International Working Capital Management: Dr. Ch. Venkata Krishna Reddy Associate Professor

Ethiopian Civil Service University, Addis Ababa
MSc. In Accounting and Finance
International Working Capital Management
Dr. Ch. Venkata Krishna Reddy

Associate Professor
Session Plan
• 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
International Financial 2
Management
Multinational Working Capital Management vs. domestic working

capital management
• Funds Availability
• Additional Risks
• Movement of Capital
• Taxes
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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

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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)
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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. International 6
Cash Positioning Decision

• Location of currency
• Type of liquid asset held
• Maturities, yields, and liquidity characteristics

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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
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Complexities of the International

Cash Positioning Decision
• Conflicting nature of cash management objectives
• Government restrictions
• Multiple taxation systems
• Multiple currencies Dr. Ch. Venkata Krishna Reddy
International 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
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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
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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. International 13
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.
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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 Dr. Ch. Venkata Krishna Reddy
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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
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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 Dr. Ch. Venkata Krishna Reddy

International 20
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
Dr. to repayment.
Ch. Venkata Krishna Reddy
International 21
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.
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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 currency against the firm’s home
International 24
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 $.55/SFr on the day the loan is to be paid
back.
• Use this information to calculate the effective cost of borrowing in
Switzerland. Dr. Ch. Venkata Krishna Reddy
International 25
Example
• Calculate the expected change in the Swiss franc:
Expected change = (forecast - current)/current), or
($.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%) Dr. Ch. Venkata Krishna Reddy
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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.

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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%) Dr. Ch. Venkata Krishna Reddy
International 28
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?
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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). Dr. Ch. Venkata Krishna Reddy
International 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%) International 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%)

International 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
International
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

International
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

International
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

International
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.

International
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.
International
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
Dr. Ch. Venkatabusiness
Krishna Reddy community
International
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

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
Dr. Ch. Venkata Krishna to
Reddysupply.
International
International trade finance: methods and instruments
The problem in international trade

• Time lag
• Cultural differences-language
• Financing the transaction
International
Importer Goods
Time and
Money
distance Exporter

International
• • Open account
Prepayment
• Accounts receivable financing
• Letters of credit
• Banker’s acceptance
• Drafts (sight/time)
• Factoring
• Consignment
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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
International
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
International
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
(3) Credit sent to
Bank Dr. Ch. Venkata Krishna Reddy
correspondent
Bank
International
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

International
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

International
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.

International
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

International
Factoring
• Involves sales of accounts receivable without recourse to

a factor
• Exporter transfers administrative burden and credit risk
to the factor
International
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

International
Next Topic
• Foreign Direct Investment

International 54
Thank you

International 55

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Ethiopian Civil Service University, Addis Ababa

MSc. In Accounting and Finance

International Working Capital Management

Dr. Ch. Venkata Krishna Reddy

• Multinational working capital management vs. domestic working capital management

• Objectives of international cash management

Multinational Working Capital Management vs. domestic working

International Cash Management

Dr. Ch. Venkata Krishna Reddy

– day-to-day transactions (transactional motive)

International Cash Management

Cash Positioning Decision

• Type of liquid asset held

• Maturities, yields, and liquidity characteristics

Objectives of an Effective Cash Management System

• Minimizing overall cash requirements

• Minimizing transactions costs

Complexities of the International

International Cash Settlements and Processing

Cash Pooling and Centralized Depositories

Dr. Ch. Venkata Krishna Reddy

Cash Pooling and Centralized Depositories

Financing Working Capital

– Intercompany loans from the parent or a sister affiliate.

Key Factors Underlying the Funding Strategy

– With forward contracts

• Minimize covered after-tax interest costs

Local Currency Financing

– Revolving Credit Agreement

• Commercial Paper Dr. Ch. Venkata Krishna Reddy

THE EFFECTIVE COST OF SHORT TERM BORROWING

1) The market interest rate on borrowed funds and,

Impact of Exposure on Borrowing Cost

Impact of Exposure on Cost of Borrowing

Calculating Effective Cost of Borrowing

• Rf = is the effective financing rate.

• if = is the market interest rate.

($.55 - .50)/.50 = .05/.50 = .10 (10.0%), then

Dr. Ch. Venkata Krishna Reddy

• Calculate the expected change in the Swiss franc:

($.49 - .50)/.50 = -0.1/.50 = -0.2 (-2.0%)

THE EFFECTIVE COST OF SHORT TERM BORROWING WITH A FORWARD COVER

• In the previous two examples, the effective cost of borrowing

Covering the Exposure

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

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

Dr. Ch. Venkata Krishna Reddy

International banking and trade

• Finance foreign trade and foreign investment

Why do banks go international?

Dr. Ch. Venkata Krishna Reddy

Why do banks go international?

Dr. Ch. Venkata Krishna Reddy

Types of foreign banking offices

Dr. Ch. Venkata Krishna Reddy

Types of foreign banking offices

Dr. Ch. Venkata Krishna Reddy

Types of foreign banking offices