Working Capital Management for the Multinational Corporation

International Financial Management

Learning Objectives How does multinational working capital management

differ from domestic working capital management? What are the objectives of international cash

management? What techniques are used by MNCs for making

cross-border payments? What key factors are associated with a firm’s funding

strategy? What short-term financing options are available?

Multinational Working Capital Management

Funds Availability Additional Risks Movement of Capital Decisions Taxes

International Cash Management A set of activities, which consists of:

Cash management - the levels of cash balances held throughout the MNC -

Cash settlements and processing - the facilitation of its movement across borders

Cash Management Cash levels are determined independently of working

capital management decisions Cash balances, including marketable securities, are held partly for

day-to-day transactions and to protect against unanticipated variations from budgeted cash flows

These two motives are called the transaction motive and the precautionary motive.

International Cash Management Goal: Minimize cash balances without reducing operations or

increasing risk. Steps:

Cash Planning - anticipating cash flows over future days, weeks, or months.

Cash Collection – getting cash into the firm as soon as possible. Cash Mobilization – moving cash within the firm to the location where

needed. Cash Disbursements – planning procedures for distributing cash. Covering Cash Shortages – managing anticipated cash shortages by

borrowing locally. Investing Surplus Cash – managing anticipated cash surpluses by

investing locally or controlling them centrally.

Cash Positioning Decision Currency of location

Type of liquid asset held

Maturities, yields, and liquidity characteristics

Objectives of an Effective Cash Management System

Minimizing overall cash requirements Minimizing currency exposure risk Minimizing political risk Minimizing transactions costs Taking full advantage of economies of

scale

Complexities of the International Cash Positioning Decision

Conflicting nature of cash management objectives

Government restrictions Multiple taxation systems Multiple currencies

International Cash Settlementsand Processing

Four techniques for simplifying and lowering the cost of settling cash flows between related and unrelated firms Wire transfers Cash pooling Payment netting Electronic fund transfers

Wire Transfers Variety of methods but two most popular for cash

settlements are CHIPS and SWIFT CHIPS is the Clearing House Interbank Payment System owned

and operated by its member banks SWIFT is the Society for Worldwide Interbank Financial

Telecommunications which also facilitates the wire transfer settlement process

Whereas CHIPS actually clears transactions, SWIFT is purely a communications system

Cash Pooling and Centralized Depositories

Key: Centralizing the cash positioning function to gain operational benefits. Subsidiaries hold minimum cash for their own transactions and no cash for

precautionary purposes All excess funds are remitted to a central cash depository

Centralized depositories provide the following advantages: Information advantage is attained by central depository on currency movements

and interest rate risk Precautionary balance advantages as MNC can reduce pool without any loss in

level of protection Interest rate advantages as funds can be borrowed at a lower cost and invested at a

more advantageous rate. Location can provide tax benefits, access to international communications, clearly

defined legal procedures.

Multilateral Netting Netting involves offsetting receivables against

payables so that only the net amounts are transferred among affiliates.

Types Bilateral netting Multilateral netting

Payments netting is useful primarily when a large number of separate foreign exchange transactions occur between subsidiaries.

Payments Netting Example: A Belgian affiliate owes an Italian affiliate $5,000,000,

while the Italian affiliate simultaneously owes the Belgian affiliate $3,000,000. Bilateral settlement calls for $2,000,000 payment from Belgium to Italy

and cancellation of the remainder via offset. Multilateral netting is an extension of bilateral netting.

Assume that payments are due between Apex’s European operations each month.

Without netting Apex de France would make three separate transactions each way.

Financing Working Capital Financing working capital requirements of

a MNC’s foreign affiliates poses a complex decision problem.

Financing options for a subsidiary include: Intercompany loans from the parent or a sister

affiliate. Local currency financing.

Key Factors Underlying the Funding Strategy

Interest Rate Without forward contracts With forward contracts

Exchange Risk Degree of Risk Aversion Taxes Political Risk

Financing Objectives Minimize covered after-tax interest costs Minimize expects costs Trade-off between expected cost and

reducing the degree of cash flow exposure

Intercompany Loans The cost of an intercompany loan is

determined by the following factors: Opportunity cost of funds Interest rate Tax rates and regulations Currency of denomination Expected exchange rate change

Local Currency Financing Bank Loans

Term Loans Line of Credit Overdraft Revolving Credit Agreement Discounting

Commercial Paper

Effective Interest Rate on Bank Loans

Simple interest loan Discount loan Loan with compensating balance

requirement Simple interest loan Discount loan

Effective Annual Percentage Cost Illustration

The Olivera Corporation, a manufacturer of olive oil products, needs to acquire €1 million in funds today to expand a pimiento-stuffing facility. Banca di Roma has offered them a choice of an 11% loan payable at maturity or a 10% loan on a discount basis. Which loan should Olivera choose?

Calculating the Dollar Costs of Alternative Financing Options

In deciding on a particular financing option, a firm needs to estimate and then compare the effective after-tax dollar costs of local currency financing and dollar financing. In reality, the value of the currency borrowed will most likely

change with respect to the borrower’s local currency over time. Breakeven analysis can be used to determine the least expensive

financing source for each future exchange rate.

Effective Financing Rate: No Taxes

Suppose that Ford has an affiliate in Mexico, which can borrow pesos at 80% or dollars at 12% for one year. If the peso is expected to devalue from MP$ 7.50/$ at the

beginning of the year to MP$ 10.23/$ at the end of the year, what is the expected before-tax dollar cost of the peso loan?

What is the cost of the dollar loan to Ford? What is the breakeven rate of currency change at which the dollar

cost of borrowing pesos is just equal to the cost of dollar financing?

Effective Financing Rate: No Taxes

Dollar cost of local currency (LC) loan rH (LC) = rL (1 + c) + c

Cost of dollar loan (HC) rH (HC) = rH

Breakeven rate of currency change rL (1 + c) + c = rH

Effective Financing Rate: With Taxes

Suppose the Mexican corporate tax rate is 53%. What is the expected after-tax dollar cost of borrowing pesos? What is the expected after-tax cost of the dollar loan? What is the breakeven rate of currency change at which the after-

tax dollar cost of local currency financing is just equal to the after-tax cost of dollar financing?

Effective Financing Rate: With Taxes

After-tax dollar cost of borrowing local currency rH (LC) = rL (1 - Ta)(1 + c) + c

After-tax cost of dollar loan rH (HC) = rH (1 - Ta) + cTa

Breakeven rate of currency change rL(1 - Ta)(1 + c) + c = rH(1 - Ta) + cTa