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Chapter 21


International Cash Management 

21 

  Chapter 

South-Western/Thomson Learning � 2003


B21 - 2  

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.

B21 - 3  

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

B21 - 4  

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.
 

Cash Flow Analysis: 
Subsidiary Perspective


B21 - 5  

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.
 

Cash Flow Analysis: 
Subsidiary Perspective


B21 - 6  

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.
 

Cash Flow Analysis: 
Subsidiary Perspective


B21 - 7  

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


B21 - 8  

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.

B21 - 9  

Cash Flow of the Overall MNC 
 

Subsidiary 

Short-Term

Securities 

Long-Term

Projects 
 

Parent 

Cash Dividends 

Sources

of Debt 

Stock-

holders 
 

Subsidiary 

Funds for

Supplies 

Interest &/or Principal 

Loans or Investment 

Fees & Earnings 

Excess Cash 

Fees & Earnings 

Excess Cash 

Interest &/or Principal 

Loans or Investment 

Purchase 

Sale 

Long-Term

Investment 

Return on

Investment 

Loans 

Repayment 

New Issues


B21 - 10  

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 impacts.

B21 - 11  

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 (direct charging of a customer’s bank account).

B21 - 12  

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


B21 - 13  

Intersubsidiary Payments Matrix 

                       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  –– 

Thousands of US$ Owed to Subsidiary in: 

Payments

Matrix 

                       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  –– 

Net Thousands of US$ Owed: 

Netting

Schedule


B21 - 14  

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.
 

Techniques to Optimize 
Cash Flows


B21 - 15  

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


B21 - 16  

Complications 
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.

B21 - 17  

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


B21 - 18  

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.

B21 - 19  

Short-Term Interest Rates 

U.K. 

Japan 

Canada 

Germany 

U.S.


B21 - 20  

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.
 

Investing Excess Cash


B21 - 21  

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 % D in the spot rate

  • If the foreign currency depreciates over the investment period, the effective yield will be less than the quoted rate.
 

Investing Excess Cash


B21 - 22  

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


B21 - 23  

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.
 

Investing Excess Cash


B21 - 24  

Use of the Forward Rate as a Forecast 

* as compared to the yield for domestic investments 

IRP 

holds? 

Investment

yield* 

Type of

Investment 

Scenario 

Yes 

Covered 

Similar 

Forward 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 rate 

Yes 

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 forecasts

future spot rate with no bias 

Yes 

Uncovered 

Similar on

average


B21 - 25  

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


B21 - 26  

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


B21 - 27  

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


B21 - 28  

Impact of International Cash Management 
on an MNC’s Value
 

    E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t

    E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t

    = weighted average cost of capital of the parent 

Returns on International Cash Management


B21 - 29  

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

Chapter Review


B21 - 30  

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

B21 - 31  

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

B21 - 32  

Chapter Review 

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