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

2. C21 - 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.

3. C21 - 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

4. C21 - 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

5. C21 - 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

6. C21 - 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

7. C21 - 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

8. C21 - 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.

9. C21 - 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

10. C21 - 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.

11. C21 - 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).

12. C21 - 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

13. C21 - 13 Intersubsidiary Payments Matrix Canada France Japan Switzerland U.S. Canada––40902040 France60 ––306050 Japan10030 ––2030 Switzerland105010 ––50 U.S.10602020 –– Thousands of US$ Owed to Subsidiary in: Payments Matrix Canada France Japan Switzerland U.S. Canada––001030 France20 ––0100 Japan100 ––1010 Switzerland000 ––30 U.S.01000 –– Net Thousands of US$ Owed: Netting Schedule

14. C21 - 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

15. C21 - 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

16. C21 - 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.

17. C21 - 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

18. C21 - 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.

19. C21 - 19 Short-Term Interest Rates U.K. Japan Canada Germany U.S.

20. C21 - 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

21. C21 - 21 Determining the Effective Yield The effective rate for foreign investments r f = ( 1 + i f ) ( 1 + e f ) – 1 wherei f =the quoted interest rate on the investment e f =the %  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

22. C21 - 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

23. C21 - 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

24. C21 - 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 Uncovere d 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

25. C21 - 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

26. C21 - 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

27. C21 - 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

28. C21 - 28 Current interest rates and exchange rates are available at http://www.bloomberg.com/.http://www.bloomberg.com/ Interest rate and exchange rate forecasts can be found at http://biz.yahoo.com/ifc/.http://biz.yahoo.com/ifc/ Online Application

29. C21 - 29 Impact of International Cash Management on an MNC’s Value E (CF j,t )=expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ER j,t )=expected exchange rate at which currency j can be converted to dollars at the end of period t k=weighted average cost of capital of the parent Returns on International Cash Management

30. C21 - 30 Cash Flow Analysis: Subsidiary Perspective ¤ Subsidiary Expenses ¤ Subsidiary Revenue ¤ Subsidiary Dividend Payments ¤ Subsidiary Liquidity Management Centralized Cash Management Chapter Review

31. C21 - 31 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

32. C21 - 32 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

33. C21 - 33 Chapter Review Impact of International Cash Management on an MNC’s Value