Currency

Issues and
Financing

MIT Center for

Transportation & Logistics ctl.mit.edu
Introduction to Lesson: Currency
Issues and Financing

2
Agenda
1. Introduction to Lesson: Currency Issues and Financing
2. Currency Fluctuations
3. Exchange Rate Risks
4. Corporate Income Taxes
5. Transfer Pricing
6. Profit Repatriation
7. Managing Working Capital
8. Trade Finance
9. Int’l Trade Payment & Letters of Credit
10. Key Points from Lesson
3
Currency Fluctuations

4
Yearly Fluctuations Price of Euro in USD

Stock Market
Crashes

Notice year to year shifts

Flight to Safety

Source: Yahoo.finance.com 5
Last 9 Years: Value of the Euro in USD

-28%

2008
CRASH
20% drop in 6 months

April June
2008 2017

6
Last 9 Years: Value of the Real in USD

59%
-46%

2008
CRASH
2008
CRASH
July June
2008 2017

7
Last 9 Years: Value of the Yuan in USD

0.165

+12% -12%
0.147 0.147

Chinese currency is controlled

so it is less volatile.

Jun 2017

8
What happened to the Yen?
Before The Disaster On Mar 11, 2011

Canada
China
$
Y
$ USA
Singapore $ £ UK

Korea W E Germany

• Japan is a powerful country economically.

• Japanese companies and institutions have lots of money
invested in all sorts of property and entities all over the
world.
• Investments in other countries are in the currencies of those
countries.
• Or, if sold, will be sold in the local currency in those countries.
9
What happened to the Yen?
After the disaster (as predicted by the currency speculators)
Sell C$, Buy Yen
Sell Yuan, Buy Yen
Canada
China Sell S$, Sell $, Buy Yen $
Y Buy Yen
Sell £, Buy Yen $ USA
Singapore
$ Sell Won,
£ UK
Buy Yen
Korea W Sell E,
Buy Yen E
Germany

• Currency speculators believed that Japan will need 124 $Billion to

rebuild.
• And that Japan would shortly begin selling their foreign assets to
bring that money back to Japan to rebuild.
• And that they would have to convert those foreign funds in to YEN
• So they rapidly bought Yen so they could later sell off at a very high
price.
10
 What happened next?
• Currency speculators rapidly bought Yen and drove the Yen up by 5% to
record highs ……. and annoyed the Group of Seven Countries
• Central Banks flooded the market with Yen driving the Yen down by 7%
squashing the speculators.

Japanese Tsunami Currency 85Yen/$

Mar 11, 2011 speculators
buy Yen Central
Banks sell
83Yen/$ Yen
Yen per US$

Price of the
Price of the Yen Yen went
went up by 5% down by 7%
79Yen/$

Tsunami
2011 Mar 11 Mar 17 Apr 7
11
Exchange Rate Risks

12
Exchange Rate Risks
• How do companies get hurt by Exchange Rates?
n Take US and Europe, assume initially 1 Euro = 1.58 USD.
n A Company in US makes Electric Motors. It costs them $10,000 each
to make them and they sell them for $11,000. So normally make
$1000 profit.
n They sign a contract to deliver 500 of them to a customer in Europe
for 7333 Euros each ($11000/1.58). This should earn them 500x
$1000 = $500K profit.
n By the time they deliver the Electric Motors two months later, the
exchange rate has shifted to 1 Euro = 1.30 USD.
n So the 7333 Euros now translates into 7333x1.3 = $9533. They have a
loss on each motor of 10,000 – 9533 = $467 which is a total loss of
$234K.
n Note that this is $500 + $234 = 734K below – so the damage caused by
currency flux was $734K
13
How to get hurt: (2 factors needed)
• Two different currencies
n Buy in one currency but get paid in another
• Time Delay between beginning and end of
transaction.
n Example: Sign contract in Month 1 but deliver goods in
month 1+n.
n Example: Buy raw materials in Month 1, but get paid for
sales in Month 1+n.

14
What is a Currency Futures Contract?
A contract to exchange one currency for another at some future point in time
at a pre-specified exchange rate. Normally there is a fee to do this.
• Example: Assume it is now March 1.
• Jane is an investor who will receive €1,000,000 on June 1.
• The current exchange rate is 1.4 US dollars per Euro.
• She is afraid the exchange rate may decrease by the time June comes
around.
• She can lock in this exchange rate if today she buys €1,000,000 worth of
futures contracts at $1.40/Euro which expire on June 1.
§ Note that she will pay a fee to buy these futures contracts (but the fee will likely be
much less than the devaluation she might suffer from a currency shift.)
• Then on June 1 she will sell her €1,000,000 worth of futures contracts for
$1,400,000. (i.e. she will trade the €1,000,000 for $1,400,000)
§ That way, she is guaranteed an exchange rate of $1.40/€ regardless of exchange rate
fluctuations in the meantime.
15
Internal Ways to Hedge Currencies
• Internal ways to Hedge Foreign Currencies –
within your own company, these are limited
n Leading Expenditure: Pay in advance if you think
the other currency will rise
n Lagging Expenditure: Pay as late as possible if you
think the other currency will fall.
n Netting Receipts and Payments: Match up
opposite currency transactions to see that the
NET exposure is to each currency
w Only works if you have lots of transactions on each side
– buying and selling between the two currencies.
Source: Sayali Bedekar Patil, Foreign Currency Hedging," Buzzle.com,
http://www.buzzle.com/articles/ 16
External Ways to Hedge Currencies
• Forward Contracts: the buyer and seller agree in
advance what exchange rate will be used.
• Currency Swaps: two parties in two countries each
take an equivalent loan in their home currency and
trade the cash
• Foreign Currency Options: the optional right to buy
or sell a specific amount of a specific currency at a
specific price at a specific future time
• Spot Contracts: contracts that are completed in 1-3
days – before the exchange rate can change very
much (not actually hedging)
Source: Sayali Bedekar Patil, Foreign Currency Hedging," Buzzle.com, 17
Example of Foreign Currency Options
For example –imagine an options contract involving Euros and USD that gives
the owner the right to sell 1,000,000 Euros and buy $1,500,000 on June 30.
n The owner has the right to buy USD and a right to sell Euros both at an
agreed-in-advance price of 1.50 US$/Euro
n By June 30 if the Exchange Rate is higher than 1.500, say 1.75, then
the owner ignores this contact and sells his 1M Euros for 1.75M USD
and sees a gain of $250K. So he is happy.
n But suppose by June 30 the Exch Rate has fallen to 1.250. Then,
without this contract, the owner would sell his 1M Euros for only
1.25M USD, thus losing $250K.
n If the owner had this contract, on June 30 he could sell his 1M Euros
for 1.5M USD regardless of the drop in the Exchange Rate. And he
could then buy back those same Euros on the Spot Market for 1.25M
USD and pocket the remaining $250K as profit.

18
Corporate Income Taxes

19
Foreign Operations can be Taxing
• Who can charge you taxes?
n Any government (Federal, state, county, city,
whatever)
• What can they charge you taxes on?
n Usually corp profits but also on inventory value
and value of property plant and equipment
If you are going to site a new manufacturing facility someplace, you better look
at all the tax implication over a long horizon. The cheapest place based on
material, labor, and investment may not be the cheapest place after you
consider taxes.

Source: M Jackson & M Highfield, "The Tax Factor in Global Site Selection, "CSCMP's SC Quarterly,
Q1/2010, p43-46 20
 International Corporate Income Taxes
Corporate
taxes are
Major points: complicated
1. Taxes in each country are charged based on how much profit
so you must
work with
was made in each country. your tax
2. Tax rates vary significantly from country to country. experts!
3. Profitability can vary significantly from product to product.
4. Margins can vary significantly from region to region (e.g.
same product priced differently in different markets).
5. Transfer pricing is used to establish intracompany selling
prices (and thus establishes the profit margin in each
country).

5 degrees of freedom – MANY combinations to think about!

21
International Factor: Tax on Corp Profits
Germany
60 > France
50

TAX %
40
30
Europe 20
10
0
AUS BEL FIN FRA GER IRE ITA NOR SWI UK
60
50
TAX %

40
Americas 30
20
10
0
Japan > ARG BRZ CAN CHI COL ECU MEX PER USA VEN
China
60
50
Asia Pacific
TAX %

40
30
20
10
0

AUS CHI HKG IND JAP KOR PHI SNG TAI THA
1995 Data
22
International Factor: Tax on Corp Profits
Now, France
> Germany
20 yrs later
Now, China
> Japan

Data Courtesy: https://home.kpmg.com 23

Foreign Operations can be Taxing
• What is a Tax Haven?
n A country with a low corp income tax rate such as Ireland,
Switzerland, Singapore, Puerto Rico
• How would you take advantage of a tax haven?
n Put the plant there – so the profit is taxed at a lower rate
n Establish a re-selling (re-invoicing) subsidiary there which
buys all products from the plants regardless of where the
plant is located.
• What is the response of non-Tax haven
countries?
n They scrutinize and disallow many of the proposed
schemes or levy additional taxes to counteract the
scheme. 24
Permanent Establishment
• What is a Permanent Establishment?
n A fixed place of business which generally gives rise to
income or value added tax liability in a particular
jurisdiction.
n The term is defined in many income tax treaties and most
European Union Value Added Tax systems.
n The tax systems in some civil law countries impose income
and value added taxes only where an enterprise maintains
a PE in the country.
n Do you want to have a PE or not have a PE?
• Not have PE – so you are less likely to be taxed.

If you are deemed to have a PE, you will be taxed!

25
Permanent Establishment
• Things that may get you labeled as having a PE in a country:
n A branch
n A warehouse
n A factory
n A mine or oil or gas well
n A management office
• Other things to avoid doing if you want to avoid PE:
n Owning inventory in a country
n Buying or selling in the country
n Being the importer of record, being the exporter of record
n Owning property in the country
n Having employees in the country
Anything on this page may get you TAXED!
26
Taxes on Foreign Earnings Tax Rate 25%
Local
Tax Rate 35% Country B Profits
Local Branch $1000
Country A
Parent Company Local
Country B
Profits
Wholly Owned Subsidiary
Simplified example scenarios only – will differ by country $1000

Country Country Tax Relief in Taxes Profit (Div.) Taxes Paid in A Comments
A B Country A? Paid in B Repatriated
Parent Branch / none 25% x 1000 N/A 35% x 1000 = $350 Foreign profits by a local branch are taxed by both countries.
Office = $250
Parent Branch / Foreign Tax 25% x 1000 N/A (35%x1000) - $250 = FTC reduces the tax due in A by the amount of tax paid in B.
Office Credit (FTC) = $250 $100 Limited so the tax due in A cannot go below zero.
Parent Sub N/A since $0 25% x 1000 $0 $0 Assuming profits earned in B are not connected to business in A,
repatriation = $250 there is $0 tax A
Parent Sub none 25% x 1000 All Profit of 35% x 1000 = $350 With no tax relief in A, repatriated income is taxed at the full rate
= $250 $1000
Parent Sub Foreign Tax 25% x 1000 All Profit of (35%x1000) - $250 = FTC reduces the tax due in A by the amount of tax paid in B.
Credit (FTC) = $250 $1000 $100 Limited so the tax due in A cannot go below zero.
Parent Sub Participation 25% x 1000 All Profit of $0 if FULL exemption, PEX provides partial to full exemption of tax in A if paid tax in B
Exemption (PEX) = $250 $1000 $0 to $350 with and parent has at least X% ownership of entity in B
PARTIAL
Parent Sub Double Taxation 25% x 1000 All Profit of Range from $0 to $350 DTA treaties vary by country pair and provide partial to full
Agreemt (DTA) = $250 $1000 dep. on terms of DTA exemption from double taxation

Key points:
• Supply chain design decisions can have big tax implications.
• Taxes on foreign earnings are very complicated, they differ by each country, so you must engage with the tax experts.
27
 Taxes on Foreign Earnings
Tax Rate 25%
Local
Country B Profits
Tax Rate 35% Local Branch $1000
Country A
Parent Company Local
Country B Profits
Wholly Owned Subsidiary $1000
Simplified example scenarios only – will differ by country
Country Country Tax Relief in Taxes Profit (Div.) Taxes Paid in A Comments
A B Country A? Paid in B Repatriated
Parent Branch / none 25% x 1000 N/A 35% x 1000 = $350 Foreign profits by a local branch are taxed by both countries.
Office = $250
Parent Branch / Foreign Tax 25% x 1000 N/A (35%x1000) - $250 = FTC reduces the tax due in A by the amount of tax paid in B.
Office Credit (FTC) = $250 $100 Limited so the tax due in A cannot go below zero.
Parent Sub N/A since $0 25% x 1000 $0 $0 Assuming profits earned in B are not connected to business in A,
repatriation = $250 there is $0 tax A
Parent Sub none 25% x 1000 All Profit of 35% x 1000 = $350 With no tax relief in A, repatriated income is taxed at the full rate
= $250 $1000
Parent Sub Foreign Tax 25% x 1000 All Profit of (35%x1000) - $250 = FTC reduces the tax due in A by the amount of tax paid in B.
Credit (FTC) = $250 $1000 $100 Limited so the tax due in A cannot go below zero.
Parent Sub Participation 25% x 1000 All Profit of $0 if FULL exemption, PEX provides partial to full exemption of tax in A if paid tax in B and
Exemption (PEX) = $250 $1000 $0 to $350 with PARTIAL parent has at least X% ownership of entity in B
Parent Sub Double Taxation 25% x 1000 All Profit of Range from $0 to $350 DTA treaties vary by country pair and provide partial to full
Agreemt (DTA) = $250 $1000 dep. on terms of DTA exemption from double taxation

Key points:
• Supply chain design decisions can have big tax implications.
• Taxes on foreign earnings are very complicated, they differ by each country, so you must engage with the tax experts.
28
Transfer Pricing

29
What is a Transfer Price?
• What is a Transfer Price?
n Establishes a “market price” for intracompany
transfers of goods.
• Why is it needed?
n Valuation is needed for Duties
n Invoice amount could be spurious

30
Transfer Price trickery
• What are the implications of a HIGH transfer price?
n More profit is realized in the exporting country, less profit is realized
in the importing country
n More import duty is paid if the goods move into the importing
country.
• What are the implications of a LOW transfer price?
n Less profit is realized in the exporting country, more profit is realized
in the importing country
n Less import duty is paid if the goods move into the importing country.
• What does the exporting country want you to do with regard
to Transfer Price?
n Set it very high -- so they get more TAXES from you.
• What does the importing country want you to do with regard
to Transfer Price?
n Mixed effect – if set high might get more duty, but less income tax. If
set low get less duty but more income tax.
31
Transfer Price Example
Country A Country B Country C
Manufacturing Cost/unit $100 ----- -----
Corp Income Tax Rate (on Profits) 30% 15% 40%
Duty Rate on Imports ----- 20% 0%
Transfer Price to Subsidary ----- $160 $200
Selling Price /unit ----- $300 $400
Number of units sold ----- 1000 1000
Duties Paid ----- $32,000 $0
Profit earned total $160,000 $108,000 $200,000

Corp Income Taxes Paid $48,000 $16,200 $80,000

Total of Duties & Taxes $48,000 $48,200 $80,000

Total T&D Across all Countries $176,200

32
 Transfer Price Example What transfer
Make Sell Sell price to
Country A Country B Country C MINIMIZE taxes
Manufacturing Cost/unit $100 ----- ----- and duties?
Corp Income Tax Rate (on Profits) 30% 15% 40%
Duty Rate on Imports ----- 20% 0%
Vary Transfer Price to County B Vary Transfer Price to County C
Transfer Price to Total Tax + Transfer Price to Total Tax +
Country B Country C Duty Country B Country C Duty
100 200 157000 160 140 182200
120 200 163400 160 160 180200
140 200 169800 160 180 178200
160 200 176200 160 200 176200
180 200 182600 160 220 174200
200 200 189000 160 240 172200
Lower is better –Why? Higher is better –Why?
Because the combined cost of country B’s Country C’s 40% tax rate is bigger than
15% tax rate and 20% duty rate is less Country A’s 30% tax rate, and there is no
than the cost of country A’s 30% tax duty involved. So it is better to have
rates. So it is better to make more profit more profit in Country A to pay less taxes.
in country B and less in country A. So a
lower transfer price to country B is best.
33
Profit Repatriation

34
What is Profit Repatriation?
• What is Profit Repatriation?
n Bringing profits earned in a foreign country back home
n Usually paid as dividends to the parent company
n Examples: Foreign auto companies in the US: Toyota,
Honda, Volkswagen, BMW
• What’s the big problem?
n What is the motivation of host country?
n What are barriers to repatriation
w Government limits
w Reporting requirements
w Withholding taxes on dividends, royalties, interest payments
w Double Taxation
Source: Sayali Bedekar Patil, ”Profit Repatriation: The Foreign Direct Investment Incentive,”
Buzzle.com, http://www.buzzle.com/articles/profit-repatriation-the-foreign-direct-investment-
incentive.html 35
 Taxes on Foreign Earnings
Tax Rate 25%
Local
Country B Profits
Tax Rate 35% Local Branch $1000
Country A
Parent Company Local
Country B Profits
Wholly Owned Subsidiary $1000
Simplified example scenarios only – will differ by country
Country Country Tax Relief in Taxes Profit (Div.) Taxes Paid in A Comments
A B Country A? Paid in B Repatriated
Parent Branch / none 25% x 1000 N/A 35% x 1000 = $350 Foreign profits by a local branch are taxed by both countries.
Office = $250

Even with a FTC or some versions

Parent Branch / Foreign Tax of PEX or DTAs, you can get
25% x 1000 N/A (35%x1000) - $250 = FTC reduces the tax due in A by the amount of tax paid in B.
Office Credit (FTC) = $250 $100 Limited so the tax due in A cannot go below zero.
taxed twice on profits that are repatriated.
Parent Sub N/A since $0 25% x 1000 $0 $0 Assuming profits earned in B are not connected to business in A,
repatriation = $250 there is $0 tax A
Parent Sub none 25% x 1000 All Profit of 35% x 1000 = $350 With no tax relief in A, repatriated income is taxed at the full rate
= $250 $1000
Parent Sub Foreign Tax 25% x 1000 All Profit of (35%x1000) - $250 = FTC reduces the tax due in A by the amount of tax paid in B.
Credit (FTC) = $250 $1000 $100 Limited so the tax due in A cannot go below zero.
Parent Sub Participation 25% x 1000 All Profit of $0 if FULL exemption, PEX provides partial to full exemption of tax in A if paid tax in B and
Exemption (PEX) = $250 $1000 $0 to $350 with PARTIAL parent has at least X% ownership of entity in B
Parent Sub Double Taxation 25% x 1000 All Profit of Range from $0 to $350 DTA treaties vary by country pair and provide partial to full
Agreemt (DTA) = $250 $1000 dep. on terms of DTA exemption from double taxation

These “double taxes” make the financial statement of the parent company look
much worse and thus discourages CFOs from repatriating income.
36
Barriers & Methods of Profit
Repatriation?
How do companies Legally Repatriate Income while avoiding
double taxation and withholding taxes?
• Key: don’t convert profits in county B into dividends and then pay the
dividends to parent in country A
• Key: have lower profits in country B and have higher expenses paid to
parent company in country A
• Examples of Legal ways to TRY to do this:
The tax
3. Leading and 4. High Interest authorities
1. Transfer 2. Royalty know about
Lagging Loan to
Pricing Payments
Payments Subsidiary all these and
sometimes
5. Parallel Inter 6. Re-invoicing 7. Counter or have special
Company Loans Centers Barter Trade taxes on
them.
Source: Sayali Bedekar Patil, ”Profit Repatriation: The Foreign Direct Investment Incentive,”
Buzzle.com, http://www.buzzle.com/articles/profit-repatriation-the-foreign-direct-investment-
incentive.html 37
Mechanics of Profit Repatriation
• Transfer Pricing (avoid the need to repatriate)
n Have transfer prices “rigged” so a lot of profit occurs in the home country.
n Example: Japanese Car company - transmissions
n Limitations: governments review for “an arms-length transaction.”

• Royalty Payments
n The parent company charges its foreign subsidiaries a big fee for the use of the parent
company’s name and brand.

• Leading and Lagging Payments

n Use currency fluctuations + payment timing to favor the home company.

• High Interest Loan to Subsidiary

n Home company give a loan to the foreign subsidiary

• Re-Invoicing Centers (RIC)

n Buy-sell Transactions are routed through a Tax Haven

• Counter or Barter Trade

n Parent company and subsidiary buy and sell or trade with each other.

Source: Sayali Bedekar Patil, ”Profit Repatriation: The Foreign Direct Investment Incentive,” Buzzle.com,
38
http://www.buzzle.com/articles/profit-repatriation-the-foreign-direct-investment-incentive.html
Managing Working Capital

39
 Cash Flow Model Typical Company

Can become 60-180 days if int’l customer

Raw Manu-
FG
Raw Goods Material Facturing Goods
Stocking Customer Past Due
Material Stocking 6 day
Bill on 21 days 30-day Payment Terms 5 days
Supplier 14 days cycle Billed
Ship, on hand upon
on hand time
10d
$ shipping
transit $
30-day Supplier Payment Terms Can become “bill on receipt” if int’l customer
$
Company Treasury funds 56 days of Working Capital
Can become Can become
30-40 days if 40-60 days if
ocean ocean
Result: Can become 160-360 days

Why important to GLOBAL supply chains?

40
 Cash to Cash Cycle Time Typical Company

Inventory (IDS) Accounts Receivable (DSO)

Raw Manu-
FG
Raw Goods Material Facturing Goods
Stocking Customer Past Due
Material Stocking 6 day
Bill on 21 days 30-day Payment Terms 5 days
Supplier 14 days cycle Billed
Ship, on hand upon
on hand time
10d
$ shipping
transit $
30-day Supplier Payment Terms

$
Company Treasury funds 56 days of Working Capital
Accounts Payable (DPO)

Note: CTC = IDS + DSO – DPO 56 days between when you

51 35 30 borrowed the money and
when you get paid
Cash to Cash Cycle Time is 56 days

41
 Cash Flow Model Typical Company

Raw Manu-
FG
Raw Goods Material facturing Goods
Stocking Customer Past Due
Material Stocking 6 day
Bill on 21 days 30-day Payment Terms 5 days
Supplier 14 days cycle Billed
Ship, on hand upon
on hand time
10d
$ shipping
transit $
30-day Supplier Payment Terms

$
Company Treasury funds 56 days of Working Capital

How would you improve this?

42
 Cash Flow Model “Dell” Model

VOI
Vendor Manu-
Raw Goods Owned Facturing Goods
Material Raw 6 day Customer
10d transit Bill on ship
Supplier Material JIT cycle
13 DOH time
Customer Credit Card charged at
shipping
$ $
Company Treasury has 29 days of
Customers’ Working Capital
$
30-day Supplier Payment Terms

The company has

Note: VOI delays transfer of ownership by 24 days 29 days worth of
Payment by Credit Card accelerates payment by 35 days cash flow of other
Resulting Cash to Cash Cycle Time is negative 29 days people’s money to
play with.

43
 Standard ways to Free up Working
Capital
Lower Inv. Sell off Lower Inv.
Smaller
Targets, More Excess & Targets, More
Return Excess Lots Segment
Freq Deliv Obsolete Freq Runs
to Suppliers Customer
Faster
Lower Cycle time Shorter Vigorous
Transit time Terms Collections
Raw Manu-
FG
Raw Goods Material facturing Goods
Stocking Customer Past Due
Material Stocking 6 day
Bill on 21 days Billed 30-day Payment Terms 5 days
Supplier 14 days cycle
Ship, on hand upon
on hand time shipping
10d
$ transit $
30-day Supplier Payment Terms

$
Longer Terms, stretch Company Treasury funds 56 days of Working Capital
this out, delay paying
your suppliers!

44
 Innovative ways to Free up Working
Capital
SMED, Pay by Credit
Vendor Owned Lean Card
Bill on w/ JIT Delivery Build to
Receipt Order Early
Cellular Payment
Manufact. Pre-Due Date
Discount
Inquiry
Raw Manu-
FG
Raw Goods Material facturing Goods
Stocking Customer Past Due
Material Stocking 6 day
Bill on 21 days Billed 30-day Payment Terms 5 days
Supplier 14 days cycle
Ship, on hand upon
on hand time shipping
10d
$ transit
EFT $
30-day Supplier Payment Terms

$
Company Treasury funds 56 days of Working Capital
8/8/17

45
Trade Finance

46
Motivations for Trade Finance

Supplier
Goods OEM

$ 30-day
100% Payment Terms

What can the What can the

Supplier do? OEM do?
47
Problems & Solutions
Goods
Supplier OEM

$ 30-day
100% Payment Terms

Possible Possible
Supplier actions OEM actions
Charge more Pay sooner
Offer discount Pay later
Shorten terms Pay more
Lengthen terms Pay less
Borrow money Post approved invoices

48
Trade Financing Actions
Always occur in pairs

Problem Solution – Supplier Solution – OEM

action action
Supplier in cash Offer discount & Pay sooner & pay
crunch shorten terms less
OEM in cash crunch Lengthen terms, Pay later & pay
charge more more
Supplier price too Shorten terms & offer Pay sooner & pay
high discount less

49
 Early Payment Program (offered by OEM)
Typical situation
Supplier Books: DSO = 30 days Goods
Revenue = 100% Supplier OEM
OEM Books: DPO = 30 days
30-day
Cost = 100% $ Payment Terms
$
100%
OEM wants discount, Supplier
needs cash, wants immediate
payment, will take a 4% discount
for early payment.
OEM initiates the change.

OEM pays Supplier early but charges

the Supplier a factor of 4%. Raw Goods
Material OEM
Supplier Books: DSO = 1 day Supplier
Revenue = 96% 1-day
Cash now available
$ Payment Terms $
96%
OEM Books: DPO = 1 day
Cost = 96%

50
 Early Payment Program (using a Funder)
Typical situation
Supplier Books: DSO = 30 days
Revenue = 100% Goods
Supplier OEM
OEM Books: DPO = 30 days
Cost = 100% 30-day
OEM wants discount, Supplier $ Payment Terms
$
100%
needs cash, wants immediate
payment, will take a 4% discount
for early payment.

OEM initiates the change. Raw Goods

Funder pays Supplier immediately, charges Material OEM
Factor of 2% to Supplier. Supplier
OEM keeps a 2% factor for itself. 1-day
$ Payment Terms $
Supplier Books: DSO = 0 96% 98%
Revenue = 96%
Cash now available “Early Payment” means OEM set up the
OEM Books: DPO = 30 days mechanism
Cost = 98%

51
 A/R Financing: Selling Receivables (using a Funder)
Almost identical to Early Payment Program (using a Funder)
Typical situation
Supplier Books: DSO = 30 days
Revenue = 100% Goods
OEM Books: DPO = 30 days Supplier OEM
Cost = 100%
$ 30-day $
Supplier needs cash, wants 100% Payment Terms
immediate payment, willing to suffer
a 4% discount for early payment.

Raw
Supplier initiates the change: Goods
Material OEM
Supplier sells their receivables to a Funder
Supplier
who pays Supplier immediately but
charges a factor of 4%. Immediate Payment
$ by Funder in
30-day $
Payment
Supplier Books: DSO = 0 96% exchange for 4% 100%
factor Terms
Revenue = 96%
Cash now available
OEM Books: DPO = 30 days • The OEM is not involved in this scheme.
Cost = 100% (no change) • This frees up a lot of cash for the supplier.
• Funder is taking a risk w/ the receivables.
52
Revolving Line of Credit – supplier goes alone
Typical situation
Supplier Books: DSO = 30 days
Revenue = 100% Goods
OEM Books: DPO = 30 days Supplier OEM
Cost = 100%
Supplier needs cash, wants $ 30-day
immediate access to money. Willing 100% Payment Terms
$
100%
to borrow money and pay interest.

Goods
Supplier initiates the change Supplier OEM
Suppliers borrows cash from a
Funder at the Supplier’s (risky) $ $ $ $
interest rate of 12%. Invoices are 12% Lend 100%
30-day Payment 100%
the collateral for the loan. interest cash Terms
Supplier Books: DSO = 30
Funder provides
Revenue = 100%
Revolving Line
Must pay interest
of Credit Interest rate is based
Cash now available
OEM Books: NO Change on Supplier’s
financial health.
53
Revolving Line of Credit – OEM helps supplier
Typical situation
Supplier Books: DSO = 30 days
Revenue = 100% Goods
OEM Books: DPO = 30 days Supplier OEM
Cost = 100%
Supplier needs cash, wants $ 30-day
immediate access to money. 100% Payment Terms
$
OEM is a big stable company.

OEM displays “Approved Invoices” … Goods

commitment to pay approved Supplier OEM
invoices. $ $ $
Suppliers borrows cash from a
5% Lend 100% 30-day Payment
Funder at the OEM’s (safe)
interest cash Terms
interest rate of 5%.
Approved Invoices are Funder provides
the collateral for the loan. List of
Revolving Line
Supplier Books: DSO = 30 of Credit Commitment to “Approved Invoices”
Revenue say 98% Pay Approved
Cash now available Invoices
OEM Books: NO Change Interest rate is based on OEM’s financial health.
54
Int’l Trade Payment & Letters of
Credit

55
Key Points
• Lots of risks in international trade – the seller and
buyer are often 1000’s of miles apart and don’t know
each other (can’t trust each other)
• Conundrum:
n Seller wants payment before he ships anything
n Buyer wants to delay payment until after the goods have
arrived

Source: US Gov Trade Finance Guide 2007 pp 3-28 56

Methods of Payment in Int’l Trade

High Cash-In-
Advance

Buyer’s
Risk Letter of
Credit
Open
Low Account
Low High
Seller’s
Risk
Source: US Gov Trade Finance Guide 2007 pp 3-28 57
Cash-In-advance Payment Method
Applicability
Recommended for New customers, customer with bad
credit, customers in risky countries

Risk
All risk is on the buyer (importer). Buyer pays
Pros up front.
• Payment before shipment
• Eliminates risk of nonpayment
Cons
• May lose customers to competitors over payment terms
• No additional earnings through financing operations

Source: US Gov Trade Finance Guide 2007 pp 3-28 58

Open Account Payment Method
Applicability
Recommended for trusted relationships only

Risk
Seller (exporter) has all the risk Seller sends a
Buyer could default on payment after monthly bill
receiving the goods.
Pros
• Boost competitiveness in the global market
• Establish and maintain a successful trade relationship
Cons
• Exposed significantly to the risk of nonpayment
• Additional costs associated with risk mitigation measures
Source: US Gov Trade Finance Guide 2007 pp 3-28 59
Letter Of Credit Payment Method
Applicability
Recommended for use in new or less-established trade
relationships.

Risk Buyer’s bank

Risk is divided between seller and buyer
commits to
Pros pay seller.
• Payment after shipment
• A variety of payment, financing and risk mitigation options
Cons
• Process is complex and labor intensive
• Relatively expensive in terms of transaction costs

Source: US Gov Trade Finance Guide 2007 pp 3-28 60

Letters of Credit
A letter of credit is a document issued by the buyer’s
bank assuring payment to the seller provided certain
documents are been presented to the bank.
• Documents must prove that the goods were
delivered
• LOC works even if the buyer fails to pay his bank
• Risk is transferred from the seller to the buyer’s bank
n Buyer pays a fee to his bank
n Buyer must prove he is trustworthy

61
 Seller’s Buyer’s
Seller demands bank bank
Letter of Credit
before sending
goods to Buyer LOC

1. Buyer Seller Buyer

arranges for his
bank to sent a
LOC to Seller

Carrier

62
 Seller’s Buyer’s
bank bank
2. Seller gives
the goods to a
Carrier to ship
the goods to
the Buyer.
Seller gets a Bill Seller Buyer
of Lading from BOL
the Carrier.

GOODS
Carrier

63
 Payment
Seller’s Buyer’s
3. Seller bank bank Payment
provides bill of BOL
lading to bank in
exchange for BOL & LOC
payment. Payment
Seller's bank BOL
exchanges bill of
lading for
payment from
Seller Buyer
buyer's bank.
Buyer's bank
exchanges bill of
lading for
payment from
the buyer Carrier

64
 Seller’s Buyer’s
bank bank

4. Buyer
provides bill
of lading to
carrier and
takes
Seller Buyer
delivery of
goods.
Goods
BOL
Carrier does not release the goods to
the buyer until the buyer shows him the Bill of Lading is most
BOL that he originally gave to the Carrier common but LOCs CAN
Shipper require other types of
documents

65
Key Points from Lesson

66
Agenda
1. Introduction to Lesson: Currency Issues and Financing
2. Currency Fluctuations
3. Exchange Rate Risks
4. Corporate Income Taxes
5. Transfer Pricing
6. Profit Repatriation
7. Managing Working Capital
8. Trade Finance
9. Int’l Trade Payment & Letters of Credit
10. Key Points from Lesson
67
Key Points from the Lesson
1. Currency Trends, Exchange Rate Risks & Hedging
n Exchange rates fluctuate a lot, can exceed logistics deltas
n Two factors lead to hurt: Two currencies and time delay
n Internal ways to hedge: leading, lagging, netting
n External ways to hedge: currency futures contract
2. Corporate Income Taxes & Permanent
Establishment
n Taxes vary significantly between countries
n Huge factor in global SC network design
n Tax deltas usually exceed Logistics deltas
n Permanent Establishment gets you taxed
n Take advantage of Tax Havens (IR, SW, SG, PR)
68
Key Points from the Lesson
3. Transfer Pricing & Profit Repatriation
n Transfer Pricing – related parties transaction
w Arms length, consequences of high v low on taxes & duties
n Profit Repatriation – country barriers
n Double Taxation – ways to avoid it - transfer pricing,
royalties, re-invoicing center, leading, lagging, loans
4. How to Free Up Working Capital
n Long lead times exacerbate WC for Global SCs
n Cash to Cash Cycle Time: CTC=IDS+DSO-DPO
n How to Free up WC:
w Dell model, speed up and shift ownership of assets

69
Key Points from the Lesson
5. Trade Financing
n OEMs can help suppliers by posting approved invoices
(commit to pay)
Problem Solution – OEM Action Solution – Supplier Action

Supplier in cash crunch Pay sooner & pay less Offer discount & shorten terms

OEM in cash crunch Pay later & pay more Lengthen terms, charge more

Supplier price too high Pay sooner & pay less Shorten terms & offer discount

OEM costs too high Pay less & pay sooner Offer discount & shorten terms

6. Int’l Trade Payment & Letters of Credit

n Three Methods studied: Cash-In-Advance, Letter of Credit,
Open Account
n Letter of Credit: Buyer’s bank commits to pay, BOL used as
proof of payment
70
 Questions, Comments, Suggestions?
Use the Discussion!

MIT SCM playing

the “Beer” Game

MIT Center for

Transportation & Logistics ctl.mit.edu 71
Images
• Slide 5-8, 11
n Graphs from finance.yahoo.com

72