Prepared by Shafiq Jadallah

Chapter 22 Working Capital Management in the MNE Prepared by Shafiq Jadallah To Accompany Fundamentals of Multinational Finance Michael H. Moffett, Arthur I. Stonehill, David K. Eiteman

Chapter 22Working Capital Managementin the MNE • Learning Objectives • Demonstrate the operation of working capital management in an MNE and its various foreign subsidiaries • Define the operating and cash conversion cycles in individual businesses, and show how they may create foreign exchange and credit exposures • Apply management guidelines to minimize the costs of funding working capital requirements

Chapter 22Working Capital Managementin the MNE • Learning Objectives • Identify devices to mange cross-border cash settlement processes • Describe the different internal and external banking and financial services which may be used by MNEs in the conduct of global business

Working Capital Management • The operating cycle of a business generates funding needs, cash inflows and outflows – the cash conversion cycle – and foreign exchange rate and credit risks • The funding needs generated by operations of the firm constitute working capital • The cash conversion cycle is the period of time extending between cash outflows for purchased inputs and cash inflow from cash settlement

Operating Cycle Accounts Payable Period Accounts Receivable Period Input Sourcing Period Quotation Period Inventory Period Price Quote Order Placed Inputs Received Order Shipped Payment Received The Firm time t0 t1 t2 t3 t4 t5 Cash Outflow Cash Intflow Cash Payment for Inputs Cash Settlement Received Cash Conversion Cycle Trident Brazil’s Operating Cycle

Trident Brazil’s Operating Cycle • Quotation period (t0) extends from the time of price quotation to the time the customer places an order (t1) • Input sourcing period (t1) extends once customer accepts order and financial terms, now Trident would order those material inputs required for the order • Inventory period (t2) begins once the inputs are received for the order, assembly/manufacturing occurs during this time period • Accounts payable period (t2) begins at this stage with the payable due for the inputs; this is the cash outflow stage

Trident Brazil’s Operating Cycle • Order shipped period (t3) begins once the order is shipped to the customer • Accounts receivable period (t4) extends once the order is shipped; this period ends once payment has been received (t5) • The cash conversion cycle occurs from stage t4 when the payable is settled until stage t5 when the receivable is settled • The entire process from stage t0 to t5 is the company’s operating cycle

Working Capital Funding • As Trident’s Brazil operations expands, it will increase its inventories and accounts payable as well as accounts receivables • These components make up net working capital • Note that short-term debt is not a part of net working capital although it is a part of gross working capital

Firm’s Balance Sheet Assets Liabilities & Net Worth Accounts payable (A/P) Cash Accounts receivable (A/R) Short-term debt Inventory Current assets Current liabilities NWC = ( A/R + Inventory ) - A/P Working Capital Funding Net Working Capital (NWC) is the net investment required of the firm to support on-going sales. NWC components typically grow as the firm buys inputs, produces product, and sells finished goods. Note that NWC is not the same as Current assets & Current liabilities.

Working Capital Funding • The previous slide depicts a key managerial decision for any subsidiary – should A/P be paid off early? • The alternative financing for NWC is short-term debt • Example: Paraña Electronics is one of Trident’s suppliers; their credit terms to Trident on a R$180,000 shipment is 5/10 net 60 • 5/10 net 60 means that the entire amount is due in 60 days but if Trident pays within 10 days they will receive a 5% discount • R$180,000 x (1-.05) = R$171,000

Working Capital Funding • Maria Gonzalez must decide which is the lower cost method for financing her NWC • Short-term debt in Brazil costs 24% p.a. so Maria must compare this cost to the cost of financing offered by Paraña’s credit terms • Trident is effectively paid 5% for giving up 50 days of financing • Assuming a 365 day count for interest;

Working Capital Financing • To calculate the effective annual interest cost of the supplier financing, the 5% discount for 50 days 7.30 times, yields a cost of carry of • Paraña is effectively charging Trident 42.8% p.a. for financing as opposed to short-term financing offered at 24% p.a.

Working Capital Financing • Days working capital is a common method used to calculate the NWC of a firm • This method is based on using a “days sales” basis • If the value of A/R, inventories and A/P are divided by the annual daily sales • The firm’s NWC can be summarized in the number of days sales of NWC • These results vary among industries and countries so the averages and levels will vary

Working Capital Financing

Working Capital Financing • Intra-Firm working capital • Within an MNE, the various subsidiaries’ operations create differing levels of payables, inventories and receivables at inter and intra-firm levels • This can create severe mismatches

Trident Brazil Balance Sheet Trident US Balance Sheet Intra-firm: 30 days 60 days 30 days A/R Inventory A/P A/R Inventory A/P A/P Local-sourcing: 60 days Brazilian Business Practices Payment terms in Brazil are longer than those typical of North America. Trident Brazil must offer 60-day terms to local customers to be competitive with other firms in the local market. United States Business Practices Payment terms used by Trident USA are typical of North America, 30 days. Trident USA’s local customers will expect to be paid in 30 days. Trident USA may consider extending longer terms to Brazil to reduce the squeeze. Working Capital Financing Cash inflows to Trident Brazil arise from local market sales. These cash flows are used to repay both intra-firm payables (to Trident USA) and local suppliers. Result: Trident Brazil is squeezed in terms of cash flow. It receives inflows in 60 days but must pay Trident USA in 30 days.

Working Capital Financing • Managing Receivables • A firm’s operating cash inflow is derived primarily from the collection of receivables • There are several factors that go into the management of receivables • Independent customers – requires decisions about currency of denomination and payments terms • Payment terms • Self-liquidating bills – secured by physical inventory that has been sold and the funds are lent based on the securitization • Other terms

Working Capital Financing • Inventory Management • Anticipating devaluation – management must decide whether to build inventory of items that carry foreign exchange exposure • Anticipating price freezes • Free trade zones and free industrial zones – free trade zones combines the idea of duty-free ports with legislation that reduces customs duties to retailers or manufacturers who structure their operations to benefit from the technique

International Cash Management • International cash management is the set of activities determining the levels of cash balances held throughout the MNE, cash management, and the facilitation of its movement cross border, settlements and processing • Cash levels are determined independently of working capital management decisions • Cash balances, including marketable securities, are held partly for day-to-day transactions and to protect against unanticipated variations from budgeted cash flows • These two motives are called the transaction motive and the precautionary motive

International Cash Management • Cash disbursed for operations is replenished from two sources • Internal working capital turnover • External sourcing, traditionally short-term borrowing • All firms engage in some sort form of the following steps • Planning – a financial manager anticipates cash flows over future days, weeks, or months • Collection – controlled through time lags between the the shipment date and the payment date

International Cash Management • Disbursement – steps included are avoiding unnecessary early payment, maximizing float and selecting a disbursement bank • Covering cash shortages – anticipated cash shortages can be managed by borrowing locally • Investing surplus cash – if a subsidiary of an MNE generates surplus cash, the MNE must decide whether to handle its own short-term liquidity or whether surplus funds should be controlled centrally

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

International Cash Settlements& Processing • Wire Transfers • Variety of methods but two most popular for cash settlements are CHIPS and SWIFT • CHIPS is the Clearing House Interbank Payment System owned and operated by its member banks • SWIFT is the Society for Worldwide Interbank Financial Telecommunications which also facilitates the wire transfer settlement process • Whereas CHIPS actually clears transactions, SWIFT is purely a communications system

Banco de São Paulo (Brazil) Bank of America (United States) Step #1: Transfer of payment CHIPS Step #2: CHIPs authenticates, stores, and acknowledges the payment message International Cash Settlements& Processing Clearing House Interbank Payment System: A Typical Transaction Step #3: CHIPs screens the payment amount against limit controls Step #4: CHIPs records a debit for Banco de São Paulo and a credit for Bank of America

International Cash Settlements& Processing Average Daily Dollar Amount Handled by CHIPS (billions of US dollars)

International Cash Settlements& Processing • Cash Pooling and Centralized Depositories • Businesses with widely dispersed operating subsidiaries can gain operational benefits by centralizing cash management • Subsidiaries hold minimum cash for their own transactions and no cash for precautionary purposes • All excess funds are remitted to a central cash depository • Information advantage is attained by central depository on currency movements and interest rate risk • Precautionary balance advantages as MNE can reduce pool without any loss in level of protection

International Cash Settlements& Processing

International Cash Settlements& Processing • Multilateral Netting • Defined as the process that cancels via offset all, or part, of the debt owed by one entity to another related entity • Netting of payments is useful primarily when a large number of separate foreign exchange transactions occur between subsidiaries

International Cash Settlements& Processing • Multilateral Netting • Example: Quad Belge owes Deutscheland Quad $5,000,000 and Deutscheland Quad simultaneously owes Quad Belge $3,000,000 • Bilateral settlement calls for $2,000,000 payment from Belgium to Germany and cancellation of remainder • Multilateral system is expanded version • Assume that payments are due between Quad’s European operations each month. • Without netting Quad Belge would make 3 separate transactions each way

$4,000 Quad United Kingdom Quad de France $3,000 $3,000 $5,000 $5,000 $5,000 $6,000 $4,000 $3,000 $2,000 $2,000 Quad Belgium Deutscheland Quad $1,000 International Cash Settlements & Processing The Four European Subsidiaries of Quad Corporation Prior to netting, the four sister subsidiaries of Quad Corporation have numerous intra-firm payments between them. Each payment results in transfer charges.

Quad United Kingdom Quad de France Pays $1,000 Pays $3,000 Pays $1,000 Quad Belgium Deutscheland Quad International Cash Settlements & Processing The Four European Subsidiaries of Quad Corporation After netting, the four sister subsidiaries of Quad Corporation have only three net payments to make among themselves to settle all intra-firm obligations

Financing Working Capital • All firms need to finance working capital and most of the short-term financing needs is done through the use of bank credit lines • Banking sources available to MNEs are • In-house Banks • Commercial Banking Offices

Financing Working Capital • In-house Bank is not a separate corporation. Rather it is a set of functions performed by the existing treasury department • The purpose of the In-house Bank is to provide banking services to the various units of the firm • It can provide lower credit spreads because it does not have to meet any capital requirements imposed on commercial banks • The In-house Bank can also better handle currency related risks

Trident Europe deposits excess cash balances with the in-house bank. Trident Europe Cash flow Trident’s In-House Bank Trident Brazil Cash flow Trident Brazil sells its receivables to the in-house bank, receiving cash and receiving working capital financing. Financing Working Capital Trident’s in-house bank reallocates cash and capital within the MNE network.

Financing Working Capital • Commercial Banking can support MNE’s needs through various offices • Correspondent Banks with local banks in important cities across the world • Representative Offices are established in a foreign country to help parent bank clients • Branch Banks are foreign branches that are a legal and operational part of the parent bank • Affiliates are locally incorporated banks owned in part by a foreign parent

Financing Working Capital • Commercial Banking can support MNE’s needs through various offices • Edge Act Corporations are subsidiaries of US banks to engage in international banking and financing operations

Summary of Learning Objectives • The operating cycle of a business generates funding needs, cash inflows and outflows – the cash conversion cycle – and potentially foreign exchange and credit risks • The funding needs generated by the operating cycle of the firm constituting working capital. The operating cycle of a business extends from the point at which a customer first requests a price quote to the final payment stage for goods received

Summary of Learning Objectives • The cash conversion cycle, a sub-component of the operating cycle, is that period between cash outflows for purchased inputs and cash inflows when cash settlement is received • The MNE poses unique challenges in the management of working capital; many MNEs manufacture goods in few specific countries and ship the intermediate products to other facilities • The payables, receivables and inventory levels of the various MNE units are a combination of intra and inter-firm creating severe mismatches in some cases

Summary of Learning Objectives • Financial managers of MNEs must control international liquid assets in order to maintain adequate liquidity in a variety of currencies while also minimizing political and foreign exchange risk • Firms attempt to minimize their net working capital balance. A/R is reduced if collections are accelerated, inventories held by the firm are reduced by carrying lower levels of goods and by speeding the rate at which goods are manufactured, reducing cycle-time

Summary of Learning Objectives • All firms must determine whether A/P should be paid off early; taking discounts by suppliers should be weighed against short-term financing through debt • Multinational business increases the complexity of making payments and settling cash flows between related and unrelated firms • Over time a number of techniques and services have evolved which simplify and reduce the costs of making these cross border payments. This includes wire transfers, cash pooling, payment netting and electronic fund transfers

Summary of Learning Objectives • MNEs can finance working capital needs through in-house banks, international banks, and local banks where subsidiaries are located • International banks finance MNEs and service these accounts through representative offices, correspondent banking relationships, branch banks, banking subsidiaries, affiliates and Edge Act Corporations (US only)

Prepared by Shafiq Jadallah