CAPITAL BUDGETING :

Capital budgeting is a process of evaluating investments and huge expenses in

order to obtain the best returns on investment.
An organization is often faced with the challenges of selecting between two
projects/investments or the buy vsreplace decision. Ideally, an organization would
like to invest in all profitable projects but due to the limitation on the availability of
capital an organization has to choose between different projects/investments.
Capital budgeting is a company’s formal process used for evaluating potential
expenditures or investments that are significant in amount. It involves the decision
to invest the current funds for addition, disposition, modification or replacement of
fixed assets. The large expenditures include the purchase of fixed assets like land
and building, new equipments, rebuilding or replacing existing equipments,
research and development, etc. The large amounts spent for these types of projects
are known as capital expenditures. Capital Budgeting is a tool for maximizing a
company’s future profits since most companies are able to manage only a limited
number of large projects at any one time.
Capital budgeting usually involves calculation of each project’s future accounting
profit by period, the cash flow by period, the present value of cash flows after
considering time value of money, the number of years it takes for a project’s cash
flow to pay back the initial cash investment, an assessment of risk, and various
other factors.
Some of the management experts have defined capital budgeting in the
following ways:
According to Charles T. Homgreen, “Capital Budgeting is long-term planning for
making and financing proposed capital outlays.”

As per Richards and Greenlaw, “The capital budgeting generally refers to

acquiring inputs and long-run returns.”

In the words of G. C. Philipattos, “Capital budgeting is concerned with the

allocation of the firm’s scarce financial resources among the available market
opportunities. The consideration of investment opportunities involves the
comparison of the expected future streams of earnings from a project; with the
immediate and subsequent stream of expenditures for it.”
According to Joel Dean, “Capital Budgeting is a kind of thinking that is necessary
to design and carry through the systematic programme for investing stockholders’
money.”

From the aforementioned definitions, it can be concluded that capital budgeting is

an important process for any organization.

CAPITAL BUDGETING PROCESS:

A) Project identification and generation:

The first step towards capital budgeting is to generate a proposal for investments.
There could be various reasons for taking up investments in a business. It could be
addition of a new product line or expanding the existing one. It could be a proposal
to either increase the production or reduce the costs of outputs.
B) Project Screening and Evaluation:
This step mainly involves selecting all correct criteria’s to judge the desirability of
a proposal. This has to match the objective of the firm to maximize its market
value. The tool of time value of money comes handy in this step.
Also the estimation of the benefits and the costs needs to be done. The total cash
inflow and outflow along with the uncertainties and risks associated with the
proposal has to be analyzed thoroughly and appropriate provisioning has to be
done for the same.
C) Project Selection:
There is no such defined method for the selection of a proposal for investments as
different businesses have different requirements. That is why, the approval of an
investment proposal is done based on the selection criteria and screening process
which is defined for every firm keeping in mind the objectives of the investment
being undertaken.
Once the proposal has been finalized, the different alternatives for raising or
acquiring funds have to be explored by the finance team. This is called preparing
the capital budget. The average cost of funds has to be reduced. A detailed
procedure for periodical reports and tracking the project for the lifetime needs to be
streamlined in the initial phase itself. The final approvals are based on profitability,
Economic constituents, viability and market conditions.
D) Implementation:
Money is spent and thus proposal is implemented. The different responsibilities
like implementing the proposals, completion of the project within the requisite
time period and reduction of cost are allotted. The management then takes up the
task of monitoring and containing the implementation of the proposals.
E) Performance review:
The final stage of capital budgeting involves comparison of actual results with the
standard ones. The unfavorable results are identified and removing the various
difficulties of the projects helps for future selection and execution of the proposals.

METHODS OF CAPITAL BUDEGETING:

The survival of a business depends upon management’s ability to conceive,

analyze, and select investment opportunities that are profitable. The firm must
select such projects that maximize the returns of the business. Capital budgeting is
the allocation of available resources to various proposals.
It involves estimation of cost and benefits of a proposal, estimation of required rate
of return and evolution of different proposals in order to select one. These cost and
benefits are expressed in terms of cash flows arising out of a proposal. The cash
flows are estimated and are compared to required rate of return; and the proposal
with the optimal return and investment is accepted using the following capital-
budgeting techniques.

1. Traditional Methods:

(a) Payback Method:

This method represents the period in which the total investment in permanent
assets is paid back with the additional earnings generated from the investments.
The firm prefers making investment in that proposal where the capital invested is
recovered as early as possible.
Payback period is defined as the period required for the proposal’s cumulative cash
flows to be equal to its cash outflows. The payback period is usually stated in
terms of number of years, it is the period for a proposal to “break even” on its net
investment.
The payback period can be ascertained in the following manner:
i. Calculate annual net earnings (profits) before depreciation and after taxes; these
are called annual cash inflows.
ii. Divide the initial cost of the project by the annual cash inflow, where the project
generates constant annual cash inflows.
Thus, PBP = Cash outlay (cost) of the project/Annual cash inflows
iii. Where the annual cash inflows are unequal, the cash flows are added up until
the total is equal to the initial cash outlay of the project.

Advantages:
1. A company can have more favorable short-run effects on earnings per share by
setting up a shorter payback period.

2. The riskiness of the project can be tackled by having a shorter payback period as
it may ensure guarantee against loss.

3. As the emphasis in pay back is on the early recovery of investment, it gives an

insight to the liquidity of the project.

Limitations:
1. It fails to take account of the cash inflows earned after the payback period.

2. It is not an appropriate method of measuring the profitability of an investment

project, as it does not consider the entire cash inflows yielded by the project.

3. It fails to consider the pattern of cash inflows, i.e., magnitude and timing of cash
inflows.

4. Administrative difficulties may be faced in determining the maximum

acceptable payback period.

(b) Rate of Return Method (ARR):

Rate of return method is also known as accounting rate of return or average rate of
return. It is based on the concept of rate of return. It measures the return on the
project with regard to investment required for the project. The return is measured
in terms of the average profit earned by the project over the duration of the project.
APR = (Average annual profit (after tax) x 100)/Average investment in the project
Average profit = Average accounting profit earned over the project duration
= Total of annual profit earned over the duration/Number of years of project
duration
Average Investment:
It is the average investment/amount of fund that remained invested or blocked in
the project over its economic life.
= ½ (Initial cost + Installation expenses – Salvage value) + Salvage value +
Additional working capital if required

Advantages:
1. It is very simple to understand and use.

2. It can be readily calculated using the accounting data.

3. It uses the entire stream of incomes in calculating the accounting rate.

Limitations:
1. It uses accounting, profits, not cash flows in appraising the projects.

2. It ignores the time value of money; profits occurring in different periods are
valued equally.

3. It does not consider the lengths of projects lives.

4. It does not allow for the fact that the profit can be reinvested.

(c)Post payback profitability method

By considering major drawback of payback period method, one more method is
suggested i.e. Post Payback Profitability. Under this method, the cash inflows after
payback period is taken into account for considering the profitability of the project.
It can be calculated in the following manners.
 Post Payback Profitability = Annual Cash Inflow (Estimated Life— Payback
Period)
The above formula is used if there is even cash inflow. In the case of uneven cash
inflows, the following formula is used.

Post Payback Profitability = Total Annual Cash Flows – Initial Investment

Post Pay-back Period method takes into account the period beyond the pay-back
method. This method is also known as Surplus Life over Pay-back method.

According to this method, the project which gives the greatest post pay-back
period may be accepted. The method can be employed successfully where the
various projects under consideration do not differ significantly as to their size and
the expected cash inflows are even throughout the life of the project.

2. Time-Adjusted or Discounted Cash Flow Methods:

Time-adjusted methods take into account the profitability and also the time value
of money unlike in the traditional methods.
These methods are popular in the modern days and also known as discounted cash
flow methods.
The traditional techniques of pay back and ARR cannot be regarded as sound and
efficient techniques. These techniques do not consider the total benefits emanating
from a proposal. They ignore the time value of money. Investment decision
techniques based on discounted cash flows replace accounting income with cash
flows.
They explicitly consider the time value of money. These techniques are also called
the present values techniques and fulfill all the requisites of a good evaluation
technique.
Cash flows occurring at different points of time do not have the same economic
worth. Cash flows that occur earlier in time are worth more than cash flows that
occur later on account of factors such as inflation and interest rates. These cash
flows must be discounted with reference to the time gap between different cash
flows and a predetermined discount rate.
a. Net Present Value Method:
The net present value method is a modern method of evaluating investment
proposals. This method takes into consideration the time value of money and
attempts to calculate the return on investments by introducing the factor of time
element. It recognizes the fact that a rupee earned today is worth more than the
same rupee earned tomorrow.

The net present values of all inflows and outflows of cash occurring during the
entire life of the project is determined separately for each year by discounting these
flows by the firm’s cost of capital or a pre-determined rate.

Steps to Be Followed for Adopting Net Present Value Method:

The following are necessary steps to be followed for adopting the net present
value method of evaluating investment proposals:

(i) First of all determine an appropriate rate of interest that should be selected as
the minimum required rate of return called ‘cut -off rate or discount rate. The rate
should be a minimum rate of return below which the investor considers that it does
not pay him to invest. The discount rate should be either the actual rate of interest
in the market on long-term loans or it should reflect the opportunity cost of capital
of the investor.

(ii) Compute the present value of total investment outlay, i.e. cash outflows at the
determined discount rate. If the total investment is to be made in the initial year,
the present value shall be the same as the cost of investment.

(iii) Compute the present values of total investment proceeds,/.e., cash inflows,
(profit before depreciation and after tax) at the above determined discount rate

(iv Calculate the net present value of each project by subtracting the present value
of cash inflows from the present value of cash outflows for each project.
(v) If the net present value is positive or zero, i.e, when present value of cash
inflows either exceeds or is equal to the present values of cash outflows, the
proposal may be accepted. But in case the present value of inflows is less than the
present value of cash outflows, the proposal should be rejected.

(vi)To select between mutually exclusive projects, projects should be ranked in

order of net present values, i.e. the first preference should be given to the project
having the maximum positive net present value.

Merits of the Net Present Value Method:

The advantages of the net present value method of evaluating investment
proposals are as follows:

(1) It recognizes the time value of money and is suitable to be applied in a situation
with uniform cash outflows and uneven cash inflows or cash flows at different
periods of time.

(2) It takes into account the earnings over the entire life of the project and the true
profitability of the investment proposal can be evaluated.

(3) It takes into consideration the objective of maximum profitability.

Demerits of the Net Present Value Method:

The net present value method suffers from the following limitations:

(1) As compared to the traditional methods, the net present value method is more
difficult to understand and operate.

(2) It may not give good results while comparing projects with unequal lives as the
project having higher net present value but realized in a longer life span may not be
as desirable as a project having something lesser net present value achieved in a
much shorter span of life of the asset.

(3) In the same way as above, it may not give good results while comparing
projects with unequal investment of funds.
(4) It is not easy to determine an appropriate discount rate.

b. Internal Rate of Return Method:

The internal rate of return method is also a modern technique of capital budgeting
that takes into account the time value of money. It is also known as ‘time adjusted
rate of return’ discounted cash flow’ ‘discounted rate of return,’ ‘yield method,’
and ‘trial and error yield method’.

In the net present value method the net present value is determined by discounting
the future cash flows of a project at a predetermined or specified rate called the
cut-off rate. But under the internal rate of return method, the cash flows of a
project are discounted at a suitable rate by hit and trial method, which equates the
net present value so calculated to the amount of the investment.

Under this method, since the discount rate is determined internally, this method is
called as the internal rate of return method. The internal rate of return can be
defined as that rate of discount at which the present value of cash-inflows is equal
to the present value of cash outflows.

The following steps are required to practice the internal rate of return
method:
(1) Determine the future net cash flows during the entire economic life of the
project. The cash inflows are estimated for future profits before depreciation but
after taxes.

(2) Determine the rate of discount at which the value of cash inflows is equal to the
present value of cash outflows. This may be determined as explained after step (4).

(3) Accept the proposal if the internal rate of return is higher than or equal to the
minimum required rate of return, i.e. the cost of capital or cut off rate and reject the
proposal if the internal rate o return is lower than the cost of cut-off rate.
(4) In case of alternative proposals select the proposal with the highest rate of
return as long as the rates are higher than the cost of capital or cut-off-rate.

Determination of Internal Rate of Return (IRR):

(a) When the annual net cash flows are equal over the life of the asset:
Firstly, find out present value factor by dividing initial outlay (cost of the
investment) by annual cash flow, i.e.,

Then consult present value annuity tables given at the end of the book as Appendix
B with the number of years equal to the life of the asset and find out the rate at
which the calculated present value factor is equal to the present value given in the
table.

b) When the annual cash flows are unequal over the life of the asset:
In case annual cash flows are unequal over the life of the asset, the internal rate of
return cannot be determined according to the technique suggested above. In such
cases, the internal rate of return is calculated by hit and trial and that is why this
method is also known as hit and trial yield method.

We may start with any assumed discount rate and find out the total present value of
cash outflows which is equal to the cost of the initial investment where total
investment is to be made in the beginning. The rate, at which the total present
value of all cash inflows equals the initial outlay, is the internal rate of return.
Several discount rates may have to be tried until the appropriate rate is found.

The calculation process may be summed up as follows:

(i) Prepare the cash flow table using an arbitrary assumed discount rate to discount
the net cash flows to the present value.

(ii) Find out the Net Present Value by deducting from the present value of total
cash flows calculated in (i) above the initial cost of the investment.
(iii) If the Net Present Value (NPV) is positive, apply higher rate of discount.

(iv) If the higher discount rate still gives a positive net present value, increase the
discount rate further until the NPV becomes negative.

(v) If the NPV is negative at this higher rate, the internal rate of return must be
between these two rates:

Advantages of Internal Rate of Return Method

The internal rate of return method has the following advantages:
(i) Like the net present value method, it takes into account the time value of money
and can be usefully applied in situations with even as well as un even cash flow at
different periods of time.

(ii) It considers the profitability of the project for its entire economic life and hence
enables evaluation of true profitability.

(iii) The determination of cost of capital is not a pre-requisite for the use of this
method and hence it is better than net present value method where the cost of
capital cannot be determined easily.

(iv) It provides for uniform ranking of various proposals due to the percentage rate
of return.

(v) This method is also compatible with the objective of maximum profitability
and is considered to be a more reliable technique of capital budgeting.

Disadvantages of Internal Rate of Return Method:

In-spite of so many advantages, it suffers from the following drawbacks:

(i) It is difficult to understand and is the most difficult method of evaluation of

investment proposals.

(ii) This method is based upon the assumption that the earnings are reinvested at
the internal rate of return for the remaining life of the project, which is not a
justified assumption particularly when the average rate of return earned by the firm
is not close to the internal rate of return. In this sense, Net Present Value method
seems to be better as it assumes that the earnings are reinvested at the rate of firm’s
cost of capital.

(iii) The results of NPV method and IRR method may differ when the projects
under evaluation differ in their size, life and timings of cash flows.

c. Profitability Index or Benefit Cost Ratio:

It is the relationship between present value of cash inflows and the present value of
cash outflows that is measured.
Thus,
Profitability index = Present value of cash inflow/Present value of cash outflow
PI = PV of cash inflows/Initial cash outlay
PI may be found for net present values of inflows.
The proposal with PI more than one is accepted, and is rejected if PI is less than
one.

Advantages of profitability index

1. PI considers the time value of money.

2. PI considers analysis all cash flows of entire life.

3. PI makes the right in the case of different amount of cash outlay of different
project.

4. PI ascertains the exact rate of return of the project.

Disadvantages Of Profitability Index (PI)

1. It is difficult to understand interest rate or discount rate.

2. It is difficult to calculate profitability index if two projects having different
useful life.

d. Terminal Value Method:

The terminal value method is an improvement over the net present value method of
making capital investment decisions. Under this method, it is assumed that each of
the future cash flows is immediately reinvested in another project at a certain
(hurdle) rate of return until the termination of the project.

In other words, the net cash flows and outlays are compounded forward rather than
discounting them backward as followed in net present value (NPV) method. In
case of a single project, the project is accepted if the present value of the total of
the compounded reinvested cash inflows is greater than the present value of the
outlays, otherwise it is rejected. In case of mutually exclusive projects, the project
with higher present value of the total of the compounded cash flows is accepted.

The terminal value method can be further extended to calculate the Terminal Rate
of Return (also called Modified Internal Rate of Return) to overcome the
shortcomings of the internal rate of return (IRR) method. The terminal rate of
return is the compound rate of return, that, when applied to the initial outlay,
accumulates to the terminal value. This method is presently being used in advanced
countries like U.S.A.

(e) Improvements in Traditional Approach to Payback Method – Discounted

Payback Period:
To overcome the limitations of the traditional approach, improvements to the
method with regard to cash inflows-generated post-payback period and time value
of money are made.
Under this method present value of cash outflows and future cash inflows are
computed at an appropriate discount rate. The project which gives discounted
payback period is accepted.
IMPORTANCE OF CAPITAL BUDGETING DECISIONS

Capital budgeting decisions are of paramount importance in financial decision. The

profitability of a business concern depends upon the level of investment made for
long period. Moreover, the investments are made properly through evaluating the
proposals by capital budgeting. So it needs special care. In this context, the capital
budgeting is getting importance. Such importances are briefly explained below.

1. Long-term Implications of Capital Budgeting

It implies that capital budgeting decisions are helpful for an organization in the
long run as these decisions have a direct impact on the cost structure and future
prospects of the organization. In addition, these decisions affect the organization’s
growth rate.

Therefore, an organization needs to be careful while making capital decisions as

any wrong decision can prove to be fatal for the organization. For example, over-
investment in various assets can cause shortage of capital to the organization,
whereas insufficient investments may hamper the growth of the organization.

2. Capital budgeting requires large amount of funds:

Capital investment decisions require large amount of funds which the majority of
the firms cannot provide since they have scarce capital resources. As a result, the
investment decisions must be thoughtful, wise and correct. Because, a
wrong/incorrect decision would result in losses and the same prevents the firm
from earning profits from other investments as well due to scarcity of resources.

3. Irreversible decisions

Capital investment decision are not easily reversible without much financial loss to
the firm because there may be no market for second-hand plant and equipment and
their conversion to other uses may not be financially viable. Hence, capital
investment decisions are to be carried out and performed carefully and effectively
in order to save the company from such financial loss. The investment decision
which is undertaken carefully and effectively can save the firm from huge financial
loss aroused due to the selection of unfavorable projects.
4. Risk and uncertainty in Capital budgeting
Capital budgeting decision is surrounded by great number of uncertainties.
Investment is present and investment is future. The future is uncertain and full of
risks. Longer the period of project, greater may be the risk and uncertainty. The
estimates about cost, revenues and profits may not come true.
5. Difficult to make decision in Capital budgeting
Capital budgeting decision making is a difficult and complicated exercise for the
management. These decisions require an over all assessment of future events
which are uncertain. It is really a marathon job to estimate the future benefits and
cost correctly in quantitative terms subject to the uncertainties caused by
economic-political social and technological factors.
6. Large and Heavy Investment
The proper planning of investments is necessary since all the proposals are
requiring large and heavy investment. Most of the companies are taking decisions
with great care because of finance as key factor.
7. Permanent Commitments of Funds
The investment made in the project results in the permanent commitment of funds.
The greater risk is also involved because of permanent commitment of funds.
Capital budgeting decision involves the funds for the long-term. So, it is long-term
investment decision. The long-term commitment of funds leads to the financial
risk. Hence, careful and effective planning is must to reduce the financial risk as
much as possible
8. Long term Effect on Profitability
Capital expenditures have great impact on business profitability in the long run. If
the expenditures are incurred only after preparing capital budget properly, there is
a possibility of increasing profitability of the firm.

9. Complicacies of Investment Decisions

Generally, the long term investment proposals have more complicated in nature.
Moreover, purchase of fixed assets is a continuous process. Hence, the
management should understand the complexities connected with each projects.
10. Maximize the worth of Equity Shareholders
The value of equity shareholders is increased by the acquisition of fixed assets
through capital budgeting. A proper capital budget results in the optimum
investment instead of over investment and under investment in fixed assets. The
management chooses only most profitable capital project which can have much
value. In this way, the capital budgeting maximize the worth of equity
shareholders.

11. Difficulties of Investment Decisions

The long term investments are difficult to be taken because decision extends
several years beyond the current account period, uncertainties of future and higher
degree of risk. Capital investment decisions are, no doubt, the most significant
since they are very difficult to make. It is because of the fact that their assessment
depends on the future uncertain events and activities of the firm. Similarly, it is
practically a difficult task to estimate the accurate future benefits and costs in terms
of money as there are economical, political and technological forces which affect
the said benefits and costs.

12. National Importance

The selection of any project results in the employment opportunity, economic
growth and increase per capita income. These are the ordinary positive impact of
any project selection made by any company.

13. Competitive Position of an Organization:

Refers to the fact that an organization can plan its investment in various fixed
assets through capital budgeting. In addition, capital investment decisions help the
organization to determine its profits in future. All these decisions of the
organization have a major impact on the competitive position of an organization.

14. Cash Forecasting:

It implies that an organization needs a large amount of funds for its investment
decisions. With the help of capital budgeting, an organization is aware of the
required amount of cash, thus, ensures the availability of cash at the right time.
FACTORS INFLUENCING CAPITAL BUDGETING DECISIONS

1. Availability of Funds
All the projects are not requiring the same level of investments. Some projects
require huge amount and having high profitability. If the company does not have
adequate funds, such projects may be given up.

2. Minimum Rate of Return on Investment

Every management expects a minimum rate of return or cut-off rate on capital
investment. It refers to the point of below which a project would not be accepted.

3. Future Earnings
The future earnings may be uniform or fluctuating. Even though, the company
expects guaranteed future earnings in total which affects the choice of a project.

4. Quantum of Profit Expected

It is necessary to assess the quantum of profit expected on implementation of
selected project. Here, the term profit refers to realized amount of projects as per
the accounting records.
5. Cash Inflows
The term cash inflows refer to profit after tax but before depreciation. The reason
is that recording of depreciation is a book entry and there is no actual cash outflow.
Hence, depreciation amount is included in the cash inflow.

6. Legal Compulsions
The management should consider the legal provisions while-selecting a project. In
the case of leather and chemical industries, there are number of legal provisions
created to protect environment pollution. Now, the management gives much
importance to legal provisions rather than cost and profit.

7. Ranking of the Capital Investment Proposal

Sometimes, a company has two or more profitable projects in hand. If there is only
one profitable project out of many and huge amount is available in the hands of
management, there is no need of ranking of capital investment proposal. Ranking
is necessary if there is many profitable projects in hand and limited funds is
available in the hands of management.
8. Degree of Risk and Uncertainty
Every proposal involves certain risk and uncertainty due to economic conditions,
competition, demand and supply conditions, consumer preferences etc. The degree
of risk and uncertainty affects the profitability of the project. Hence, degree of risk
and uncertainty of the project is taken into consideration for selection.
9. Urgency
A project may be selected immediately due to emergency or urgency. The reason is
that such immediate selection saves the life of the company i.e. survival of a
company is the primary importance than other factors.

10. Research and Development Projects

Research and Development project is highly required for technology based
industries. The reason is that there is a lot of changes made within short period in
technology. The research and development project gives more benefits in the long
run. Hence, profitability is getting less importance and survival of business is
getting much importance in the case of research and development project.
11. Obsolescence
The replacement of existing fixed assets is compulsory since there is an
obsolescence of plant and machinery.

12. Competitors Activities

Every company should watch the activities of the competitors. The company
should take a decision by considering the activities of the competitors. If so, the
company can withstand in competition by implementing new projects.
13. Intangible Factors
Goodwill of the company, industries relations, safety and welfare of the employees
are considered while selecting a project instead of considering profit alone. These
factors are also high responsible for selection of any project.
 MULTINATIONAL CAPITAL BUDGETING:

Multinational capital budgeting, like traditional capital budgeting, focuses on cash

inflows and outflows associated with long-term investments. Multinational capital
budgeting techniques are used in foreign direct investment analysis.

Capital budgeting process:

A) Project identification and generation:
The first step towards capital budgeting is to generate a proposal for investments.
There could be various reasons for taking up investments in a business. It could be
addition of a new product line or expanding the existing one. It could be a proposal
to either increase the production or reduce the costs of outputs.

B) Project Screening and Evaluation:

This step mainly involves selecting all correct criteria’s to judge the desirability of
a proposal. This has to match the objective of the firm to maximize its market
value. The tool of time value of money comes handy in this step.
Also the estimation of the benefits and the costs needs to be done. The total cash
inflow and outflow along with the uncertainties and risks associated with the
proposal has to be analyzed thoroughly and appropriate provisioning has to be
done for the same.
C) Project Selection:
There is no such defined method for the selection of a proposal for investments as
different businesses have different requirements. That is why, the approval of an
investment proposal is done based on the selection criteria and screening process
which is defined for every firm keeping in mind the objectives of the investment
being undertaken.
Once the proposal has been finalized, the different alternatives for raising or
acquiring funds have to be explored by the finance team. This is called preparing
the capital budget. The average cost of funds has to be reduced. A detailed
procedure for periodical reports and tracking the project for the lifetime needs to be
streamlined in the initial phase itself. The final approvals are based on profitability,
Economic constituents, viability and market conditions.
D) Implementation:
Money is spent and thus proposal is implemented. The different responsibilities
like implementing the proposals, completion of the project within the requisite
time period and reduction of cost are allotted. The management then takes up the
task of monitoring and containing the implementation of the proposals.
E) Performance review:
The final stage of capital budgeting involves comparison of actual results with the
standard ones. The unfavorable results are identified and removing the various
difficulties of the projects helps for future selection and execution of the proposals

Basic steps of multinational capital budgeting are:

1. Identify the capital put at risk.

2. Estimate the future cash flows generated by the project.

3. Identify the appropriate discount rate.

4. Apply traditional capital budgeting decision criteria such as NPV and IRR to
determine the acceptability or ranking of potential projects.
Factors to Consider in Multinational Capital Budgeting

1. Exchange rate fluctuations. Different scenarios should be considered

together with their probability of occurrence.

2. Inflation. Although price/cost forecasting implicitly considers inflation,

inflation can be quite volatile from year to year for some countries.

3. Ž Financing arrangement. Financing costs are usually captured by the

discount rate. However, many foreign projects are partially financed by
foreign subsidiaries.

4. Blocked funds. Some countries may require that the earnings be reinvested
locally for a certain period of time before they can be remitted to the parent.

5. Uncertain salvage value. The salvage value typically has a significant

impact on the project’s NPV, and the MNC may want to compute the break-
even salvage value.

6. Impact of project on prevailing cash flows. The new investment may

compete with the existing business for the same customers.
 7. Host government incentives. These should also be considered in the analysis.

Complexities of Budgeting for a Foreign Project

• Parent cash flows must be distinguished from project cash flows.

• Parent cash flows often depend on the form of financing which means that
financing cash flows cannot be clearly separated.

• Additional cash flows from a new subsidiary may reduce the cash flows from
another subsidiary.

• Nonfinancial payments such as license fee and import payments can generate
cash flows from subsidiaries.

• Differing rates of national inflation have to be anticipated.

• The possibility of unanticipated changes in foreign exchange rates must be kept
in mind.

• Political risk must be evaluated.

• Terminal value may be hard to estimate because potential buyers may have
different views about the value of the company’s cash flows.

MULTINATIONAL companies are constantly acquiring and disposing of assets

globally in the normal course of business. Shareholder wealth is created when the
MNC makes an investment that will return more (in present value terms) than what
it costs. Among the most important decisions those MNC managers face is the
choice of capital projects globally. These investments will determine the firm's
competitive position in the marketplace, its overall profitability, and, ultimately, its
long-run survival.

Multinational capital budgeting, like domestic capital budgeting, focuses on the

cash flows of prospective long-term investment projects. It is used both in
traditional foreign direct investment analysis, such as the construction of a chain of
retail stores in another country, as well as cross-border mergers and acquisitions
activity. Capital budgeting for a foreign project uses the same net present value
(NPV) discounted cash flow model used in domestic capital budgeting.
However, multinational capital budgeting is considerably more complex due
to a number of additional factors that need to be considered. Some of these
factors are as follows.

Parent versus project cash flows: Parent (that is, home-country) cash flows must
be distinguished from project (that is, host-country) cash flows. While parent cash
flows reflect all cash flow consequences for the consolidated entity, project cash
flows look only at the single country where the project is located. For example,
cash flows generated by an investment in Spain may be partly or wholly taken
away from one in Italy, with the end result that the net present value of the
investment is positive from the Spanish affiliate's point of view but contributes
little to the firm's world-wide cash flows.

Financing versus operating cash flows: In multinational investment projects, the

type of financing package is often critical in making otherwise unattractive projects
attractive to the parent company. Thus, cash may flow back to the parent because
the project is structured to generate such flows via royalties, licensing fees,
dividends, and so on. Unlike in domestic capital budgeting, operating cash flows
cannot be kept separate from financing decisions.

Foreign currency fluctuations: Another added complexity in multinational capital

budgeting is the significant effect that fluctuating exchange rates can have on the
prospective cash flows generated by the investment. From the parent's perspective,
future cash flows abroad have value only in terms of the exchange rate at the date
of repatriation. In conducting the analysis, it is necessary to forecast future
exchange rates and to conduct sensitivity analysis of the project's viability under
various exchange rates scenarios.

Long-term inflation rates: Differing rates of national inflation and their potential
effect on competitiveness must be considered. Inflation will have the following
effects on the value of the project: a) it will impact the local operating cash flows
both in terms of the prices of inputs and outputs and also in terms of the sales
volume depending on the price elasticity of the product, b) it will impact the
parent's cash flow by affecting the foreign exchange rates, c) it will affect the real
cost of financing choices between foreign and domestic sources of capital.

Subsidized financing: In situations where a host government provides subsidised

project financing at below-market rates, the value of that subsidy must be explicitly
considered in the capital budgeting analysis. If a company uses the subsidised rates
in the analysis, there is an implicit assumption that the subsidy will exist through
the life of the project. Another approach might be to incorporate the subsidised
interest rates into the analysis by including the present value of the subsidy rather
than adjusting the cost of capital.

Political risk: This is another factor that can significantly impact the viability and
profitability of foreign projects. Whether it be through democratic elections or as a
result of sudden developments such as revolutions or military coups, changes in a
country's government can affect the attitude in that country towards foreign
investors and investments. This can affect the future cash flows of a project in that
country in a variety of ways. Political developments may also affect the life and the
terminal value of foreign investments.

Terminal values: While terminal values of long-term projects are difficult to

estimate even in the domestic context, they become far more difficult in the
multinational context due to the added complexity from some of the factors
discussed above. An added dimension is that potential acquirers may have widely
divergent perspectives on the value to them of acquiring the terminal assets. This is
particularly relevant if the assets are located in a country that is economically
segmented due to a host of restrictions on cross-border flow of physical or
financial assets.

In conducting multinational capital budgeting analyses from a parent's perspective,

the additional risk arising from projects located abroad can be handled in at least
two ways. One possibility is to add a foreign risk premium to the discount rate that
would be used for a domestic project.

This higher rate is intended to capture the additional uncertainties arising from
exchange risk, political risk, inflation, and such factors. The second possibility is to
adjust the cash flows for the foreign projects to reflect the additional risk. The
discount rate stays the same as for domestic projects.Thus, the additional
complexities resulting from doing business abroad must be incorporated in the
analysis through adjustments to either the discount rate or the projected cash flows.
Rather than make these adjustments arbitrarily, firms can use wide-ranging
publicly available data, historical analysis, and professional advice to make
reasonable decisions.

Input for Multinational Capital Budgeting:

Regardless of the long-term project to be considered, an MNC will normally

require forecasts of the economic and financial characteristics related to the
project. Each of these characteristics is briefly described here:
1. Initial investment. The parent’s initial investment in a project may
constitute the major source of funds to support a particular project. Funds
initially invested in a project may include not only whatever is necessary to
start the project but also additional funds, such as working capital, to support
the project over time. Such funds are needed to finance inventory, wages,
and other expenses until the project begins to generate revenue. Because
cash inflows will not always be sufficient to cover upcoming cash outflows,
working capital is needed throughout a project’s lifetime.

2. Price and consumer demand. The price at which the product could be sold
can be forecasted using competitive products in the markets as a
comparison. A long term capital budgeting analysis requires projections for
not only the upcoming period but the expected lifetime of the project as
well. The future prices will most likely be responsive to the future inflation
rate in the host country (where the project is to take place), but the future
inflation rate is not known. Thus, future inflation rates must be forecasted in
order to develop projections of the product price over time. When projecting
a cash flow schedule, an accurate forecast of consumer demand for a product
is quite valuable, but future demand is often difficult to forecast. For
example, if the project is a plant in Germany that produces automobiles, the
MNC must forecast what percentage of the auto market in Germany it can
pull from prevailing auto producers. Once a market share percentage is
forecasted, projected demand can be computed. Demand forecasts can
sometimes be aided by historical data on the market share other MNCs in the
industry pulled when they entered this market, but historical data are not
always an accurate indicator of the future. In addition, many projects reflect
a first attempt, so there are no predecessors to review as an indicator of the
future.

3. Costs. Like the price estimate, variable-cost forecasts can be developed

from assessing prevailing comparative costs of the components (such as
hourly labor costs and the cost of materials). Such costs should normally
move in tandem with the future inflation rate of the host country. Even if the
variable cost per unit can be accurately predicted, the projected total variable
cost (variable cost per unit times quantity produced) may be wrong if the
demand is inaccurately forecasted. On a periodic basis, the fixed cost may be
 easier to predict than the variable cost since it normally is not sensitive to
changes in demand. It is, however, sensitive to any change in the host
country’s inflation rate from the time the forecast is made until the time the
fixed costs are incurred.

4. Tax laws. The tax laws on earnings generated by a foreign subsidiary or

remitted to the MNC’s parent vary among countries. Under some
circumstances, the MNC receives tax deductions or credits for tax payments
by a subsidiary to the host country (see the chapter appendix for more
details). Withholding taxes must also be considered if they are imposed on
remitted funds by the host government. Because after-tax cash fl ows are
necessary for an adequate capital budgeting analysis, international tax
effects must be determined on any proposed foreign projects.

5. Remitted funds. In some cases, a host government will prevent a

subsidiary from sending its earnings to the parent. This restriction may
reflect an attempt to encourage additional local spending or to avoid
excessive sales of the local currency in exchange for some other currency.
Since the restrictions on fund transfers prevent cash from coming back to the
parent, projected net cash flows from the parent’s perspective will be
affected. If the parent is aware of these restrictions, it can incorporate them
when projecting net cash flows. Sometimes, however, the host government
adjusts its restrictions over time; in that case, the MNC can only forecast the
future restrictions and incorporate these forecasts into the analysis.

6. Exchange rates. Any international project will be affected by exchange

rate fluctuations during the life of the project, but these movements are often
very difficult to forecast. While it is possible to hedge over longer periods
(with long-term forward contracts or currency swap arrangements), the
MNC has no way of knowing the amount of funds that it should hedge. This
is because it is only guessing at its future costs and revenue due to the
project. Thus, the MNC may decide not to hedge the projected foreign
currency net cash flows.
7. Salvage (liquidation) value. The after-tax salvage value of most projects is
difficult to forecast. It will depend on several factors, including the success
of the project and the attitude of the host government toward the project. As
an extreme possibility, the host government could take over the project
without adequately compensating the MNC. Some projects have indefinite
lifetimes that can be difficult to assess, while other projects have designated
specific lifetimes, at the end of which they will be liquidated. This makes the
capital budgeting analysis easier to apply. It should be recognized that the
MNC does not always have complete control over the lifetime decision. In
some cases, political events may force the firm to liquidate the project earlier
than planned. The probability that such events will occur varies among
countries.

8. Required rate of return. Once the relevant cash flows of a proposed

project are estimated, they can be discounted at the project’s required rate of
return, which may differ from the MNC’s cost of capital because of that
particular project’s risk. An MNC can estimate its cost of capital in order to
decide what return it would require in order to approve proposed projects.
The manner by which an MNC determines its cost of capital is discussed in
Chapter 17. Additional considerations will be discussed after a simplifi ed
multinational capital budgeting example is provided. In the real world,
magic numbers aren’t provided to MNCs for insertion into their computers.
The challenge revolves around accurately forecasting the variables relevant
to the project evaluation. If garbage (inaccurate forecasts) is input into the
computer, the analysis output by the computer will also be garbage.
Consequently, an MNC may take on a project by mistake. Since such a
mistake may be worth millions of dollars, MNCs need to assess the degree
of uncertainty for any input that is used in the project evaluation.

Multinational Capital Budgeting Formula

NPV = Net Present Value

i = the required rate of return on the project
n = project lifetime in terms of periods
 SV = Salvage Value
CF0 = Initial investment (cash outlay)
CF1 = Cash Flow of year one
CF2 = Cash Flow of year Two
If NPV > 0, the project can be accepted.

CASH MANAGEMENT OF MNC

Cash Management in an MNC is primarily aimed at minimizing the overall cash

requirements of the firm as a whole without adversely affecting the smooth
functioning of the company and each affiliate, minimizing the currency exposure
risk, minimizing political risk, minimizing the transaction costs and taking full
advantage of the economies of scale as also to avail of the benefit of superior
knowledge of market forces.

However, these objectives are in conflict with each other leading to increased
complexity of the cash management. For instance, minimization of the political
risk involves conversion of all receipts in foreign currencies in the currency of the
home country.

This may, however, go against the interest of the affiliates who need minimum
working capital to be kept in the local currency to meet their operational
requirements.

Further, minimization of transaction costs involved in currency conversions calls

for holding cash balances in the currency in which they are received. In another
respect too, primary objectives are antagonistic to each other. A subsidiary, for
example, may need to carry minimum cash balances in anticipation of future
payments due to the time required to channelize funds to such a country.

Holding of such balances in excess of immediate requirements may ostensibly

impinge on the objective to benefit from economies of scale in earning the highest
possible rate of return from investing these resources.
Another major problem which an MNC faces in managing cash is with respect to
estimation of cash flows emanating out of operations of its affiliates. This problem
arises because of foreign exchange fluctuations.

Similar problem arises in estimating cash inflows stemming out of future sales
because actual volume of sales to overseas buyers depends on foreign exchange
fluctuations. The sales volume of exports is also susceptible to business cycles of
the importing countries.

Uncertainty arises in regard to cash collections from receivables because it is

quality of credit standards that will decide the value of goods sold to be received
back in cash. Liberal credit standards may cause a slow-down in cash inflows from
sales which could offset the benefits of augmented sales.

In view of the above, problems leading to increased uncertainty in estimating cash

flows, the management may be constrained to carry larger amount of cash balances
so as to protect the firm against any crisis. This kind of problem is not encountered
by a domestic firm.

Cash management in an MNC is further complicated by the absence of effective

tools to expedite transfers and by the great variations in the practices of financial
institutions. As such, an international finance manager must exercise great
prudence in forecasting cash flows of the affiliates.

• To explain the difference between subsidiary perspective and a parent

perspective in analyzing the 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.

 Motives for Holding Cash

Definition: The Motives for Holding Cash is simple, the cash inflows and outflows
are not well synchronized, i.e. sometimes the cash inflows are more than the cash
outflows while at other times the cash outflows could be more. Hence, the cash is
held by the firms to meet the certain as well as uncertain situations.

Motives for Holding Cash

Majorly there are three motives for which the firm holds cash.

1. Transaction Motive: The transaction motive refers to the cash required by a firm
to meet the day to day needs of its business operations. In an ordinary course of
 business, the firm requires cash to make the payments in the form of salaries,
wages, interests, dividends, goods purchased, etc.

Likewise, it also receives cash from its sales, debtors, investments. Often the firm’s
cash inflows and outflows do not match, and hence, the cash is held up to meet its
routine commitments.

2. Precautionary Motive: The precautionary motive refers to the tendency of a firm

to hold cash, to meet the contingencies or unforeseen circumstances arising in the
course of business.

Since the future is uncertain, a firm may have to face contingencies such as an
increase in the price of raw materials, labor strike, lockouts, change in the demand,
etc. Thus, in order to meet with these uncertainties, the cash is held by the firms to
have un-interrupted business operations.

3. Speculative Motive: The firms hold cash for the speculative purposes to avail the
benefit of bargain purchases that may arise in the future. For example, if the firm
feels the prices of raw material are likely to fall in the future, it will hold cash and
wait till the prices actually fall.

Thus, a firm holds cash to exploit the possible opportunities that are out of the
normal course of business. These opportunities could be in the form of the low-
interest rate charged on the borrowed funds, expected fall in the raw material
prices or favorable change in the government policies.

Thus, the cash is the most significant and liquid asset that the firm holds. It is
significant as it is used to pay off the firm’s obligations and helps in the expansion
of business operations.

Cash Flow Analysis: Subsidiary Perspective:

Prudent working capital management of an MNC is dependent, inter alia, upon
liquidity management of its affiliates. This, therefore, calls for estimating cash
outflows and inflows periodically to ascertain excess or deficient cash for a period
of time.

Cash outflow by the subsidiary occurs when the latter buys raw materials or
supplies. Cash is also needed to meet the costs incurred in manufacturing goods.
Cash inflow to the subsidiary takes place when sales proceeds are received in cash
and receivables for the goods sold on credit are collected after sometime.

Cash outflow by subsidiary also comprises dividend payments and other fees to be
made periodically to the parent. The level of dividends paid by subsidiaries to the
parent is dependent on liquidity needs, potential uses of funds at various subsidiary
locations, expected movements in the currencies of subsidiaries and host-country
government regulations.

Once estimates of cash outflows and inflows are made, the subsidiary will be in a
position to know about the position of cash surplus or deficit for a particular
period. If cash deficiency is expected, short-term financing is necessary. In case of
excess cash, it must decide how the surplus cash will be used. A firm, it must be
noted, may maintain liquidity without substantial cash balances.

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
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

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:

So as to maintain adequate liquidity without jeopardizing profitability, an MNC
and its subsidiaries carry minimum amount of cash balances to meet transactional
and precautionary demands.

While each subsidiary manages its working capital and reaches its own decision as
to the appropriate level in most of the cases, the affiliates are better equipped to
make a decision as to what constitutes adequate balances in view of their intimate
knowledge of their circumstances.

However, there is a strong need to monitor and manage the cash flows between the
parent and the subsidiaries as also between the individual subsidiaries. This task of
international cash management should, therefore, be delegated to a centralized cash
management group.

Centralization, in this context, does not necessarily entail the pooling of overall
liquid resources, although some degree of pooling would take place, but rather the
centralization of reports, information and most important, the decision-making
process as to cash mobilization, movement and investment outlets.

An effectively designed and managed centralized system has the major advantage
of holding of overall cash balances to the minimum, enabling the MNC to make
fuller utilization of the idle cash and maximize earnings without risking liquidity
throughout the system.

Besides, the centralized system permits the centre to make full utilization of a
multilateral netting system, both inter-affiliate and between the MNC and other
corporations so as to minimize transaction costs and currency exposure and enables
the centre to employ optimally the various hedging strategies available to the firm
so as to ensure enforcement of the MNCs foreign exchange exposure policies.
Above all, with centralized system of cash management, an MNC can make
maximum advantage of the transfer pricing mechanism within the legal and
administrative mechanism and thereby improve the profitability of the corporation.

It may not be always possible for the centralized cash management division of an
MNC to accurately forecast events that affect parent-subsidiary or inter-subsidiary
cash flows. It should, however, be adequately equipped to respond quickly to any
event by considering any potential adverse impact on cash flows and take measures
to avoid such an adverse impact.

It should have sources of funds (credit lines) available to meet the state of cash
strategies and it must have suitable strategies to deploy the excess funds in the
system.

Techniques to Optimize Cash Flows:

1. Accelerating cash inflows

2. Minimizing currency conversion costs

3. Managing blocked funds

4. Managing inter-subsidiary cash transfers

5. Investing excess cash

1. Accelerating Cash Inflows:

Cash inflows can be prompted through quick deposit of customer’s cheques,
establishing collection centers, lock-box method and other devices.

2. Minimizing Currency Conversion Costs:

Cash flow can also be optimized through Netting. Netting involves offsetting
receivables against payables of the various entities so that only the net amounts are
eventually transferred among affiliates. An MNC can also utilize multilateral
netting with outside firms and agencies.
This technique optimizes cash flow by reducing the administrative and transaction
costs arising out of currency conversion. It also reduces unnecessary float, funds
that are in the process of being transferred among affiliates instead of being
invested by the centre.

The process of netting forces tight control over information on transaction between
subsidiaries leading to greater coordination among all subsidiaries to accurately
report and settle their various accounts. Netting also makes cash flows forecasting
easier since only net cash transfers are made at the end of each period, rather than
individual cash transfers throughout the period.

There are two kinds of netting. A bilateral netting system involves transactions
between two units: between the parent and a subsidiary or between two
subsidiaries. A multilateral netting system usually involves a more complex
interchange among the parent and several subsidiaries’.

Multilateral netting system is most useful to MNCs in reducing administrative and

currency conversion costs. Such a system is highly centralized so that all necessary
information’s are consolidated. With the help of the consolidated cash flow
information net cash positions for each pair of units (subsidiaries or whatever) can
be determined and the actual reconciliation at the end of each period can be
dictated.

3. 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

Fundsin the host country, adjust the transfer pricingpolicy (such that higher fees ha
ve to be paid tothe parent), borrow locally rather than from theparent, etc.
4. Managing Inter-subsidiary Cash Transfers:
Through techniques of leading and lagging cash flows can be managed to the
advantage of a subsidiary. For example, firm A needs funds, while firm B has
surplus funds. If A purchases supplies from B and pays for its supplies earlier than
necessary, this technique is called leading.

Alternately, if B sells supplies to A, it could provide financing by allowing A to lag

its payments. The leading or lagging strategy can help in improving efficiency of
cash utilization and thereby reducing debt. Some host governments prohibit this
practice by requiring that a payment between subsidiaries occurs at the time at
which goods are transferred.

MNC management must, therefore, be aware of existence of such prohibitory laws.

Complications in Optimization of Cash Flow:

Flow most complications encountered in optimizing cash flow can be classified
into three categories:

a) Company-related characteristics

b) Government restrictions

c) Characteristics of banking systems

Each complication is discussed in turn.

a) Company-Related Characteristics :

In some cases, optimizing cash flow can become complicated due to characteristics
of the MNC. If one of the subsidiaries delays payments to other subsidiaries for
supplies received, the other subsidiaries may be forced to borrow until the
payments arrive. A centralized approach that monitors all inter-subsidiary
payments should be able to minimize such problems.

b) Government Restrictions :
The existence of government restrictions can disrupt a cash flow optimization
policy. Some governments prohibit the use of a netting system, as noted earlier. In
addition, some countries periodically prevent cash from leaving the country,
thereby preventing net payments from being made. These problems can arise even
for MNCs that do not experience any company-related problems. Countries in
Latin America commonly impose restrictions that affect an MNC’s cash flows.

c) Characteristics of Banking Systems

The abilities of banks to facilitate cash transfers for MNCs vary among countries.
Banks in the United States are advanced in this field, but banks in some other
countries do not offer services. MNCs prefer some form of zero-balance account,
where excess funds can be used to make payments but earn interest until they are
used. In addition, some MNCs benefit from the use of lockboxes. Such services are
not available in some countries. In addition, a bank may not update the MNC’s
bank account information sufficiently or provide a detailed breakdown of fees for
banking services. Without full use of banking resources and information, the
effectiveness of international cash management is limited. In addition, an MNC
with subsidiaries in, say, eight different countries will typically be dealing with
eight different banking systems. Much progress has been made in foreign banking
systems in recent years. As time passes and a more uniform global banking system
emerges, such problems may be alleviated.

5. Investing Excess Cash:

Investing surplus cash in liquid assets such as Euro currency deposits, foreign
treasury bills and commercial paper, etc. is one of the key functions of
international finance manager. While making decision in this regard many crucial
issues merit thorough consideration.

These issues are:

1. Should the excess cash of all subsidiaries be pooled together or remain
separated?

2. How can the effective yield expected from each possible alternative be
determined?
3. What does interest rate parity suggest about short-term financing?

4. Will it be useful to diversify investment among currencies?

These issues shall be discussed in the following paragraphs.

1. Separate or Centralized approach:

While handling the issue regarding deployment of surplus cash, an MNC has to
decide if individual subsidiaries will make separate investments on their own or a
centralized approach will be followed to pool the excess cash from each subsidiary
which will then be converted into a single currency for investment purposes.

However, the advantage of pooling may be offset by the transaction costs involved
in conversion in a single currency. Even then centralized cash management could
be useful.

Alternately, the short-term cash available in each currency could be pooled

together so that there would be a separate pool for each currency. The excess cash
of subsidiaries in a particular currency can still be used to satisfy other subsidiary
deficiencies in that currency. This strategy will save transaction costs of the MNC.

If an MNC is left with excess cash and expects future cash outflows in foreign
currencies which are to gain in value, it may decide to cover such positions by
taking short-term deposits in those currencies, dovetailing the maturity of a deposit
to the date of payment.

The remaining cash, if any, may be invested in domestic or foreign short-term

securities keeping in view potential yield of the securities and possible exchange
rate movements.

2. Determining the Effective Yield:

For an international finance manager it is effective yield, not the interest rate,
which is important because the effective yield, say of a bank deposit, considers
both the interest rate and the rate of appreciation (or depreciation) of the currency
denominating the deposit and can, therefore, be very much different from the
quoted interest rate on a deposit denominated in a foreign currency.

The effective yield on the foreign deposit can be determined by using the
following formula:
r = (1 + if) (1 + ef) – 1

where;

r- Represents the effective yield on the foreign deposit;

if- represents the quoted interest rate;

ef- is the percentage change in the value of the currency representing the foreign
deposit from the date of deposit to the date of withdrawal.

Suppose that an MNC X of the US has surplus cash of $2,000,000. It can invest in
a one-year domestic bank deposit @ 6 percent. The company finds that one-year
deposit in Australian bank would fetch 9 percent, the exchange rate of the
currency.

3. Implications of Interest Rate Parity:

Generally, it is believed that a foreign currency with a high interest rate would be
an ideal short-term investment outlet for covered interest arbitrage. However, such
a currency will normally exhibit a forward discount that reflects the differential
between its interest rate and the investor's home interest rate. This relationship is
based on the theory of interest rate parity. Investors will not lock in higher return
when attempting covered interest arbitrage if interest rate parity exists. Short-term
investment may be feasible if interest rate parity exists but this has to be on an
uncovered basis (without use of the forward market). In other words, shortterm
foreign investing may be more profitable than domestic investing but it cannot be
guaranteed.

4. Diversifying Cash across Currencies:

In order to avoid the possibility of incurring substantial losses arising out of
depreciation of a foreign currency, an MNC prefers to diversify its investible funds
among various foreign currencies. To what extent a portfolio of investments
denominated in various currencies will reduce risk would depend on the currency
correlations. Ideally, the currencies represented within the portfolio will show low
or negative correlations with each other. When currencies are likely to be affected
by the same underlying event, their movements tend to be highly correlated, and
diversification among these types of currencies does not substantially minimize
exchange rate risk.

WORKING CAPITAL MANAGEMENT FOR MNC

A multinational enterprise to survive and succeed in a fiercely competitive

environment must manage its working capital prudently. Working capital
management in an MNC requires managing its current assets and current liabilities
in such a way as to reduce funds tied in working capital while simultaneously
providing adequate funding and liquidity for the conduct of its global businesses so
as to enhance value to the equity shareholders and so also to the firm. While the
basics of managing working capital are, by and large, the same both in a domestic
or multinational organization, risks and options involved in working capital
management in MNCs are much greater than their domestic counterparts. Further,
working capital management in a multinational firm focuses on inter subsidiary
transfer of funds as well as transfers from the affiliates to the parent firm. Besides,
there are specific approaches to manage cash, receivables and inventories in
MNCs. All these aspects are dealt with in this unit in this unit.

WORKING CAPITAL MANAGEMENT IN DOMESTIC AND

MULTINATIONAL ENTERPRISES

Working Capital Management for MNCs although the fundamental principles

governing the managing of working capital such as optimization and suitability are
almost the same in both domestic and multinational enterprises, the two differ in
respect of the following:

• MNCs, in managing their working capital, encounter with a number of risks

peculiar to sourcing and investing of funds, such as the exchange rate risk and
the political risk.
• Unlike domestic firms, MNCs have wider options of procuring funds for
satisfying their requirements or the requirements of their subsidiaries such as
financing of subsidiaries by the parent, borrowings from local sources including
banks and funds from Eurocurrency markets, etc.
• MNCs enjoy greater latitude than the domestic firms in regard to their
capability to move their funds between different subsidiaries, leading to fuller
utilization of the resources.
• MNCs face a number of problems in managing working capital of their
subsidiaries because they are widely separated geographically and the
management is not very well acquainted with the actual financial state of affairs
of the affiliates and working of the local financial markets. As such, the task of
decision making in the case of MNCs' subsidiaries is complex.
• Finance managers of MNCs face problems in taking financing decision because
of different taxation systems and tax rates.

In sum, through MNCs have some advantages in terms of latitude and options in
financing, the problems of working capital management in MNCs are more
complicated than those in domestic firms mainly because of additional risks in the
form of the currency exposure and political risks as also due to differential tax
codes and taxation rates.

The goals of working capital management in an MNC are the same as those of a
domestic firm that is to manage the firm's current assets and liabilities in such a
way that a satisfactory level of working capital is maintained. The discussion of the
working capital management in section is made with reference to:

(i) Cash management

(ii) Receivables management

(iii) Inventory management.

(i). CASH MANAGEMENT:

Cash management is the corporate process of collecting and managing cash, as

well as using it for short-term investing. It is a key component of a company's
financial stability and solvency. Corporate treasurers or business managers are
frequently responsible for overall cash management and related responsibilities to
remain solvent.

The Cash Management is concerned with the collection, disbursement and the
management of cash in such a way that firm’s liquidity is maintained. In other
words, it is concerned with managing the cash flows within and outside the firm
and making decisions with respect to the investment of surplus cash or raising the
cash from outside for financing the deficit.

Function of Cash Management

It is well acknowledged in financial reports and various studies that cash

management is concerned with minimizing fruitless cash balances, investing
temporarily excess cash usefully and to make the best possible arrangements for
meeting planned and unexpected demands on the firm's cash (Hunt, 1966). Cash
Management must have objective to reduce the required level of cash but minimize
the risk of being unable to discharge claims against the company as they arise.
There are five cash management functions:

1. Cash Planning: Experts emphases the wise planning of funds that can lead
to huge success. For any management decision, planning is the primary
requirement. According to theorists, "Planning is basically an intellectual
process, a mental pre-disposition to do things in an orderly way, to think
before acting and to act in the light of facts rather than of a guess." Cash
planning is a practise, which comprises of planning for and controlling of
cash. It is a management process of predicting the future need of cash, its
available resources and various uses for a specified period. Cash planning
deals at length with formulation of necessary cash policies and procedures in
order to perform business process constantly. A good cash planning aims at
providing cash, not only for regular but also for irregular and abnormal
requirements.

2. Managing Cash Flows: Second function of cash management is to properly

manage cash flows. It means to manage efficiently the flow of cash coming
inside the business i.e. cash inflow and cash moving out of the business i.e.
cash outflow. These two can be effectively managed when a firm succeeds
in increasing the rate of cash inflow together with minimizing the cash
outflow. As observed accelerating collections, avoiding excessive
 inventories, improving control over payments contribute to better
management of cash. Whereby, a business can protect cash and thereof
would require lesser cash balance for its operations.

3. Controlling the Cash Flows: It has been observed that prediction is not an
exact knowledge because it is based on certain conventions. Therefore, cash
planning will unavoidably be at variance with the results actually obtained.
Due to this, control becomes an unavoidable function of cash management.
Moreover, cash controlling becomes indispensable as it increases the
availability of usable cash from within the enterprise. It is understandable
that greater the speed of cash flow cycle, greater would be the number of
times a firm can convert its goods and services into cash and so lesser will
be the cash requirement to finance the desired volume of business during
that period. Additionally, every business is in possession of some concealed
cash, which if traced out significantly decreases the cash requirement of the
enterprise.

4. Optimizing the Cash Level: It is important that a financial manager must

focus to maintain sound liquidity position i.e. cash level. All his efforts
relating to planning, managing and controlling cash should be diverted
towards maintaining an optimum level of cash. The prime need of
maintaining optimum level of cash is to meet all requirements and to settle
the obligations well in time. Optimization of cash level may be related to
establishing equilibrium between risk and the related profit expected to be
earned by the company.

5. Investing Idle Cash: Idle cash or surplus cash is described as the extra cash
inflows over cash outflows, which do not have any specific operations or
any other purpose to solve currently. Usually, a firm is required to hold cash
for meeting working needs facing contingencies and to maintain as well as
develop friendliness of bankers.

In banking area, cash management is a marketing term for some services related to
cash flow offered mainly to huge business customers. It may be used to describe all
bank accounts (such as checking accounts) provided to businesses of a certain size,
but it is more often used to describe specific services such as cash concentration,
zero balance accounting, and automated clearing house facilities. Sometimes,
private banking customers are given cash management services.
Financial instruments involved in cash management include money market funds,
treasury bills, and certificates of deposit.

Cash Management in an MNC is primarily aimed at minimizing the overall cash

requirements of the firm as a whole without adversely affecting the smooth
functioning of the company and each affiliate, minimizing the currency exposure
risk, minimizing political risk, minimizing the transaction costs and taking full
advantage of the economies of scale as also to avail of the benefit of superior
knowledge of market forces.

However, these objectives are in conflict with each other leading to increased
complexity of the cash management. For instance, minimization of the political
risk involves conversion of all receipts in foreign currencies in the currency of the
home country.

This may, however, go against the interest of the affiliates who need minimum
working capital to be kept in the local currency to meet their operational
requirements.

Further, minimization of transaction costs involved in currency conversions calls

for holding cash balances in the currency in which they are received. In another
respect too, primary objectives are antagonistic to each other. A subsidiary, for
example, may need to carry minimum cash balances in anticipation of future
payments due to the time required to channelize funds to such a country.

Holding of such balances in excess of immediate requirements may ostensibly

impinge on the objective to benefit from economies of scale in earning the highest
possible rate of return from investing these resources.

Another major problem which an MNC faces in managing cash is with respect to
estimation of cash flows emanating out of operations of its affiliates. This problem
arises because of foreign exchange fluctuations.
Similar problem arises in estimating cash inflows stemming out of future sales
because actual volume of sales to overseas buyers depends on foreign exchange
fluctuations. The sales volume of exports is also susceptible to business cycles of
the importing countries.

Uncertainty arises in regard to cash collections from receivables because it is

quality of credit standards that will decide the value of goods sold to be received
back in cash. Liberal credit standards may cause a slow-down in cash inflows from
sales which could offset the benefits of augmented sales.

In view of the above, problems leading to increased uncertainty in estimating cash

flows, the management may be constrained to carry larger amount of cash balances
so as to protect the firm against any crisis. This kind of problem is not encountered
by a domestic firm.

Cash management in an MNC is further complicated by the absence of effective

tools to expedite transfers and by the great variations in the practices of financial
institutions. As such, an international finance manager must exercise great
prudence in forecasting cash flows of the affiliates.

• To explain the difference between subsidiary perspective and a parent

perspective in analyzing the 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.

 Motives for Holding Cash

Definition: The Motives for Holding Cash is simple, the cash inflows and outflows
are not well synchronized, i.e. sometimes the cash inflows are more than the cash
outflows while at other times the cash outflows could be more. Hence, the cash is
held by the firms to meet the certain as well as uncertain situations.

Motives for Holding Cash

Majorly there are three motives for which the firm holds cash.

4. Transaction Motive: The transaction motive refers to the cash required by a firm
to meet the day to day needs of its business operations. In an ordinary course of
 business, the firm requires cash to make the payments in the form of salaries,
wages, interests, dividends, goods purchased, etc.

Likewise, it also receives cash from its sales, debtors, investments. Often the firm’s
cash inflows and outflows do not match, and hence, the cash is held up to meet its
routine commitments.

5. Precautionary Motive: The precautionary motive refers to the tendency of a firm

to hold cash, to meet the contingencies or unforeseen circumstances arising in the
course of business.

Since the future is uncertain, a firm may have to face contingencies such as an
increase in the price of raw materials, labor strike, lockouts, change in the demand,
etc. Thus, in order to meet with these uncertainties, the cash is held by the firms to
have un-interrupted business operations.

6. Speculative Motive: The firms hold cash for the speculative purposes to avail the
benefit of bargain purchases that may arise in the future. For example, if the firm
feels the prices of raw material are likely to fall in the future, it will hold cash and
wait till the prices actually fall.

Thus, a firm holds cash to exploit the possible opportunities that are out of the
normal course of business. These opportunities could be in the form of the low-
interest rate charged on the borrowed funds, expected fall in the raw material
prices or favorable change in the government policies.

Thus, the cash is the most significant and liquid asset that the firm holds. It is
significant as it is used to pay off the firm’s obligations and helps in the expansion
of business operations.

Techniques to Optimize Cash Flows:

1. Accelerating cash inflows

2. Minimizing currency conversion costs

3. Managing blocked funds

4. Managing inter-subsidiary cash transfers

5. Investing excess cash

1. Accelerating Cash Inflows:

Cash inflows can be prompted through quick deposit of customer’s cheques,
establishing collection centers, lock-box method and other devices.

2. Minimizing Currency Conversion Costs:

Cash flow can also be optimized through Netting. Netting involves offsetting
receivables against payables of the various entities so that only the net amounts are
eventually transferred among affiliates. An MNC can also utilize multilateral
netting with outside firms and agencies.

This technique optimizes cash flow by reducing the administrative and transaction
costs arising out of currency conversion. It also reduces unnecessary float, funds
that are in the process of being transferred among affiliates instead of being
invested by the centre.

The process of netting forces tight control over information on transaction between
subsidiaries leading to greater coordination among all subsidiaries to accurately
report and settle their various accounts. Netting also makes cash flows forecasting
easier since only net cash transfers are made at the end of each period, rather than
individual cash transfers throughout the period.

There are two kinds of netting. A bilateral netting system involves transactions
between two units: between the parent and a subsidiary or between two
subsidiaries. A multilateral netting system usually involves a more complex
interchange among the parent and several subsidiaries’.

Multilateral netting system is most useful to MNCs in reducing administrative and

currency conversion costs. Such a system is highly centralized so that all necessary
information’s are consolidated. With the help of the consolidated cash flow
information net cash positions for each pair of units (subsidiaries or whatever) can
be determined and the actual reconciliation at the end of each period can be
dictated.

3. 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

Fundsin the host country, adjust the transfer pricingpolicy (such that higher fees ha
ve to be paid tothe parent), borrow locally rather than from theparent, etc.

4. Managing Inter-subsidiary Cash Transfers:

Through techniques of leading and lagging cash flows can be managed to the
advantage of a subsidiary. For example, firm A needs funds, while firm B has
surplus funds. If A purchases supplies from B and pays for its supplies earlier than
necessary, this technique is called leading.

Alternately, if B sells supplies to A, it could provide financing by allowing A to lag

its payments. The leading or lagging strategy can help in improving efficiency of
cash utilization and thereby reducing debt. Some host governments prohibit this
practice by requiring that a payment between subsidiaries occurs at the time at
which goods are transferred.

MNC management must, therefore, be aware of existence of such prohibitory laws.

Complications in Optimization of Cash Flow:

Flow most complications encountered in optimizing cash flow can be classified
into three categories:

d) Company-related characteristics

e) Government restrictions

f) Characteristics of banking systems

Each complication is discussed in turn.

d) Company-Related Characteristics :

In some cases, optimizing cash flow can become complicated due to characteristics
of the MNC. If one of the subsidiaries delays payments to other subsidiaries for
supplies received, the other subsidiaries may be forced to borrow until the
payments arrive. A centralized approach that monitors all inter-subsidiary
payments should be able to minimize such problems.

e) Government Restrictions :

The existence of government restrictions can disrupt a cash flow optimization

policy. Some governments prohibit the use of a netting system, as noted earlier. In
addition, some countries periodically prevent cash from leaving the country,
thereby preventing net payments from being made. These problems can arise even
for MNCs that do not experience any company-related problems. Countries in
Latin America commonly impose restrictions that affect an MNC’s cash flows.

f) Characteristics of Banking Systems

The abilities of banks to facilitate cash transfers for MNCs vary among countries.
Banks in the United States are advanced in this field, but banks in some other
countries do not offer services. MNCs prefer some form of zero-balance account,
where excess funds can be used to make payments but earn interest until they are
used. In addition, some MNCs benefit from the use of lockboxes. Such services are
not available in some countries. In addition, a bank may not update the MNC’s
bank account information sufficiently or provide a detailed breakdown of fees for
banking services. Without full use of banking resources and information, the
effectiveness of international cash management is limited. In addition, an MNC
with subsidiaries in, say, eight different countries will typically be dealing with
eight different banking systems. Much progress has been made in foreign banking
systems in recent years. As time passes and a more uniform global banking system
emerges, such problems may be alleviated.
5. Investing Excess Cash:
Investing surplus cash in liquid assets such as Euro currency deposits, foreign
treasury bills and commercial paper, etc. is one of the key functions of
international finance manager. While making decision in this regard many crucial
issues merit thorough consideration.

These issues are:

1. Should the excess cash of all subsidiaries be pooled together or remain
separated?

2. How can the effective yield expected from each possible alternative be
determined?

3. What does interest rate parity suggest about short-term financing?

4. Will it be useful to diversify investment among currencies?

These issues shall be discussed in the following paragraphs.

1. Separate or Centralized approach:

While handling the issue regarding deployment of surplus cash, an MNC has to
decide if individual subsidiaries will make separate investments on their own or a
centralized approach will be followed to pool the excess cash from each subsidiary
which will then be converted into a single currency for investment purposes.

However, the advantage of pooling may be offset by the transaction costs involved
in conversion in a single currency. Even then centralized cash management could
be useful.

Alternately, the short-term cash available in each currency could be pooled

together so that there would be a separate pool for each currency. The excess cash
of subsidiaries in a particular currency can still be used to satisfy other subsidiary
deficiencies in that currency. This strategy will save transaction costs of the MNC.

If an MNC is left with excess cash and expects future cash outflows in foreign
currencies which are to gain in value, it may decide to cover such positions by
taking short-term deposits in those currencies, dovetailing the maturity of a deposit
to the date of payment.

The remaining cash, if any, may be invested in domestic or foreign short-term

securities keeping in view potential yield of the securities and possible exchange
rate movements.

2. Determining the Effective Yield:

For an international finance manager it is effective yield, not the interest rate,
which is important because the effective yield, say of a bank deposit, considers
both the interest rate and the rate of appreciation (or depreciation) of the currency
denominating the deposit and can, therefore, be very much different from the
quoted interest rate on a deposit denominated in a foreign currency.

The effective yield on the foreign deposit can be determined by using the
following formula:
r = (1 + if) (1 + ef) – 1

where;

r- Represents the effective yield on the foreign deposit;

if- represents the quoted interest rate;

ef- is the percentage change in the value of the currency representing the foreign
deposit from the date of deposit to the date of withdrawal.

Suppose that an MNC X of the US has surplus cash of $2,000,000. It can invest in
a one-year domestic bank deposit @ 6 percent. The company finds that one-year
deposit in Australian bank would fetch 9 percent, the exchange rate of the
currency.

3. Implications of Interest Rate Parity:

Generally, it is believed that a foreign currency with a high interest rate would be
an ideal short-term investment outlet for covered interest arbitrage. However, such
a currency will normally exhibit a forward discount that reflects the differential
between its interest rate and the investor's home interest rate. This relationship is
based on the theory of interest rate parity. Investors will not lock in higher return
when attempting covered interest arbitrage if interest rate parity exists. Short-term
investment may be feasible if interest rate parity exists but this has to be on an
uncovered basis (without use of the forward market). In other words, shortterm
foreign investing may be more profitable than domestic investing but it cannot be
guaranteed.

4. Diversifying Cash across Currencies:

In order to avoid the possibility of incurring substantial losses arising out of

depreciation of a foreign currency, an MNC prefers to diversify its investible funds
among various foreign currencies. To what extent a portfolio of investments
denominated in various currencies will reduce risk would depend on the currency
correlations. Ideally, the currencies represented within the portfolio will show low
or negative correlations with each other. When currencies are likely to be affected
by the same underlying event, their movements tend to be highly correlated, and
diversification among these types of currencies does not substantially minimize
exchange rate risk.

(ii) INVENTORY MANAGEMENT

Every enterprise needs inventory for smooth running of its activities. It serves as a
link between production and distribution processes. There is, generally, a time lag
between the recognition of need and its fulfillment. The greater the time – lag, the
higher the requirements for inventory.
The investment in inventories constitutes the most significant part of current
assets/working capital in most of the undertakings. Thus, it is very essential to have
proper control and management of inventories. The purpose of inventory
management is to ensure availability of materials in sufficient quantity as and
when required and also to minimise investment in inventories.

Meaning and Nature of inventory

In accounting language it may mean stock of finished goods only. In a
manufacturing concern, it may include raw materials, work in process and stores,
etc. Inventory includes the following things:
(a) Raw Material: Raw material form a major input into the organisation. They are
required to carry out production activities uninterruptedly. The quantity of raw
materials required will be determined by the rate of consumption and the time
required for replenishing the supplies. The factors like the availability of raw
materials and government regulations etc. too affect the stock of raw materials.
(b) Work in Progress: The work-in-progress is that stage of stocks which are in
between raw materials and finished goods. The raw materials enter the process of
manufacture but they are yet to attain a final shape of finished goods. The quantum
of work in progress depends upon the time taken in the manufacturing process. The
greater the time taken in manufacturing, the more will be the amount of work in
progress.
(c) Consumables: These are the materials which are needed to smoothen the
process of production. These materials do not directly enter production but they act
as catalysts, etc. Consumables may be classified according to their consumption
and criticality.
(d) Finished goods: These are the goods which are ready for the consumers. The
stock of finished goods provides a buffer between production and market. The
purpose of maintaining inventory is to ensure proper supply of goods to customers.
(e) Spares: Spares also form a part of inventory. The consumption pattern of raw
materials, consumables, finished goods are different from that of spares. The
stocking policies of spares are different from industry to industry. Some industries
like transport will require more spares than the other concerns. The costly spare
parts like engines, maintenance spares etc. are not discarded after use, rather they
are kept in ready position for further use.
Purpose/Benefits of Holding Inventors
There are three main purposes or motives of holding inventories:
(i) The Transaction Motive which facilitates continuous production and
timely execution of sales orders.
(ii) The Precautionary Motive which necessitates the holding of inventories
for meeting the unpredictable changes in demand and supplies of materials.
(iii) The Speculative Motive which induces to keep inventories for taking
advantage of price fluctuations, saving in re-ordering costs and quantity
discounts, etc.
Risk and Costs of Holding Inventors
The holding of inventories involves blocking of a firm’s funds and
incurrence of capital and other costs. It also exposes the firm to certain risks.
The various costs and risks involved in holding inventories are as below:
(i) Capital costs: Maintaining of inventories results in blocking of the
firm’s financial resources. The firm has, therefore, to arrange for
additional funds to meet the cost of inventories. The funds may be
arranged from own resources or from outsiders. But in both cases, the
firm incurs a cost. In the former case, there is an opportunity cost of
investment while in later case the firm has to pay interest to outsiders.

(ii) Cost of Ordering: The costs of ordering include the cost of

acquisition of inventories. It is the cost of preparation and execution
of an order, including cost of paper work and communicating with
supplier. There is always minimum cot involve whenever an order for
replenishment of good is placed. The total annual cost of ordering is
equal to cost per order multiplied by the number of order placed in a
year.

(iii) Cost of Stock-outs: A stock out is a situation when the firm is not
having units of an item in store but there is demand for that either
from the customers or the production department. The stock out refer
to demand for an item whose inventory level is reduced to zero and
insufficient level. There is always a cost of stock out in the sense that
 the firm faces a situation of lost sales or back orders. Stock out are
quite often expensive.

(iv) Storage and Handling Costs. Holding of inventories also involves

costs on storage as well as handling of materials. The storage costs
include the rental of the godown, insurance charge etc.

(v) Risk of Price Decline. There is always a risk of reduction in the

prices of inventories by the suppliers in holding inventories. This may
be due to increased market supplies, competition or general
depression in the market.

(vi) Risk of Obsolescence. The inventories may become obsolete due to

improved technology, changes in requirements, change in customer’s
tastes etc.

(vii) Risk Deterioration in Quality: The quality of the materials may also
deteriorate while the inventories are kept in stores.

The investment in inventory is very high in most of the organizations engaged in

manufacturing, wholesale and retail trade. The amount of investment is sometimes
more in inventory than in other assets.

About 90% part of working capital is invested in inventories. It is necessary for

every management to give proper attention to inventory management. A proper
planning of purchasing, handling, storing and accounting should form a part of
inventory management. An efficient system of inventory management will
determine (a) what to purchase (b) how much to purchase (c) from where to
purchase (d) where to store, etc

The purpose of inventory management is to keep the stock in such a neither way
that neither there is overstocking nor under-stocking. The overstocking will mean a
reduction of liquidity and starving of other production processes. Under-stocking,
on the other hand, will result in stoppage of work. The investment in inventory
should be kept under reasonable limits.

Objectives of Inventory Management:

The main objectives of inventory management are operational and financial. The
operational objectives mean that the materials and spares should be available in
sufficient quantity so that work is not disrupted for want of inventory. The
financial objective mean that investments in inventories should not remain idle and
minimum working capital should be locked in it. The followings are the objectives
of inventory management:

1. To ensure continuous supply of materials spares and finished goods so that

production should not suffer at any time and the customer’s demand should also be
met.

2. To avoid both overstocking and under-stocking of inventory.

3. To maintain investment in inventories at the optimum level as required by the

operational and sales activities.

4. To keep materials cost under control so that they contribute in reducing cost of
production and overall cost.

5. To eliminate duplication in ordering or replenishing stocks. This is possible with

the help of centralizing purchases.

6. To minimize losses through deterioration, pilferage, wastages and damages.

7. To design proper organization for inventory management. Clear cut

accountability should be fixed at various levels of the organization.

8. To ensure perpetual inventory control so that materials shown in stock ledgers

should be actually lying in the stores.

9. To ensure right quality goods at reasonable prices. Suitable quality standards

will ensure proper quality stocks. The price analysis, the cost analysis and value
analysis will ensure payment of proper prices.
10. To facilitate furnishing of data for short term and long term planning and
control of inventory.

Inventory Management Techniques:

Below is a list of some of the most popular and effective inventory

management techniques you can use to improve your business.
1. Determination of stock level :(learn from the image given
below)
2. Economic order quantity :(learn from the image given below)
 3. ABC Analysis
ABC analysis of inventory is a method of sorting your inventory into 3
categories according to how well they sell and how much they co st to hold:
• A-Items – Best-selling items that don’t take up all your warehouse space or
cost
• B-Items – Mid-range items that sell regularly but may cost more than A-
items to hold
• C-Items – The rest of your inventory that makes up the bulk of your
inventory costs while contributing the least to your bottom line
ABC analysis of inventory helps you keep working capital costs low
because it identifies which items you should reorder more frequently and
which items don’t need to be stocked often – reducing obsolete
inventory and optimizing the rate of inventory turnover.
4. Just In Time Inventory Management
Just-in-Time Inventory Management is simply making what is needed, when
it’s needed, in the amount needed.
Many companies operate on a “just-in-case” basis – holding a small amount
of stock in case of an unexpected peak in demand.
JIT attempts to establish a “zero inventory” system by manufacturing goods
to order; it operates on a “pull” system whereby an order comes through and
 initiates a cascade response throughout the entire supply chain – signaling to
the staff they need to order inventory or begin producing the required item.
Here are some of the benefits of just-in-time inventory:
• Minimize costs such as rent and insurance by reducing your inventory
• Less obsolete, outdated, and spoiled inventory
• Reduce waste and increase efficiency by minimizing or eliminating
warehousing and stockpiling, while maximizing inventory turnover
• Maintain healthy cash flow by ordering stock only when necessary
• Production errors can be identified and fixed faster since production
happens on a smaller, more focused level, allowing easier adjustments or
maintenance on capital equipment
5. FIFO and LIFO
FIFO and LIFO are accounting methods used to value your inventory and
report your profitability.
FIFO (first in, first out) is an inventory accounting method that says the first
items in your inventory are the first ones that leave – meaning you get rid of
your oldest inventory first.
LIFO (last in, first out) is an inventory accounting method that says the last
items in your inventory are the first ones that leave – meaning you get rid of
the newest inventory first.
If you handle food inventory management or operate any business with
perishable items, then you pretty much have to use FIFO. Otherwise, you’ll
end up with obsolete inventory that you’ll have to write-off as a loss.
With that said, LIFO is a great method for non-perishable homogeneous
goods like stone or brick. So, if you get a fresh batch of items like these,
you don’t need to rearrange your warehouse or rotate batches since they’ll
be the first ones out anyway.

6. VED Analysis:
VED stands for vital, essential and desirable. This analysis relates to the classifica-
tion of maintenance spare parts and denotes the essentiality of stocking spares.
The spares are split into three categories in order of importance. From the view-
points of functional utility, the effects of non-availability at the time of requirement
or the operation, process, production, plant or equipment and the urgency of
replacement in case of breakdown.

Some spares are so important that their non-availability renders the equipment or a
number of equipment in a process line completely inoperative, or even causes
extreme damage to plant, equipment or human life.

On the other hand some spares are non-functional, serving relatively unimportant
purposes and their replacement can be postponed or alternative methods of repair
found. All these factors will have direct effects on the stocks of spares to be
maintained.

Therefore, it is necessary to classify the spares in the following categories:

V:
Vital items which render the equipment or the whole line operation in a process
totally and immediately inoperative or unsafe; and if these items go out of stock or
are not readily available, there is loss of production for the whole period.

E:
Essential items which reduce the equipment’s performance but do not render it
inoperative or unsafe; non-availability of these items may result in temporary loss
of production or dislocation of production work; replacement can be delayed
without affecting the equipment’s performance seriously; temporary repairs are
sometimes possible.

D:
Desirable items which are mostly non-functional and do not affect the performance
of the equipment.

As the common saying goes “Vital Few — trivial many”, the number of vital
spares in a plant or a particular equipment will only be a few while most of the
spares will fall in ‘the desirable and essential’ category.
However, the decision regarding the stock of spares to be maintained will depend
not only on how critical the spares are from the functional point of view (VED
analysis) but also on the annual consumption (user) cost of spares (ABC —
analysis) and, therefore, for control of spare parts both VED and ABC analyses are
to be combined.

7. FSN Analysis:
Here the items are classified into fast-moving (F), slow-moving (S) and Non-
moving (N) items on the basis of quantity and rate of consumption. The non-
moving items (usually, not consumed over a period of two years) are of great
importance. It is found that many companies maintain huge stocks of non-moving
items blocking quite a lot of capital.

Moreover, there are thousands of such items. Scrutiny of these items is made to
determine whether they could be used or to be disposed off. The classification of
fast and slow moving items helps in arrangement of stocks in stores and their
distribution and handling methods.

8. Inventory turnover ratio

The inventory turnover ratio is an efficiency ratio that shows how effectively
inventory is managed by comparing cost of goods sold with average inventory for
a period. This measures how many times average inventory is “turned” or sold
during a period

9. Aging schedule of inventory:

Classification of inventories according the period of (age) their holding also helps
in identifying slow moving inventories thereby helping in effective control and
management of inventories.

(iii) RECEIVABLES OR DEBTORS MANAGEMENT

A sound managerial control requires proper management of liquid assets and

inventory. These assets are a part of working capital of the business. An efficient
use of financial resources is necessary to avoid financial distress. Receivables
result from credit sales. A concern is required to allow credit sales in order to
expand its sales volume. It is not always possible to sell goods on cash basis only.
Sometimes, other concerns in that line might have established a practice of selling
goods on credit basis. Under these circumstances, it is not possible to avoid credit
sales without adversely affecting sales. The increase in sales is also essential to
increase profitability. After a certain level of sales the increase in sales will not
proportionately increase production costs. The increase in sales will bring in more
profits.

Thus, receivables constitute a significant portion of current assets of a firm.

But, for investment in receivables, a firm has to incur certain costs. Further, there
is a risk of bad debts also. It is, therefore, very necessary to have a proper control
and management of receivables.
Meaning of Receivables
Receivables represent amounts owed to the firm as a result of sale of goods
or services in the ordinary course of business. These are claims of the firm against
its customers and form part of its current assets. Receivables are also known as
accounts receivables, trade receivables, customer receivables or book debts. The
receivables are carried for the customers. The period of credit and extent of
receivables depends upon the credit policy followed by the firm. The purpose of
maintaining or investing in receivables is to meet competition, and to increase the
sales and profits.

Costs of Maintaining Receivables

The concern incurs the following cost on maintaining receivables:

(1) Cost of Financing Receivables: When goods and services are provided
on credit then concern’s capital is allowed to be used by the customers. The
receivables are financed from the funds supplied by shareholders for long term
financing and through retained earnings. The concern incurs some cost for
colleting funds which finance receivables.
(2) Cost of Collection: A proper collection of receivables is essential for
receivables management. The customers who do not pay the money during a
stipulated credit period are sent reminders for early payments. Some persons may
have to be sent for collection these amounts. All these costs are known as
collection costs which a concern is generally required to incur.
(3) Bad Debts : Some customers may fail to pay the amounts due towards
them. The amounts which the customers fail to pay are known as bad debts.
Though a concern may be able to reduced bad debts through efficient collection
machinery but one cannot altogether rule out this cost.
Factors Influencing the Size of Receivables
Besides sales, a number of other factors also influence the size of
receivables. The following factors directly and indirectly affect the size of
receivables.
(1) Size of Credit Sales: The volume of credit sales is the first factor which
increases or decreases the size of receivables. If a concern sells only on cash basis
as in the case of Bata Shoe Company, then there will be no receivables. The higher
the part of credit sales out of total sales, figures of receivables will also be more or
vice versa.
(2) Credit Policies: A firm with conservative credit policy will have a low
size of receivables while a firm with liberal credit policy will be increasing this
figure. If collections are prompt then even if credit is liberally extended the size of
receivables will remain under control. In case receivables remain outstanding for a
longer period, there is always a possibility of bad debts.
(3) Terms of Trade: The size of receivables also depends upon the terms of
trade. The period of credit allowed and rates of discount given are linked with
receivables. If credit period allowed is more then receivables will also be more.
Sometimes trade policies of competitors have to be followed otherwise it becomes
difficult to expand the sales.
(4) Expansion Plans: When a concern wants to expand its activities, it will
have to enter new markets. To attract customers, it will give incentives in the form
of credit facilities. The period of credit can be reduced when the firm is able to get
permanent customers. In the early stages of expansion more credit becomes
essential and size of receivables will be more.
(5) Relation with Profits: The credit policy is followed with a view to
increase sales. When sales increase beyond a certain level the additional costs
incurred are less than the increase in revenues. It will be beneficial to increase sales
beyond the point because it will bring more profits. The increase in profits will be
followed by an increase in the size of receivables or vice-versa.
 (6) Credit Collection Efforts: The collection of credit should be streamlined.
The customers should be sent periodical reminders if they fail to pay in time. On
the other hand, if adequate attention is not paid towards credit collection then the
concern can land itself in a serious financial problem. An efficient credit collection
machinery will reduce the size of receivables.
(7) Habits of Customers: The paying habits of customers also have bearing
on the size of receivables. The customers may be in the habit of delaying payments
even though they are financially sound. The concern should remain in touch with
such customers and should make them realise the urgency of their needs.
Meaning and Objectives of Receivables Management
Receivables management is the process of making decisions relating to
investment in trade debtors. We have already stated that certain investment in
receivables is necessary to increase the sales and the profits of a firm. But at the
same time investment in this asset involves cost considerations also. Further, there
is always a risk of bad debts too. Thus, the objective of receivables management is
to take a sound decision as regards investment in debtors. In the words of Bolton,
S.E., the objectives of receivables management is “to promote sales and profits
until that point is reached where the return on investment in further funding of
receivables is less than the cost of funds raised to finance that additional credit.”
Dimensions of Receivables Management
Receivables management involves the careful consideration of the following
aspects:

1. Forming of credit policy.

2. Executing the credit policy.
3. Formulating and executing collection policy.
1. Forming of Credit Policy
For efficient management of receivables, a concern must adopt a credit
policy. A credit policy is related to decisions such as credit standards, length of
credit period, cash discount and discount period, etc.
 (a) Quality of Trade Accounts of Credit Standards: The volume of sales
will be influenced by the credit policy of a concern. By liberalising credit policy
the volume of sales can be increased resulting into increased profits. The increased
volume of sales is associated with certain risks too. It will result in enhanced costs
and risks of bad debts and delayed receipts. The increase in number of customers
will increase the clerical wok of maintaining the additional accounts and collecting
of information about the credit worthiness of customers. There may be more bad
debt losses due to extension of credit to less worthy customers. These customers
may also take more time than normally allowed in making the payments resulting
into tying up of additional capital in receivables. On the other hand, extending
credit to only credit worthy customers will save costs like bad debt losses,
collection costs, investigation costs, etc. The restriction of credit to such customers
only will certainly reduce sales volume, thus resulting in reduced profits.
A finance manager has to match the increased revenue with additional
costs. The credit should be liberalized only to the level where incremental revenue
matches the additional costs. The quality of trade accounts should be decided so
that credit facilities are extended only up to that level. The optimum level of
investment in receivables should be where there is a tradeoff between the costs and
profitability. On the other hand, a tight credit policy increases the liquidity of the
firm. On the other hand, a tight credit policy increases the liquidity of the firm.
Thus, optimum level of investment in receivables is achieved at a point where
there is a tradeoff between cost, profitability and liquidity as depicted below:
 (b) Length of Credit Period: Credit terms or length of credit period means
the period allowed to the customers for making the payment. The customers paying
well in time may also be allowed certain cash discount. A concern fixes its own
terms of credit depending upon its customers and the volume of sales. The
competitive pressure from other firms compels to follow similar credit terms,
otherwise customers may feel inclined to purchase from a firm which allows more
days for paying credit purchases. Sometimes more credit time is allowed to
increase sales to existing customers and also to attract new customers. The length
of credit period and quantum of discount allowed determine the magnitude of
investment in receivables.
(c) Cash Discount: Cash discount is allowed to expedite the collection of
receivables. The concern will be able to use the additional funds received from
expedited collections due to cash discount. The discount allowed involves cost.
The discount should be allowed only if its cost is less than the earnings from
additional funds. If the funds cannot be profitably employed then discount should
not be allowed.
(d) Discount Period: The collection of receivables is influenced by the
period allowed for availing the discount. The additional period allowed for this
facility may prompt some more customers to avail discount and make payments.
This will mean additional funds released from receivables which may be
alternatively used. At the same time the extending of discount period will result in
late collection of funds because those who were getting discount and making
payments as per earlier schedule will also delay their payments.

2. Executing Credit Policy

After formulating the credit policy, its proper execution is very important.
The evaluation of credit applications and finding out the credit worthiness of
customers should be undertaken.
(a) Collecting Credit information: The first step in implementing credit
policy will be to gather credit information about the customers. This information
should be adequate enough so that proper analysis about the financial position of
the customers is possible. This type of investigation can be undertaken only upto a
certain limit because it will involve cost.
The sources from which credit information will be available should be
ascertained. The information may be available from financial statements, credit
rating agencies, reports from banks, firm’s records etc. Financial reports of the
customer for a number of years will be helpful in determining the financial position
and profitability position. The balance sheet will help in finding out the short term
and long term position of the concern. The income statements will show the
profitability position of concern. The liquidity position and current assets
movement will help in finding out the current financial position. A proper analysis
of financial statements will be helpful in determining the credit worthiness of
customers. There are credit rating agencies which can supply information about
various concerns. These agencies regularly collect information about business units
from various sources and keep this information upto date. The information is kept
in confidence and may be used when required.
Credit information may be available with banks too. The banks have their
credit departments to analyze the financial position of a customer.
In case of old customers, business own records may help to know their credit
worthiness. The frequency of payments, cash discounts availed, interest paid on
overdue payments etc. may help to form an opinion about the quality of credit.
(b) Credit Analysis: After gathering the required information, the finance
manager should analyze it to find out the credit worthiness of potential customers
and also to see whether they satisfy the standards of the concern or not. The credit
analysis will determine the degree of risk associated with the account, the capacity
of the customer borrow and his ability and willingness to pay.
(c) Credit Decision: After analyzing the credit worthiness of the customer,
the finance manager has to take a decision whether the credit is to be extended and
if yes then up to what level. He will match the creditworthiness of the customer
with the credit standards of the company. If customer’s creditworthiness is above
the credit standards then there is no problem in taking a decision. It is only in the
marginal case that such decisions are difficult to be made. In such cases the benefit
of extending the credit should be compared to the likely bad debt losses and then
decision should be taken. In case the customers are below the company credit
standards then they should not be out rightly refused. Rather they should be offered
some alternative facilities. A customer may be offered to pay on delivery of goods,
invoices may be sent through bank. Such a course help in retaining the customers
at present and their dealings may help in reviewing their requests at a later date.
(d) Financing Investments in Receivables and Factoring: Accounts
receivables block a part of working capital. Efforts should be made that funds are
not tied up in receivables for longer periods. The finance manager should make
efforts to get receivables financed so that working capital needs are met in time.
The quality of receivables will determine the amount of loan. The banks will
accept receivable of dependable parties only. Another method of getting funds
against receivables is their outright sale to the bank. The bank will credit the
amount to the party after deducting discount and will collect the money from the
customers later. Here too, the bank will insist on quality receivables only. Besides
banks, there may be other agencies which can buy receivables and pay cash for
them. This facility is known as factoring. The factoring may be with or without
recourse. It is without recourse then any bad debt loss is taken up by the factor but
if it is with recourse then bad debts losses will be recovered from the seller.
Factoring is collection and finance service designed to improve he cash flow
position of the sellers by converting sales invoices into ready cash. The procedure
of factoring can be explained as follows:

1. Under an agreement between the selling firm and factor firm, the latter makes an
appraisal of the credit worthiness of potential customers and may also set the
credit limit and term of credit for different customers.
2. The sales documents will contain the instructions to make payment directly to
factor who is responsible for collection.
3. When the payment is received by the factor on the due date the factor shall
deduct its fees, charges etc and credit the balance to the firm’s accounts.
4. In some cases, if agreed the factor firm may also provide advance finance to
selling firm for which it may charge from selling firm. In a way this tantamount
to bill discounting by the factor firm. However factoring is something more than
mere bill discounting, as the former includes analysis of the credit worthiness of
the customer also. The factor may pay whole or a substantial portion of sales
vale to the selling firm immediately on sales being affected. The balance if any,
may be paid on normal due date.

MULTI -NATIONAL CAPITAL STRUCTURE

In case of an MNC, capital structure decision is concerned with determining the

mix of debt and equity for the parent entity and for all consolidated and
unconsolidated subsidiaries. As a matter of fact, capital structure decision in an
MNC is about striking tradeoff between using debt and using equity for financing
its operations.

The opportunities as well as the complexities of multinational capital strategy are

much more complex than those of their domestic counterparts. MNCs have
comparatively greater flexibility in choosing the markets and currencies in which it
garnishes funds. By assessing unsaturated demand in international capital markets,
the MNC can lower its cost of debt and equity capital and thereby increase its
value.

In recent years, many major firms across the globe have tended to internationalize
their capital structure by raising funds from foreign as well as domestic sources.
This tendency has gained further prominence because of a conscious effort on the
part of the firms to lower cost of capital by international sourcing of funds but also
the on-going liberalization and deregulation of international financial markets that
make them accessible for many firms.

Thrust of MNCs is on worldwide capital structure because suppliers of capital to a

multinational firm are assumed to associate the risk of default with the MNC’s
worldwide debt ratio. This association stems from the view that bankruptcy or
other forms of financial distress in an overseas subsidiary can seriously impair the
parent company’s ability to operate domestically.

Choice of debt Vs. equity financing by MNCs depends on corporate characteristics

specific to these corporations as well as to the countries where the MNCs have
established their subsidiaries.

This article throws light upon the five characteristics of capital structure
decision of MNC specific to country. The characteristics are: 1. Investment
Restrictions in Host Countries 2. Current Interest Rates in Host Countries 3.
Strength of Host Country Currency 4. Country Risk in Host Countries 5.
Taxation in Host Countries.
Characteristic # 1. Investment Restrictions in Host Countries:
As MNC, operating in countries where investment opportunities are limited due to
their governments restrictions on outside investors to invest in local stocks, may be
able to raise equity share capital at a relatively low cost. This could tempt the
MNC to issue equity shares in these countries to fund its operations.
Characteristic # 2. Current Interest Rates in Host Countries:
Interest rate on loans varies across countries because of government-imposed
barriers on capital flows along with potential adverse exchange rate, tax and
country risk effects as such, MNCs may raise borrowed funds at cheaper rate in
some countries than in others thus, MNC’s preference of debt financing would
depend on availability of loan-able funds at cheaper rate in countries of their
operations.

Characteristic # 3. Strength of Host Country Currency:

If an MNC believes that currency of host country is likely to appreciate against the
domestic currency, it may direct the subsidiary firm to regain larger portion of its
earning for funding its operations. The MNC may provide financial support to
meet the subsidiary’s immediate financial requirements.

Thus, there would be a transfer of funds from the parent to the subsidiary, causing
more external financing by the parent and less debt financing by the subsidiary.

Converse will hold true in case of likely depreciation of local currency because the
MNC would like its subsidiary to raise debt in local currency to finance its
operations. This would, thus, lend to rise in proportion of debt financing in total
capitalisation of the MNC. The amount of remittance of earnings by the subsidiary
to the parent would tend to be less owing to interest payments on local debt.

Characteristic # 4. Country Risk in Host Countries:

Where there is danger of host country government blocking funds to be remitted by
the subsidiary to the parent or risk of confiscation of the assets or termination of
operation of the subsidiary, the MNC would prefer to use local debt financing.

Another alternate financing strategy to cope with a high degree of country risk
could be issue of equity stock by the subsidiary within the host country. This move
will benefit the local minority shareholders from a profitable subsidiary. Because
of the minority interest in a subsidiary, the local investors may offer some
protection against the impending threats of adverse actions by the host
government.
Characteristic # 5. Taxation in Host Countries:
Taxation laws existing in a host country do impact the capital structure decision of
an MNC, For instance, MNC may direct its subsidiary to rely largely on local debt
so as to reduce withholding tax liability on remitted earnings as also to minimize
corporate tax liability, especially when tax rates are high.

In recent years, MNCs have restructured their capital structures to reduce with-
holding taxes on remitted earnings by subsidiaries!

In brief, MNCs may place greater reliance on debt financing when their cash flows
are stable, have high credit standing and limited access to retained earnings. MNCs
would like their subsidiaries to take recourse to more of a debt when local interest
rates are low, local currency is weak high degree of country risk and tax rates are
high.

Factors Influencing MNCs Capital Structure Decision:

Some of the major characteristics unique to each MNC that impact its capital
structure decision are outlined below:

(i) Character of MNC’s Cash Flows:

An MNC having volatile cash flows can ill afford debt financing because it is not
assured of generating adequate cash to service debt periodically. In refreshing
contrast to this, MNCs having stable cash flows can manage more debt due to
regular flow of earnings.

MNCs having diversified operations across the globe usually have relatively more
stable cash flows because the conditions in a country do not exert major influence
on their cash flows. Hence such companies can comfortably have greater financial
leverage in their capitalization.

(ii) Credit Standing of MNC:

MNCs enjoying high reputation and low credit risk find it easy to access to cheaper
debt. Further, those with marketable assets that serve as acceptable collateral can
raise borrowings at reasonable terms. In contrast, MNCs with high credit risk and
assets which are not highly marketable are left with no option but to take recourse
to equity financing.

(iii) Profitability of MNC:

MNCs operating profitably are in a position to build retained earnings which can
be employed to finance their expansion programmes economically. Such
corporations have lower degree of leverage as compared to those having small
levels of retained earnings. Growth oriented MNCs usually rely on debt financing
because of their limited access to retained earnings.

(iv) MNCs Guarantees on Debt:

Where an MNC guarantees borrowings of its subsidiary, the latter is likely to rely
less on equity financing. However, the borrowing capacity of such MNCs will tend
to decline as suppliers are less willing to supply large funds to the parent if those
funds are needed to rescue a parent’s subsidiary.

(v) Monitoring of Subsidiary by MNC:

Where investors of the parent company are finding it difficult to monitor
operations of the subsidiary effectively, the latter will be induced to issue equity
shares in the local market. This will enable the parent company to monitor the
managers to ensure maximization of the firm’s stock price.

This strategy can affect the MNC’s capital structure also. Success of this strategy
hinges essentially upon the initiatives taken by the MNC’s parent to beef up the
image of the subsidiary in the host country.