International Cash Management 21 Chapter South-Western/Thomson Learning © 2003

International Cash ManagementInternational Cash Management

2121 Chapter Chapter

South-Western/Thomson Learning © 2003

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Chapter 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¤ liquidity 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.

• If the sales volume is highly volatile, larger cash balances may need to be maintained in order to cover unexpected inventory 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.

• International cash management can be segmented into two functions:¤ optimizing cash flow movements, and¤ investing excess cash.

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Cash Flow of the Overall MNC

Subsidiary

Short-TermSecurities

Long-TermProjects

Parent

Cash Dividends

Sourcesof Debt

Stock-holders

Subsidiary

Funds forSupplies

Interest &/or Principal

Loans or Investment

Fees & Earnings

Excess Cash

Fees & Earnings

Excess Cash

Interest &/or Principal

Loans or Investment

Purchase

Sale

Long-TermInvestment

Return onInvestment

Loans

Repayment

New Issues

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• 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 impacts.

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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 mail float) and preauthorized payments (direct charging of a customer’s bank account).

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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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Intersubsidiary Payments Matrix

Canada France Japan Switzerland U.S.

Canada –– 40 90 20 40France 60 –– 30 60 50Japan 100 30 –– 20 30Switzerland 10 50 10 –– 50U.S. 10 60 20 20 ––

Thousands of US$ Owed to Subsidiary in:

PaymentsMatrix

Canada France Japan Switzerland U.S.

Canada –– 0 0 10 30France 20 –– 0 10 0Japan 10 0 –– 10 10Switzerland 0 0 0 –– 30U.S. 0 10 0 0 ––

Net Thousands of US$ Owed:NettingSchedule

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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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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.

Complicationsin Optimizing Cash Flows

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Investing Excess Cash

• Excess funds can be invested in domestic or foreign short-term securities, such as Eurocurrency deposits, bills, and commercial papers.

• Sometimes, foreign short-term securities have higher interest rates. However, firms must also account for the possible exchange rate movements.

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Short-Term Interest Rates

0

5

10

15

20

25

1978 1982 1986 1990 1994 1998 2002

0

5

10

15

20

25

1978 1982 1986 1990 1994 1998 2002

U.K.

Japan

Canada

Germany U.S.

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• 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 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.


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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.


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Use of the Forward Rate as a Forecast

* as compared to the yield for domestic investments

IRP holds?

Investment yield*

Type of InvestmentScenario

Yes Covered SimilarForward rate accurately

predicts future spot rate

Yes Uncovered Similar

Forward rate over-estimates future spot

rate

Yes Uncovered Lower

Forward rate under-estimates future spot

rateYes Uncovered Higher

Forward premium(discount)

exceeds (is less than)interest rate differential

No Covered Higher

Forward premium (discount)

is less than (exceeds)interest rate differential

No Covered Lower

Forward rate forecastsfuture spot rate with no

biasYes Uncovered Similar on

average

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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.

• 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.


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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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• Current interest rates and exchange rates are available at http://www.bloomberg.com/.

• Interest rate and exchange rate forecasts can be found at http://biz.yahoo.com/ifc/.

Online Application

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Impact of International Cash Managementon an MNC’s Value

n

tt

m

jtjtj

k1=

1 , ,

1

ER ECF E

= Value

E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period tE (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period tk = weighted average cost of capital of the parent

Returns on International Cash Management

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• Cash Flow Analysis: Subsidiary Perspective¤ Subsidiary Expenses¤ Subsidiary Revenue¤ Subsidiary Dividend Payments¤ Subsidiary Liquidity Management

• Centralized Cash Management

Chapter Review

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Chapter Review

• Techniques to Optimize Cash Flows¤ Accelerating Cash Inflows¤ Minimizing Currency Conversion Costs¤ Managing Blocked Funds¤ Managing Intersubsidiary Cash Transfers

• Complications in Optimizing Cash Flows¤ Company-Related Characteristics¤ Government Restrictions¤ Characteristics of Banking Systems

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Chapter Review

• Investing Excess Cash¤ How to Invest Excess Cash¤ Centralized Cash Management¤ Determining the Effective Yield¤ Implications of Interest Rate Parity¤ Use of the Forward Rate as a Forecast¤ Use of Exchange Rate Forecasts¤ Diversifying Cash Across Currencies¤ Use of Dynamic Hedging to Manage Cash

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Chapter Review

• Impact of International Cash Management on an MNC’s Value

Documents

International Cash Management 21 Chapter South-Western/Thomson Learning © 2003