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International Cash ManagementInternational Cash Management

2121ChapterChapter

South-Western/Thomson Learning 2003


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Chapter Objectives

To explain the difference between asubsidiary perspective and a parent

perspective in analyzing cash flows;

To explain the various techniques used tooptimize cash flows;

T

o explain common complications inoptimizing cash flows; and

To explain the potential benefits and risksof foreign investments.


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Cash Flow Analysis:

Subsidiary Perspective

The management of working capital has adirect 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 materialsor supplies are more likely to be difficult

to manage because of exchange rate

fluctuations, quotas, etc.

If the sales volume is highly volatile, largercash balances may need to be maintained

in order to cover unexpected inventory

demands.

Cash Flow Analysis:



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Subsidiary Revenue

International sales are more likely to bevolatile because of exchange rate

fluctuations, business cycles, etc.

Looser credit standards may increase

sales (accounts receivable), though oftenat the expense of slower cash inflows.

Cash Flow Analysis:



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Subsidiary Dividend Payments

Forecasting cash flows will be easier if thedividend payments and fees (royalties and

overhead charges) to be sent to the parent

are known in advance and denominated in

the subsidiarys currency.

Cash Flow Analysis:



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Subsidiary Liquidity Management

After accounting for all cash outflows andinflows, the subsidiary must either invest

its excess cash or borrow to cover its

cash deficiencies.

If the subsidiary has access to lines ofcredit and overdraft facilities, it may

maintain adequate liquidity without

substantial cash balances.

Cash Flow Analysis:



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Centralized Cash Management

While each subsidiary is managing its ownworking capital, a centralized cash

management group is needed to monitor,and possibly manage, the parent-

subsidiary and intersubsidiary cash flows.

International cash management can besegmented into two functions: optimizing cash flow movements, and

investing excess cash.


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The centralized cash management divisionof 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 Optimize

Cash Flows

Accelerating Cash Inflows

The more quickly the cash inflows arereceived, the more quickly they can be

invested or used for other purposes.

Common methods include the

establishment oflockboxes around theworld (to reduce mail float) and

preauthorized payments (direct charging

of a customers bank account).


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Minimizing Currency Conversion Costs

Nettingreduces administrative andtransaction costs through the accounting

of all transactions that occur over a period

to determine one net payment.

A bilateral netting system involvestransactions between two units, while a

multilateral netting system usually

involves more complex interchanges.


Cash Flows


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Managing Blocked Funds

A government may require that fundsremain within the country in order to

create jobs and reduce unemployment.

The MNC should then reinvest the excess

funds in the host country, adjust thetransfer pricing policy (such that higher

fees have to be paid to the parent), borrow

locally rather than from the parent, etc.


Cash Flows


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Managing Intersubsidiary Cash Transfers

A subsidiary with excess funds canprovide financing by paying for its

supplies earlier than is necessary. This

technique is called leading.

Alternatively, a subsidiary in need offunds can be allowed to lag its payments.

This technique is called lagging.


Cash Flows


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Complications

in Optimizing Cash Flows

Company-Related Characteristics

When a subsidiary delays its payments to

the other subsidiaries, the othersubsidiaries 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 amongcountries.

The banking systems in different countries

usually differ too.

Complications

in Optimizing Cash Flows


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Investing Excess Cash

Excess funds can be invested in domesticor foreign short-term securities, such as

Eurocurrency deposits, bills, andcommercial papers.

Sometimes, foreign short-term securities

have higher interest rates. However, firmsmust also account for the possible

exchange rate movements.


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Centralized cash management allows formore efficient usage of funds and possibly

higher returns.

When multiple currencies are involved, a

separate pool may be formed for eachcurrency. 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 theinvestment

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 interestrate will normally exhibit a forward

discount that reflects the differential

between its interest rate and the investors

home interest rate.

However, short-term foreign investing onan 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 usedas 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 theforward rate at the time the investment is

undertaken, and vice versa.



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Use of Exchange Rate Forecasts

Given an exchange rate forecast, theexpected effective yield of a foreign

investment can be computed, and then

compared with the local investment yield.

It may be useful to use probabilitydistributions 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 exchangerates 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 willreduce risk depends on the correlations

among the currencies.



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Use of DynamicHedging to Manage Cash

Dynamic hedging refers to the strategy ofhedging when the currencies held are

expected to depreciate, and not hedging

when they are expected to appreciate.

The overall performance is dependent onthe firms ability to accurately forecast the

direction of exchange rate movements.



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Impact of International Cash Managementon an MNCs Value

? A

v!

n

tt

j

tjtj

k1=

1

,,

1

ERECFE

=V l

E (CFj,t) = expected cash flows in currencyjto be received

by the U.S. parent at the end of period t

E (ERj,t) = expected exchange rate at which currencyjcan

be converted to dollars at the end of period t

k = weighted average cost of capital of the parent

Returns on InternationalCash Management


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Cash Flow Analysis: SubsidiaryPerspective

Subsidiary Expenses Subsidiary Revenue

Subsidiary Dividend Payments

Subsidiary Liquidity Management


Chapter Review


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Chapter Review

Techniques to Optimize Cash FlowsAccelerating 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 Managementon an MNCs Value

Documents

International Cash Management_1