Part 2 - International Corporate Finance
2.1. Foreign Exchange Exposure
1
International Corporate Finance
• Part 2 : International Corporate Finance (10 hrs)
– Foreign Exchange Exposure (Chap. Eiteman 8 & 9 - 2h):
 Transaction exposure + decision case
 Operating exposure
– Financing the Global Firm (Chap. 11 & 13 – 2h):
 Global cost and availability of capital
 Financial structure and international debt
– Foreign Investment Decision (Chap. 15, 16 & 18 – 3h):
 FDI theory and strategy
 Multinational capital budgeting
 Adjusting for risk in foreign investment + decision case
– Managing Multinational Operations (Chap. 21 & 22 –3h)
 Repositioning funds
 Working capital management + decision case
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Foreign Exchange Exposure
• Type of foreign exchange exposures
– The three main types of foreign exchange exposure are:
transaction, operating, and translation exposure.
– Transaction exposure
 Impact of settling outstanding obligations entered into before change
in exchange rates but to be settled after change in exchange rates.
– Operating exposure
 Change in expected future cash flows arising from an unexpected
change in exchange rates.
– Translation exposure
 Changes in reported owner’s equity in consolidated financial
statements caused by a change in exchange rates. “Accounting
exposure”.
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FX - To hedge or not to hedge?
• There is a debate between supporters and opponents of FX
hedging. Some arguments of the two groups are:
• NOT hedge, because :
– Shareholders are much more capable of diversifying currency risk than the
management of the firm.
– Currency risk management does not increase the expected cash flows of
the firm, but rather decreases the variance of the CF, and decrease them
as well by the hedging costs.
– Managers cannot outguess the market, if and when markets are in
equilibrium with respect to parity conditions, the expected net present
value of hedging is zero.
– In efficient markets, investors and analysts can see across the “accounting
veil” and therefore have already factored the foreign exchange effect into
a firm's market valuation.
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FX - To hedge or not to hedge?
• HEDGE, because :
– Reduction of risk in future cash flows reduces the likelihood that
the firm’s cash flow will fall below the necessary minimum.
– Management has comparative advantage over the individual
shareholder in knowing the actual currency risk of the firm.
– Markets are usually in disequilibrium because of structural and
institutional imperfections, as well as unexpected external shocks.
Management is in a better position than shareholders to take
advantage of the one-time opportunities theses imperfections
cause, to enhance the firm value through selective hedging.
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Transaction Exposure
• Transaction exposure
– Transaction exposure arises from :
 Purchasing or selling on credit goods or services when prices are
stated in foreign currency.
 Borrowing or lending funds when repayments is to be made in a
foreign currency.
 Being a party to an unperformed foreign exchange forward contract.
 Otherwise acquiring assets or incurring liabilities denominated in
foreign currencies.
– Most common example :
 Transaction exposure of a firm has a receivable denominated in a
foreign currency.
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Transaction Exposure
• Transaction exposure - example
– Sale of telecom equipment from Trident (US multinational
corporation) to a British company.
– Payment is made in £ : 1 MM due in three months.
– If the £ appreciate toward the $, Trident makes a bigger profit, but
if the £ depreciates, Tridents loses part (or all) of its margin :
transaction exposure.
– Spot rate = $1.7640/£. The budget rate, the lowest acceptable
dollar per pound exchange rate is established at $1.70/£ to
maintain acceptable margin.
– Four alternatives available to Trident to manage the exposure:
 Remain unhedged
 Hedge in the forward market
 Hedge in the money market
 Hedge in the options markets
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Transaction Exposure
• Transaction exposure - example
– Forward market hedge
 This involves a forward (or futures) contract and a source of funds to
fulfill that contract.
 The forward contract is entered into at the time the transaction
exposure is created.
 The sequence is as follows :
– Day 0 : sell £1 MM forward at $1.7540 (fwd rate 3 mths)
– In 3 mths : receive £1 MM (from buyer), deliver £1 MM against forward
sale, receive $1,754 MM (price of the fwd rate).
 The forward contract is “covered” or “square”, the funds on hand or to
be received are matched by the funds to be paid.
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Transaction Exposure
• Transaction exposure - example
– Money market hedge
 Like a forward market hedge, a money market hedge also includes a
contract and a source of funds. The contract is here a loan agreement.
 The firm seeking the hedge borrows in one currency and exchange the
proceeds for another currency. If funds to fulfill the contract are
generated by business operations, the hedge is “covered”. If the funds are
to buy of the spot market, the hedge is “uncovered” or “open”.
 The structure is similar to the forward hedge. Here, the price is
determined by the interest rate differential between the two currencies,
whereas in the fwd hedge, the price is the forward premium. In efficient
fwd markets, interest rate parity states that these prices are the same.
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Transaction Exposure
• Transaction exposure - example
– Money market hedge
 The sequence is as follows :
– Day 0 : borrow enough to repay £1 MM in 3mths; that is : £1MM / 1+0.25
= £ 975,610.
– Day 0 : exchange £ 975,610 against $ at spot rate (1.7640), that is
$1,720,976
– In 3 mths : receive £1 MM (from buyer), deliver £1 MM to repay the loan,
that is £ 975,610 principal + £ 24,390 interests.
 Depending on the relative prices of forward markets and interest rates
differences, the money market hedge or the forward hedge will be
preferable.
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Transaction Exposure
• Transaction exposure - example
– Option market hedge
 The transaction exposure could also be covered by a £ 1 MM put
option. This technique allows speculation on the upside appreciation
of the pound while limiting the downside risk to a know amount (the
premium of the option).
 The sequence is as follows :
– Day 0 : buy put option to sell pounds at $1.75/£, pay $26,460 for the
option.
– Option cost = (size of option)x(premium)x(spot rate) = £1,000,000 x
0.015 x $1.7640 = $ 26,460
– In 3 mths : receive £1 MM. Either deliver £1 MM against put, receiving
$1,750,000 or sell £1 MM spot if current spot rate > $1.75/£
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Transaction Exposure
• Transaction exposure - example
– Comparison of alternatives
 In order to evaluate the full cost of the option hedge, one has to include the
opportunity cost of the premium paid.
 If one considers 12% of cost of capital ,it makes 3% a quarter. The full premium
cost of the option is thus: $26,460x1.03 = $27,254. In contrast, the downside risk
is limited to the premium cost incurred, in case of an option hedge. But the upside
gain is unlimited.
 We can calculate the trading range for the £ that defines the break-even for the
option compared to others alternatives.
 The upper bound of the range is determined compared to the forward rate. The £
must appreciate enough above the forward rate to cover the 0.0273$/£ to cover
the cost of the option : $1.7540 + $0.0273 = $1.7813/£.
 The lower bound is is determined compared to the unhedged strategy. If the spot
rate falls below $1.75/£, the option is exercised.
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Transaction Exposure
• Transaction exposure - example
– Comparison of alternatives
 One can thus compare the various gains or losses brought by the hedge at strike
price £1.75/$, depending on the realized FX rate :
– Option cost (future value) : $27.254
– Proceeds if exercises : $1,750,000
– Minimum net proceeds : $1,722,746 (proceeds at strike - cost)
– Maximum net proceeds : unlimited
– Break-even spot rate (upside) : $1.7813/£
– Break-even spot rate (downside) : $1.75/£
– Strategy choice and Outcome
 Two selection criteria : risk tolerance & expectations of the direction and
distance the exchange rate will move the period considered.
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Transaction Exposure
Value in US dollars of
Trident’s £1,000,000 A/R
Uncovered
Forward rate
is $1.7540/£
1.84
ATM put option
1.82
1.80
Money market
1.78
1.76
Forward contract
1.74
1.72
1.70
1.68
1.68
1.70
1.72
1.74
1.76
1.78
1.80
Ending spot exchange rate (US$/£)
1.82
1.84
1.86
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Transaction Exposure
• Risk Management in practice
– No real consensus seems to emerge, according to international
surveys.
– In most firms, treasury functions are responsible for transaction
exposure management and usually considered a cost function.
Expected to act as conservative.
– Transaction exposure generally allowed to be hedged once actually
booked as receivables and payables (transaction certain).
– Transaction management programs divided among those using
options, and those who do not. The latter rely almost exclusively on
fwd contracts and money market hedges.
– Many firms establish risk mgt policy requiring proportional hedging on
a % of the total exposure. The remainder is selectively hedged on the
basis of expectations and views.
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Transaction Exposure
• Risk Management in practice - Decision Case
– See : Lufthansa’s purchase of Boeing 737
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Operating Exposure
• Definition
– Operating exposure (OE) measures any change in the present
value of a firm resulting from changes in future operating ash
flows caused by any unexpected change in exchange rates.
– Operating exposure analysis examines the consequences of
changing FX rates on a firm’s own operations over the coming
months and years and on its competitive position relative to other
firms.
– Operating exposure and transaction exposure are both related to
future cash-flows. They differ in terms of which CF are considered
and why they change when FX rates change.
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Operating Exposure
• Attributes of Operating exposure
– Measuring the OE of a firm requires forecasting and analyzing all
the firm’s future exposures of all the firm’s competitors and
potential competitors worldwide. OE is far more important for the
long-run health of a business than transaction exposure or
translation exposure.
– The CF can be divided in operating cash-flows and financial cashflows.
 Operating cash flows arise from intercompany and intracompany
receivables and payables, rent and lease payments of facilities, royalties
and license fees, etc.
 Financial cash flows are payments for the use of intercompany and
intracompany loans and stockholders equity.
– Each of these CF can occur in different time intervals, amounts,
currencies and denomination, and each has a different predictability
of occurrence.
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Operating Exposure
• Attributes of Operating exposure
– Financial and Operating Cash Flows between a Parent and Affiliate
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Operating Exposure
• Attributes of Operating exposure
– An expected change in FX rates is not included in the definition of
OE, because it has already been included in the firm’s valuation
parameters. Only unexpected changes in FX rate, or inefficient
foreign exchange market should cause market value to change.
– OE is not just the sensitivity of a firm’s future CF to unexpected
change in FX rates, but also its sensitivity to other key
macroeconomic variables.
• Illustrating of Operating Exposure : Trident
– Suppose an MNE US Corp. Deriving much of its profits from its
German subsidiary. If the euro unexpectedly falls in value :
 How will Trident Europe’s revenue change (prices in euro terms and
volumes) ?
 How will its costs change (input costs in euro) ?
 How will its competitors react ?
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Operating Exposure
• Illustrating of Operating Exposure : Trident
– Imagine that input are bought in Europe, labeled in Euro. Half of
the production is sold in Europe, half is exported to non-European
countries.
– All sales are invoiced in Euros, and the average collection of period
account receivables is 90 days.
– Following a Euro depreciation, Trident might choose to :
 maintain its domestic price constant in euro terms
 try to raise domestic prices because competing imports are now priced
higher in Europe
 keep exports prices constant in terms of foreign currencies, in terms of
euro, or some where in between (partial pass-through)
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Operating Exposure
• Illustrating of Operating Exposure : Trident
– The strategy undertaken depends largely on management's
opinion about the price elasticity of demand.
– On the cost side, Trident Europe might raise price because of
more expensive imported raw material or components.
– Trident’s domestic sales and costs might also be partly
determined by the effect of the euro devaluation on demand.
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Operating Exposure
• Strategic Management of Operating Exposure
– The objective of both transaction and operating exposure
management is to anticipate and to influence the effect of the
changes in FX rates on a firm’s future cash-flows.
– To this end, management can :
 Diversify operations : sales, location of production facilities, and
raw material sources. Flexibility can allow firms to change its
operating structure according to international changes (ex. Goodyear
and the Mexican Peso devaluation)
 Diversify financing : raise funds in more than one capital market
and in more than one currency.
– A diversification strategy permits the firm to react either actively or
passively, depending on management’s risk preferences, and to
opportunities presented by disequilibirum conditions in the FX,
capital, or products markets.
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Operating Exposure
• Proactive Management of Operating Exposure
– Operating and transaction exposures can be partially managed by
adopting policies that partially offset the effect of FX changes. The
four most common used techniques are the following :
– 1. Matching currency cash-flow : Ex : exporting US firm in Canada:
match the in flows of CAD from its sales by the outflows of part of
its debt labeled in CAD.
– 2. Risk sharing agreements : contractual arrangements in which
the buyer and the seller agree to split currency movements
impacts on payments between them.
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Operating Exposure
• Proactive Management of Operating Exposure
– 3. Back-to-back or parallel loans, or credit swaps : two business
firms in separate countries agree to borrow each other’s currency
from a limited period of time. At an agreed terminal date, they
return to their borrowed currencies. The transaction takes place
outside of the FX markets, although the spot quotation can be used
as a reference point.
– 4. Currency swaps : similar to a back-to-back loan but off balance
sheet. Agreement between two parties to exchange a given
amount of one currency for another and, after a period of time, to
give back the original amounts swapped. Currency swaps can be
negotiated for a wide range of maturities and currencies. The swap
dealer or swap bank acts as a middleman in setting up the swap
agreement.
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Operating Exposure
• Proactive Management of Operating Exposure
– 4. Currency swaps :
Japanese
Corporation
Assets
United States
Corporation
Liabilities & Equity
Inflow
Assets
Liabilities & Equity
Inflow
Sales to US
Sales to Japan
Debt in yen
of US$
Debt in US$
of yen
Receive
yen
Pay
dollars
Wishes to enter into a swap to
“pay dollars” and “receive yen”
Pay
yen
Swap Dealer
Receive
dollars
Wishes to enter into a swap to
“pay yen” and “receive dollars”
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Part 2 - International Corporate Finance
2.2. Financing the Global Firm
27
International Corporate Finance
• Global cost and availability of capital
– Purpose of firms having access to global capital markets:
 Minimize their cost of capital
 Maximize the availability of capital
– This allows them to :
 Accept more long-term projects
 Invest more in capital improvements and expansion
– If markets are segmented :
 A national capital market is segmented if the required rate of return on
securities differs across markets, for comparable securities.
– Market segmentation : due to various market imperfections
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International Corporate Finance
Local Market Access
Global Market Access
Firm-Specific Characteristics
Firm’s securities appeal only
to domestic investors
Firm’s securities appeal to
international portfolio investors
Market Liquidity for Firm’s Securities
Illiquid domestic securities market
and limited international liquidity
Highly liquid domestic market and
broad international participation
Effect of Market Segmentation on Firm’s Securities and Cost of Capital
Segmented domestic securities
market that prices shares
according to domestic standards
Access to global securities market
that prices shares according to
international standards
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Global Cost of Capital
• Weighted Average Cost of Capital (WACC)
k WACC
E
D
 ke
 k d (1  t)
V
V
Where
kWACC = weighted average cost of capital
ke
= risk adjusted cost of equity
kd
= before tax cost of debt
t
= tax rate
E
= market value of equity
D
= market value of debt
V
= market value of firm (D+E)
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Global Cost of Capital
• Weighted Average Cost of Capital (WACC)
– Cost of equity : CAPM (Capital Asset Pricing Model)
k e  k rf   j (k m  k rf )
Where
ke
= expected rate of return on equity
krf
= risk free rate on bonds
km
= expected rate of return on the market
βj
= coefficient of firm’s systematic risk = jmj/m
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Global Cost of Capital
• Weighted Average Cost of Capital (WACC)
– Cost of Debt
 Requires the forecast of :
–
–
–
–
–
the interest rates for the next few years,
the proportions of various classes of debt used by the firm in the years
the corporate income tax (t)
if kd is the cost of debt before tax,
then : kd(1-t) = weighted average after-tax cost of debt
– WACC
 Usually used as the risk-adjusted discount rate whenever a firm ’s
new projects are in the same general risk class as its existing
projects.
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Availability of Capital
• Availability of Capital
– Demand for foreign securities
 Role of International Portfolio Investors : international investment
to increase the risk/return ratio of a portfolio invested globally in
different regions, countries, stage of development.
– Link between cost and availability of capital
 If capital in indefinitely available its cost does not rise as demand
for funds increases. This requires a very liquid market, which is
not the case of most domestic markets.
 An access to multinational markets improves the liquidity available
to the firm and allows the firm to preserve its optimal financial
financial structure (constant D/E ratio).
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Availability of Capital
• Availability of Capital
– Link between cost and availability of capital
 If market are fully integrated, securities of comparable expected
return and risk should have the same required rate of return in each
national market, after adjustment for foreign exchange risk and
political risk.
 Capital market segmentation is a financial market imperfection
caused by government constraints, institutional practices, and
investors perception.
 Segmentation does not imply that market are inefficient, at least a
domestic level.
– Influence of illiquidity and segmentation on MNE’s
 Higher cost of capital / Rising cost of capital / Shifts in the optimal
financial structure / Rising cost of projects
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NOVO Industri
• Illustrative case : NOVO industri
– Novo : Danish pharmaceuticals company
 Had a lack of availability and higher cost of capital than its main
competitors, due to market segmentation.
 P/E ratio of Novo: around 5; main international competitors : around
10.
 Causes linked to several characteristics of the Danish equity market:
– Asymmetric information base of Danish and foreign investors
– Taxation : capital gains on equity taxed at 50%; capital gains on bonds
tax free
– Very few alternative set of feasible portfolios due to prohibition of
foreign security ownership. Stock prices were then closely correlated
with a high systemic risk.
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NOVO Industri
 Financial risk : high leverage of Scandinavian firms compared to
US/UK standards
 Foreign exchange risk
– Steps taken by Novo to overcome the market segmentation:
 Closing the information gap : disclosure of information in English
version; issuance of Eurobonds with a UK investment bank as
underwriter.
 The biotechnology boom : seminar organised by Novo in NYC made
investors flooding, the stock price doubled, P/E up to 16, share
ownership rise from 0 to 30%.
 Direct share issues in the US : prospectus made for an eventual
registration of NYSE.
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NOVO Industri
– Impacts on Novo’s cost of capital :
 Stock market reaction : price drop in Copenhagen by 10% at
announcement of a US share issue (1981), where the loss was
immediately recovered. Typical reaction of an illiquid market to a
threat of dilution effect of the new share issue.
 Effect on WACC : reduction of WACC and reduction of marginal
cost of capital.
– Nowadays
 Significant reduction of market segmentation, following
globalisation. But reduced gains of international portfolio
diversification.
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Cost of Capital in MNE ’s
• Cost of Capital of MNE’s compared to domestic firms
– Availability of capital : better. Allows firms to maintain their
desired D/E ratio
– Financial structure and systematic risk for MNE’s
 Theoretically, MNE’s should be able to afford higher D/E ratios since
their cash-flow are internationally diversified and yet their variability
is minimised.
 However, empirical studies show an opposite conclusion:
international diversification does not compensate for higher agency
costs, political risk, and foreign exchange risks that MNE’s face.
 These lead to lower D/E ratios and rather higher cost of capital.
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Cost of Capital in MNE ’s
• Cost of Capital of MNEs compared to domestic firms
– Is the WACC really higher for MNEs?
 The explanation of this apparent contradiction may lie in the
opportunity set of projects of international companies. As it increases,
the firms needs to increase its capital budget to the point where its
marginal cost of capital increases.
 In that case, at constant opportunity set, the WACC of a domestic firm
is higher. See graph.
 Empirically: firms seems to show some risk aversion and try to avoid
the point where their marginal cost of capital increases. So the
observed WACC of international companies is higher. See equation.
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Cost of Capital in MNE ’s
Marginal cost of capital
and rate of return (percentage)
MCCDC
20%
MCCMNE
15%
10%
MRRMNE
5%
MRRDC
100
140
300
350
400
Budget
(millions of $)
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Cost of Capital in MNE ’s
Is MNEwacc > or < Domesticwacc ?
kWACC = ke
[
Equity
Value
]
+ kd ( 1 – tx )
[
Debt
Value
]
Empirical studies : MNEs have a lower debt/capital ratio, leading to
a higher cost of capital than their domestic counterparts.
Indications are that : MNEs have a lower average cost of debt, leading
to a lower cost of capital than their domestic counterparts.
• Cost of equity required : higher for MNE’s.
• Possible explanations : higher levels of political risk, foreign exchange risk, and higher
agency costs of doing business in a multinational managerial environment.
• However, at relatively high levels of the optimal capital budget, the MNE would have
a lower cost of capital.
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Sourcing Equity Globally
• In order to benefit from global financial markets, a firm may decide
to cross-list its shares on foreign stock exchanges.
• More specifically, it can be motivated by one or more of the following
reasons :
– Improving liquidity of its existing shares and support a liquid secondary
market for new equity issues in foreign markets.
– Increase its share price by overcoming mispricing by a segmented, illiquid
home market.
– Establish a secondary market for shares used to acquire others firms in the
host market.
– Increase the firm’s visibility & political acceptance to its customers, suppliers,
creditors and host governments.
– Create a secondary market for shares that will be used to compensate local
management and employees in foreign subsidiaries.
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Sourcing Equity Globally
• According to the goal pursued, the type of listing will be different :
– If it is to support a new equity issue or to establish a market for share swaps,
the target market should also be the listing market.
– If it is to increase the firm’s commercial and political visibility or to
compensate local management and employees, it should be in markets in
which the firm has significant operations.
– If it is to improve liquidity of a firm’s shares, the major liquid stock markets
are New York, London, Tokyo, Frankfurt and Paris.
• By cross-listing and selling equity abroad, a firm faces two barriers
– Increased commitment to full disclosure
– A continuing investor relations program
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Financial Structure & int. debt
• Financial structure and international debt
– Optimal financial structure
 A firm should optimally have the mix of debt and equity that minimises
the firm’s cost of capital for a given level of business risk.
 The WACC decreases when debt increases, due to the lower cost of
debt and the tax deductibility of interests.
 But, partly offsetting this, the cost of equity increases because equity
investors perceive a higher risk in a higher leveraged firm. The optimal
range of debt ratio is estimated between 30% and 60%.
 Within that range, the optimal ratio is influenced by : the industry of
the firm; the volatility of the sales and operating income; the collateral
value of the assets.
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Financial Structure & int. debt
• Optimal financial structure
Cost of Capital (%)
ke = cost of equity
30
28
26
24
22
20
18
16
14
12
10
8
6
4
2
Minimum cost
of capital range
kWACC = weighted average
after-tax cost of capital
kd (1-tx) = after-tax cost of debt
0
20
40
Debt Ratio (%) =
60
Total Debt (D)
Total Assets (V)
80
100
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Financial Structure & int. debt
• Financial structure and international debt
– Optimal financial structure : the case of the MNE
 Compared to domestic companies, the theory of optimal structure
of capital needs to be adapted to the international case in four
ways :
 (1) The availability of capital : that allows a MCC constant (see
previous section)
 (2) Diversification of cash-flows : that could allow for higher D/E
acceptable ratios
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Financial Structure & int. debt
– (3) Foreign exchange risk : foreign currency denominated debt
should be adjusted for any foreign exchange gains or losses.
– When a firm issues foreign currency denominated debt, its effective
cost equals the after-tax cost of repayment in terms of the firm’s
own currency.
Where
$
kd


Sfr
1  kd
x 1  s1
kd$
= Cost of borrowing for US firm in home country
kdSfr = Cost of borrowing for US firm in Swiss francs
s
= Percentage change in spot rate
– (4) Expectations of international portfolio investors : dominance of
US - UK norms on global markets, for firms overcoming market
segmentation.
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Financial Structure & int. debt
• Financial structure of foreign subsidiaries
– Since MNE are assessed on consolidated statements, financial
structures of subsidiaries are relevant only if they affect this overall
goal.
– Subsidiaries do not have independent cost of capital. Therefore, their
financial structure should not be based on minimising it.
– Empirically, studies show that country-specific environment are key
determinants of debt ratios : historical development, taxation,
corporate governance, bank influence, bond market, attitude toward
risk…
– Debts considered here : only those borrowed from sources outside
the MNE : local and foreign currency loans, and Eurocurrency loans.
|48
Financial Structure & int. debt
• Financial structure of foreign subsidiaries
– Main advantages of localization
 Localized financial structure reduces criticism of foreign subsidiaries that
have been operating with too high proportion of debt (by local
standards).
 It helps management evaluate return on equity investment relative to
local competitors in the same industry.
 In economies where interest rates are high because of scarcity of capital
and real resources are fully utilized, the penalty paid for borrowing local
funds reminds management that unless ROA is greater than local price
of capital, there is probably a misallocation of domestic real resources,
such as land and labor.
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Financial Structure & int. debt
• Financial structure of foreign subsidiaries
– Main disadvantages of localization
 An MNE is expected to have comparative advantage over local firms
through better availability of capital and ability to diversify risk.
 If each subsidiary localizes its financial structure, the resulting
consolidated balance sheet might show a structure that doesn’t
conform with any one country’s norm; the debt ratio would simply be a
weighted average of all outstanding debt.
 Typically, any subsidiary’s debt is guaranteed by the parent, and the
parent won’t allow a default on the part of the subsidiary. This makes
the debt ratio more cosmetic for the foreign subsidiary.
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Financial Structure & int. debt
• Financial structure of foreign subsidiaries
– Compromise solution
 Both domestic firms and MNE’s should try to minimize their cost of capital.
But if debt is available in a foreign subsidiary at equal cost than elsewhere
after correcting for risk, then localizing the financial structure could be an
advantage.
• Financing the Foreign Subsidiary
– In addition to choosing an appropriate financial structure, financial
managers need to choose among the alternative sources of funds for
financing. In particular, between internal and external sources of
funds.
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Financial Structure & int. debt
• Financing the Foreign Subsidiary
– Internal sources of funds (see graph below)
 In general, although the equity provided by the parent, internal sources of
funds are kept to the minimum to reduce risk of invested capital.
 Debt is the preferable form for subsidiary financing. Since debt from host
country is generally limited at early stages of the development, the foreign
subsidiary must acquire its debt from the parent company or sister
subsidiaries.
 Next, its ability to generate funds internally may become critical for the
subsidiary’s future growth. The sources of internal funds include retained
earnings, depreciation, and other non-cash expenses.
|52
Internal Sources of Funds
Cash
Equity
Funds
From
Within
the
Multinational
Enterprise
(MNE)
Funds from
parent company
Real goods
Debt -- cash loans
Leads & lags on intra-firm payables
Funds from
sister subsidiaries
Debt -- cash loans
Leads & lags on intra-firm payables
Subsidiary borrowing with parent guarantee
Depreciation & non-cash charges
Funds Generated Internally by the
Foreign Subsidiary
Retained earnings
|53
Financial Structure & int. debt
• Financing the Foreign Subsidiary
– External sources of funds (see graph below)
 There are 3 categories of external sources :
– debt from the parent’s country,
– from outside the parent’s country,
– and local equity.
 Local debt is valuable for the foreign subsidiary, since it provides a
financial hedge against the fluctuations of the operating cash inflows,
by matching.
|54
External Sources of Funds
Borrowing from sources
in parent country
Funds
External
to
the
Multinational
Enterprise
(MNE)
Banks & other financial institutions
Security or money markets
Local currency debt
Borrowing from sources
outside of parent country
Third-country currency debt
Eurocurrency debt
Individual local shareholders
Local equity
Joint venture partners
|55
External Sources of Funds
• The Eurocurrency Markets
– One of the important innovation in international finance over the
past 50 years. Provide a basis for many corporate finance innovation
for multinational companies.
• Eurocurrencies
– Definition : Domestic currencies of one country on deposit in a
second country. Time deposit maturities from overnight funds to
longer periods. Any convertible currency can exist in “Euro-”
form.
– Eurocurrency markets serve two purposes :
 Eurocurrency deposits are an efficient and convenient money market
device for holding excess corporate liquidity
 Eurocurrency market is a major source of short-tem bank loans to
finance corporate working capital needs.
|56
External Sources of Funds
• International Debt Markets
– Variety of different maturities, repayment structures and currencies
of denomination
– Three major sources of funding are:
 (1) International bank loans and syndicated credits
 (2) Euronote market
 (3) International bond market
– Bank loan and syndicated credits
 Traditionally sourced in eurocurrency markets, extended by banks in
countries other than in whose currency the loan is denominated
|57
External Sources of Funds
• Syndicated credits
 Enable banks to risk lending large amounts
 Arranged by a lead bank with participation of other bank
– Narrow spread, usually less than 100 basis points
• Euronote market
 Collective term for medium and short term debt instruments sourced in
the Eurocurrency market, e.g. Euro-commercial paper (ECP), Euro
medium-term notes (EMTNs).
• International bond market
– Fall within two broad categories
 Eurobonds
 Foreign bonds
|58
External Sources of Funds
• International bond market
– The distinction between categories is based on whether the
borrower is a domestic or a foreign resident and whether the issue
is denominated in a local or in a foreign currency.
– Eurobonds : underwritten by an international syndicate of banks
and other securities firms, and sold exclusively in other countries
than the currency of denomination. Issued by MNEs, large domestic
corporations, sovereign governments, governmental enterprises
and international institutions.
– Success factors : absence of regulatory interference - favorable tax
status (bearer from) - less stringent disclosure.
– Foreign bonds : underwritten by a syndicate of members from a
single country, and sold principally in that country. But the issuers
is from another country.
|59
External Sources of Funds
Bank Loans &
Syndications
(floating-rate,
short-to-medium term)
Euronote
Market
(floating-rate,
short-to-medium term)
International
Bond Market
(fixed & floating-rate,
medium-to-long term)
International Bank Loans
Eurocredits
Syndicated Credits
Euronotes & Euronote Facilities
Eurocommercial Paper (ECP)
Euro Medium Term Notes (EMTNs)
Eurobond
* straight fixed-rate issue
* floating-rate note (FRN)
* equity-related issue
Foreign Bond
|60
Project Financing
• Project Finance
– Is the arrangement of financing for long-term capital projects,
large in scale and generally high in risk.
– Widely used by MNEs in the development of infrastructure
projects in emerging markets.
– Most projects are highly leveraged for two reasons:
 Scale of project often precludes a single equity investor or collection
of private equity investors,
 Many projects involve subjects funded by governments.
– This high level of debt requires additional levels of risk reduction.
|61
Project Financing
• Four basic properties critical to the success of project financing :
– (1) Separation of the project from its investors:
 Project is established as an individual entity, separated legally and
financially from the investors;
 Allows project to achieve its own credit rating and cash flows.
– (2) Long-lived and capital intensive singular projects.
– (3) Cash flow predictability from third-party commitments
 Third party commitments are usually suppliers or customers of the
project.
– (4) Finite projects with finite lives.
|62
Part 2 - International Corporate Finance
2.3. FDI Theory & Strategy
63
Why Do Firms Become Multinational?
• Five categories of strategic motives:
–
–
–
–
–
Market seekers
Raw material seekers
Production efficiency seekers
Knowledge seekers
Political safety seekers
• In markets where oligopolistic competition: subclassified into
proactive and defensive investments
|64
Why Do Firms Become Multinational?
• Markets imperfections : a rationale for the existence of
multinational firms
– Imperfections in the market for products translate into market
opportunities for MNEs.
• Sustaining and transferring competitive advantage
– First step: Identification
– The competitive advantage must be firm-specific, transferable, and
powerful enough to compensate the firm for the potential
disadvantages of operating abroad.
– It implies for an MNE to have one or several of the following
elements, that would give them an edge over their local competitors
to exploit these market opportunities.
|65
Why Do Firms Become Multinational?
• Sustaining and transferring competitive advantage
– The superiority of a MNE may come from :
 Economies of scale and scope
 Managerial and marketing expertise
 Advanced technology
 Financial strength
 Differentiated products
– Competitiveness of the Home Market
 It can increase firm’s competitive advantage in operating abroad.
 Referred to as the “diamond of national advantages”.
|66
Why Do Firms Become Multinational?
– “Diamond of national advantages”:
 Factor conditions : availability of appropriate factor production
 Demand conditions : demanding customers increase marketing and
quality control skills.
 Related and supporting industries
 Firm strategy, structure and rivalry : a competitive home market
forces firms to fine tune their strategy and operational effectiveness.
– Global competitions in oligopolistic industries may substitute for
domestic competition : telecom, high-tech, cosmetics...
|67
Why Do Firms Become Multinational?
• The OLI paradigm and internalisation
– Creates a framework to explain the prevalence of FDI over other
forms of international expansion.
– The conditions for a successful investment require a competitive
advantage to be :
 O : owner-specific : can be transferred abroad. Ex. Product
differentiation.
 L : location-specific : will be exploitable in the targeted market. Ex.
Market imperfections or competitive advantage.
 I : internalisation : the competitive position is preserved by controlling
the entire value chain in the industry. Ex. Proprietary information and
human capital control in research-intensive industries.
|68
Where to Invest?
• In theory, a firm should search the best location world-wide to
take advantage of market imperfections and enjoy its
competitive advantages.
• In practice, firms have been observed to follow a sequential
search pattern. This relates to two behavioral theories of FDI :
– Behavioral approach : firms tend to invest first in countries that are not
too far in psychic terms and for limited investments. Psychic distance is
defined in terms of cultural, legal and institutional environment. As firms
learn, they are willing to take more risks, both in terms of distance and
size of investments.
– International network theory : sees MNE as a member of an
international network with nodes based in each of the foreign subsidiaries,
competing with each other and influencing the strategy and the
reinvestment decisions.
|69
How to Invest Abroad?
• Modes of Foreign Involvement
– Exporting versus Production Abroad
 Exporting : none of the risks faced with FDI
 Disadvantages of exporting : inability to internalise and exploit the results of R&D
investments.
 Risk of losing markets to imitators and global competitors.
– Licensing and Management Contracts vs. Control of Assets Abroad
 Licensing : popular method to take advantage of foreign markets without
committing sizeable funds. Political risk is minimized.
 Disadvantages of licensing : license fees lower than FDI profits
|70
How to Invest Abroad?
• Licensing and Management Contracts
– Other disadvantages :
 Possible loss of quality control
 Establishment of a potential competitor
 Risk of technology stolen, or becoming outdated
 High agency costs
– In practice, MNE’s use licensing with foreign subsidiaries or with joint
ventures.
– Management contracts are similar to licensing in terms of cash-flows, and
reduce political risk since repatriation of managers is easy.
– Cost effective of licensing with regard to FDI depends on the price host
countries will pay for the services.
– Since MNE continue to prefer FDI, the price is assumed to be too low (due
to the lack of synergies in licensing?)
– MINI - CASE : Benecol’s global licensing agreement.
|71
How to Invest Abroad?
• Joint Venture vs. Wholly Owned Subsidiary
– Partially owned foreign business : termed as foreign affiliate (case
of a joint venture). Foreign business owned at more 50%: foreign
subsidiary
– Key success factor of a joint venture : find the right local partner.
– Some advantages of a local partner :
 Better understanding of the local market;
 Provision of competent management, and/or appropriate local technology;
 Enhanced contacts and reputation, eased access to the local financial markets.
– Potential disadvantages :
 Risk of conflicts and difficulties, divergent views, decreased control over
financing or over production rationalisation;
 Increased political and reputation risk, if the wrong partner is chosen.
|72
How to Invest Abroad?
• Greenfield investment vs. Acquisition
– Greenfield investment : establishing a production or service facility
starting from the ground up.
– Cross-borders acquisitions : quicker, could be more cost-effective
in gaining competitive advantage such as technology, brand names,
logistic and distribution.
– Disadvantages of cross-borders acquisitions :
 Problems of paying a too high price (but some undervaluation cases, too,
especially in crisis situation),
 Difficulties on the post-acquisition process, and the merger of different corporate
cultures.
 Additional difficulties from host governments intervention in pricing, financing,
employment guarantees…
|73
How to Invest Abroad?
• Strategic alliances - different stages :
– Simple exchange of share ownership (as a takeover defense);
– Establishment of a separate joint venture to develop and
manufacture a product or a service (common in high-tech
industries);
– Joint marketing and servicing agreement (often forbidden by
national laws)
|74
Multinational Capital Budgeting
• Multinational Capital Budgeting
– Same theoretical framework
– The net present value criteria can be applied based on the expected cash
flows of the project, like in case of a domestic investment.
• Complexities of budgeting a foreign project
– Parent cash flows must be distinguished from project cash flows, each
contributing to a different view of value;
– Financing mode, remittance of funds, tax systems, differing inflation rates
and foreign exchange rate movements must be taken into account;
– Political risk and government interference should be included in the analysis
– Terminal value is more difficult to estimate, because of various potential
purchasers, in host country or abroad, public or private.
|75
Multinational Capital Budgeting
• Project versus Parent Valuation
– Strong theoretical statement to analyse the project from the point of view
of the parent, since it is the ultimate basis for dividend payments and
other reinvestment decisions.
– However, this violates the rule that, in capital budgeting, financial cash
flows should not be mixed with operating cash flows.
– Evaluation of a project from a local viewpoint serves some useful purposes
and should be subordinated to evaluation from the parent’s viewpoint. In
practice, firms use both viewpoints for evaluation.
|76
Multinational Capital Budgeting
• General rules
– Almost any project should be at least giving the same return to that on
host government bonds, that is generally the local risk-free rate
including a premium reflecting the expected inflation rate (Ex. 33% in
India).
– Multinational firms should invest only if they can earn a risk-adjusted
return greater than their locally based competitors.
|77
Multinational Capital Budgeting
• Illustrative case : Cemex enters Indonesia
– See reference textbook pp 354 - 365
– For information and illustration
• Project valuation sensitivity analysis
– First valuation is made on a set of “most likely” assumptions.
– Next, and in particular in uncertain environments, a sensitivity analysis is
required, under a variety of “what if” scenarios.
– For example, in international projects :
 Political risk : what if the host country imposed controls on dividend payment,
what if funds are blocked?
 Foreign exchange risk : how is the value of the project affected by a x% decrease
(increase) in the host currency rate? What about the relative impacts of
competitiveness and cash flows changes?
 Other sensitivity variables : change in the assumed terminal value, the capacity
utilisation rate, the initial project cost...
|78
Multinational Capital Budgeting
• Real Option Analysis
– For investments that have long lives, cash flows returns in later years, or
higher levels of risks compared to the current business of the firm, are often
rejected by the DCF approach.
– When MNE’s evaluate competitive projects, DCF analysis fails to capture the
strategic options that an investment may offer.
– Real option analysis overcomes this weakness by applying option theory to
capital budgeting decisions. It is a cross between decision-tree analysis and
pure option-based valuation.
– Very useful when analysing investment projects that can take very different
values depending on the decisions made at certain points in time (defer,
abandon, reduce capacity,..). The range of values give the volatility of the
project’s value.
– MINI-CASE : Trident’s Chinese Market entry.
|79
Adjusting for Risk
• Defining Risk
– One-sided risk : only potential for loss. Example : expropriation, blocked
funds. Often described in probabilities of occurrence, qualitative in character.
Best thought of as “acceptable” / “unacceptable”.
– Two-sided risk : risk of loss or gain. Example : foreign exchange, host
government economic policies. Often assessed through statistical analysis,
allowing rank-order of investments alternatives.
• Risk Measurement Origins
– From the market : credit spreads, sovereign spreads.
– From institutions : constructed indices ranking countries on the basis of
their macro risk fundamentals, i.e. political and economic stability.
Inherently subjective.
|80
Adjusting for Risk
• Defining Foreign Investments Risks
– Firm-specific risks : micro risks, at project or corporate level
– Country-specific risks : macro risks, affecting the project, but
originated at the country level
– Global-specific risks
– see illustration
|81
Adjusting for Risk
Firm-Specific
Risks
Country-Specific
Risks
Global-Specific
Risks
• Business risks
• Transfer risk
• Terrorism
• Foreign-exchange
• War and ethnic strife
• Anti-globalization
risks
• Governance risks
• Nepotism and corruption
• Defective economic and
social infrastructure
• Macroeconomic
disequilibrium
movement
• Cyber attacks
• Poverty
• Environmental
• Sovereign credit risk
safety
• Cultural and religious heritage
• Intellectual property rights
|82
Adjusting for Risk
• Strategies of Foreign Investments Risks Management
– Sensitivity Analysis
– Minimize Assets at Risk
– Diversification
– Insurance
– see illustration
|83
Risk Management Strategies
Sensitivity Analysis
Minimize Assets at Risk
Simulating business plans
Adjusting discount rate
Adjusting cash flows
Minimize equity in subsidiary
Borrow locally
Diversification
Insurance
Plant location
Source of debt & equity
Currency of denomination
Supply sources
Sales locations
Hedging currency risk
Risk-sharing agreement
Country investment agreements
Investment guarantees
|84
Adjusting for Risk
• Measuring and Managing Foreign Investments Risks
– Business risk : project viewpoint measurement vs. parent viewpoint
measurement (adjusting discount rates or adjusting cash flows), and
portfolio risk measurement
– Foreign exchange risk : see previous lectures
– Governance risk management :
 Negotiate investment agreements
 Investment insurance and guarantees : specific institutions
 Operating strategies after FDI decisions : local sourcing, facility location, control
of transportation, control of technology, control of markets, brand name and
trademark control, thin equity base, multiple-source borrowing.
|85
Adjusting for Risk
• Country-specific risks
– Transfer risk : limitations on the MNE’s ability to transfer funds into and
out of the host country without restrictions. Restrictions usually decided by
a government running out of foreign currency reserves. Most severe form
of restriction is non convertibility.
– Three types of reactions for MNE’s :
 Prior to investment : analyse the risks and their effects in the project design
 During operations : move funds using various techniques
 If movements of funds are impossible, find the best reinvestment alternatives in
the host country.
|86
Adjusting for Risk
• Country-specific risks
– Moving blocked funds : techniques
 Use of alternative conduits
 Adapt transfer pricing of goods and services between parent and subsidiaries
 Use leading and lagging payments
– and :
 Fronting loans : parent to subsidiary loan channelled through a financial
intermediary in a third country (“link financing”)
 Create unrelated exports : help easing the currency shortage for the host
currency
 Obtain special dispensation : possible for some key industries.
|87
Country-Specific Risks
Country-Specific Risks: Measurement and Management
Transfer Risk
Cultural Differences
Protectionism
• Blocked funds
• Religion
• Defense industry
• Macroeconomic
disequilibrium
• Nepotism and
corruption
• Agriculture
• Intellectual property
rights
• Infant industry
• Economic
infrastructure
• Sovereign credit
risk
|88
Adjusting for Risk
• Global-specific risks
– Terrorism
– Anti-globalization movement
 The role of international institutions such as the IMF and World Bank
– Environmental concerns
– Poverty
– Cyber attacks
|89
Part 2 - International Corporate Finance
2.4. Repositioning Funds and Working Capital
Management
90
Repositioning Funds
• As an MNE aims at maximizing the shareholder value, one of its
tasks is to reposition the profits as legally and as practically as
possible, in low tax environments.
• Repositioning profits is also useful to redeploy cash-flows or fund in
more value-creating activities, or to minimize exposure to a currency
collapse, or political crisis.
• To this end, it can use a variety of techniques :
– Unbundling fund transfers
– Dividend remittances
– Payment of fees
– Home overhead charges
• Example : Trident has operations in Brazil, China and Europe, each
with their own constraints and opportunities for Trident to reposition
funds
|91
Repositioning Funds
Trident Corporation
(Los Angeles, USA)
Country:
Currency: the dollar (US$)
Tax rate: 35%
Capital restrictions: None
Trident Europe
Trident Brazil
Trident China
(Hamburg, Germany)
(Sáo Paulo, Brazil)
(Shanghai, China)
Greenfield
Investment
Acquisition
Investment
Joint Venture
Investment
Country:
Currency: the euro (€)
Tax rate: 45%
Capital restrictions: None
Country:
Currency: the real (R$)
Tax rate: 25%
Capital restrictions: Some
Country:
Currency: the renminbi (Rmb)
Tax rate: 30%
Capital restrictions: Many
Subsidiary status:
Subsidiary status:
Subsidiary status:
Business: mature
Business: immediate growth
potential
Business: long-term growth
potential
|92
Repositioning Funds
• The strategy for each subsidiary will be
– Trident Europe – reposition profits from Germany to the US while
maintaining the value of the European market’s maturity
– Trident Brazil – reposition or in some way manage the capital at
risk subject to foreign exchange risk while still providing adequate
capital for growth
– Trident China – reposition the quantity of funds in and out of China
to protect against transfer risk while balancing the needs of the
joint venture partner
|93
Repositioning Funds
• Constraints on Positioning funds:
– Political constraints : governments can block the movement of
funds (transfer risk).
– Tax constraints : tax liabilities may prohibit fund transfer; tax
structures may be complex and possibly contradictory.
– Transaction costs : foreign exchange conversion and fees for
money transfers. Become significant for large or frequent
transfers. MNE avoid then unnecessary back-and-forth transfers.
– Liquidity needs : each subsidiary needs to maintain adequate
working capital.
|94
Conduits for Moving Funds
Foreign Subsidiary’s Income Statement
Payment to Parent Company
Sales
Cost of goods sold
Gross profit
Payments to parent
for goods or services
General & administrative expenses
License fees
Royalties
Management fees
Operating profit (EBITDA)
Payments for technology,
trademarks, copyrights,
management or other
shared services
Depreciation & amortization
Earnings before interest & taxes (EBIT)
Foreign exchange gains (losses)
Interest expenses
Earnings before tax (EBT)
Corporate income tax
Net income (NI)
Dividends
Retained earnings
Before-Tax
in the
Host Country
Payments of interest
to parent for intrafirm debt
Distribution of
dividends to parent
After-Tax
in the
Host Country
|95
Transfer Pricing
• Transfer pricing : pricing of goods and services transferred to a
foreign subsidiary from an affiliated company.
• A parent wishing to reposition funds out of or into a particular country
can charge higher or lower prices on goods sold among subsidiaries
– This will affect the income statement of the subsidiary and
effectively raise or lower taxes, with an opposite effect on the
selling subsidiary.
– Efficient conduit to avoid high taxation environments, but subject
to abuses and, therefore, controls by the fiscal authorities. (see
examples)
|96
Transfer Pricing
• Methods of determining transfer prices
– Comparable Uncontrolled Price Method
 Regarded as the best evidence of arm’s length pricing
 A market determined price
– Resale Price Method
 Subtracts appropriate markup for the distribution subsidiary from the final selling
price to an independent purchaser
– Cost-Plus Method
 Sets price by adding a appropriate profit markup to the seller’s full cost
 Often used where semi-finished products are sold between subsidiaries
– Other Pricing Methods
 Some tax authorities allow low pricing for establishment of new market so long as
the cut price is passed on to final customer
|97
License, Royalty Fees & Shared Services
• License fees : remuneration paid to the owners of the patents,
technologies, trade names, etc.
– Usually based on a percentage of the value of the product or the volume of
production
• Royalty fees : similar compensation paid for the use of intellectual
property
• Such fees are typically paid for identifiable services received by the
subsidiary
• Shared services : also referred to as distributed charges or overhead,
are charges to compensate the parent for costs incurred in the general
management of international operations and other corporate services
provided to the subsidiary.
|98
Dividend Remittances
• The classic way in which funds are transferred from subsidiary to
parent
• Dividend payout policies have change over the years and now
incorporate several variables in determining the payout strategy. These
are :
– Tax implications : dividends are very tax-inefficient
– Political risk : incite firms to remit all funds locally generated that are not
necessary to locally.
– Foreign exchange risk : if an FX loss is anticipated, the MNE will speed the
transfer of funds.
– Distributions and cash flows : growth is not always accompanied with
liquidity, especially is working capital funding are high.
– Joint venture factors : firms may be reluctant to vary the level of dividends
paid, and tying its obligations toward the partner.
|99
Leads and Lags
• Firms can reduce both operating and transaction exposure by
accelerating or decelerating the timing of payments that must be made
or received in foreign currencies
• To lead is to pay early
– A firm holding a “soft currency” or debts denominated in “hard
currency” will lead by using the soft currency to pay off the debts
before the soft currency loses value.
• To lag is to pay late
– A firm holding a hard currency and debts denominated in soft
currency will lag by using the hard currency to pay off the debts in
hopes of having to use less of the hard currency
• Leading and lagging is more feasible within a related firm
|100
Reinvoicing Centers
• A reinvoicing center is a separate corporate subsidiary that
serves as an intermediary between the parent and all foreign
subsidiaries. Title of ownership and invoices pass through the center
but the physical movement of goods is direct.
• Advantages
– Managing foreign exchange exposure is centrally located for all
subsidiaries allowing center to attain specialized expertise
– Guaranteeing the exchange rate for future orders can be done
through the center by setting firm local currency costs in advance
– Managing intra-subsidiary cash flows, including leads and lags of
payments is better managed and allows center to hedge only the
net exposure of cash flows
• Disadvantage : that the cost of center may be greater than the
benefits attained.
|101
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.
• The entire process from stage t0 to t5 is the company’s operating
cycle.
|102
The Operating Cycle
Operating Cycle
Accounts
Payable
Period
Input
Sourcing
Period
Quotation
Period
Price
Quote
The
Firm
t0
Order
Placed
t1
Accounts
Receivable
Period
Inventory
Period
Inputs
Received
t2
Order
Shipped
t3
Payment
Received
t4
time
t5
Cash
Outflow
Cash
Intflow
Cash
Payment
for Inputs
Cash
Settlement
Received
Cash
Conversion Cycle
|103
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.
Net workin g capital(NW C)  (A/R  Inventory) - (A/P)
• 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.
|104
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
• Inventory Management
– Anticipating devaluation – management must decide whether to build
inventory of items that carry foreign exchange exposure
– Anticipating price freezes
|105
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-today transactions (transaction motive) and to protect against
unanticipated variations from budgeted cash flows (precautionary
motive)
• Cash disbursed for operations is replenished from two sources
– Internal working capital turnover
– External sourcing, traditionally short-term borrowing
|106
International Cash Management
• 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 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 MNE generates
surplus cash, the MNE must decide whether to handle its own
short-term liquidity or whether surplus funds should be controlled
centrally.
|107
International Cash Settlements
• Four techniques for simplifying and lowering the cost of settling cash
flows between related and unrelated firms
– Wire transfers : Variety of methods but two most popular for
cash settlements are CHIPS and SWIFT
– Cash pooling
– Payment netting
– Electronic fund transfers
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International Cash Settlements
• 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.
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International Cash Settlements
• 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.
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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 : set of functions performed by the existing
treasury department, providing banking services to the various
units of the firm.
– Commercial Banking Offices :
 Correspondent Banks with local banks across the world
 Representative Offices established in a foreign country
 Branch Banks and Affiliates
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