After completing this chapter, students will be able to: To explain the difference in analyzing cash flows from a subsidiary perspective versus a parent perspective; 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.
Lecture 27 International Cash Management Chapter Objectives To explain the difference in analyzing cash flows from a subsidiary perspective versus a parent perspective; 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 21 - Cash Flow Analysis: Subsidiary Perspective • The management of working capital has a direct influence on the amount and timing of cash flow • Subsidiary expenses – It is difficult to forecast the payments for international purchases of raw materials or supplies because of exchange rate fluctuations, quotas, sales volume volatility, etc 21 - Cash Flow Analysis: Subsidiary Perspective • Subsidiary revenue – International sales may be more volatile than domestic sales because of exchange rate fluctuations, business cycles, etc • Subsidiary dividend payments – If the payments and fees (royalties, overhead charges) for the parent are known and denominated in the subsidiary’s currency, forecasting cash flows will be easier 21 - Cash Flow Analysis: Subsidiary Perspective Subsidiary Liquidity Management • After accounting for all cash outflows and inflows, the subsidiary must either invest its excess cash or borrow to cover its cash deficiencies • If the subsidiary has access to lines of credit and overdraft facilities, it may maintain adequate liquidity without substantial cash balances 21 - Centralized Cash Management • While each subsidiary is managing its own working capital, a centralized cash management group is needed to monitor, and possibly manage, the parentsubsidiary and intersubsidiary cash flows • International cash management can be segmented into two functions: Ô optimizing cash flow movements, and Ô investing excess cash 21 - Cash Flow of the Overall MNC Interest &/or Principal Purchase Loans or Investment Sale Fees & Earnings Short-Term Securities Long-Term Investment Subsidiary Excess Cash Return on Long-Term Investment Projects Funds for Supplies Parent Loans Subsidiary Excess Cash Sources of Debt Repayment Fees & Earnings Loans or Investment Interest &/or Principal New Issues Stockholders Cash Dividends 21 - Centralized Cash Management • The centralized cash management division of an MNC cannot always accurately forecast the events that affect parentsubsidiary or intersubsidiary cash flows • It should, however, be ready to react to any event by considering ¤ any potential adverse impact on cash flows, and ¤ how to avoid such adverse impacts 21 - Techniques to Optimize Cash Flows Accelerating cash inflows • The more quickly the cash inflows are received, the more quickly they can be invested or used for other purposes • Common methods include the establishment of lockboxes around the world (to reduce mail float) and preauthorized payments (charging a customer’s bank account directly) 21 - Techniques to Optimize Cash Flows Minimizing currency conversion costs • Netting reduces administrative and transaction costs through the accounting of all transactions that occur over a period to determine one net payment • A bilateral netting system involves transactions between two units, while a multilateral netting system usually involves more complex interchanges 21 - 10 Complications in Optimizing Cash Flows Characteristics of banking systems Ô Ô The abilities of banks to facilitate cash transfers for MNCs may vary among countries The banking systems in different countries usually differ too 21 - 16 Investing Excess Cash • Excess funds can be invested in domestic or foreign short-term securities, such as Eurocurrency deposits, Treasury bills, and commercial papers • Sometimes, foreign short-term securities have higher interest rates However, firms must also account for the possible exchange rate movements 21 - 17 Short-Term Interest Rates as of February 2004 21 - 18 Investing Excess Cash Centralized Cash Management • Centralized cash management allows for more efficient usage of funds and possibly higher returns • When multiple currencies are involved, a separate pool may be formed for each currency Funds can also be invested in securities that are denominated in the currencies needed in the future 21 - 19 Investing Excess Cash Centralized Cash Management • Given the current online technology, MNCs should be able to efficiently create a multinational communications network among their subsidiaries to ensure that information about their cash positions is continually updated 21 - 20 Investing Excess Cash Determining the Effective Yield • The effective yield on foreign investments r = (1 + if )(1 + ef ) – where if = the quoted interest rate on the investment ef = the % in the spot rate • If the foreign currency depreciates over the investment period, the effective yield will be less than the interest rate 21 - 21 Investing Excess Cash Implications of Interest Rate Parity (IRP) • A foreign currency with a high interest rate will normally exhibit a forward discount that reflects the differential between its interest rate and the investor’s home interest rate • However, short-term foreign investing on an uncovered basis may still result in a higher effective yield 21 - 22 Investing Excess Cash Use of the Forward Rate as a Forecast • If IRP exists, the forward rate can be used as a break-even point to assess the shortterm investment decision • The effective yield will be higher than the domestic yield if the spot rate at maturity is more than the forward rate at the time the investment was undertaken 21 - 23 Use of the Forward Rate as a Forecast 21 - 24 Investing Excess Cash Use of Exchange Rate Forecasts • Given an exchange rate forecast, the expected effective yield of a foreign investment can be computed, and then compared with the local investment yield • It may be useful to use probability distributions instead of point estimates, or to compute the break-even exchange rate that will equate foreign and local yields 21 - 25 Investing Excess Cash Deriving the Value of ef that Equates Foreign and Domestic Yields r = (1 + if )(1 + ef ) – ef = (1 + r ) – (1 + if ) • r = 11%, if = 14% breakeven ef = -2.63% If the foreign currency depreciates by less than 2.63%, the foreign currency deposit will be more rewarding 21 - 26 Use of Probability Distributions 21 - 27 Probability Distribution of Effective Yield 21 - 28 Investing Excess Cash Diversifying Cash Across Currencies • If an MNC is not sure of how exchange rates will change over time, it may prefer to diversify its cash among securities that are denominated in different currencies • The degree to which such a portfolio will reduce risk depends on the correlations among the currencies 21 - 29 Investing Excess Cash Use of Dynamic Hedging to Manage Cash • Dynamic hedging refers to the strategy of hedging when the currencies held are expected to depreciate, and not hedging when they are expected to appreciate • The overall performance is dependent on the firm’s ability to accurately forecast the direction of exchange rate movements 21 - 30 ... 21 - Cash Flow of the Overall MNC Interest &/or Principal Purchase Loans or Investment Sale Fees & Earnings Short-Term Securities Long-Term Investment Subsidiary Excess Cash Return on Long-Term... foreign short-term securities have higher interest rates However, firms must also account for the possible exchange rate movements 21 - 17 Short-Term Interest Rates as of February 2004 21 - 18 Investing... breakeven ef = -2 .63% If the foreign currency depreciates by less than 2.63%, the foreign currency deposit will be more rewarding 21 - 26 Use of Probability Distributions 21 - 27 Probability