent are known in advance and denominated in the subsidiary’s currency.

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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.

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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 intersubsidiary cash flows. (Exhibit 9.1)

• International cash management can be

segmented into two functions:– optimizing cash flow movements, and

– investing excess cash.

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Exhibit 9.1 Cash Flow of the Overall MNC

parent

Short-term Securities

Long-termProjects

Sources of Debt

Stockholders

Subsidiary “1”

Subsidiary “2”

Interest and Principal on Excess Cash Invested by Subsidiary

Loans or Investment

Fees and Part

of Earnings

Excess Cash to be Invested

Excess Cash to be Invested

Fees and Part of Earnings

Loans or Investment

Interest and principal on Excess Cash Invested by Subsidiary

Funds for

Sup

plies

Funds for

Sup

plies

Purchase of Securities

Funds Received from

Sales of Securities

Long-term Investment

Return on Investment

Loans

Repayment on Loans

Funds Received from New Stock Issues

Cash Dividends

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Centralized Cash Management

• The centralized cash management division of an MNC cannot always accurately forecast the events that may 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 impact.

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Techniques to OptimizeCash 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 mailing

time) and preauthorized payments (direct

charging of a customer’s bank account)

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• Lockboxes is a service offered by banks to companies in which the company receives payments by mail to a post office box and the bank picks up the payments several times a day, deposits them into the company's account, and notifies the company of the deposit. This enables the company to put the money to work as soon as it's received, but the amounts must be large in order for the value obtained to exceed the cost of the service.

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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.

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Note that MNCs commonly monitor the

cash flows between their subsidiaries with

the use of an intersubsidiary payment

matrix.

Example: Exhibit 9.2

Exhibit 9.3

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Exhibit 9.2 Intersubsidiary Payments Matrix

Payments Owed U.S. $ Value (in Thousands ) Owed

by Subsidiary to Subsidiary Located in:

Located in: Canada France Japan Switzerland U.S.

Canada —— 40 90 20 40

France 60 —— 30 60 50

Japan 100 30 —— 20 30

Switzerland 10 50 10 —— 50

U.S. 10 60 20 20 ——

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Exhibit 9.3 Netting Schedule

Net Payments Net U.S. Dollar Value (in Thousands)

to be made owed to Subsidiary

by Subsidiary Located in:

Located in: Canada France Japan Switzerland U.S.

Canada —— 0 0 10 30

France 20 —— 0 10 0

Japan 10 0 —— 10 10

Switzerland 0 0 0 —— 30

U.S. 0 10 0 0 ——

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Managing Blocked Funds• A government may require that funds remain

within the country in order to create jobs and

reduce unemployment.• The MNC should then reinvest the excess funds

in 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.

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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.

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Complicationsin 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.

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Complicationsin Optimizing Cash Flows

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.

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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 (P469 Exhibit 18.4). However, firms must also account for the possible exchange rate movements.

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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. The investment securities may also be denominated in the currencies that will be needed in the future.

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Determining the Effective Yield• The effective rate for foreign investments

rf = ( 1 + if ) ( 1 + ef ) – 1

where if = the quoted interest rate(deposit rate) on the investment

ef = the % in the spot rate

• If the foreign currency depreciates over the investment period, the effective yield will be less than the quoted rate. *(Example: P471-473)

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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.

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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 if the spot rate at maturity is more than the forward rate at the time the investment is undertaken, and vice versa. The key implications of IRP and the forward rate as a predicator of future spot rate for foreign investing are summarized in the following:

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Considerations When Investing Excess Cash

IRP holds? Scenario Type of investment Investment yield

Yes Covered Similar Yes Forward rate accurately Uncovered Similar predicts future spot rate

Yes Forward rate forecasts future Uncovered Similar on

spot rate with no bias average Yes Forward rate overestimates Uncovered Lower future spot rate

Yes Forward rate underestimates Uncovered Higher future spot rate

No Forward premium(discount) Covered Higher exceeds (is less than) interest rate differential

No Forward premium (discount) Covered Lower is less than (exceeds) interest rate differential

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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. (Example:P475)• 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. (Example:P475-477)

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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.

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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.

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Topics for Class Discussion

• Should international cash management be conducted at the subsidiary level or at the centralized level?

Elaborate.• What is the use of netting to an MNC?• How can firm deal with blocked funds?• Assume that as a treasurer of a U.S. corporation, you believe that the British pound’s forward rate is an accurate forecast of the pound’s future spot rate. What does this imply about your decision of whether to invest cash in the U.S. or in the U.K.?

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Questions and Applications

*1. Discuss the general functions involved in

International Cash Management.

*2. What is “netting” and how can it improve

an MNC’s performance?

*3. How can an MNC implement leading and

lagging techniques to help subsidiaries in

need of funds?

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*4. How can a centralized cash management

system be beneficial to the MNC?

5. Evansville, Inc., has $2 million in cash

available for 90 days. It is considering

the use of covered interest arbitrage, since the

euro’s 90-day interest rate is higher than the

U.S. interest rate. What will determine whether

this strategy is feasible?

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6. Dallas Co. Has determined that the interest rate on euros is 16 percent while the U.S. interest rate is 11 percent for one-year treasury bills. The one-year forward rate of the euro has a discount of 7 percent. Does interest rate parity exist? Can Dallas achieve a higher effective yield by using covered interest arbitrage than by investing in U.S. Treasury bills? Explain.

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7. Fort Collins, Inc., has $1 million in cash available for 30 days. It can earn 1 percent on a 30-day investment in the United States. Alternatively, if it converts the dollar to Mexican pesos, it can earn 1½ percent on a Mexican deposit. The spot rate of the Mexican Peso is $.12. The spot rate 30 days from now is expected to be $.10. Should Fort Collins invest its cash in the United States or in Mexico? Substantiate your answer.

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8. Assume that the one-year U.S. interest rate is 10 percent and the one-year Canadian interest rate is 13 percent. If a U.S. firm invests its funds in Canada, by what percentage will the Canadian dollar have to depreciate to make its effective yield the same as the U.S. interest rate from the U.S. firm’s perspective?

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9. Pittsburgh Co. Plans to invest its excess cash in Mexican pesos for one year. The one-year Mexican interest rate is 19 percent. The probability of the peso’s percentage change in value during the next year is shown below: Possible Rate of Change in the Mexican Peso over Probability of the Life of the Investment Occurrence -15% 20% - 4% 50% 0 30%

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What is the expected value of the effective yield based on this information? Given that the U.S. interest rate for one year is 7 percent, what is the probability that a one- year investment in pesos will generate a lower effective yield than could be generated if Pittsburgh Co. simply invested domestically?

International Financial Management 9

Documents

investing excess cashuse

intersubsidiary cash flows

cash flow analysis

exchange rate movements

exchange rate fluctuations

international cash management

covered interest arbitrage

centralized cash management