28. A19 - 28
Б лгийн зорилгоү
• To explain why MNCs consider foreign
financing;
• To explain how MNCs determine whether to
use foreign financing; and
• To illustrate the possible benefits of
financing with a portfolio of currencies.
29. A19 - 29
Sources of Short-Term Financing
• Euronotes are unsecured debt securities
with typical maturities of 1, 3 or 6 months.
They are underwritten by commercial
banks.
• MNCs may also issue Euro-commercial
papers to obtain short-term financing.
• MNCs utilize direct Eurobank loans to
maintain a relationship with the banks too.
30. A19 - 30
Internal Financing by MNCs
• Before an MNC’s parent or subsidiary
searches for outside funding, it should
determine if any internal funds are
available.
• Parents of MNCs may also raise funds by
increasing their markups on the supplies
that they send to their subsidiaries.
31. A19 - 31
Why MNCs Consider
Foreign Financing
• An MNC may finance in a foreign currency to
offset a net receivables position in that
foreign currency.
• An MNC may also consider borrowing
foreign currencies when the interest rates
on such currencies are attractive, so as to
reduce the costs of financing.
32. A19 - 32
Determining the
Effective Financing Rate
The actual cost of financing depends on
the interest rate on the loan, and
the movement in the value of the borrowed
currency over the life of the loan.
33. A19 - 33
Effective financing rate, rf
=
{(1+if ) × St+1} – {1 × St}
=(1+if )
St+1 –1
{1 × St} St
where if = the interest rate on the loan
St = beginning spot rate
St+1 = ending spot rate
Determining the
Effective Financing Rate
The effective rate can be rewritten as
rf = (1+if ) (1+ef ) – 1
where ef = the % ∆ in the spot rate
34. A19 - 34
Criteria Considered for
Foreign Financing
• There are various criteria an MNC must
consider in its financing decision, including
¤ interest rate parity,
¤ the forward rate as a forecast, and
¤ exchange rate forecasts.
35. A19 - 35
Criteria Considered for
Foreign Financing
Interest Rate Parity (IRP)
• If IRP holds, foreign financing with a
simultaneous hedge of that position in the
forward market will result in financing
costs similar to those for domestic
financing.
36. A19 - 36
The Forward Rate as a Forecast
• If the forward rate is an unbiased predictor
of the future spot rate, then the effective
financing rate of a foreign loan will on
average be equal to the domestic financing
rate.
Criteria Considered for
Foreign Financing
37. A19 - 37
Exchange Rate Forecasts
• Firms may use exchange rate forecasts to
forecast the effective financing rate of a
foreign currency, or they may compute the
break-even exchange rate that will equate
the domestic and foreign financing rates.
• Sometimes, it may be useful to develop
probability distributions, instead of relying
on single point estimates.
Criteria Considered for
Foreign Financing
38. A19 - 38
Financing with a
Portfolio of Currencies
• While foreign financing can result in
significantly lower financing costs, the
variance in the costs is higher.
• MNCs may be able to achieve lower
financing costs without excessive risk by
financing with a portfolio of currencies.
39. A19 - 39
Financing with a
Portfolio of Currencies
• If the chosen currencies are not highly
positively correlated, they will not be likely
to experience a high level of appreciation
simultaneously.
• Thus, the chances that the portfolio’s
effective financing rate will exceed the
domestic financing rate are reduced.
40. A19 - 40
• A firm that repeatedly finances in a
currency portfolio will normally prefer to
compose a financing package that exhibits a
somewhat predictable effective financing
rate on a periodic basis.
• When comparing different financing
packages, the variance can be used to
measure how volatile a portfolio’s effective
financing rate is.
Financing with a
Portfolio of Currencies
41. A19 - 41
For a two-currency portfolio,
E(rP) = wAE(rA) + wBE(rB)
where rP = the effective financing
rate of the portfolio
rX = the effective financing
rate of currency X
wX = the % of total funds
financed from currency X
Financing with a
Portfolio of Currencies
42. A19 - 42
Var(rP) = wA
2
σA
2
+ wB
2
σB
2
+ 2wAwBσAσBCORRAB
σX
2
= the variance of currency
X’s effective financing rate
CORRAB = the correlation
coefficient of the two currencies’
effective finance rates
Financing with a
Portfolio of Currencies
For a two-currency portfolio,
43. A19 - 43
Impact of Short-Term Financing Decisions
on an MNC’s Value
( ) ( )[ ]
( )∑
∑
+
×
=
n
t
t
m
j
tjtj
k1=
1
,,
1
ERECFE
=Value
E (CFj,t ) = expected cash flows in
currency j to be received by the U.S. parent at the
end of period t
E (ERj,t ) = expected exchange rate at
which currency j can be converted to dollars at
Expenses Incurred from
Short-Term Financing
45. A19 - 45
Chapter Objectives
• To explain the difference between a
subsidiary perspective and a parent
perspective in analyzing cash flows;
• To explain the various techniques used to
optimize cash flows;
• To explain common complications in
optimizing cash flows; and
• To explain the potential benefits and risks
of foreign investments.
46. A19 - 46
Cash Flow Analysis:
Subsidiary Perspective
• The management of working capital has a
direct influence on the amount and timing
of cash flow :
¤ inventory management
¤ accounts receivable management
¤ cash management
¤ liquidity management
47. A19 - 47
Subsidiary Expenses
• International purchases of raw materials or
supplies are more likely to be difficult to
manage because of exchange rate
fluctuations, quotas, etc.
• If the sales volume is highly volatile, larger
cash balances may need to be maintained in
order to cover unexpected inventory
demands.
Cash Flow Analysis:
Subsidiary Perspective
48. A19 - 48
Subsidiary Revenue
• International sales are more likely to be
volatile because of exchange rate
fluctuations, business cycles, etc.
• Looser credit standards may increase sales
(accounts receivable), though often at the
expense of slower cash inflows.
Cash Flow Analysis:
Subsidiary Perspective
49. A19 - 49
Subsidiary Dividend Payments
• Forecasting cash flows will be easier if the
dividend payments and fees (royalties and
overhead charges) to be sent to the parent
are known in advance and denominated in
the subsidiary’s currency.
Cash Flow Analysis:
Subsidiary Perspective
50. A19 - 50
Subsidiary Liquidity Management
• After accounting for all cash outflows and
inflows, the subsidiary must either invest its
excess cash or borrow to cover its cash
deficiencies.
• If the subsidiary has access to lines of credit
and overdraft facilities, it may maintain
adequate liquidity without substantial cash
balances.
Cash Flow Analysis:
Subsidiary Perspective
51. A19 - 51
Centralized Cash Management
• While each subsidiary is managing its own
working capital, a centralized cash
management group is needed to monitor,
and possibly manage, the parent-subsidiary
and intersubsidiary cash flows.
• International cash management can be
segmented into two functions:
¤ optimizing cash flow movements, and
¤ investing excess cash.
52. A19 - 52
Centralized Cash Management
• The centralized cash management division
of an MNC cannot always accurately forecast
the events that may affect parent-
subsidiary or intersubsidiary cash flows.
• It should, however, be ready to react to any
event by considering
¤ any potential adverse impact on cash flows,
and
¤ how to avoid such adverse impacts.
53. A19 - 53
Techniques to Optimize
Cash Flows
Accelerating Cash Inflows
• The more quickly the cash inflows are
received, the more quickly they can be
invested or used for other purposes.
• Common methods include the
establishment of lockboxes around the
world (to reduce mail float) and
preauthorized payments (direct charging of
a customer’s bank account).
54. A19 - 54
Minimizing Currency Conversion Costs
• Netting reduces administrative and
transaction costs through the accounting of
all transactions that occur over a period to
determine one net payment.
• A bilateral netting system involves
transactions between two units, while a
multilateral netting system usually involves
more complex interchanges.
Techniques to Optimize
Cash Flows
55. A19 - 55
Managing Blocked Funds
• A government may require that funds
remain within the country in order to create
jobs and reduce unemployment.
• The MNC should then reinvest the excess
funds in the host country, adjust the
transfer pricing policy (such that higher fees
have to be paid to the parent), borrow
locally rather than from the parent, etc.
Techniques to Optimize
Cash Flows
56. A19 - 56
Managing Intersubsidiary Cash Transfers
• A subsidiary with excess funds can provide
financing by paying for its supplies earlier
than is necessary. This technique is called
leading.
• Alternatively, a subsidiary in need of funds
can be allowed to lag its payments. This
technique is called lagging.
Techniques to Optimize
Cash Flows
57. A19 - 57
Complications
in Optimizing Cash Flows
Company-Related Characteristics
¤ When a subsidiary delays its payments to the
other subsidiaries, the other subsidiaries
may be forced to borrow until the payments
arrive.
Government Restrictions
¤ Some governments may prohibit the use of a
netting system, or periodically prevent cash
from leaving the country.
58. A19 - 58
Characteristics of Banking Systems
¤ The abilities of banks to facilitate cash
transfers for MNCs may vary among
countries.
¤ The banking systems in different countries
usually differ too.
Complications
in Optimizing Cash Flows
59. A19 - 59
Investing Excess Cash
• Excess funds can be invested in domestic or
foreign short-term securities, such as
Eurocurrency deposits, bills, and
commercial papers.
• Sometimes, foreign short-term securities
have higher interest rates. However, firms
must also account for the possible exchange
rate movements.
60. A19 - 60
Centralized Cash Management
• Centralized cash management allows for
more efficient usage of funds and possibly
higher returns.
• When multiple currencies are involved, a
separate pool may be formed for each
currency. The investment securities may
also be denominated in the currencies that
will be needed in the future.
Investing Excess Cash
61. A19 - 61
Determining the Effective Yield
• The effective rate for foreign investments
rf = (1+if ) (1+ef ) – 1
where if = the quoted interest rate on the
investment
ef = the % D in the spot rate
• If the foreign currency depreciates over the
investment period, the effective yield will be
less than the quoted rate.
Investing Excess Cash
62. A19 - 62
Implications of Interest Rate Parity (IRP)
• A foreign currency with a high interest rate
will normally exhibit a forward discount
that reflects the differential between its
interest rate and the investor’s home
interest rate.
• However, short-term foreign investing on an
uncovered basis may still result in a higher
effective yield.
Investing Excess Cash
63. A19 - 63
Use of the Forward Rate as a Forecast
• If IRP exists, the forward rate can be used as
a break-even point to assess the short-term
investment decision.
• The effective yield will be higher if the spot
rate at maturity is more than the forward
rate at the time the investment is
undertaken, and vice versa.
Investing Excess Cash
64. A19 - 64
Use of Exchange Rate Forecasts
• Given an exchange rate forecast, the
expected effective yield of a foreign
investment can be computed, and then
compared with the local investment yield.
• It may be useful to use probability
distributions instead of point estimates, or
to compute the break-even exchange rate
that will equate foreign and local yields.
Investing Excess Cash
65. A19 - 65
Diversifying Cash Across Currencies
• If an MNC is not sure of how exchange rates
will change over time, it may prefer to
diversify its cash among securities that are
denominated in different currencies.
• The degree to which such a portfolio will
reduce risk depends on the correlations
among the currencies.
Investing Excess Cash
66. A19 - 66
Use of Dynamic Hedging to Manage Cash
• Dynamic hedging refers to the strategy of
hedging when the currencies held are
expected to depreciate, and not hedging
when they are expected to appreciate.
• The overall performance is dependent on
the firm’s ability to accurately forecast the
direction of exchange rate movements.
Investing Excess Cash
67. A19 - 67
Impact of International Cash Management
on an MNC’s Value
( ) ( )[ ]
( )∑
∑
+
×
=
n
t
t
m
j
tjtj
k1=
1
,,
1
ERECFE
=Value
E (CFj,t ) = expected cash flows in
currency j to be received by the U.S. parent at the
end of period t
E (ERj,t ) = expected exchange rate at
which currency j can be converted to dollars at
Returns on International
Cash Management
