International Financial

Management (MAF612)
Chapter 5 - International Working
Capital Management
 Topics to be discussed
• Multinational working capital management vs.
domestic working capital management
• Objectives of international cash management
• Techniques used by MNCs for making cross-border
payments
• Firm’s funding strategy
• Short-term financing options
• International banking and trade
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 Multinational Working Capital
Management vs. domestic working
capital management
• Funds Availability
• Additional Risks
• Movement of Capital
• Taxes

3
 International Cash Management

• A set of activities, which consists of:

– Cash management - the levels of cash balances
held throughout the MNC
– Cash settlements and processing - the facilitation
of its movement across borders

4
 Cash Management
• Cash levels are determined independently of working
capital management decisions
• Cash balances, including marketable securities, are held for:

– day-to-day transactions (transactional motive)

– protect against unanticipated variations from
budgeted cash flows (precautionary motive) and
– possible profit (speculative motive)
5
 International Cash Management
• Goal: Minimize cash balances without increasing risk.
• Steps:
• Cash Planning - anticipating cash flows over the future
• Cash Collection – getting cash into the firm as soon as possible.
• Cash Mobilization – moving cash within the firm
• Cash Disbursements – planning procedures for distributing cash.
• Covering Cash Shortages – managing anticipated cash shortages.
• Investing Surplus Cash – managing anticipated cash surpluses by
investing locally or controlling them centrally.
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 Cash Positioning Decision
• Location of currency

• Type of liquid asset held

• Maturities, yields, and liquidity characteristics

7
 Objectives of an Effective Cash
Management System
• Minimizing overall cash requirements
• Minimizing currency exposure risk
• Minimizing political risk
• Minimizing transactions costs
• Taking full advantage of economies of scale

8
 Complexities of the International
Cash Positioning Decision

• Conflicting nature of cash management objectives

• Government restrictions
• Multiple taxation systems
• Multiple currencies

9
 International Cash Settlements
and Processing
• Four techniques for simplifying and lowering the cost of
settling cash flows between related and unrelated firms
– Wire transfers
– Cash pooling
– Payment netting
– Electronic fund transfers

10
 Wire Transfers
• Variety of methods but two most popular for cash settlements
are CHIPS and SWIFT
– CHIPS is the Clearing House Interbank Payment System
owned and operated by its member banks
– SWIFT is the Society for Worldwide Interbank Financial
Telecommunications which also facilitates the wire transfer
settlement process
– Whereas CHIPS actually clears transactions, SWIFT is purely a
communications system
11
 Cash Pooling and Centralized
Depositories
• Centralizing the cash positioning function to gain
operational benefits.
– Subsidiaries hold minimum cash for their own
transactions and no cash for precautionary purposes
– All excess funds are remitted to a central cash
depository

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 Cash Pooling and Centralized
Depositories
• Centralized depositories provide the following advantages:
– Information advantage is attained by central depository on
currency movements and interest rate risk
– Precautionary balance advantages as MNC can reduce pool
without any loss in level of protection
– Interest rate advantages as funds can be borrowed at a
lower cost and invested at a more advantageous rate.
– Location can provide tax benefits, access to international
communications, clearly defined legal procedures.
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 Netting
• Netting involves offsetting receivables against payables so
that only the net amounts are transferred among affiliates.
• Types

– Bilateral netting

– Multilateral netting

• Payments netting is useful primarily when a large number

of separate foreign exchange transactions occur between
subsidiaries.
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 Payments Netting
• Example: A Belgian affiliate owes an Italian affiliate
$5,000,000, while the Italian affiliate simultaneously
owes the Belgian affiliate $3,000,000.
– Bilateral settlement calls for $2,000,000 payment
from Belgium to Italy and cancellation of the
remainder via offset.
– Multilateral netting is an extension of bilateral
netting.
15
 Financing Working Capital
• Financing working capital requirements of a MNC’s
foreign affiliates poses a complex decision problem.
• Financing options for a subsidiary include:
– Intercompany loans from the parent or a sister
affiliate.
– Local currency financing.

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

• Minimize covered after-tax interest costs

• Minimize expects costs
• Trade-off between expected cost and reducing the
degree of cash flow exposure

18
 Intercompany Loans
• The cost of an intercompany loan is determined by the
following factors:
– Opportunity cost of funds
– Interest rate
– Tax rates and regulations
– Currency of denomination
– Expected exchange rate change
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 Local Currency Financing
• Bank Loans
– Term Loans
– Line of Credit
– Overdraft
– Revolving Credit Agreement
– Discounting
• Commercial Paper
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 THE EFFECTIVE COST OF SHORT TERM
BORROWING
• When borrowing in international money markets, the firm must
consider two issues:
1) The market interest rate on borrowed funds and,
2) The (anticipated) change in the exchange rate during the
period that the funds will be borrowed.
– Prior to paying back the borrowed funds.
– This needs to be considered because the firm has an exposed
foreign currency position or the period up to repayment.
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 Impact of Exposure on Borrowing
Cost
• If the foreign currency appreciates, the “effective”
cost of borrowing increases.
• Why?
– It will take more home currency to pay off the
debt. Thus,
– Effective borrowing cost = market interest rate +
foreign currency appreciation.
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 Impact of Exposure on Cost of
Borrowing
• If the foreign currency depreciates, the “effective” cost of
borrowing decreases.
• Why?
– It will take less home currency to pay off the debt. Thus,
Effective borrowing cost = market interest rate – foreign
currency depreciation.

23
 Calculating Effective Cost of
Borrowing
• Effective financing rate is:

Rf = (1 + if)(1 + ef) – 1

– Where:

• Rf = is the effective financing rate.

• if = is the market interest rate.

• ef = is the expected (percentage) change in the foreign

24
currency against the firm’s home currency.
 Example
• Assume a U.S. firm is quoted a borrowing rate in
Switzerland of 4% on a one-year loan.
• The U.S. firm has forecasted a change in the Swiss
franc from $.50/SFr on the day the loan is made to
$.55/SFr on the day the loan is to be paid back.
• Use this information to calculate the effective cost of
borrowing in Switzerland.

25
 Example
• Calculate the expected change in the Swiss franc:

Expected change = (forecast - current)/current), or

($.55 - .50)/.50 = .05/.50 = .10 (10.0%), then
• Using the effective rate formula:
Rf = (1 + if)(1 + ef) – 1
= (1 + .04)(1 + .10) - 1
= (1.04)(1.10) - 1
= 1.144 - 1
= .144 (or 14.4%)
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 Example

• Now assume that your forecast for the Swiss franc

called for an exchange rate of $.49/Sfr one year from
now.
• Given this assumption and the information above,
calculate the effective cost of borrowing Swiss francs.

27
 Example
• Calculate the expected change in the Swiss franc:
Expected change = (forecast - current)/current), or
($.49 - .50)/.50 = -0.1/.50 = -0.2 (-2.0%)

• Using the effective rate formula:

Rf = (1 + if)(1 + ef) – 1
= (1 + .04)(1 - 0.02) - 1
= (1.04)(.98) - 1
= 1.0192 – 1
= .0192 (or 1.92%)

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THE EFFECTIVE COST OF SHORT TERM BORROWING WITH
A FORWARD COVER

• In the previous two examples, the effective cost of

borrowing was calculated on the basis of the firm
having an uncovered position in the foreign currency.

• Question?
– What if we elect to cover the exposure associated with the
borrowing? 29
 Covering the Exposure
• The effective rate formula can also be used to incorporate the
cost of a forward cover (given that the forward rate will provide
us with a “exact” future exchange rate).
Rfc = (1 + if)(1 +/- c) - 1

Where:
Rfc = is the effective covered financing rate.
if = is the market interest rate.
c = is the forward discount or premium for the foreign
currency against its spot.
• Note: If the foreign currency is selling at a discount, you
subtract (-c) and if it is selling at a premium, you add (+c).
30
 Example
• Assume a U.S. firm is quoted a borrowing rate in Switzerland of
4% on a 1-year loan.
• The U.S. firm has been given a forward 1-year quote of –1% (the
franc is selling at a discount of its spot of 1%).

Rfc = (1 + if)(1 +/- c) - 1

= (1 + .04)(1 -.01) - 1
= (1.04)(.99) - 1
= 1.0296 - 1
= .0296 (or 2.96%) 31
 Example
• Assume that the Swiss franc is quoted at a 2% premium of its
spot.
• The calculated covered cost of borrowing under this assumption
is:

Rfc = (1 + if)(1 +/- c) - 1

= (1 + .04)(1 +.02) - 1
= (1.04)(1.02) - 1
= 1.0608-1
= .0608 (or 6.08%) 32
 International banking and trade
• Operations of International banks
• Finance foreign trade and foreign investment
• Underwrite international bonds
• Borrow and lend in the foreign currency
• Organize syndicated loans
• Participate in international cash management
 Why do banks go international?
• Managerial and marketing knowledge developed at
home can be used abroad with low marginal cost
• Foreign bank subsidiaries have a knowledge advantage
over local banks
• Large international banks have high-perceived prestige,
liquidity, and deposit safety
 Why do banks go international?

• Foreign bank subsidiaries have a regulatory advantage

over local banks
• Growth prospects in a home market may be limited
because market is saturated
• Reduce risk through international diversification
• Follow their multinational customers abroad to prevent
erosion of their client base to foreign banks
 Types of foreign banking offices
Representative office
• Obtain information, give advice, and arrange local
contacts for their parent bank’s business customers
• Do not have traditional banking functions such as
deposits, loans, letters of credit, drafts
 Types of foreign banking offices
Correspondent Banking
• An informal arrangement in which a bank in a country
maintains deposit balances with banks in foreign
countries and looks to them for services and assistance.

• Correspondent banks accept drafts and honor letters of

credit.
 Types of foreign banking offices
Branch Banks
• Do not have a corporate charter, board of directors, or
shares stock outstanding.
• They are an operational part of the parent bank; their
assets and liabilities are those of the parent bank.
• Provide a full range of banking services under the name
and guarantee of the parent bank.
 Types of foreign banking offices
Foreign Subsidiary Banks:
• Have their own charter, board of directors,
stockholders, managers
• They are able to attract additional local deposits and
have greater access to the local business community
 International banking and trade
International loans
• US, Japanese and European banks extend large
international loans to many developing countries
• These loans become part of sovereign debts of a
country
 International banking and trade
Syndicated loans
• A credit in which a group of banks makes funds available
on common terms and conditions to a particular
borrower.
• It is a device a group of banks adopt to handle large
loans that one bank is unable or unwilling to supply.
International trade finance: methods
and instruments
The problem in international trade
• Time lag
• Cultural differences-language
• Financing the transaction
International trade finance: methods
and instruments

Importer
Goods

Time and
distance
Money Exporter
 International trade finance:
methods and instruments
• Prepayment • Open account

• Letters of credit • Accounts receivable

financing
• Drafts (sight/time)
• Banker’s acceptance
• Consignment
• Factoring
 Prepayment
• Exporter ships goods only after importer remits
payment.
• Payment is made in the form of an international wire
transfer to the exporter’s bank account or foreign
bank draft.
• Safest to the exporter
• Riskiest to the importer
 Letters of Credit (L/Cs)
• Instrument issued by a bank on behalf of the importer
promising to pay the exporter upon presentation of shipping
documents in compliance with the terms stipulated therein
• Is a compromise between seller and buyer
• Importer relies on exporter to ship goods described in the
documents
• No risk to exporter
 Letter of credit

(1) Sales contract

Importer Exporter
(5) Delivery of goods

(8) Doc & (2) (6)

claim for Request Document (4) L/C
payment for credit presented Delivered
(7) Doc presented to
issuing bank

Importer’s (9) Payment Exporter’s

Bank (3) Credit sent to Bank
correspondent
 Drafts(bill of exchange)
• Unconditional promise drawn by the exporter,
instructing the buyer to pay the face amount of the draft
upon presentation.
• Does not obligate banks to honor the payment on behalf
of the importer
• It is riskier than L/C
 Consignment

• The exporter ships the goods to the importer while

retaining actual title
• The importer pays for the goods only when they are sold
to a third party
• The exporter trusts the importer to remit payment for
the goods sold.
• Highly risky for the exporter
 Open Account
• The exporter ships the merchandise and expects the
buyer to remit payment.
• The exporter relies upon the financial credit worthiness,
integrity, and reputation of the buyer.
• This method is used when the seller and buyer have
mutual trust and a great deal of experience with each
other.
 Accounts receivable financing

• Is when exporter needs money to finance accounts

receivable
• Exporter obtains a bank loan by assigning accounts
receivable
• Payment of loan to bank remains exporter’s
responsibility
 Factoring

• Involves sales of accounts receivable without recourse to

a factor
• Exporter transfers administrative burden and credit risk
to the factor
 Banker’s acceptance
• Time draft along with shipping documents accepted by
importer’s bank
• Can be sold by the exporter in the money market
• Less risky to the exporter
End