Management of the Short
Content
Management of the Short-Term Investment Portfolio A major task of international cash management is to determine the levels and currency denominations of the multinational group‘s investment in cash balances and money market instruments. Firms with seasonal or cyclical cash flows have special problems, such as spacing investment maturities to coincide with projected needs. To manage, this investment properly requires (a) a forecast of future cash needs based on the company‘s current budget and past experience and (b) an estimate of a minimum cash position for the coming period. Successful management of an MNC’s required cash balances and of any excess funds generated by the firm and its affiliates depends largely on the astute selection of appropriate short-term money market instruments. Rewarding opportunities exist in many countries, but the choice of an investment medium depends on government regulations, the structure of the market, and the tax laws, all of which vary widely. Available money instruments differ among the major markets, and at times, foreign firms are denied access to existing investment opportunities. Only a few markets, such as the broad and diversified U.S. market and the Eurocurrency markets, are truly free and international. Common-sense guidelines for globally managing the marketable securities portfolio are as follows.
Diversify the instruments in the portfolio to maximize the yield for a given level of risk. Don‘t invest only in government securities. Eurodollar and other instruments may be nearly as safe. Review the portfolio daily to decide which securities should be liquidated and what new investment should be made. In revising the portfolio, make sure that incremental interest earned more than compensates for such added costs clerical work, the income lost between investments, fixed charges such as the foreign exchange spread, and commission on the sale and purchase of securities. If rapid conversion to cash is an important consideration, then carefully evaluate the security‘s marketability (liquidity). Ready markets exist for some securities, but not for others. Tailor the maturity of the investment to the firm‘s projected cash needs. Or a secondary market with high liquidity should exist. Carefully consider opportunities for covered or uncovered interest arbitrage Accounts Receivable as Collateral Pledging accounts receivable occurs when accounts receivable are used as collateral for a loan.
After investigating the desirability and liquidity of the receivables, banks will normally lend between 50 and 90 percent of the face value of acceptable receivables. In addition, to protect its interests, the lender files a lien on the collateral and is made on a non-notification basis (the customer is not notified). Factoring accounts receivable involves the outright sale of receivables at a discount to a factor. Factors are financial institutions that specialize in purchasing accounts receivable and may be either departments in banks or companies that specialize in this activity. Factoring is normally done on a notification basis where the factor receives payment directly from the customer. Inventory as Collateral The most important characteristic of inventory as collateral is its marketability. Perishable items such as fruits or vegetables may be marketable, but since the cost of handling and storage is relatively high, they are generally not considered to be a good form of collateral. Specialized items with limited sources of buyers are also generally considered not to be desirable collateral. A floating inventory lien is a lenders claim on the borrower’s general inventory as collateral. This is most desirable when the level of inventory is stable and it consists of a diversified group of relatively inexpensive items. Because it is difficult to verify the presence of the inventory, lenders generally advance less than 50% of the book value of the average inventory and charge 3 to 5 percent above prime for such loans. A trust receipt inventory loan is an agreement under which the lender advances 80 to 100 percent of the cost of a borrower’s relatively expensive inventory in exchange for a promise to repay the loan on the sale of each item. The interest charged on such loans is normally 2% or more above prime and are often made by a manufacturer’s wholly-owned subsidiary (captive finance company). Good examples would include GE Capital and GMAC. A warehouse receipt loan is an arrangement in which the lender receives control of the pledged inventory which is stored by a designated agent on the lender’s behalf. The inventory may stored at a central warehouse (terminal warehouse) or on the borrower’s property (field warehouse). Regardless of the arrangement, the lender places a guard over the inventory and written approval is required for the inventory to be released. Costs run from about 3 to 5 percent above prime. 3.2.2 Short-term finance
Short-term sources of finance include overdrafts, short-term bank loans and trade credit. An overdraft is an agreement by a bank to allow a company to borrow up to a certain limit without the need for further discussion. The company will borrow as much or as little as it needs up to the overdraft limit and the bank will charge daily interest at a variable rate on the debt outstanding. The bank may also require security or collateral as protection against the risk of non-payment by the company. An overdraft is a flexible source of finance in that a company only uses it when the need arises. However, an overdraft is technically repayable on demand, even though a bank is likely in practice to give warning of its intention to withdraw agreed overdraft facilities. A short-term loan is a fixed amount of debt finance borrowed by a company from a bank, with repayment to be made in the near future, for example after one year. The company pays interest on the loan at either a fixed or a floating (i.e. variable) rate at regular intervals, for example quarterly. A short-term bank loan is less flexible than an overdraft, since the full amount of the loan must be borrowed over the loan period and the company takes on the commitment to pay interest on this amount, whereas with an overdraft interest is only paid on the amount borrowed, not on the agreed overdraft limit. As with an overdraft, however, security may be required as a condition of the short-term loan being granted. Trade credit is an agreement to take payment for goods and services at a later date than that on which the goods and services are supplied to the consuming company. It is common to find one, two or even three months’ credit being offered on commercial transactions and trade credit is a major source of shortterm finance for most companies. Short-term sources of finance are usually cheaper and more flexible than longterm ones. Short-term interest rates are usually lower than long-term interest rates, for example, and an overdraft is more flexible than a long-term loan on which a company is committed to pay fixed amounts of interest every year. However, short-term sources of finance are riskier than long-term sources from the borrower’s point of view in that they may not be renewed (an overdraft is, after all, repayable on demand) or may be renewed on less favorable terms (e.g. when short-term interest rates have increased). Another source of risk for the short-term borrower is that interest rates are more volatile in the short term than in the long term and this risk is compounded if floating rate short-term debt (such as an overdraft) is used. A company must clearly balance profitability and risk in reaching a decision on how the funding of current and noncurrent assets is divided between long-term and short-term sources of funds. Why Do Firms Need Short-term Financing? Cash flow from operations may not be sufficient to keep up with growth-related financing needs. Firms may prefer to borrow now for their inventory or other short term asset needs rather than wait until they have saved enough. Firms prefer short-term financing instead of long-term sources of financing due to: • easier availability
• •
usually has lower cost (remember yield curve) matches need for short term assets, like inventory
Relationship to domestic financial management
In recent years, there has been abundance of researches in the area of international corporate finance. The major thrust of these works has been to apply the methodology and rationale of financial economics as a strategy to take key international financial decisions. Critical problem areas, such as foreign exchange risk management and foreign investment analysis, have benefited from the insights provided by financial economics-a discipline that emphasizes the use of economic analysis to understand the basic workings of financial markets, particularly the measurement and pricing of risk and the inter- temporal allocation of funds. By focusing on the behavior of financial markets and their participants, rather than on how to solve specific problems, we can derive fundamental principles of valuation and develop from them superior approaches to financial management-much as a better understanding of the basic laws of physics leads to better-designed and functioning products. We can also better gauge the validity of existing approaches to financial decision making by seeing whether their underlying assumptions are consistent with our knowledge of financial markets and valuation principles. Three concepts arising in financial economics have proved to be of particular importance in developing a theoretical foundation for international corporate finance: arbitrage, market efficiency, and capital asset pricing.
Arbitrage
Arbitrage has traditionally been defined as the purchase of securities or commodities on one market for immediate resale on another in order to profit from a price discrepancy. However, in recent years, arbitrage has been used to describe a broader range of activities. Tax arbitrage, for example, involves the shifting of gains or losses from one tax jurisdiction to another in order to profit from differences in tax rates. In a broader context, risk arbitrage or speculation, describes the process that leads to equality of risk-adjusted returns on different securities, unless market imperfections that hinder this adjustment process exist. In fact, it is the process of arbitrage that ensures market efficiency.
Market Efficiency
An efficient market is one in which the prices of traded securities readily incorporate new information. Numerous studies of U.S. and foreign capital markets have shown that traded securities are correctly priced in that trading rules based on past prices or publicly available information cannot consistently lead to profits (after adjusting for transactions costs) in excess of those due solely to risk taking. The predictive power of markets lies in their ability to collect in one place a mass of individual judgments from around the world. These judgments are based on current information. If the trend of future policies changes people will revise their expectations, and price will change to incorporate the corporate with the new information.
Capital Assets Pricing
Capital asset pricing refers to the way in which securities are valued in line with their anticipated risks and returns. Because risk is such an integral element of international financial decisions, this section briefly summarizes the results of over two decades of study on the pricing of risk in capital markets. The outcome of this research has been to show a specific relationship between risk (measured by return variability) and required asset return, which is needed now to be formalized in the capital asset pricing model (CAPM). The CAPM assumes that the total variability of an asset's returns can be attributed to two sources: (1) market-wide influences that affect all assets to some extent, such as the state of the economy, and (2) other risks that are specific to a given firm, such as a strike. The former type of risk is usually termed as systematic or nondiversifiable risk, and the latter, unsystematic or diversifiable risk. It can be shown that unsystematic risk is largely irrelevant to the highly diversified holder of securities because the effects of such disturbances cancel out, on average, in the portfolio. On the other hand, no matter how well diversified a stock portfolio is, systematic risk, by definition, cannot be eliminated, and thus the investor must be compensated for bearing this risk. This distinction between systematic risk and unsystematic risk provides the theoretical foundation for the study of risk in the multinational corporation. Identification and analysis of political risks Broadly speaking, there are three types of political risk – Transfer risk, Operational risk and Ownership Control risk. Transfer risks arise due to government restrictions on transfer of capital, people, technology and other resources in and out of the country. Operational risks result when government policies constrain the firm’s operations and decision -making processes. These include pricing and financing restrictions, export commitments, taxes and local sourcing requirements. Ownership control risks are due to government policies or actions that impose restrictions on the ownership or control of local operations. These include limits on foreign equity stakes. Macro political risk analysis At a macro-level, MNCs should review major political decisions or events that could affect enterprises across the country on an ongoing basis. One important event which business
leaders monitor closely is elections. Political swings to the left are normally bad for business. Some companies closely align themselves with the ruling party. When the opposition comes to power, they face problems. The M A Chidambaram group in the south Indian state of Tamil Nadu is a good example. The group, which supports a local political party runs into problems when the other main political grouping returns to power. Regions where political unrest is common are best avoided by MNCs. This is especially applicable to parts of the Middle East, eastern Europe and Africa and more recently, countries like Indonesia. In Islamic countries, the probability of moderate governments being supplanted by extremist regimes must be carefully evaluated. Micro political risk analysis Companies need to understand how government policies will influence certain sectors of the economy. Examples include specific regulations, taxes, local content laws and media restrictions. Businesses may be given preferential treatment based on the priorities of the government. It is a good idea to understand these priorities and explain to the government how the company’s policies are consistent with these priorities. The C P group in China is a good example. Its expansion of poultry operations in China has been consistent with the government’s policies of improving protein off-take and general health among the population and generating rural employment opportunities. Similarly PepsiCo, while entering India gave an assurance to the government that it would develop processed food industries in Punjab, along with its core beverages business. This was a decisive factor in getting the approval for entry into a crucial emerging market. Country risk assessment A country analysis examines three different areas: a) Economic and social performance b) The country’s goals and policies c) The political, institutional, ideological, physical and international context. (See Appendix at the end of the chapter for details of Euromoney’s country risk ratings.) Under economic performance, the following parameters are generally important: Balance of payments Currency movements GDP growth Inflation Savings rates Unemployment Wage costs Under social performance, the following factors are usually considered: Distribution of income
Educational achievements – literacy percentage and number of average years of schooling Life expectancy Migration Nutrition standards Population growth Public health The goals of a country have to be understood by analysing the behavior of political leaders including their decisions. The following government policies must be examined in detail: Fiscal policy Foreign policy Foreign trade and investment policies Industrial policy Monetary policy Social policies In the political context, the following factors are important: Mechanisms for transition of power Key power blocs Extent of popular support for the government Degree of consensus in policy making The processes through which political differences are resolved In the institutional context, the important parameters to be considered include: Independence of the judiciary and the executive Competence and honesty of bureaucrats and senior government officials Importance of informal power networks outside the government Structure, technology, management practices and financial strength of business institutions Labour conditions, including pattern of unionisation and collective bargaining practices In the ideological context, one must consider the following: The rights and duties of the members of society Whether there is a broad consensus Serious ideological tensions The country’s performance must be measured, against its own past performance, the performance of other countries and the goals of the government. A performance which falls short of goals and is poor in relation to the performance of competing countries will result in demand for changes in policies. It will also produce tensions in the political leadership. Analysts must also look for inconsistencies between strategy and context and examine the quality of
political leadership in the country. If the performance of the political leadership is poor, the key factors behind the poor performance must be identified. Specific methods of reducing country risk Keeping control of crucial elements of operations Maintaining close control of key operations can force the government into a state of dependence on the firm. This method may however, not be sustainable beyond a point of time. In the long run, local people may pick up skills. Also, the host government may feel that such skills can be purchased for a price from other sources. Proactive approach to planned divestment One way to prevent government interference is to give an assurance that ownership will be handed over partially or completely to local people in a phased manner. This helps the company to generate goodwill and win the support of the government. Joint ventures Joint ventures can minimise expropriation risk as the local partners usually do not take kindly to the interference of the local government. However, if expropriation means more ownership or control for the local partner, it may mean muted local opposition. Moreover, excessive dependence on the local partner, to manage political risk is not desirable. Even if the local partner has excellent relations with the government, problems could still arise, if governments change after elections, or there is a military coup or political unrest. Local debt By raising debt in the host country, the risk of expropriation can be minimised. However, countries with high political risk often tend to be ones with poorly developed capital markets or a small base of equity holders. Consequently, mobilisation of capital in the local markets, may be difficult beyond a point. Integrative and defensive strategies to manage political risk Integrative approaches Develop good communication channels with the host government. Make expatriates familiar with the language, customs and culture of the host country. Make extensive use of locals to run the operations. Be prepared to renegotiate the contract, if the local government considers it to be unfair. Invest in projects of local importance, such as education. Use joint ventures to make the locals feel a part of the firm. Follow fair, open and accurate financial reporting practices. Defensive approaches
Source key components from outside to ensure continued dependence on the firm. Use as few host-country nationals as possible in key positions. Select joint venture partners from more than one country. The host government may be reluctant to offend many governments simultaneously. Make full use of intellectual property rights such as patents and copyrights to protect proprietary technology. Raise as much equity and debt as possible from the host country Insist on host government guarantees wherever possible. Keep local retained earnings to the minimum.
3.2 INTERNATIONAL CASH MANAGEMENT IN A MULTINATIONAL FIRM Cash management is an important aspect of working capital management and principles of domestic and international cash management are the same. The basic difference between the two is, international cash management is wider in scope and is more complicated because it has to consider the principles and practices of other countries. The cash management is mainly concerned with the cash balances, including marketable securities, are held partly to allow normal day-to-day cash disbursements and partly to protect against unanticipated variations from budgeted cash flows. These two motives are called the transaction motive and precautionary motive. Cash disbursement for operations is replenished from two sources: • Internal working capital turnover • Short-term borrowings. The efficient cash management is mainly concerned with to reduce cash tied up unnecessarily in the system, without diminishing profit or increasing risk so as to increase the rate of return on capital employed. The main objectives of cash management are: (i) How to manage and control the cash resources of the company as quickly and efficiently as possible. (ii) To achieve the optimum and conservation of cash. The first objective of international cash management can be achieved by improving the cash collections and disbursements with the help of accurate and timely forecast of the cash flow. The second objective of international cash management can be achieved by minimising the required level of cash balances and increasing the risk adjusted return on capital employed. Both the objectives mentioned above conflict each other because minimising transaction costs of currency convers would require that cash balances be kept in the currency in which they have been received which conflicts with both the currency and political exposure criteria. The key to developing an optimum system is centralised of cash management.
3.3 CENTRALISATION OF CASH MANAGEMENT SYSTEM Centralisation of cash management refers to centralisation of information, reports and decision-making process as to cash mobilisation, movement and investment of cash. Centralised cash management system will benefit the multinational firm in the following ways: • Maintaining minimum cash balance during the year. • Helpful to generate maximum possible returns by investing all cash resources. • To manage the liquidity requirements of the centre. • Helpful to take complete benefits of bilateral netting and multinational netting for reducing transaction costs. • Helpful in utilising the various hedging strategies to minimise the foreign exchange exposure. • Helpful to get the benefit of transfer pricing mechanism to enhance the profitability of the firm. The international cash management requires achieving the two basic objectives: i) Optimising cash flow movements and ii) Investing excess cash 3.4.4 Using netting to reduce overall transaction costs Netting is a technique of optimising cash flow movements with the joint efforts of subsidiaries. Netting is, in fact, the elimination of counter payments. This means that only net amount is paid. For example, if the parent company is to receive US $ 6.0 million from its subsidiary and if the same subsidiary is to get US $ 2.0 million from the parent company, these two transactions can be netted to one transaction where the subsidiary will transfer US $ 4.00 million to the parent company. If the amount of these two payments is equal, there will be no movements of funds, and transaction cost will reduce to zero. The process involves the reduction of administration and transaction costs that result from currency conversion. Netting is of two types: (i) Bilateral netting system; and (ii) Multinational netting system. 3.4.5 Bilateral netting system A bilateral netting system involves transactions between the parent and a subsidiary or between two subsidiaries. For example, US parent and the German affiliate have to receive net $ 40,000 and $ 30,000 from one another. Thus, under a bilateral netting system, only one payment will be made the German affiliate pays the US parent an amount equal to $ 10,000 (Fig. 3.1). 3.4.6 Multinational netting system
A multinational netting system involves a move complex interchange among the parent and its several affiliates but it results in a considerable saving in exchange and transfer costs. Under this system, each affiliate nets all its interaffiliate receipts against all its disbursements. It then transfers or receives the balance, depending on whether it is a net receiver or a payer. To make a multinational netting system effective, it needs the services of a centralised communication system and discipline on the part of subsidiaries involved. Consider an example of multinational netting system, subsidiary X sells $ 20 million worth of goods to subsidiary Y, subsidiary Y sells $ 20 million worth of goods to subsidiary Z and subsidiary Z sells $ 20 million worth of goods to subsidiary X. In this case, multinational netting would eliminate interaffiliate fund transfers completely (Fig. 3.2). INVESTING SURPLUS CASH The other important function of international cash management is investing surplus cash. The Eurocurrency market helps in investing and accommodating excess cash in the international money market. Investment in foreign markets has been made much simpler and easier due to improved telecommunication systems and integration among money markets in various countries. Several aspects of short-term investing by an MNC need further clarification namely(i) Should an MNC develop a centralised cash-management strategy whereby excess funds with the individual subsidiaries are pooled together or maintain a separate investment for all subsidiaries. (ii) Where to invest the excess funds once the MNC has used whatever excess funds were needed to cover financing needs. (iii) May it be worthwhile for an MNC to diversify its portfolio of securities across countries with different currency denominations because the MNC is not very sure as to how exchange rates will change over time. 3.6.4 Cash budgets Cash budgets are central to the management of cash. They show expected cash inflows and outflows over a budget period and highlight anticipated cash surpluses and deficits. Their preparation assists managers in the planning of borrowing and investment, and facilitates the control of expenditure. Computer spreadsheets allow managers to undertake ‘what if’ analysis to anticipate possible cash flow difficulties as well as to examine possible future scenarios. To be useful, cash budgets should be regularly updated by comparing estimated figures with actual results, using a rolling cash budget system. Significant variances from planned figures must always be investigated. 3.6.2 Optimum cash levels Given the variety of needs a company may have for cash and the different reasons it may have for holding cash, the optimum cash level will vary both over time and between companies. The optimum amount of cash held by a company will depend on the following factors: ■ forecasts of the future cash inflows and outflows of the company;
■ the efficiency with which the cash flows of the company are managed; ■ the availability of liquid assets to the company; ■ the borrowing capability of the company; ■ the company’s tolerance of risk, or risk appetite.
Diversify the instruments in the portfolio to maximize the yield for a given level of risk. Don‘t invest only in government securities. Eurodollar and other instruments may be nearly as safe. Review the portfolio daily to decide which securities should be liquidated and what new investment should be made. In revising the portfolio, make sure that incremental interest earned more than compensates for such added costs clerical work, the income lost between investments, fixed charges such as the foreign exchange spread, and commission on the sale and purchase of securities. If rapid conversion to cash is an important consideration, then carefully evaluate the security‘s marketability (liquidity). Ready markets exist for some securities, but not for others. Tailor the maturity of the investment to the firm‘s projected cash needs. Or a secondary market with high liquidity should exist. Carefully consider opportunities for covered or uncovered interest arbitrage Accounts Receivable as Collateral Pledging accounts receivable occurs when accounts receivable are used as collateral for a loan.
After investigating the desirability and liquidity of the receivables, banks will normally lend between 50 and 90 percent of the face value of acceptable receivables. In addition, to protect its interests, the lender files a lien on the collateral and is made on a non-notification basis (the customer is not notified). Factoring accounts receivable involves the outright sale of receivables at a discount to a factor. Factors are financial institutions that specialize in purchasing accounts receivable and may be either departments in banks or companies that specialize in this activity. Factoring is normally done on a notification basis where the factor receives payment directly from the customer. Inventory as Collateral The most important characteristic of inventory as collateral is its marketability. Perishable items such as fruits or vegetables may be marketable, but since the cost of handling and storage is relatively high, they are generally not considered to be a good form of collateral. Specialized items with limited sources of buyers are also generally considered not to be desirable collateral. A floating inventory lien is a lenders claim on the borrower’s general inventory as collateral. This is most desirable when the level of inventory is stable and it consists of a diversified group of relatively inexpensive items. Because it is difficult to verify the presence of the inventory, lenders generally advance less than 50% of the book value of the average inventory and charge 3 to 5 percent above prime for such loans. A trust receipt inventory loan is an agreement under which the lender advances 80 to 100 percent of the cost of a borrower’s relatively expensive inventory in exchange for a promise to repay the loan on the sale of each item. The interest charged on such loans is normally 2% or more above prime and are often made by a manufacturer’s wholly-owned subsidiary (captive finance company). Good examples would include GE Capital and GMAC. A warehouse receipt loan is an arrangement in which the lender receives control of the pledged inventory which is stored by a designated agent on the lender’s behalf. The inventory may stored at a central warehouse (terminal warehouse) or on the borrower’s property (field warehouse). Regardless of the arrangement, the lender places a guard over the inventory and written approval is required for the inventory to be released. Costs run from about 3 to 5 percent above prime. 3.2.2 Short-term finance
Short-term sources of finance include overdrafts, short-term bank loans and trade credit. An overdraft is an agreement by a bank to allow a company to borrow up to a certain limit without the need for further discussion. The company will borrow as much or as little as it needs up to the overdraft limit and the bank will charge daily interest at a variable rate on the debt outstanding. The bank may also require security or collateral as protection against the risk of non-payment by the company. An overdraft is a flexible source of finance in that a company only uses it when the need arises. However, an overdraft is technically repayable on demand, even though a bank is likely in practice to give warning of its intention to withdraw agreed overdraft facilities. A short-term loan is a fixed amount of debt finance borrowed by a company from a bank, with repayment to be made in the near future, for example after one year. The company pays interest on the loan at either a fixed or a floating (i.e. variable) rate at regular intervals, for example quarterly. A short-term bank loan is less flexible than an overdraft, since the full amount of the loan must be borrowed over the loan period and the company takes on the commitment to pay interest on this amount, whereas with an overdraft interest is only paid on the amount borrowed, not on the agreed overdraft limit. As with an overdraft, however, security may be required as a condition of the short-term loan being granted. Trade credit is an agreement to take payment for goods and services at a later date than that on which the goods and services are supplied to the consuming company. It is common to find one, two or even three months’ credit being offered on commercial transactions and trade credit is a major source of shortterm finance for most companies. Short-term sources of finance are usually cheaper and more flexible than longterm ones. Short-term interest rates are usually lower than long-term interest rates, for example, and an overdraft is more flexible than a long-term loan on which a company is committed to pay fixed amounts of interest every year. However, short-term sources of finance are riskier than long-term sources from the borrower’s point of view in that they may not be renewed (an overdraft is, after all, repayable on demand) or may be renewed on less favorable terms (e.g. when short-term interest rates have increased). Another source of risk for the short-term borrower is that interest rates are more volatile in the short term than in the long term and this risk is compounded if floating rate short-term debt (such as an overdraft) is used. A company must clearly balance profitability and risk in reaching a decision on how the funding of current and noncurrent assets is divided between long-term and short-term sources of funds. Why Do Firms Need Short-term Financing? Cash flow from operations may not be sufficient to keep up with growth-related financing needs. Firms may prefer to borrow now for their inventory or other short term asset needs rather than wait until they have saved enough. Firms prefer short-term financing instead of long-term sources of financing due to: • easier availability
• •
usually has lower cost (remember yield curve) matches need for short term assets, like inventory
Relationship to domestic financial management
In recent years, there has been abundance of researches in the area of international corporate finance. The major thrust of these works has been to apply the methodology and rationale of financial economics as a strategy to take key international financial decisions. Critical problem areas, such as foreign exchange risk management and foreign investment analysis, have benefited from the insights provided by financial economics-a discipline that emphasizes the use of economic analysis to understand the basic workings of financial markets, particularly the measurement and pricing of risk and the inter- temporal allocation of funds. By focusing on the behavior of financial markets and their participants, rather than on how to solve specific problems, we can derive fundamental principles of valuation and develop from them superior approaches to financial management-much as a better understanding of the basic laws of physics leads to better-designed and functioning products. We can also better gauge the validity of existing approaches to financial decision making by seeing whether their underlying assumptions are consistent with our knowledge of financial markets and valuation principles. Three concepts arising in financial economics have proved to be of particular importance in developing a theoretical foundation for international corporate finance: arbitrage, market efficiency, and capital asset pricing.
Arbitrage
Arbitrage has traditionally been defined as the purchase of securities or commodities on one market for immediate resale on another in order to profit from a price discrepancy. However, in recent years, arbitrage has been used to describe a broader range of activities. Tax arbitrage, for example, involves the shifting of gains or losses from one tax jurisdiction to another in order to profit from differences in tax rates. In a broader context, risk arbitrage or speculation, describes the process that leads to equality of risk-adjusted returns on different securities, unless market imperfections that hinder this adjustment process exist. In fact, it is the process of arbitrage that ensures market efficiency.
Market Efficiency
An efficient market is one in which the prices of traded securities readily incorporate new information. Numerous studies of U.S. and foreign capital markets have shown that traded securities are correctly priced in that trading rules based on past prices or publicly available information cannot consistently lead to profits (after adjusting for transactions costs) in excess of those due solely to risk taking. The predictive power of markets lies in their ability to collect in one place a mass of individual judgments from around the world. These judgments are based on current information. If the trend of future policies changes people will revise their expectations, and price will change to incorporate the corporate with the new information.
Capital Assets Pricing
Capital asset pricing refers to the way in which securities are valued in line with their anticipated risks and returns. Because risk is such an integral element of international financial decisions, this section briefly summarizes the results of over two decades of study on the pricing of risk in capital markets. The outcome of this research has been to show a specific relationship between risk (measured by return variability) and required asset return, which is needed now to be formalized in the capital asset pricing model (CAPM). The CAPM assumes that the total variability of an asset's returns can be attributed to two sources: (1) market-wide influences that affect all assets to some extent, such as the state of the economy, and (2) other risks that are specific to a given firm, such as a strike. The former type of risk is usually termed as systematic or nondiversifiable risk, and the latter, unsystematic or diversifiable risk. It can be shown that unsystematic risk is largely irrelevant to the highly diversified holder of securities because the effects of such disturbances cancel out, on average, in the portfolio. On the other hand, no matter how well diversified a stock portfolio is, systematic risk, by definition, cannot be eliminated, and thus the investor must be compensated for bearing this risk. This distinction between systematic risk and unsystematic risk provides the theoretical foundation for the study of risk in the multinational corporation. Identification and analysis of political risks Broadly speaking, there are three types of political risk – Transfer risk, Operational risk and Ownership Control risk. Transfer risks arise due to government restrictions on transfer of capital, people, technology and other resources in and out of the country. Operational risks result when government policies constrain the firm’s operations and decision -making processes. These include pricing and financing restrictions, export commitments, taxes and local sourcing requirements. Ownership control risks are due to government policies or actions that impose restrictions on the ownership or control of local operations. These include limits on foreign equity stakes. Macro political risk analysis At a macro-level, MNCs should review major political decisions or events that could affect enterprises across the country on an ongoing basis. One important event which business
leaders monitor closely is elections. Political swings to the left are normally bad for business. Some companies closely align themselves with the ruling party. When the opposition comes to power, they face problems. The M A Chidambaram group in the south Indian state of Tamil Nadu is a good example. The group, which supports a local political party runs into problems when the other main political grouping returns to power. Regions where political unrest is common are best avoided by MNCs. This is especially applicable to parts of the Middle East, eastern Europe and Africa and more recently, countries like Indonesia. In Islamic countries, the probability of moderate governments being supplanted by extremist regimes must be carefully evaluated. Micro political risk analysis Companies need to understand how government policies will influence certain sectors of the economy. Examples include specific regulations, taxes, local content laws and media restrictions. Businesses may be given preferential treatment based on the priorities of the government. It is a good idea to understand these priorities and explain to the government how the company’s policies are consistent with these priorities. The C P group in China is a good example. Its expansion of poultry operations in China has been consistent with the government’s policies of improving protein off-take and general health among the population and generating rural employment opportunities. Similarly PepsiCo, while entering India gave an assurance to the government that it would develop processed food industries in Punjab, along with its core beverages business. This was a decisive factor in getting the approval for entry into a crucial emerging market. Country risk assessment A country analysis examines three different areas: a) Economic and social performance b) The country’s goals and policies c) The political, institutional, ideological, physical and international context. (See Appendix at the end of the chapter for details of Euromoney’s country risk ratings.) Under economic performance, the following parameters are generally important: Balance of payments Currency movements GDP growth Inflation Savings rates Unemployment Wage costs Under social performance, the following factors are usually considered: Distribution of income
Educational achievements – literacy percentage and number of average years of schooling Life expectancy Migration Nutrition standards Population growth Public health The goals of a country have to be understood by analysing the behavior of political leaders including their decisions. The following government policies must be examined in detail: Fiscal policy Foreign policy Foreign trade and investment policies Industrial policy Monetary policy Social policies In the political context, the following factors are important: Mechanisms for transition of power Key power blocs Extent of popular support for the government Degree of consensus in policy making The processes through which political differences are resolved In the institutional context, the important parameters to be considered include: Independence of the judiciary and the executive Competence and honesty of bureaucrats and senior government officials Importance of informal power networks outside the government Structure, technology, management practices and financial strength of business institutions Labour conditions, including pattern of unionisation and collective bargaining practices In the ideological context, one must consider the following: The rights and duties of the members of society Whether there is a broad consensus Serious ideological tensions The country’s performance must be measured, against its own past performance, the performance of other countries and the goals of the government. A performance which falls short of goals and is poor in relation to the performance of competing countries will result in demand for changes in policies. It will also produce tensions in the political leadership. Analysts must also look for inconsistencies between strategy and context and examine the quality of
political leadership in the country. If the performance of the political leadership is poor, the key factors behind the poor performance must be identified. Specific methods of reducing country risk Keeping control of crucial elements of operations Maintaining close control of key operations can force the government into a state of dependence on the firm. This method may however, not be sustainable beyond a point of time. In the long run, local people may pick up skills. Also, the host government may feel that such skills can be purchased for a price from other sources. Proactive approach to planned divestment One way to prevent government interference is to give an assurance that ownership will be handed over partially or completely to local people in a phased manner. This helps the company to generate goodwill and win the support of the government. Joint ventures Joint ventures can minimise expropriation risk as the local partners usually do not take kindly to the interference of the local government. However, if expropriation means more ownership or control for the local partner, it may mean muted local opposition. Moreover, excessive dependence on the local partner, to manage political risk is not desirable. Even if the local partner has excellent relations with the government, problems could still arise, if governments change after elections, or there is a military coup or political unrest. Local debt By raising debt in the host country, the risk of expropriation can be minimised. However, countries with high political risk often tend to be ones with poorly developed capital markets or a small base of equity holders. Consequently, mobilisation of capital in the local markets, may be difficult beyond a point. Integrative and defensive strategies to manage political risk Integrative approaches Develop good communication channels with the host government. Make expatriates familiar with the language, customs and culture of the host country. Make extensive use of locals to run the operations. Be prepared to renegotiate the contract, if the local government considers it to be unfair. Invest in projects of local importance, such as education. Use joint ventures to make the locals feel a part of the firm. Follow fair, open and accurate financial reporting practices. Defensive approaches
Source key components from outside to ensure continued dependence on the firm. Use as few host-country nationals as possible in key positions. Select joint venture partners from more than one country. The host government may be reluctant to offend many governments simultaneously. Make full use of intellectual property rights such as patents and copyrights to protect proprietary technology. Raise as much equity and debt as possible from the host country Insist on host government guarantees wherever possible. Keep local retained earnings to the minimum.
3.2 INTERNATIONAL CASH MANAGEMENT IN A MULTINATIONAL FIRM Cash management is an important aspect of working capital management and principles of domestic and international cash management are the same. The basic difference between the two is, international cash management is wider in scope and is more complicated because it has to consider the principles and practices of other countries. The cash management is mainly concerned with the cash balances, including marketable securities, are held partly to allow normal day-to-day cash disbursements and partly to protect against unanticipated variations from budgeted cash flows. These two motives are called the transaction motive and precautionary motive. Cash disbursement for operations is replenished from two sources: • Internal working capital turnover • Short-term borrowings. The efficient cash management is mainly concerned with to reduce cash tied up unnecessarily in the system, without diminishing profit or increasing risk so as to increase the rate of return on capital employed. The main objectives of cash management are: (i) How to manage and control the cash resources of the company as quickly and efficiently as possible. (ii) To achieve the optimum and conservation of cash. The first objective of international cash management can be achieved by improving the cash collections and disbursements with the help of accurate and timely forecast of the cash flow. The second objective of international cash management can be achieved by minimising the required level of cash balances and increasing the risk adjusted return on capital employed. Both the objectives mentioned above conflict each other because minimising transaction costs of currency convers would require that cash balances be kept in the currency in which they have been received which conflicts with both the currency and political exposure criteria. The key to developing an optimum system is centralised of cash management.
3.3 CENTRALISATION OF CASH MANAGEMENT SYSTEM Centralisation of cash management refers to centralisation of information, reports and decision-making process as to cash mobilisation, movement and investment of cash. Centralised cash management system will benefit the multinational firm in the following ways: • Maintaining minimum cash balance during the year. • Helpful to generate maximum possible returns by investing all cash resources. • To manage the liquidity requirements of the centre. • Helpful to take complete benefits of bilateral netting and multinational netting for reducing transaction costs. • Helpful in utilising the various hedging strategies to minimise the foreign exchange exposure. • Helpful to get the benefit of transfer pricing mechanism to enhance the profitability of the firm. The international cash management requires achieving the two basic objectives: i) Optimising cash flow movements and ii) Investing excess cash 3.4.4 Using netting to reduce overall transaction costs Netting is a technique of optimising cash flow movements with the joint efforts of subsidiaries. Netting is, in fact, the elimination of counter payments. This means that only net amount is paid. For example, if the parent company is to receive US $ 6.0 million from its subsidiary and if the same subsidiary is to get US $ 2.0 million from the parent company, these two transactions can be netted to one transaction where the subsidiary will transfer US $ 4.00 million to the parent company. If the amount of these two payments is equal, there will be no movements of funds, and transaction cost will reduce to zero. The process involves the reduction of administration and transaction costs that result from currency conversion. Netting is of two types: (i) Bilateral netting system; and (ii) Multinational netting system. 3.4.5 Bilateral netting system A bilateral netting system involves transactions between the parent and a subsidiary or between two subsidiaries. For example, US parent and the German affiliate have to receive net $ 40,000 and $ 30,000 from one another. Thus, under a bilateral netting system, only one payment will be made the German affiliate pays the US parent an amount equal to $ 10,000 (Fig. 3.1). 3.4.6 Multinational netting system
A multinational netting system involves a move complex interchange among the parent and its several affiliates but it results in a considerable saving in exchange and transfer costs. Under this system, each affiliate nets all its interaffiliate receipts against all its disbursements. It then transfers or receives the balance, depending on whether it is a net receiver or a payer. To make a multinational netting system effective, it needs the services of a centralised communication system and discipline on the part of subsidiaries involved. Consider an example of multinational netting system, subsidiary X sells $ 20 million worth of goods to subsidiary Y, subsidiary Y sells $ 20 million worth of goods to subsidiary Z and subsidiary Z sells $ 20 million worth of goods to subsidiary X. In this case, multinational netting would eliminate interaffiliate fund transfers completely (Fig. 3.2). INVESTING SURPLUS CASH The other important function of international cash management is investing surplus cash. The Eurocurrency market helps in investing and accommodating excess cash in the international money market. Investment in foreign markets has been made much simpler and easier due to improved telecommunication systems and integration among money markets in various countries. Several aspects of short-term investing by an MNC need further clarification namely(i) Should an MNC develop a centralised cash-management strategy whereby excess funds with the individual subsidiaries are pooled together or maintain a separate investment for all subsidiaries. (ii) Where to invest the excess funds once the MNC has used whatever excess funds were needed to cover financing needs. (iii) May it be worthwhile for an MNC to diversify its portfolio of securities across countries with different currency denominations because the MNC is not very sure as to how exchange rates will change over time. 3.6.4 Cash budgets Cash budgets are central to the management of cash. They show expected cash inflows and outflows over a budget period and highlight anticipated cash surpluses and deficits. Their preparation assists managers in the planning of borrowing and investment, and facilitates the control of expenditure. Computer spreadsheets allow managers to undertake ‘what if’ analysis to anticipate possible cash flow difficulties as well as to examine possible future scenarios. To be useful, cash budgets should be regularly updated by comparing estimated figures with actual results, using a rolling cash budget system. Significant variances from planned figures must always be investigated. 3.6.2 Optimum cash levels Given the variety of needs a company may have for cash and the different reasons it may have for holding cash, the optimum cash level will vary both over time and between companies. The optimum amount of cash held by a company will depend on the following factors: ■ forecasts of the future cash inflows and outflows of the company;
■ the efficiency with which the cash flows of the company are managed; ■ the availability of liquid assets to the company; ■ the borrowing capability of the company; ■ the company’s tolerance of risk, or risk appetite.
