© 2018 Cambridge University Press 19-1
Michala Moravcová
Department of Finance, Masaryk University
International Finance
Managing net working capital
International Finance
© 2018 Cambridge University Press 19-2
• Every corporation maintains a stock of current assets and current liabilities to
buffer the inflows and outflows of cash generated by the firm’s business.
• Working capital
• Current assets (i.e., cash, marketable securities, accounts receivable, and inventories) held by
a firm at any point in time
• Net working capital (NWC)
• 𝑁𝑊𝐶 = 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 – 𝐹𝑖𝑟𝑚 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
• Firm current liabilities: short-term debt and accounts payable
• If a firm can be managed with a smaller stock of net working capital, cash can be paid to
shareholders = run a corporation efficiently in order to minimize the need for net working
capital.
1. The Purpose of Net Working Capital
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• Inventories as assets
• Includes raw materials, goods that represent work-in-progress, and finished goods
• Cost of production are lower if production is smoothed over time
• Increases in inventories seen as an investment for future cash (rate of return to the
capital/inventories )
• Other current assets
• Increases in cash marketable securities and accounts receivable should also be viewed as
investment for future cash
• Short-term liabilities
• May be used to buy e.g., raw materials without changing NWC
= firms try to hold enough net working capital to smooth out the production–sales cycle.
1. The Purpose of Net Working Capital
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© 2018 Cambridge University Press 19-4
• Goals:
• to establish control over the cash resources of the organization
• to invest excess short-term funds in an optimal way
• to obtain short-term financing at the lowest cost
• Constraints
• Government restrictions on the transfers of funds
• Blocked funds
• Unattractive foreign exchange rates
• Taxes that depend on the type of fund transfer
• Transaction costs in the foreign exchange market
• Problems maintaining the liquidity of all foreign affiliates
2. International Cash Management
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• Cash management with a centralized pool
• Transactions demand for money: arises because a firm realizes that it has some expenditure
that will be incurred in the near future.
• Precautionary demand for money: arises because a firm may need to purchase something
due to unanticipated change in its environment
• MNCs can reduce transaction costs by centralizing the management of short-term cash
balances of its foreign affiliates
2. International Cash Management
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© 2018 Cambridge University Press 19-6
Daily Cash Reports of an
MNC’s European Affiliates
(in thousands of euros)
• The management of a firm’s
centralized cash pool
• MNC that has European affiliates
operating in Great Britain,
Denmark, Netherlands, Spain.
• The cash flows for each of the
affiliates are converted into
euros at current exchange rates.
• Month’s cumulative cash flows
before any multilateral netting
for the European affiliates of a
multinational corporation
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Consolidated Daily Cash Reports of an MNC’s European
Affiliates (in thousands of euros)
Minimum desired balance should be adjusted downward in light of the interest rates and the expectations of
depreciation.
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© 2018 Cambridge University Press 19-8
The Cash Flows of an MNC’s Affiliates Before
Multilateral Netting (in thousands of euros)
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Cash Flows After Multilateral Netting (in thousands of
euros)
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© 2018 Cambridge University Press 19-10
• Managing surpluses and deficits
• Surpluses can be invested in short-term money market instruments
• Deficits can be borrowed through banks or in the commercial paper market
• Forecasts of cash flows
• Five-day rolling forecasts
• Can be checked for accuracy
• Enables assessment of short-term needs of each affiliate in light of forecasted movements in
exchange rate
• Used to generate overall forecasts of the net cash flows
• Multilateral netting system
• Save on transaction costs
2. International Cash Management
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© 2018 Cambridge University Press 19-11
• Using a centralized cash management system to reduce precautionary cash
demands
• Can use probability distributions to help the firm manage the cash
• Normal distribution à 97.5% probability that the cash demands will not exceed the mean plus two
times the standard deviation
• This can be done at a specific location or even by region
• Limits:
• MNCs must diversify across banks as even the largest banks have the potential to default
2. International Cash Management
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European Affiliates’ Demands for Cash
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© 2018 Cambridge University Press 19-13
• Dividends payments
• Most common, makes up > 50% of transfers
• Tax planning – policy / timing should minimize taxes
• Political risk
• To avoid questions from foreign governments, it is advantageous to have dividend policies in place
• Foreign exchange risk – timing may be used to maximize benefit or minimize loss
• Other factors, e.g., joint venture relationships
3. Cash Transfers from Affiliates to Parents
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© 2018 Cambridge University Press 19-14
• Royalties and management-fees
• Royalties – payments to owners of technology, patent or trademark for its use
• Fees for management or consulting services
• Tax advantages of royalties and fees – not taxes in some countries
• Repatriation in a joint venture – important to ensure that there is no confusion about future
payments
• Paid out of pretax income, which reduces withholding taxes of other repatriated funds
3. Cash Transfers from Affiliates to Parents
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© 2018 Cambridge University Press 19-15
• Transfer pricing and cash flows
• Set prices for goods being sold to firm’s affiliates
• Not always easy to determine if these prices are fair value (especially for semi-finished goods,
which have no market price)
• High transfer pricing shifts income / tax payments from the affiliate paying to the affiliate
receiving
• Governments do not like this
• Shift income and tax burdens between countries
3. Cash Transfers from Affiliates to Parents
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© 2018 Cambridge University Press 19-16
Effects of High and
Low Transfer Prices
on Net Income
The increase in the transfer price shifted
income from the distribution
affiliate to the manufacturing affiliate.
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© 2018 Cambridge University Press 19-17
• Transfer pricing regulations establish what is an appropriate price
• In U.S. this is one which reflects an “arm’s-length price”
• Methods to calculate this (for U.S. and OECD member nations) include:
• The comparable uncontrolled price method
• The resale price method
• The cost-plus method
• The comparable-profits method
• Other acceptable methods
3. Cash Transfers from Affiliates to Parents
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© 2018 Cambridge University Press 19-18
• How transfer prices affect manager incentives
• Makes in more difficult to evaluate management since it can artificially cause some locations
to appear more profitable than others
• Using transfer prices to offset tariffs (taxes on imported goods)
• Can offset tariffs by imposing a low transfer price
• Increase gross income of the purchasing affiliate, which will result in higher income taxes
3. Cash Transfers from Affiliates to Parents
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© 2018 Cambridge University Press 19-19
• Using transfer pricing to deal with foreign exchange quotas
• Similar to offsetting tariffs, quotas push up the value of each unit so affiliates can offset this
with lower transfer prices
• Transfer pricing in joint ventures
• More difficult since partner is from another country and incentives are different
3. Cash Transfers from Affiliates to Parents
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© 2018 Cambridge University Press 19-20
• Any firm that decides to issue trade credit must perform five tasks
• Assess credit risk of customer
• Determine terms of credit (term length and interest penalties for late payments)
• Finance the receivable between the production and the receipt of funds from the sale
• Collect the receivable
• Bear the default risk of companies that are extended credit
• Currency of denomination
• MNC must decide whether its foreign sales should be denominated in the domestic currency,
in the currency of the foreign customer, or possibly in a third currency
• Exports in currencies most likely to appreciate
• Imports in currencies most likely to depreciate
4. Managing Accounts Receivable
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© 2018 Cambridge University Press 19-21
• Pricing airplanes for British Airways
• British Airways will have to pay Boeing $100M in 1 year when they deliver the planes
• The spot and forward rates are as follows: Spot: $1.65/£; 1-yr Forward: $1.60/£
• Using the forward contract, BA would pay
• $100𝑀/($1.60/£) = £62.5𝑀
• They are therefore indifferent between paying £62.5M or hedging $100M.
4. Managing Accounts Receivable – Example: Currency
denomination
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© 2018 Cambridge University Press 19-22
• Pricing airplanes for Bangkok Airways
• Spot = THB25/$ with no forward market
• 50% chance spot will stay the same
• 50% chance the baht will fall to THB40/$
• Price of plane = $100M in 1 year
• BA can buy $ today and invest or bear the risk for a year:
• 𝐸[𝐹] = [0.5×(𝑇𝐻𝐵25/$)] + [0.5×(𝑇𝐻𝐵40/$)] = 𝑇𝐻𝐵32.5/$
• Boeing thinks THB40/$ will occur with 55% probability:
• 𝐸[𝐹] = [0.45×(𝑇𝐻𝐵25/$)] + [0.55×(𝑇𝐻𝐵40/$)] = 𝑇𝐻𝐵33.25/$
• Boeing could charge this price in THB if they wanted to
• If this happened, BA would prefer to be invoiced in $s since THB32.5 < THB33.25
4. Managing Accounts Receivable – Example 2
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• Timing of payments can affect liquidity of an MNC’s affiliates
• Leading payment – payment made earlier than usual
• Lagging payment – payment made later than usual
• Cost must be considered
• Funds should be moved from affiliates that have low opportunity costs of NWC to affiliates with
high opportunity costs
4. Managing Accounts Receivable
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© 2018 Cambridge University Press 19-24
• Different borrowing and lending rates for affiliates
• U.S. parent 8% borrowing rate; 7% lending rate
• British affiliate 8.2% borrowing rate; 6.9% lending rate
• The U.S. parent has surplus funds and British affiliate must borrow – parent should lend
funds to the affiliate
• $1𝑀×(8.2 – 7)/100×(90/360) = $3,000
• The U.S. parent must borrow and affiliate has surplus – the affiliate should lend to the parent
• $1𝑀×(8.0 − 6.9)/100×(90/360) = $2,750
4. Managing Accounts Receivable
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© 2018 Cambridge University Press 19-25
• Both the parent and the affiliate have surplus
• Parent can earn more so the affiliate should flow funds to parent
• $1𝑀×(7 − 6.9)/100×(90/360) = $250
• Both parent and affiliate must borrow
• Since the parent borrows at a lower cost, funds should flow from parent to affiliate
• $1𝑀×(8.2 – 8.0)/100×(90/360) = $500
4. Managing Accounts Receivable
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© 2018 Cambridge University Press 19-26
• 1. The U.S. parent has surplus funds, and the British affiliate must borrow: The U.S. parent can invest
funds at 7%, whereas the British affiliate borrows at 8.2%.Clearly, the U.S. parent should lend funds to
the British affiliate.
• 2. The U.S. parent must borrow, and the British affiliate has surplus funds: The U.S. parent borrows
funds at 8.0%, whereas the British affiliate earns only 6.9% on its lending. Clearly, the British affiliate
should lend to the U.S. parent.
• 3. Both the U.S. parent and the British affiliate have surplus funds: Because both the U.S. parent and
the British affiliate have funds to invest, we merely compare what they can earn. The U.S. parent can
earn 7%, whereas the British affiliate can only earn 6.9%. Clearly, funds should flow from the British
affiliate to the U.S.
• Both the U.S. parent and the British affiliate must borrow: Because both the U.S. parent and the
British affiliate must borrow, we merely compare their respective borrowing rates. The U.S. parent
borrows at 8.0%, whereas the British affiliate borrows at 8.2%. Clearly, funds should flow from the
U.S. parent to the British affiliate.
4. Managing Accounts Receivable - Summary
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© 2018 Cambridge University Press 19-27
• Inventory kept to smooth the production process
• Inventory is costly, however
• If a firm’s cost of capital is 15%, $100M of inventory costs the firm $15M
• Firm exposed to losses if inventory is stolen, destroyed or becomes obsolete
• Insurance can be bought for this but will be another cost
• Optimal inventory theory
• MB of production smoothing = MC of holding inventory
• Devaluation or depreciation risk at foreign subsidiaries
5. Inventory Management
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© 2018 Cambridge University Press 19-28
• What is net working capital? Why should it be considered an investment that a
firm must make to increase its future profitability?
• What distinguishes international cash management from purely domestic cash
management? In particular, what constraints arise in the international
environment?
• How can transfer pricing be used to shift income around the world?/How can
transfer pricing be used to avoid tariffs?
• Why is the threat of devaluation an insufficient reason for a firm to build up its
stocks of inventories?
• What are the five tasks involved in issuing trade credit?
QUESTIONS:
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