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Working Capital Management for the Multinational Corporation

Working Capital Management for the Multinational Corporation. International Financial Management. Dr. A. DeMaskey. Learning Objectives. How does multinational working capital management differ from domestic working capital management? What are the objectives of international cash management?

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Working Capital Management for the Multinational Corporation

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  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

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