Chapter 9

International Cash Management


This chapter emphasizes the decisions involved in management of cash by an MNC. The additional opportunities and risks of cash management for an MNC versus a domestic firm should be stressed. The specific objectives are:


• 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.

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


Cash Flow Analysis: Subsidiary Perspective
Subsidiary Expenses • International purchases of raw materials or supplies are more likely to be difficult to manage because of exchange rate fluctuations, quotas, etc. a larger inventory is thus required by MNC compared with domestic firms. • If the sales volume is highly volatile, larger cash balances may need to be maintained in order to cover unexpected demands.

Cash Flow Analysis: Subsidiary Perspective
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
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
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.


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. (Exhibit 9.1) • International cash management can be segmented into two functions:
– optimizing cash flow movements, and – investing excess cash.

Exhibit 9.1 Cash Flow of the Overall MNC
Interest and Principal on Excess Cash Invested by Subsidiary Loans or Investment Purchase of Securities Funds Received from Sales of Securities

Fees and Part

Short-term Securities

Subsidiary ―1‖
Funds for Supplies Funds for Supplies

of Earnings

Long-term Investment Excess Cash to be Invested Excess Cash to be Invested
Fees and Part of Earnings Return on Investment Loans Repayment on Loans Funds Received from New Stock Issues

Long-term Projects


Sources of Debt

Subsidiary ―2‖

Cash Dividends 10

Loans or Investment Interest and principal on Excess Cash Invested by Subsidiary

Centralized Cash Management
• The centralized cash management division of an MNC cannot always accurately forecast the events that may 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 impact.

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 mailing time) and preauthorized payments (direct charging of a customer’s bank account)

Techniques to Optimize Cash Flows
• Lockboxes is a service offered by banks to companies in which the company receives payments by mail to a post office box and the bank picks up the payments several times a day, deposits them into the company's account, and notifies the company of the deposit. This enables the company to put the money to work as soon as it's received, but the amounts must be large in order for the value obtained to exceed the cost of the service.

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.

Techniques to Optimize Cash Flows
Note that MNCs commonly monitor the cash flows between their subsidiaries with the use of an intersubsidiary payment matrix. Example: Exhibit 9.2 Exhibit 9.3


Exhibit 9.2 Intersubsidiary Payments Matrix
Payments Owed U.S. $ Value (in Thousands ) Owed U.S. 40 50 30 50 ——

by Subsidiary to Subsidiary Located in: Located in: Canada France Japan Switzerland Canada —— 40 90 20 France 60 —— 30 60 Japan 100 30 —— 20 Switzerland 10 50 10 —— U.S. 10 60 20 20


Exhibit 9.3 Netting Schedule
Net Payments Net U.S. Dollar Value (in Thousands)

to be made owed to Subsidiary by Subsidiary Located in: Located in: Canada France Japan Switzerland U.S. Canada —— 0 0 10 30 France 20 —— 0 10 0 Japan 10 0 —— 10 10 Switzerland 0 0 0 —— 30 U.S. 0 10 0 0 ——

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. • 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
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.

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.

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.


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 (P469 Exhibit 18.4). However, firms must also account for the possible exchange rate movements.

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. The investment securities may also be denominated in the currencies that will be needed in the future.

Investing Excess Cash
Determining the Effective Yield • The effective rate for foreign investments
where rf = ( 1 + if ) ( 1 + ef ) – 1 if = the quoted interest rate(deposit 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 quoted rate. *(Example: P471-473)

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.

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 if the spot rate at maturity is more than the forward rate at the time the investment is undertaken, and vice versa. The key implications of IRP and the forward rate as a predicator of future spot rate for foreign 26 investing are summarized in the following:

Considerations When Investing Excess Cash
IRP holds? Scenario Type of investment Investment yield

Yes Yes
Yes Yes Yes No No

Forward rate accurately

Covered Uncovered

Similar Similar
Similar on average Lower Higher Higher Lower

predicts future spot rate Forward rate forecasts future Uncovered

spot rate with no bias
Forward rate overestimates future spot rate Forward rate underestimates future spot rate Forward premium(discount) exceeds (is less than) interest rate differential

Uncovered Uncovered Covered

Forward premium (discount) Covered is less than (exceeds) interest rate


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. (Example:P475) • 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. (Example:P475-477)

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.

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.

Topics for Class Discussion
• Should international cash management be conducted at the subsidiary level or at the centralized level? Elaborate. • What is the use of netting to an MNC? • How can firm deal with blocked funds? • Assume that as a treasurer of a U.S. corporation, you believe that the British pound’s forward rate is an accurate forecast of the pound’s future spot rate. What does this imply about your decision of whether to invest cash in the U.S. or in the U.K.?

Questions and Applications
*1. Discuss the general functions involved in International Cash Management. *2. What is “netting” and how can it improve an MNC’s performance? *3. How can an MNC implement leading and lagging techniques to help subsidiaries in need of funds?

Questions and Applications
*4. How can a centralized cash management system be beneficial to the MNC? 5. Evansville, Inc., has $2 million in cash available for 90 days. It is considering the use of covered interest arbitrage, since the euro’s 90-day interest rate is higher than the U.S. interest rate. What will determine whether this strategy is feasible?

Questions and Applications
6. Dallas Co. Has determined that the interest rate on euros is 16 percent while the U.S. interest rate is 11 percent for one-year treasury bills. The one-year forward rate of the euro has a discount of 7 percent. Does interest rate parity exist? Can Dallas achieve a higher effective yield by using covered interest arbitrage than by investing in U.S. Treasury bills? Explain.

Questions and Applications
7. Fort Collins, Inc., has $1 million in cash available for 30 days. It can earn 1 percent on a 30-day investment in the United States. Alternatively, if it converts the dollar to Mexican pesos, it can earn 1½ percent on a Mexican deposit. The spot rate of the Mexican Peso is $.12. The spot rate 30 days from now is expected to be $.10. Should Fort Collins invest its cash in the United States or in Mexico? Substantiate your answer.

Questions and Applications
8. Assume that the one-year U.S. interest rate is 10 percent and the one-year Canadian interest rate is 13 percent. If a U.S. firm invests its funds in Canada, by what percentage will the Canadian dollar have to depreciate to make its effective yield the same as the U.S. interest rate from the U.S. firm’s perspective?

Questions and Applications
9. Pittsburgh Co. Plans to invest its excess cash in Mexican pesos for one year. The one-year Mexican interest rate is 19 percent. The probability of the peso’s percentage change in value during the next year is shown below: Possible Rate of Change in the Mexican Peso over Probability of the Life of the Investment Occurrence -15% 20% - 4% 50% 0 30%

Questions and Applications
What is the expected value of the effective yield based on this information? Given that the U.S. interest rate for one year is 7 percent, what is the probability that a oneyear investment in pesos will generate a lower effective yield than could be generated if Pittsburgh Co. simply invested domestically?

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