Lecture

11
International Cash Management

South-Western/Thomson Learning © 2006

 Chapter Objectives
 To explain the difference in
analyzing cash flows from a subsidiary
perspective versus a parent perspective;
 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.
• 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.

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 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.
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 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.
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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
Interest &/or Principal Purchase
Loans or Investment Sale Short-Term
Securities
Fees & Earnings
Long-Term
Subsidiary Excess Cash Investment
Return on Long-Term
Investment Projects
Funds for
Supplies Parent
Loans Sources
of Debt
Subsidiary Excess Cash Repayment
Fees & Earnings
New Issues Stock-
Loans or Investment
holders
Interest &/or Principal Cash Dividends
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 Centralized Cash Management
• The centralized cash management division
of an MNC cannot always accurately
forecast the events that 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 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).

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 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.

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Intersubsidiary Payments Matrix & Netting Schedule

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 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.

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 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.

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 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.
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 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.

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 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.

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Short-Term Interest Rates
as of February 2004

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 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.

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 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.

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 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.
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 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.

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 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 short-
term 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.

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Use of the Forward Rate as a Forecast

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 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.

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 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.
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Use of Probability Distributions

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Probability Distribution of Effective Yield
UK interest rate = 11%

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 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.

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 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.

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