CHAPTER 19 MULTINATIONAL CASH MANAGEMENT SUGGESTED ANSWERS AND 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 = [($40,000)2 + ($60,000)2 + ($30,000)2 + ($70,000)2] = $104,881.

MINI CASE 1: 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

Receipts

Singapore

Hong Kong

U.K.

U.S.

Total Receipts

Singapore

--

40

75

55

170

Hong Kong

--

--

22

30

U.K.

15

--

--

17

32

U.S.

11

25

--

45

Total disbursements

34

65

84

94

277

Suggested Solution to Mini Case 1: Efficient Funds Flow at Eastern Trading Company

S$8 Singapore S$40 Hong Kong

S$11 S$15 S$75 S$55 S$25 S$22

S$9 United Kingdom S$17

United States

Bilateral Netting

Singapore

S$32

Hong Kong

S$60 S$44

S$3

United Kingdom

S$8

United States

Multilateral Netting

Singapore

S$35

Hong Kong

S$52 S$49

United Kingdom

United States

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 2: EASTERN TRADING COMPANYS 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 one-half 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 S$125,000 60,000 95,000 70,000

One Deviation S$40,000 25,000 40,000 35,000

Standard

Singapore Hong Kong United Kingdom United States

Suggested Solution to Mini Case 2: Eastern Trading Companys New M.B.A.

Affiliate

Expected Transactions

(a)

One Standard Deviation (b)

Expected Needs plus Precautionary (a + 2.5b)

Singapore Hong Kong United Kingdom United States Total

S$125,000 60,000 95,000 70,000 S$350,000

S$40,000 25,000 40,000 35,000

S$225,000 122,500 195,000 157,500 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. 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: In total, it is holding S$700,000 under its decentralized cash

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.