CHAPTER 19 MULTINATIONAL CASH MANAGEMENT ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS QUESTIONS 1. Describe the key factors contributing to effective cash management within a firm. Why is the cash management process more difficult in a MNC? Answer: An effective cash management system should be based on a cash budget that projects expected cash inflows and outflows over some planning horizon. It provides for the systematic receipt and disbursement of cash. It also provides for funds mobilization, where cash shortages are covered by borrowing at the most favorable rates and surplus funds are invested at the most advantageous rates. Within a MNC the complexity of the cash management process is compounded because the firm does business in a variety of currencies, and hence the cost of foreign exchange transactions is an additional dimension to be managed. 2. Discuss the pros and cons of a MNC having a centralized cash manager handle all investment and borrowing for all affiliates of the MNC versus each affiliate having a local manager who performs the cash management activities of the affiliate. Answer: Under a centralized cash management system, the cash manager will have a global view of the cash requirements of the MNC. There will be less chance that funds will be mislocated, i.e., denominated in the wrong currency. Additionally, under a global view, transaction exposure for the MNC can be more efficiently managed. Moreover, a centralized system readily allows for investing excess cash at the most advantageous rates and borrowing to cover cash shortages at the most favorable rates. Under a decentralized system, the local cash manager is given more responsibility for managing the cash needs of the affiliate than under a centralized system. Consequently, the local cash management position serves as good training for higher level positions within the affiliate or MNC. Also, under a decentralized system, local bank relationships are better developed since the affiliate conducts more of its cash management functions at the local level. This may prove important if funds need to be borrowed locally. But overall, the benefits of a centralized cash management system tend to outweigh its disadvantages. PROBLEMS 1. Assume that interaffiliate cash flows are uncorrelated with one another. Calculate the standard deviation of the portfolio of cash held by the centralized depository for the following affiliate members: Expected Standard Affiliate Transactions Deviation _______________________________________________ U.S. $100,000 $40,000 Canada $150,000 $60,000 Mexico $175,000 $30,000 Chile $200,000 $70,000 Solution: Portfolio standard deviation = Square root of [($40,000)2 + ($60,000)2 + ($30,000)2 + ($70,000)2] = $104,881. MINI CASE: EFFICIENT FUNDS FLOW AT EASTERN TRADING COMPANY The Eastern Trading Company of Singapore purchases spices in bulk from around the world, packages them into consumer-size quantities, and sells them through sales affiliates in Hong Kong, the United Kingdom, and the United States. For a recent month, the following payments matrix of interaffiliate cash flows, stated in Singapore dollars, was forecasted. Show how Eastern Trading can use multilateral netting to minimize the foreign exchange transactions necessary to settle interaffiliate payments. If foreign exchange transactions cost the company .5 percent, what savings result from netting? Eastern Trading Company Payments Matrix (S$000) Disbursements Singapore -- 40 75 55 170 Hong Kong 8 -- -- 22 30 U.K. 15 -- -- 17 32 U.S. 11 25 9 -- 45 Total 34 65 84 94 277 disbursements Suggested Solution to Mini Case 1: Efficient Funds Flow at Eastern Trading Company Bilateral Netting Multilateral Netting Without netting, S$277,000 of interaffiliate foreign exchange transactions occur among the four affiliates of Eastern Trading. With multilateral netting, interaffiliate foreign exchange transactions are reduced to S$136,000, or by S$141,000. The savings are .005 x S$141,000 = S$705 for the planning period. MINI CASE: EASTERN TRADING COMPANY’S NEW M.B.A. The Eastern Trading Company of Singapore presently follows a decentralized system of cash management where it and its affiliates each maintain their own transaction and precautionary cash balances. Eastern Trading believes that it and its affiliates’ cash needs are normally distributed and independent from one another. It is corporate policy to maintain two and onehalf standard deviations of cash as precautionary holdings. At this level of safety there is a 99.37 percent chance that each affiliate will have enough cash holdings to cover transactions. A new MBA hired by the company claims that the investment in precautionary cash balances is needlessly large and can be reduced substantially if the firm converts to a centralized cash management system. Use the projected information for the current month, which is presented below, to determine the amount of cash Eastern Trading needs to hold in precautionary balances under its current decentralized system and the level of precautionary cash it would need to hold under a centralized system. Was the new MBA a good hire? Affiliate Expected Transactions One Standard Deviation Singapore S$125,000 S$40,000 Hong Kong 60,000 25,000 United Kingdom 95,000 40,000 United States 70,000 35,000 Suggested Solution to Mini Case 2: Eastern Trading Company’s New M.B.A. Affiliate Expected Transaction (a) s One Standar Deviation (b) d Expected Needs plus Precautionary (a + 2.5b) Singapore S$125,000 S$40,000 S$225,000 Hong Kong 60,000 25,000 122,500 United Kingdom 95,000 40,000 195,000 United States 70,000 35,000 157,500 Total S$350,000 S$700,000 Eastern Trading is holding S$350,000 to cover expected transactions and S$350,000 as precautionary balances among the four affiliates. In total, it is holding S$700,000 under its decentralized cash management system. If Eastern Trading views its cash needs from a portfolio perspective under a centralized cash management system, one portfolio standard deviation of cash would be: Portfolio = (S $40,000 ) 2 + ( S $25,000 ) 2 + ( S $40,000 ) 2 + ( S $35,000 ) 2 Std . Dev . = S $71,063 Hence, under a centralized system, Eastern Trading would continue to need S$350,000 to cover expected transactions, but precautionary cash balances could be reduced to $177,658 (= 2.5 x S$71,063). Thus, the investment in precautionary cash can be reduced by S$172,342 (= S$350,000 – 177,658). The new MBA was a good hire. Multinational Cash Management Chapter Nineteen Chapter Outline • The Management of Multinational Cash Balances • Bilateral Netting of Internal and External Net Cash Flows • Reduction in Precautionary Cash Flows • Cash Management Systems in Practice The Management of International Cash Balances • The size of cash balances • The currency denomination • Where these cash balances are located The Size of Cash Balances • The optimal size of the firm’s cash balances depend upon: – The cost of keeping “too much” cash on hand. • i.e., the opportunity costs of holding cash. – The cost of not keeping enough cash on hand. • i.e., the trading costs associated with having too little cash. – The variability of cash flows. The Size of Cash Balances Opportunity Costs Trading costs C* Size of cash balance Choice of Currency • By maintaining cash balances in a particular currency, the MNC is essentially speculating (or hedging?) in that currency. Where Cash Balances are Located • Should the firm have centralized cash management in the home country? • Should the firm let each affiliate handle it locally? • Where are borrowing costs lowest and investment returns highest? Netting: Bilateral and Multilateral • Multilateral netting is an efficient and costeffective mechanism for settling interaffiliate foreign exchange transactions. • Not all countries allow MNCs to net payments. – By limiting netting, more unnecessary foreign exchange transactions flow through the local banking system. Consider a U.S. MNC with Three Subsidiaries and These Intrafirm Transactions ($000s): The U.S. MNC Can Use Bilateral Netting to Cut the Number of Transactions by Multilateral Netting Reduces the Number of Transactions Further: First Total Each Party Multilateral Netting Reduces the Number of Transactions Further: Then Minimize the Transactions Netting with Central Depository Some firms use a central depository as a cash pool to facilitate funds mobilization and reduce the chance of misallocated funds. Netting with Central Depository Affiliate Net Receipts from Net Excess Cash from Net Flow Multilateral Netting Transactions with Third Parties U.S. $55,000 $20,000 $35,000 Canada ($15,000) ($30,000) $15,000 Germany 0 $75,000 ($75,000) U.K. ($40,000) ($25,000) ($15,000) Total ($40,000) In a new example, consider the net cash flows of the affiliates with the rest of the world: Netting with Central Depository Net cash flows after multilateral netting and net payments from external transactions: Reduction in Precautionary Cash Balances • An additional benefit of a centralized cash depository is that the MNC’s investment in precautionary cash balances can be substantially reduced without a decline in its ability to cover unforeseen expenses. • In the above examples, suppose that each affiliate had to have the cash on hand to make disbursements before it received what it was owed—that would result in a big cash drain on the firm. . Cash Management Systems in Practice • The most frequently cited benefits of a multilateral netting system are: – The decrease in the expense associated with funds transfer, which in some cases can be over $1,000 for a large international transfer of foreign exchange. – The reduction in the number of foreign exchange transactions and the associated reduced cost of making fewer (but larger) transactions. – The reduction in intracompany float, which is frequently as high as five days even for wire transfers. – The savings in administrative time. – The benefits that accrue from the establishment of a formal information system, which serves as the foundation for centrally managing transaction exposure and the investment of excess funds. Exposure Netting with Multiple Currencies • Many multinational firms use a reinvoice center, which is a financial subsidiary that nets out the intrafirm transactions. • Once the residual exposure is determined, then the firm implements hedging. • In the following slides, a firm faces the following exchange rates: £1.00 = $2.00 €1.00 = $1.50 SFr 1.00 = $0.90 Exposure Netting Exposure Netting Exposure Netting Exposure Netting Exposure Netting: How to Double Check Your Answer • It’s always good practice to check your work. • It’s better for you to find your mistakes than your professor (or the boss). • You can check your work in exposure netting by adding up each subsidiary’s debits and credits. • When you’re done, check that you haven’t destroyed or “created” any money. • A new example follows to practice checking your work. $25$20 +$55+$45 –$20+$75 $60$140 $100 $60+$40 $140 Alternative $60Solution $140 Another Example –$30 –$25 –$15 Another Example $55 –$15 $0–$40 Solution Manual for International Financial Management Cheol S. Eun, Bruce G. Resnick 9780077861605
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