Management of the Short

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Management of the Short-Term Investment Portfolio

A major task of international cash management is to determine the levels and currency

denominations of the multinational groups investment in cash balances and money

market instruments. Firms with seasonal or cyclical cash flows have special problems,

such as spacing investment maturities to coincide with projected needs. To manage,

this investment properly requires (a) a forecast of future cash needs based on the

companys current budget and past experience and (b) an estimate of a minimum cash

position for the coming period. Successful management of an MNCs required cash

balances and of any excess funds generated by the firm and its affiliates depends

largely on the astute selection of appropriate short-term money market instruments.

Rewarding opportunities exist in many countries, but the choice of an investment

medium depends on government regulations, the structure of the market, and the tax

laws, all of which vary widely. Available money instruments differ among the major

markets, and at times, foreign firms are denied access to existing investmentopportunities. Only a few markets, such as the broad and diversified U.S. market and

the Eurocurrency markets, are truly free and international. Common-sense guidelines

for globally managing the marketable securities portfolio are as follows.

Diversify the instruments in the portfolio to maximize the yield for a given level of risk.

Dont invest only in government securities. Eurodollar and other instruments may be

nearly as safe.

Review the portfolio daily to decide which securities should be liquidated and what new

investment should be made.

In revising the portfolio, make sure that incremental interest earned more than

compensates for such added costs clerical work, the income lost between investments,

fixed charges such as the foreign exchange spread, and commission on the sale and

purchase of securities.

If rapid conversion to cash is an important consideration, then carefully evaluate the

securitys marketability (liquidity). Ready markets exist for some securities, but not for

others.

Tailor the maturity of the investment to the firms projected cash needs. Or a secondarymarket with high liquidity should exist.

Carefully consider opportunities for covered or uncovered interest arbitrage Accounts Receivable as Collateral

Pledging accounts receivable occurs when accounts receivable are used ascollateral for a loan.


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After investigating the desirability and liquidity of the receivables, banks willnormally lend between 50 and 90 percent of the face value of acceptable

receivables.

In addition, to protect its interests, the lender files a lien on the collateral and ismade on a non-notification basis (the customer is not notified).

Factoring accounts receivable involves the outright sale of receivables at adiscount to a factor.

Factors are financial institutions that specialize in purchasing accountsreceivable and may be either departments in banks or companies that

specialize in this activity.

Factoring is normally done on a notification basis where the factor receivespayment directly from the customer.

Inventory as CollateralThe most important characteristic of inventory as collateral is its

marketability.

Perishable items such as fruits or vegetables may be marketable, but since the

cost of handling and storage is relatively high, they are generally notconsidered to be a good form of collateral.

Specialized items with limited sources of buyers are also generally considerednot to be desirable collateral.

A floating inventory lien is a lenders claim on the borrowers general inventoryas collateral.

This is most desirable when the level of inventory is stable and it consists of adiversified group of relatively inexpensive items.

Because it is difficult to verify the presence of the inventory, lenders generally

advance less than 50% of the book value of the average inventory and charge 3

to 5 percent above prime for such loans.

A trust receipt inventory loan is an agreement under which the lenderadvances 80 to 100 percent of the cost of a borrowers relatively expensive

inventory in exchange for a promise to repay the loan on the sale of each item.

The interest charged on such loans is normally 2% or more above prime andare often made by a manufacturers wholly-owned subsidiary (captive finance

company).

Good examples would include GE Capital and GMAC.A warehouse receipt loan is an arrangement in which the lender receives

control of the pledged inventory which is stored by a designated agent on the

lenders behalf.

The inventory may stored at a central warehouse (terminal warehouse) or on

the borrowers property (field warehouse).Regardless of the arrangement, the lender places a guard over the inventory

and written approval is required for the inventory to be released.

Costs run from about 3 to 5 percent above prime.

3.2.2 Short-term finance


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Short-term sources of finance include overdrafts, short-term bank loans andtrade credit. An overdraft is an agreement by a bank to allow a company toborrow up to a certain limit without the need for further discussion. The companywill borrow as much or as little as it needs up to the overdraft limit and the bankwill charge daily interest at a variable rate on the debt outstanding. The bank may

also require security or collateral as protection against the risk of non-payment bythe company. An overdraft is a flexible source of finance in that a company onlyuses it when the need arises. However, an overdraft is technically repayable ondemand, even though a bank is likely in practice to give warning of its intention towithdraw agreed overdraft facilities. A short-term loan is a fixed amount of debtfinance borrowed by a company from a bank, with repayment to be made in thenear future, for example after one year. The company pays interest on the loan ateither a fixed or a floating (i.e. variable) rate at regular intervals, for examplequarterly. A short-term bank loan is less flexible than an overdraft, since the fullamount of the loan must be borrowed over the loan period and the companytakes on the commitment to pay interest on this amount, whereas with an

overdraft interest is only paid on the amount borrowed, not on the agreedoverdraft limit. As with an overdraft, however, security may be required as acondition of the short-term loan being granted.

Trade credit is an agreement to take payment for goods and services at a laterdate than that on which the goods and services are supplied to the consumingcompany. It is common to find one, two or even three months credit beingoffered on commercial transactions and trade credit is a major source of short-term finance for most companies.

Short-term sources of finance are usually cheaper and more flexible than long-term ones. Short-term interest rates are usually lower than long-term interestrates, for example, and an overdraft is more flexible than a long-term loan onwhich a company is committed to pay fixed amounts of interest every year.However, short-term sources of finance are riskier than long-term sources fromthe borrowers point of view in that they may not be renewed (an overdraft is,after all, repayable on demand) or may be renewed on less favorable terms (e.g.when short-term interest rates have increased).

Another source of risk for the short-term borrower is that interest rates are morevolatile in the short term than in the long term and this risk is compounded iffloating rate short-term debt (such as an overdraft) is used. A company mustclearly balanceprofitabilityand riskin reaching a decision on how the funding ofcurrent and noncurrent assets is divided between long-term and short-termsources of funds.

Why Do Firms Need Short-term Financing? Cash flow from operations may not be sufficient to keep up with growth-related

financing needs. Firms may prefer to borrow now for their inventory or other short term asset

needs rather than wait until they have saved enough. Firms prefer short-term financing instead of long-term sources of financing due

to: easier availability


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usually has lower cost (remember yield curve) matches need for short term assets, like inventory

Relationship to domestic financial management

In recent years, there has been abundance of researches in the area of

international corporate finance. The major thrust of these works has been to apply the

methodology and rationale of financial economics as a strategy to take key international

financial decisions. Critical problem areas, such as foreign exchange risk management

and foreign investment analysis, have benefited from the insights provided by financial

economics-a discipline that emphasizes the use of economic analysis to understand the

basic workings of financial markets, particularly the measurement and pricing of risk and

the inter- temporal allocation of funds.

By focusing on the behavior of financial markets and their participants, rather

than on how to solve specific problems, we can derive fundamental principles of

valuation and develop from them superior approaches to financial management-much

as a better understanding of the basic laws of physics leads to better-designed and -

functioning products. We can also better gauge the validity of existing approaches to

financial decision making by seeing whether their underlying assumptions are

consistent with our knowledge of financial markets and valuation principles.

Three concepts arising in financial economics have proved to be of particular

importance in developing a theoretical foundation for international corporate finance:

arbitrage, market efficiency, and capital asset pricing.

Arbitrage


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Arbitrage has traditionally been defined as the purchase of securities or

commodities on one market for immediate resale on another in order to profit from a

price discrepancy. However, in recent years, arbitrage has been used to describe a

broader range of activities. Tax arbitrage, for example, involves the shifting of gains or

losses from one tax jurisdiction to another in order to profit from differences in tax rates.

In a broader context, risk arbitrage or speculation, describes the process that leads to

equality of risk-adjusted returns on different securities, unless market imperfections that

hinder this adjustment process exist. In fact, it is the process of arbitrage that ensures

market efficiency.

Market Efficiency

An efficient market is one in which the prices of traded securities readily

incorporate new information. Numerous studies of U.S. and foreign capital markets

have shown that traded securities are correctly priced in that trading rules based on

past prices or publicly available information cannot consistently lead to profits (after

adjusting for transactions costs) in excess of those due solely to risk taking.

The predictive power of markets lies in their ability to collect in one place a mass

of individual judgments from around the world. These judgments are based on current

information. If the trend of future policies changes people will revise their expectations,

and price will change to incorporate the corporate with the new information.

Capital Assets Pricing


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Capital asset pricing refers to the way in which securities are valued in line with

their anticipated risks and returns. Because risk is such an integral element of

international financial decisions, this section briefly summarizes the results of over two

decades of study on the pricing of risk in capital markets. The outcome of this research

has been to show a specific relationship between risk (measured by return variability)

and required asset return, which is needed now to be formalized in the capital asset

pricing model (CAPM).

The CAPM assumes that the total variability of an asset's returns can be

attributed to two sources: (1) market-wide influences that affect all assets to some

extent, such as the state of the economy, and (2) other risks that are specific to a given

firm, such as a strike. The former type of risk is usually termed as systematic or non-

diversifiable risk, and the latter, unsystematic or diversifiable risk. It can be shown that

unsystematic risk is largely irrelevant to the highly diversified holder of securities

because the effects of such disturbances cancel out, on average, in the portfolio. On the

other hand, no matter how well diversified a stock portfolio is, systematic risk, by

definition, cannot be eliminated, and thus the investor must be compensated for bearing

this risk. This distinction between systematic risk and unsystematic risk provides the

theoretical foundation for the study of risk in the multinational corporation.

Identification and analysis of political risks

Broadly speaking, there are three types of political risk Transfer risk, Operational risk and

Ownership Control risk. Transfer risks arise due to government restrictions on transfer ofcapital, people, technology and other resources in and out of the country. Operational risks

result when government policies constrain the firms operations and decision-making

processes. These include pricing and financing restrictions, export commitments, taxes and

local sourcing requirements. Ownership control risks are due to government policies or actions

that impose restrictions on the ownership or control of local operations. These include limits on

foreign equity stakes.

Macro political risk analysis

At a macro-level, MNCs should review major political decisions or events that could affect

enterprises across the country on an ongoing basis. One important event which business


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leaders monitor closely is elections. Political swings to the left are normally bad for business.

Some companies closely align themselves with the ruling party. When the opposition comes to

power, they face problems. The M A Chidambaram group in the south Indian state of Tamil

Nadu is a good example. The group, which supports a local political party runs into problems

when the other main political grouping returns to power. Regions where political unrest iscommon are best avoided by MNCs. This is especially applicable to parts of the Middle East,

eastern Europe and Africa and more recently, countries like Indonesia. In Islamic countries, the

probability of moderate governments being supplanted by extremist regimes must be carefully

evaluated.

Micro political risk analysis

Companies need to understand how government policies will influence certain sectors of the

economy. Examples include specific regulations, taxes, local content laws and media restrictions.

Businesses may be given preferential treatment based on the priorities of the government. It is agood idea to understand these priorities and explain to the government how the companys

policies are consistent with these priorities. The C P group in China is a good example. Its

expansion of poultry operations in China has been consistent with the governments policies ofimproving protein off-take and general health among the population and generating rural

employment opportunities. Similarly PepsiCo, while entering India gave an assurance to the

government that it would develop processed food industries in Punjab, along with its corebeverages business. This was a decisive factor in getting the approval for entry into a crucial

emerging market.

Country risk assessment

A country analysis examines three different areas:

a) Economic and social performance

b) The countrys goals and policies

c) The political, institutional, ideological, physical and international context.

(See Appendix at the end of the chapter for details of Euromoneys country risk ratings.)

Under economic performance, the following parameters are generally important:

Balance of payments

Currency movements

GDP growth

Inflation Savings rates

Unemployment

Wage costs

Under social performance, the following factors are usually considered:

Distribution of income


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Educational achievements literacy percentage and number of average years of

schooling

Life expectancy

Migration

Nutrition standards

Population growth Public health

The goals of a country have to be understood by analysing the behavior of political

leaders including their decisions. The following government policies must be examined in detail:

Fiscal policy

Foreign policy

Foreign trade and investment policies

Industrial policy

Monetary policy

Social policiesIn the political context, the following factors are important:

Mechanisms for transition of power

Key power blocs

Extent of popular support for the government

Degree of consensus in policy making

The processes through which political differences are resolved

In the institutional context, the important parameters to be considered include:

Independence of the judiciary and the executive

Competence and honesty of bureaucrats and senior government officials

Importance of informal power networks outside the government

Structure, technology, management practices and financial strength of business

institutions

Labour conditions, including pattern of unionisation and collective bargaining practices

In the ideological context, one must consider the following:

The rights and duties of the members of society

Whether there is a broad consensus

Serious ideological tensions

The countrys performance must be measured, against its own past performance, the

performance of other countries and the goals of the government. A performance which falls

short of goals and is poor in relation to the performance of competing countries will result in

demand for changes in policies. It will also produce tensions in the political leadership. Analysts

must also look for inconsistencies between strategy and context and examine the quality of


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political leadership in the country. If the performance of the political leadership is poor, the key

factors behind the poor performance must be identified.

Specific methods of reducing country risk

Keeping control of crucial elements of operations

Maintaining close control of key operations can force the government into a state of dependence

on the firm. This method may however, not be sustainable beyond a point of time. In the long

run, local people may pick up skills. Also, the host government may feel that such skills can bepurchased for a price from other sources.

Proactive approach to planned divestment

One way to prevent government interference is to give an assurance that ownership will be

handed over partially or completely to local people in a phased manner. This helps the company

to generate goodwill and win the support of the government.

Joint ventures

Joint ventures can minimise expropriation risk as the local partners usually do not take kindly to

the interference of the local government. However, if expropriation means more ownership orcontrol for the local partner, it may mean muted local opposition. Moreover, excessive

dependence on the local partner, to manage political risk is not desirable. Even if the local

partner has excellent relations with the government, problems could still arise, if governments

change after elections, or there is a military coup or political unrest.

Local debt

By raising debt in the host country, the risk of expropriation can be minimised. However,

countries with high political risk often tend to be ones with poorly developed capital markets or asmall base of equity holders. Consequently, mobilisation of capital in the local markets, may be

difficult beyond a point.

Integrative and defensive strategies to manage political risk

Integrative approaches

Develop good communication channels with the host government.

Make expatriates familiar with the language, customs and culture of the host country.

Make extensive use of locals to run the operations. Be prepared to renegotiate the contract, if the local government considers it to be

unfair.

Invest in projects of local importance, such as education.

Use joint ventures to make the locals feel a part of the firm.

Follow fair, open and accurate financial reporting practices.

Defensive approaches


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Source key components from outside to ensure continued dependence on the firm.

Use as few host-country nationals as possible in key positions.

Select joint venture partners from more than one country. The host government may bereluctant to offend many governments simultaneously.

Make full use of intellectual property rights such as patents and copyrights to protect

proprietary technology. Raise as much equity and debt as possible from the host country

Insist on host government guarantees wherever possible.

Keep local retained earnings to the minimum.

3.2 INTERNATIONAL CASH MANAGEMENT IN A MULTINATIONAL FIRM

Cash management is an important aspect of working capital management andprinciples of domestic and international cash management are the same. Thebasic difference between the two is, international cash management is wider in

scope and is more complicated because it has to consider the principles andpractices of other countries. The cash management is mainly concerned withthe cash balances, including marketable securities, are held partly to allownormal day-to-day cash disbursements and partly to protect against un-anticipated variations from budgeted cash flows. These two motives are calledthe transaction motive and precautionary motive. Cash disbursement foroperations is replenished from two sources: Internal working capital turnover

Short-term borrowings.

The efficient cash management is mainly concerned with to reduce cash tied upunnecessarily in the system, without diminishing profit or increasing risk so asto increase the rate of return on capital employed. The main objectives of cashmanagement are:(i) How to manage and control the cash resources of the company as quickly

and efficiently as possible.(ii) To achieve the optimum and conservation of cash.

The first objective of international cash management can be achieved byimproving the cash collections and disbursements with the help of accurateand timely forecast of the cash flow. The second objective of international cash

management can be achieved by minimising the required level of cash balancesand increasing the risk adjusted return on capital employed.

Both the objectives mentioned above conflict each other because minimisingtransaction costs of currency convers would require that cash balances be keptin the currency in which they have been received which conflicts with both thecurrency and political exposure criteria. The key to developing an optimumsystem is centralised of cash management.


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3.3 CENTRALISATION OF CASH MANAGEMENT SYSTEM

Centralisation of cash management refers to centralisation of information,reports and decision-making process as to cash mobilisation, movement andinvestment of cash. Centralised cash management system will benefit the

multinational firm in the following ways: Maintaining minimum cash balance during the year. Helpful to generate maximum possible returns by investing all cash

resources. To manage the liquidity requirements of the centre. Helpful to take complete benefits of bilateral netting and multinational

netting for reducing transaction costs. Helpful in utilising the various hedging strategies to minimise the foreign

exchange exposure. Helpful to get the benefit of transfer pricing mechanism to enhance the

profitability of the firm.

The international cash management requires achieving the two basicobjectives:i) Optimising cash flow movements andii) Investing excess cash

3.4.4 Using netting to reduce overall transaction costs

Netting is a technique of optimising cash flow movements with the joint effortsof subsidiaries. Netting is, in fact, the elimination of counter payments. This

means that only net amount is paid. For example, if the parent company is toreceive US $ 6.0 million from its subsidiary and if the same subsidiary is to getUS $ 2.0 million from the parent company, these two transactions can benetted to one transaction where the subsidiary will transfer US $ 4.00 millionto the parent company. If the amount of these two payments is equal, there willbe no movements of funds, and transaction cost will reduce to zero. Theprocess involves the reduction of administration and transaction costs thatresult from currency conversion. Netting is of two types: (i) Bilateral nettingsystem; and (ii) Multinational netting system.

3.4.5 Bilateral netting system

A bilateral netting system involves transactions between the parent and a subsidiary orbetween two subsidiaries. For example, US parent and the German affiliate have to receive net

$ 40,000 and $ 30,000 from one another. Thus, under a bilateral netting system, only one

payment will be made the German affiliate pays the US parent an amount equal to $ 10,000

(Fig. 3.1).

3.4.6 Multinational netting system


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A multinational netting system involves a move complex interchange among the parent and its

several affiliates but it results in a considerable saving in exchange and transfer costs. Under

this system, each affiliate nets all its interaffiliate receipts against all its disbursements. It then

transfers or receives the balance, depending on whether it is a net receiver or a payer. To make

a multinational netting system effective, it needs the services of a centralised communicationsystem and discipline on the part of subsidiaries involved. Consider an example of multinational

netting system, subsidiary X sells $ 20 million worth of goods to subsidiary Y, subsidiary Y sells $

20 million worth of goods to subsidiary Z and subsidiary Z sells $ 20 million worth of goods to

subsidiary X. In this case, multinational netting would eliminate interaffiliate fund transfers

completely (Fig. 3.2).

INVESTING SURPLUS CASH

The other important function of international cash management is investing

surplus cash. The Eurocurrency market helps in investing and accommodatingexcess cash in the international money market. Investment in foreign marketshas been made much simpler and easier due to improved telecommunicationsystems and integration among money markets in various countries. Severalaspects of short-term investing by an MNC need further clarification namely-(i) Should an MNC develop a centralised cash-management strategy whereby

excess funds with the individual subsidiaries are pooled together ormaintain a separate investment for all subsidiaries.

(ii) Where to invest the excess funds once the MNC has used whatever excessfunds were needed to cover financing needs.

(iii) May it be worthwhile for an MNC to diversify its portfolio of securities

across countries with different currency denominations because the MNCis not very sure as to how exchange rates will change over time.3.6.4 Cash budgetsCash budgets are central to the management of cash. They show expected cashinflowsand outflows over a budget period and highlight anticipated cash surpluses and deficits.Their preparation assists managers in the planning of borrowing and investment,and facilitates the control of expenditure. Computer spreadsheets allow managers toundertake what if analysis to anticipate possible cash flow difficulties as well as toexamine possible future scenarios. To be useful, cash budgets should be regularlyupdated by comparing estimated figures with actual results, using a rolling cash budget

system. Significant variances from planned figures must always be investigated.

3.6.2 Optimum cash levelsGiven the variety of needs a company may have for cash and the different reasons itmay have for holding cash, the optimum cash level will vary both over time andbetween companies. The optimum amount of cash held by a company will depend onthe following factors:

forecasts of the future cash inflows and outflows of the company;


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the efficiency with which the cash flows of the company are managed;the availability of liquid assets to the company;the borrowing capability of the company;the companys tolerance of risk, or risk appetite.

Management of the Short

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