Working Capital Management for the Multinational Corporation

1. Working Capital Management for the Multinational Corporation International Financial Management Dr. A. DeMaskey

2. Learning Objectives • How does multinational working capital management differ from domestic working capital management? • What are the objectives of international cash management? • What techniques are used by MNCs for making cross-border payments? • What key factors are associated with a firm’s funding strategy? • What short-term financing options are available?

3. Multinational Working Capital Management • Funds Availability • Additional Risks • Movement of Capital • Decisions • Taxes

4. International Cash Management • A set of activities, which consists of: • Cash management - the levels of cash balances held throughout the MNC - • Cash settlements and processing - the facilitation of its movement across borders

5. Cash Management • 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.

6. International Cash Management • Goal: Minimize cash balances without reducing operations or increasing risk. • Steps: • Cash Planning - anticipating cash flows over future days, weeks, or months. • Cash Collection – getting cash into the firm as soon as possible. • Cash Mobilization – moving cash within the firm to the location where needed. • Cash Disbursements – planning procedures for distributing cash. • Covering Cash Shortages – managing anticipated cash shortages by borrowing locally. • Investing Surplus Cash – managing anticipated cash surpluses by investing locally or controlling them centrally.

7. Cash Positioning Decision • Currency of location • Type of liquid asset held • Maturities, yields, and liquidity characteristics

8. Objectives of an Effective Cash Management System • Minimizing overall cash requirements • Minimizing currency exposure risk • Minimizing political risk • Minimizing transactions costs • Taking full advantage of economies of scale

9. Complexities of the International Cash Positioning Decision • Conflicting nature of cash management objectives • Government restrictions • Multiple taxation systems • Multiple currencies

10. International Cash Settlementsand 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

11. 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

12. Cash Pooling and Centralized Depositories • Key: Centralizing the cash positioning function to gain operational benefits. • Subsidiaries hold minimum cash for their own transactions and no cash for precautionary purposes • All excess funds are remitted to a central cash depository • Centralized depositories provide the following advantages: • 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 • Interest rate advantages as funds can be borrowed at a lower cost and invested at a more advantageous rate. • Location can provide tax benefits, access to international communications, clearly defined legal procedures.

13. Multilateral Netting • Netting involves offsetting receivables against payables so that only the net amounts are transferred among affiliates. • Types • Bilateral netting • Multilateral netting • Payments netting is useful primarily when a large number of separate foreign exchange transactions occur between subsidiaries.

14. Payments Netting • Example: A Belgian affiliate owes an Italian affiliate $5,000,000, while the Italian affiliate simultaneously owes the Belgian affiliate $3,000,000. • Bilateral settlement calls for $2,000,000 payment from Belgium to Italy and cancellation of the remainder via offset. • Multilateral netting is an extension of bilateral netting. • Assume that payments are due between Apex’s European operations each month. • Without netting Apex de France would make three separate transactions each way.

15. Financing Working Capital • Financing working capital requirements of a MNC’s foreign affiliates poses a complex decision problem. • Financing options for a subsidiary include: • Intercompany loans from the parent or a sister affiliate. • Local currency financing.

16. Key Factors Underlying the Funding Strategy • Interest Rate • Without forward contracts • With forward contracts • Exchange Risk • Degree of Risk Aversion • Taxes • Political Risk

17. Financing Objectives • Minimize covered after-tax interest costs • Minimize expects costs • Trade-off between expected cost and reducing the degree of cash flow exposure

18. Intercompany Loans • The cost of an intercompany loan is determined by the following factors: • Opportunity cost of funds • Interest rate • Tax rates and regulations • Currency of denomination • Expected exchange rate change

19. Local Currency Financing • Bank Loans • Term Loans • Line of Credit • Overdraft • Revolving Credit Agreement • Discounting • Commercial Paper

20. Effective Interest Rate on Bank Loans • Simple interest loan • Discount loan • Loan with compensating balance requirement • Simple interest loan • Discount loan

21. Effective Annual Percentage Cost Illustration • The Olivera Corporation, a manufacturer of olive oil products, needs to acquire €1 million in funds today to expand a pimiento-stuffing facility. Banca di Roma has offered them a choice of an 11% loan payable at maturity or a 10% loan on a discount basis. Which loan should Olivera choose?

22. Calculating the Dollar Costs of Alternative Financing Options • In deciding on a particular financing option, a firm needs to estimate and then compare the effective after-tax dollar costs of local currency financing and dollar financing. • In reality, the value of the currency borrowed will most likely change with respect to the borrower’s local currency over time. • Breakeven analysis can be used to determine the least expensive financing source for each future exchange rate.

23. Effective Financing Rate: No Taxes • Suppose that Ford has an affiliate in Mexico, which can borrow pesos at 80% or dollars at 12% for one year. • If the peso is expected to devalue from MP$ 7.50/$ at the beginning of the year to MP$ 10.23/$ at the end of the year, what is the expected before-tax dollar cost of the peso loan? • What is the cost of the dollar loan to Ford? • What is the breakeven rate of currency change at which the dollar cost of borrowing pesos is just equal to the cost of dollar financing?

24. Effective Financing Rate: No Taxes • Dollar cost of local currency (LC) loan • rH (LC) = rL (1 + c) + c • Cost of dollar loan (HC) • rH (HC) = rH • Breakeven rate of currency change • rL (1 + c) + c = rH

25. Effective Financing Rate: With Taxes • Suppose the Mexican corporate tax rate is 53%. • What is the expected after-tax dollar cost of borrowing pesos? • What is the expected after-tax cost of the dollar loan? • What is the breakeven rate of currency change at which the after-tax dollar cost of local currency financing is just equal to the after-tax cost of dollar financing?

26. Effective Financing Rate: With Taxes • After-tax dollar cost of borrowing local currency • rH (LC) = rL (1 - Ta)(1 + c) + c • After-tax cost of dollar loan • rH (HC) = rH (1 - Ta) + cTa • Breakeven rate of currency change • rL(1 - Ta)(1 + c) + c = rH(1 - Ta) + cTa