International Finance

1. International Finance FIN456Michael Dimond

2. Working Capital Management Management of cash, accounts receivable and inventory, and the financing of these current assets, is crucial to a MNC. The operating cycle of a business generates funding needs, cash inflows and outflows Remember how o compute the operating cycle & the cash cycle?

3. Days Working Capital for Selected U.S. and European Technology Hardware and Equipment Firms, 2001

4. International Cash Management International cash management is the set of activities determining the levels of cash balances held throughout the MNC, cash management, and the facilitation of its movement cross border, settlements and processing This takes a significant amount of time from treasurers of MNCs Most large banks have services for international money management, including a variety of money market products and servicing of payables & receivables 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

5. 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 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 MNC generates surplus cash, the MNC must decide whether to handle its own short-term liquidity or whether surplus funds should be controlled centrally

6. 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

7. 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

8. 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 MNC can reduce pool without any loss in level of protection

9. Decentralized vs Centralized Cash Depositories

10. 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 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

11. Multilateral Matrix Before Netting (US$ 000s)

12. Multilateral Matrix Before Netting (US$ 000s)

13. Repositioning Decisions Multinational firms often unbundle their transfers of funds into separate flows for specific purposes The conduits, or means of moving funds, are separable into those which are before-tax and after-tax in the host country These are various conduits available for repositioning funds:

14. Repositioning Decisions While fund flows between units of a domestic business are generally unimpeded, a firm operating globally faces a variety of considerations which limit its ability to move funds easily and without cost from one country or currency to another; Political constraints Tax constraints Transaction costs Liquidity needs

15. As foreign operations expand, a MNC 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 Working Capital Funding

16. NWC management in broader financial strategy • If forward contracts exist, the only strategic objective of borrowing is to minimize covered after‑tax interest costs. • If forward contracts do not exist, MNCs can establish some trade‑off between reducing expected costs and reducing the degree of cash flow exposure • Offset operating cash inflows in a currency with financing cash outflows in that same currency. • Borrowing decisions should be integrated with hedging decisions. • MNCs will attempt to minimize expected costs

17. Working Capital Funding Timing of AP payments is a key policy decision The alternative financing for NWC is short-term debt Example: Paraña Electronics is a Brazilian supplier; their credit terms state 5/10 net 60 on a R$180,000 shipment 5/10 net 60 means that the entire amount is due in 60 days but if the buyer pays within 10 days they will receive a 5% discount R$180,000 x (1-.05) = R$171,000 Managers must decide which is the lower cost method for financing the NWC Short-term debt in Brazil costs 24% p.a. so we must compare this cost to the cost of financing offered by Paraña’s credit terms The buyer is effectively paid 5% for giving up 50 days of financing Assuming a 365 day count for interest

18. 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 42.8% p.a. for financing as opposed to short-term financing offered at 24% p.a. Some argue this figure should not be compounded, in which case the rate is 5% x 7.30 = 36.50% p.a.

19. 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

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

21. 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

22. 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

23. 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 MNCs are In-house Banks Commercial Banking Offices 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

24. Financing Working Capital Commercial Banking can support MNC’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 Edge Act Corporations are subsidiaries of US banks to engage in international banking and financing operations