Lecture 27 International Cash Management Chapter Objectives n

Lecture 27 International Cash Management

Chapter Objectives n To explain the difference in analyzing cash flows from a subsidiary perspective versus a parent perspective; n To explain the various techniques used to optimize cash flows; n To explain common complications in optimizing cash flows; and n To explain the potential benefits and risks of foreign investments. 21 - 2

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. 21 - 3

Cash Flow Analysis: Subsidiary Perspective • 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. 21 - 4

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. 21 - 5

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 parentsubsidiary and intersubsidiary cash flows. • International cash management can be segmented into two functions: ¤ optimizing cash flow movements, and ¤ investing excess cash. 21 - 6

Cash Flow of the Overall MNC Interest &/or Principal Purchase Loans or Investment Sale Fees & Earnings Short-Term Securities Long-Term Investment Subsidiary Excess Cash Return on Long-Term Investment Projects Funds for Supplies Parent Loans Subsidiary Excess Cash Sources of Debt Repayment Fees & Earnings Loans or Investment Interest &/or Principal New Issues Stockholders Cash Dividends 21 - 7

Centralized Cash Management • The centralized cash management division of an MNC cannot always accurately forecast the events that affect parentsubsidiary 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. 21 - 8

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). 21 - 9

Techniques to Optimize Cash Flows 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. 21 - 10

Intersubsidiary Payments Matrix & Netting Schedule 21 - 11

Techniques to Optimize Cash Flows 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. 21 - 12

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. 21 - 13

• Source: Adopted from South. Western/Thomson Learning © 2006 21 - 14

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. 21 - 15

Complications in 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. ¤ 21 - 16

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. 21 - 17

Short-Term Interest Rates as of February 2004 21 - 18

Investing Excess Cash 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. 21 - 19

Investing Excess Cash Centralized Cash Management • 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. 21 - 20

Investing Excess Cash 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 % D in the spot rate • If the foreign currency depreciates over the investment period, the effective yield will be less than the interest rate. 21 - 21

Investing Excess Cash 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. 21 - 22

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 shortterm 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. 21 - 23

Use of the Forward Rate as a Forecast 21 - 24

Investing Excess Cash 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. 21 - 25

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 will be more rewarding. 21 - 26

Use of Probability Distributions 21 - 27

Probability Distribution of Effective Yield 21 - 28

Investing Excess Cash 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. 21 - 29

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. 21 - 30