International Finance

MODULE 5 – MANAGEMENT OF FUNDS

CONCEPT OF RISK - RETURN

Investors have different motives for investing. The majority of investors have one
of the following motives or a combination of them:

i. Regular income either in the form of dividend or interest

ii. Capital gains or capital appreciation
iii. Hedge against inflation, a positive real rate of return
iv. Safety of funds and regularity of payment of interest and principal
v. Liquidity and marketability in the sense that investor can convert his
investments into cash or liquidity and back again into investments when
cash is not needed.

The first three motives of income, capital appreciation and a positive hedge
against inflation refer to the expected return. The last two motives of the investor
lead to the risks involved in the investments.

Components of Return and Risk Concept

Return is measured by taking the income plus the price change. Income is either
dividend or interest, and price change of the security is the capital gain or loss. All
investments are risky, whether in stock and capital market or banking and
financial sector, real estate, bullion, gold, foreign exchange, etc. The degree of risk
however varies on the basis of the features of the assets, investment instrument,

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the mode of investment, or the issuer of the security, etc. even the so called
riskless assets like bank deposits carry some cost and time in realization of
proceeds or in conversion into cash.

Risk and uncertainty go together. Risk suggests that the decision maker knows
that there is some possible consequence of an investment decision, but
uncertainty involves a situation, where the outcome is not known to the decision
maker. Some risks can be controlled by the investors and some by the issuers of
securities by planning. Others cannot be so controlled and they are to be borne
compulsorily by the investor.

Risk is measured by the variability of returns. The higher the coefficient of

variability, the more risky is the project or portfolio and more is the returns. Total
risk of any investment is the total variance or volatility of returns on that
investment. Risk return assessment can be made by the investor, using CAPM.

INTERNATIONAL CAPITAL ASSET PRICING MODEL (CAPM)

Capital Asset Pricing Model (CAPM) is one of the premier methods of evaluation
of capital investment proposals. It describes the relationship between risk and
expected return and that is used in the pricing of risky securities. The model was
developed by William Sharpe.

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The portfolio theory considers the relationship between the risk and reward of a
portfolio, where risk was measured as the standard deviation of returns. CAPM
recognized that total risk (as considered in portfolio theory) comprises two
elements:

i. Systematic risk
ii. Unsystematic risk

An investor who already holds a well – diversified portfolio is able to diversify

away any unsystematic risk, so he only looks to be rewarded for a share’s
systematic risk. The relevant risk of a security is not its total risk but the impact it
has on the risk of the portfolio to which it is added.

Systematic and unsystematic risk

A part of risk arises from the uncertainties which are unique to individual
securities and which is diversifiable if large number of securities are combined to
form well diversified portfolios. This part of the risk can be totally reduced
through diversification and it is called unsystematic or unique risk. Examples of
unsystematic risk are a strike of workers, formidable competitor enters the
market, a company loses a big contract in a bid, and a government increases
custom duty on materials used by a company.

Another part of the risk is the tendency individual securities to move together
with changes in the market. This cannot be reduced through diversification and it

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is called Systematic risk or market risk, examples are, changes in interest rate
policy, corporate tax rate increase, increase in inflation rate.

Total risk, which in the case of an individual security is the variance (or standard
deviation) of its return. It can be divided into two parts.

Total risk = systematic risk + unsystematic risk.

CAPM simply allows us to split the total risk of a security into the proportion that
may be diversified away, and the proportion that will remain after the
diversification process.

It uses the concept of Beta to link risk with return. Using CAPM, investors can
assess the risk return trade off involved in any investment decision. Beta is a
measure of non-diversifiable risk (systematic risk). It shows how the price of a
security responds to changes in market prices. The equation for calculation of
Beta is

Ri = a + βi Rm, where

Ri = Estimated return on i stock

a = Expected return when market return is zero

βi = Beta measuring stock’s sensitivity to the market index

Rm = Return on market index

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Using Beta concept, the CAPM will help define the required return on a security.
Normally the higher is the risk we take, the higher should be the return, as
otherwise we avoid risk. So, the higher the β, the higher should be the return. The
equation for CAPM is

Ri = Rf + βi (Rm+ Rf), where

Ri = Required return

Rf = Risk free return

βi = Measure of systematic risk which is non-diversifiable

Rm = Average market return

Risk free return is say 12% as the Treasury bill or bank rate and market return is
expected to vary with the β chosen. Let us take β as 1.2 and expected market
return is 18%, then the return on stock ‘i’ is as follows:

Ri =12% + 1.2 (18 – 12)

= 0.12 + 1.2 (0.06)

= 19.2%

If the investor is risk taking type and chooses a Beta of 1.8, then the expected
return will be higher as shown:

Ri =12% + 1.8 (18 – 12)

= 0.12 + 1.8 (0.06)

= 22.8%
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INTERNATIONAL CAPITAL BUDGETING

Capital budgeting is budgeting for capital projects. The exercise involves

ascertaining / estimating cash inflows and outflow, matching the cash inflows
with the outflows appropriately and evaluation of desirability of the project.

Business concerns invest in capital projects of different nature. These capital

projects involve investment in physical assets land, building, plant, machinery,
etc. to manufacturer a product or process certain raw products into fine ones as
against financial investment which involve investment in financial assets like
shares, bonds or mutual funds. Capital projects necessarily involve
processing/manufacturing/service works. These require investments with a longer
time horizon. The initial investment is heavy in fixed assets and investment in
permanent working capital is also heavy. The benefits from the projects last for a
few to many years.

Capital projects may be new ones, expansion of existing ones, and diversification
of existing ones, renovation or rehabilitation of infirm ones, R&D activities, or
captive service projects. An enterprise may put up a new subsidiary, increase
stake in existing subsidiary or acquire a running firm, all these are considered
capital projects.

Capital projects involve huge outlay and last for years. Hence these4 are riskier
than investment in financial investments. So, careful analysis is needed. Decisions
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once taken cannot be reversed in respect of capital projects. So, “listen before
leaping” and “think before jumping” are the caveats needed. Through evaluation
of costs and benefits is needed.

Significance of Capital Budgeting

Every business has to commit funds in fixed assets and permanent working
capital. The type of fixed assets that a firm owns influences (i) the pattern of its
cost (i.e. high or low fixed cost per unit given a certain volume of production), (ii)
the minimum price the firm has to charge per unit of product, (iii) the break-even
position of the company, (iv) the operating leverage of the business and so on.
These are very vital issues shaping the profitability and risk complexion of
business. Hence the significance of capital budgeting.

Capital budgeting is significant because it deals with right kind of evaluation of

projects. A project must be scientifically evaluated, so, that no undue favor or
disfavor is shown to a project. A good project must not be rejected and a bad
project must not be selected. Hence the significance of capital budgeting.

Capital investment proposals involve

i. Longer gestation period,

ii. Huge capital outlay,
iii. Technological considerations needing technological forecasting,

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iv. Environmental issues too, which require the extension of the scope of
evaluation to go beyond economic costs and benefits.
v. Irreversible decision once gets committed,
vi. Considerable peep into the future which is normally very difficult,
vii. Measuring of and dealing with project risk which is a daunting task in deed
and so on.

Capital budgeting involves capital rationing. That is, the available funds must be
allocated to competing projects in the order of project potentials. Usually, the
indivisibility of project poses the problem of capital rationing because required
funds and available funds may not be the same. A slightly high return projects
involving higher outlay may have to be skipped to choose one with slightly low4er
return but requiring less outlay. These types of trade-off have to be skipped to
choose one with slightly lower return but requiring less outlay. This type of trade-
off has to be skillfully made.

An investment proposal can be evaluated using two types of method non-

discounting and discounting methods.

The non-discounting methods are simple to compute but are not as accurate as
discounting methods as they do not take into consideration the time value of
money. The focus would mainly be on the discounting methods.

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Non-Discounting Methods

1. Average Accounting Rate of Return: It takes into account profit before

interest and tax with respect to investment. The profit is then compared to
the required rate of return. A project is acceptable if the mean profit is
higher than the required rate of return. The negative aspects of this
method are that it is based on accounting income and not on the cash flow;
it considers profit before tax and it also ignores the time value of money.

2. Pay Back Period: It is the number of years required in order to recover the
initial investment. This method mainly focuses on early recovery of funds
but does not consider the cash flow after the pay back period i.e. it does
not take into account the life of the project.

The advantage of such non-discounting methods are that they are easy to
compute and can be used in the initial stages of project in order to compare
which project would be able to recover the investment quicker.

Discounting Methods

3. Net Present Value: In this approach projects are accepted where the
present value of net cash inflow during the life span of project is greater
than initial investment. It is computed using.

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Choice between different methods

During comparing two proposals sometimes the result of two methods may differ
as they rest on different assumptions concerning the reinvestment of funds
released from the project. The NPV rule implies reinvestment at a rate equivalent
to the required rate of return which is used as the discount rate whereas IRR
assumes the funds to be reinvested at IRR. However, in such a case NPV is given
preference as there are a few limitations of IRR method.

Firstly, where projects of different life span are considered IRR inflates desirability
of a short-life project as IRR is a function of both the time involved and size of
capital investment. Secondly, IRR remains to be lower on projects with a longer
gestation period, even when NPV remains larger because IRR is high in those
projects where several benefits accrue in early part of their economic life. Thirdly,
there is a possibility of two IRR rates coming for a given NPV as they are
computed using a polynomial equation. Between PI and NPV, NPV is given
preference as it represents an absolute value.

Adjusted Present Value Approach

There is a method for capital budgeting developed by Lessard which is known as

adjusted present value technique. It takes into account most of the complexities
emerging in the computation of cash flow and in determination of discount rates.
Under this technique initial cash flow consists of capital cost of project minus

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blocked funds (if any). This amount is then converted into home country currency
at spot exchange rate.

Similarly, the operating cash flow under the APV technique consists of:

• Present value of after tax cash flow from subsidiary to parent converted
into home currency at expected spot rate minus profits on lost sales of
parent company

• Present value of tax adjusted depreciation allowances in terms of home

currency

• Present value of contribution of project to borrowing capacity in terms of

home currency subject to adjustment for taxes

• Face value of loan in host country currency minus present value of

repayments converted into home currency

• Present value of expected savings on account of tax deferrals and transfer

pricing

• Present value of expected illegal repatriation of income

International investments are much more risky than domestic investments as the
investor is not completely aware about the economic, political and other
conditions prevailing in foreign country. There is a possibility of changes in cash
flow from the anticipated one. If demand falls suddenly then whether to

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postpone or if situation doesn't improve whether to expand. On the other hand if

demand suddenly rises whether to expand or not expand. These are the decisions
to be taken by International Finance Manager. A few options are discussed below
there could be many more.

Abandonment

If the NPV computed comes out to be negative due to sudden rise in raw material
prices or other factors the company might consider abandoning the project. But
in case of MNC's it is not easy to abandon a project and restart the same as high
costs are incurred for entering and exiting. If once the investment is done
companies would prefer to run at a loss for sometime rather than abandoning
and restarting unless and until the losses are very high. Such a situation where a
company is expecting favorable conditions in future is known as hysteresis that
mainly arises following changes in exchange rates.

Expansion and Contraction

If the demand rises suddenly the NPV for expansion would become more and
company might think about expanding. But rise and fall in demand are cyclic it
could be that demand also falls suddenly in that case the company might incur
costs for facilities it is not using. Companies should evaluate decision to expand
and contract carefully.

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Thus, with increase in Globalization and the policies of import-export getting

more and more liberal International Operations have become a part of most
companies. Many companies look to invest abroad due to lower competition or
better price advantage. Developing countries like India and China with cheap
labor can afford to sell their goods at a lower price in US. While US can invest in
India in order to utilize cheap labor. In order to evaluate the feasibility and
profitability of the project several factors should be kept in mind. Adjustments
due to inflation and other factors should be properly made in order to get an
accurate forecast. Failing to do so might result in inaccurate project evaluation
leading to erroneous decisions which would finally impact the bottom line of the
company.

INTERNATIONAL PORTFOLIO MANAGEMENT

Portfolio management is the art and science of making decisions about

investment mix and policy, matching investments to objectives, asset allocation
for individuals and institutions, and balancing risk against performance. It is all
about strengths, weaknesses, opportunities and threats in the choice of debt vs.
equity, domestic vs. international, growth vs. safety, and many other tradeoffs
encountered in the attempt to maximize return at a given appetite for risk.

The recent surge in international portfolio investments reflects the globalization

of financial markets. Specifically, many countries have liberalized and deregulated
their capital and foreign exchange markets in recent years. In addition,
commercial and investment banks have facilitated international investments by
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introducing such products as American Depository Receipts (ADRs) and country

funds. Also, recent advancements in computer and telecommunication
technologies led to a major reduction in transaction and information costs
associated with international investments. In addition, investors might have
become more aware of the potential gains from international investments.

The following three major activities are involved in an efficient portfolio

management:

i. Identification of assets or securities, allocation of investment and

identifying assets classes
ii. Deciding about major weights/proportion of different assets/securities in
the portfolio
iii. Security selection within the asset classes as identified earlier.

INTERNATIONAL WORKING CAPITAL MANAGEMENT

MNCs tie up funds when investing in their working capital, which includes short-
term assets such as inventory, accounts receivable, and cash. They attempt
working capital management by maintaining sufficient short-term assets to
support their operations. Yet, they do not want to invest excessively in short-term
assets because these funds might be put to better use.

The management of working capital is more complex for MNCs that have foreign
subsidiaries because each subsidiary must have adequate working capital to
support its operations. If a subsidiary experiences a deficiency in inventory, its

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production may be delayed. If it is short of cash, it may be unable to purchase

supplies or materials. If the parent of an MNC is aware of the working capital
situation at every subsidiary, it may be able to transfer working capital from one
subsidiary to another in order to solve temporary deficiencies at any subsidiary.

Subsidiary Expenses

Begin with outflow payments by the subsidiary to purchase raw materials or

supplies. The subsidiary will normally have a more difficult time forecasting future
outflow payments if its purchases are international rather than domestic because
of exchange rate fluctuations. In addition, there is a possibility that payments will
be substantially higher due to appreciation of the invoice currency. Consequently,
the firm may wish to maintain a large inventory of supplies and raw materials so
that it can draw from its inventory and cut down on purchases if the invoice
currency appreciates. Still another possibility is that imported goods from another
country could be restricted by the host government (through quotas, etc.).

In this event, a larger inventory would give a firm more time to search for
alternative sources of supplies or raw materials. A subsidiary with domestic
supply sources would not experience such a problem and therefore would not
need such a large inventory. Outflow payments for supplies will be influenced by
future sales. If the sales volume is substantially influenced by exchange rate
fluctuations, its future level becomes more uncertain, which makes its need for
supplies more uncertain. Such uncertainty may force the subsidiary to maintain
larger cash balances to cover any unexpected increase in supply requirements.

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Subsidiary Revenue

If subsidiaries export their products, their sales volume may be more volatile than
if the goods were only sold domestically. This volatility could be due to the
fluctuating exchange rate of the invoice currency. Importers’ demand for these
finished goods will most likely decrease if the invoice currency appreciates. The
sales volume of exports is also susceptible to business cycles of the importing
countries.

If the goods were sold domestically, the exchange rate fluctuations would not
have a direct impact on sales, although they would still have an indirect impact
since the fluctuations would influence prices paid by local customers for imports
from foreign competitors. Sales can often be increased when credit standards are
relaxed. However, it is important to focus on cash inflows due to sales rather than
on sales themselves. Looser credit standards may cause a slowdown in cash
inflows from sales, which could offset the benefits of increased sales. Accounts
receivable management is an important part of the subsidiary’s working capital
management because of its potential impact on cash inflows.

Subsidiary Dividend Payments

The subsidiary may be expected to periodically send dividend payments and other
fees to the parent. These fees could represent royalties or charges for overhead
costs incurred by the parent that benefit the subsidiary. An example is research

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and development costs incurred by the parent, which improve the quality of
goods produced by the subsidiary. Whatever the reason, payments by the
subsidiary to the parent are often necessary.

When dividend payments and fees are known in advance and denominated in the
subsidiary’s currency, forecasting cash flows is easier for the subsidiary. The level
of dividends paid by subsidiaries to the parent is dependent on the liquidity needs
of each subsidiary, potential uses of funds at various subsidiary locations,
expected movements in the currencies of the subsidiaries, and regulations of the
host country government.

Subsidiary Liquidity Management

After accounting for all outflow and inflow payments, the subsidiary will find itself
with either excess or deficient cash. It uses liquidity management to either invest
its excess cash or borrow to cover its cash deficiencies. If it anticipates a cash
deficiency, short-term financing is necessary, as described in the previous
chapter. If it anticipates excess cash, it must determine how the excess cash
should be used. Investing in foreign currencies can sometimes be attractive, but
exchange rate risk makes the effective yield uncertain.

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Liquidity management is a crucial component of a subsidiary’s working capital

management. Subsidiaries commonly have access to numerous lines of credit and
overdraft facilities in various currencies. Therefore, they may maintain adequate
liquidity without substantial cash balances. While liquidity is important for the
overall MNC, it cannot be properly measured by liquidity ratios. Potential access
to funds is more relevant than cash on hand.

Thus, the management of working capital in an international firm is very much

complex as compared to a domestic one. The reasons for such complexity are:

i. A multinational firm has a wider option for financing its current assets. Host
country funds can be used if needed. Funds flow from different units of the
same firm. Approach is made from the international financial market.
However, domestic firms find it difficult to avail such funds.

ii. Interest and tax rates vary from one country to the other. A manager
associated with a multinational firm has to consider the interest /tax rate
differentials while financing current assets. This is not the case for domestic
firms.

iii. A multinational firm is confronted with foreign exchange risk due to the
value of inflow/outflow of funds as well as the value of import/export are
influenced by exchange rate variations. Restrictions imposed by the home
or host country government towards movement of cash and inventory on
account of political considerations affect the growth of MNCs. Domestic

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firm limit their operations within the country and do not face such
problems.

iv. With limited knowledge of politico-economic conditions prevailing in

different host countries, a multinational manager often finds it difficult to
manage working capital of different units of the firm operating in these
countries. The pace of development taking place in the communication
system has to some extent eased this problem but it is still there very
much.

v. Intra flows of funds is available with multinational firms as cash positioning

and cash mobilization, an important aspect of international working capital
management becomes easier to handle. This is not possible for domestic
firms.

A study of International Working Capital Management requires knowledge of

International Cash Management, International Inventory Management and
International Receivables Management.

INTERNATIONAL INVENTORY MANAGEMENT

An international firm possesses normally a bigger stock than EOQ and this process
is known as stock piling. The different units of the firm get a large part of their
inventory from sister units in different countries. This is possible in a vertical
setup. For political disturbance there will be bottlenecks in import. If the currency
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of the importing country depreciates, import will be costlier thereby giving rise to
stock piling. To take a decision against stock piling the firm has to weigh the
cumulative carrying cost vis-à-vis expected increase in the price of input due to
changes in exchange rate. If the probability of interruption in supply is very high,
the firm may opt for stock piling even if it is not justified on account of higher
cost.

Also in case of global firms, lead time is larger on various units as they are located
far off in different parts of the globe. Even if they reach port in time, a lot of
customs formalities have to be carried out. Due to these factors, reorder point for
international firm’s lies much earlier. The final decision depends on the quantity
of goods to imported and how much of them are locally available. Relying on
imports varies from unit to unit but it is very much large for a vertical setup.

INTERNATIONAL RECEIVABLES MANAGEMENT

Firms grant trade credit to customers, both domestically and internationally,

because they expect the investment in receivables to be profitable, either by
expanding sales volume or by retaining sales that otherwise would be lost to
competitors.

Some companies also earn a profit on the financing charges they levy on credit
sales.

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The need to scrutinize credit terms is particularly important in countries

experiencing rapid rates of inflation. The incentive for customers to defer
payment, liquidating their debts with less valuable money in future, is great.
Furthermore, credit standards abroad are often more relaxed than in home
market, especially in countries lacking alternative sources of credit for small
customers. To remain competitive, MNCs may feel compelled to loosen their own
credit standards. Finally, the compensation system in many companies tends to
reward higher sales more than it penalizes an increased investment in accounts
receivable. Local managers frequently have an incentive to expand sales even if
the MNC overall does not benefit.

The effort to better manage receivables overseas will not get far if finance and
marketing don’t coordinated their efforts. In many companies, finance and
marketing work at cross purposes. Marketing thinks about selling, and finance
thinks about speeding up cash flows. One way to ease the tensions between
finance and marketing is to educate the sales force on how credit and collection
affect company profits.

Another way is to tie bonuses for salespeople to collected sales or to adjust sales
bonuses for the interest cost of credit sales. Forcing managers to bear the
opportunity cost of working capital ensure their credits, inventory, and other
working capital decisions will be more economical.

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INTERNATIONAL CASH MANAGEMENT

The term cash management can be broadly defined to mean optimization of cash
flows and investment of excess cash. From an international perspective, cash
management is very complex because laws pertaining to cross-border cash
transfers differ among countries. In addition, exchange rate fluctuations can
affect the value of cross-border cash transfers.

Financial managers need to understand the advantages and disadvantages of

investing cash in foreign markets so that they can make international cash
management decisions that maximize the value of the MNC. International money
managers attempt to attain on a worldwide basis the traditional domestic
objectives of cash management: (1) bringing the company‘s cash resources within
control as quickly and efficiently as possible and (2) achieving the optimum
conservation and utilization of these funds.

Accomplishing the first goal requires establishing accurate, timely forecasting and
reporting systems, improving cash collections and disbursements, and decreasing
the cost of moving funds among affiliates. The second objective is achieved by
minimizing the required level of cash balances, making money available when and
where it is needed, and increasing the risk-adjusted return on those funds that
can be invested. Restrictions and typical currency controls imposed by
governments inhibit cash movements across national boundaries. These

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restrictions are different from one country to other. Managers require lot of
foresight, planning, and anticipation.

Centralized Cash Management

A key component of working capital management is cash management. MNCs

have large cash inflows and outflows in various currencies, and the cash inflows
and outflows will not balance in any currency in any given month. An MNC may
have consistent surpluses in cash for some currencies each month and consistent
shortages for some other currencies. Many of its currencies will likely have
surplus cash positions in some months and shortages in other months. For MNCs
with foreign subsidiaries, cash management is even more complicated because
every subsidiary may be short of cash in some currencies and have excess
currency in others.

Each subsidiary’s management may naturally focus on managing its own cash
positions. However, such a decentralized management is not optimal because it
will force the MNC overall to maintain a larger investment in cash than is
necessary. Thus, MNCs commonly use centralized cash management to monitor
and manage the parent- subsidiary and inter-subsidiary cash flows. This role is
critical since it can often benefit individual subsidiaries in need of funds or overly
exposed to exchange rate risk.

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Techniques to Optimize Cash Flows

Cash inflows can be optimized by the following techniques:

• Accelerating cash inflows

• Minimizing currency conversion costs
• Managing blocked funds
• Managing inter-subsidiary cash transfers

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Accelerating Cash Inflows

The first goal in international cash management is to accelerate cash inflows since
the more quickly the inflows are received, the more quickly they can be invested
or used for other purposes. Several managerial practices are advocated for this
endeavor, some of which may be implemented by the individual subsidiaries.
First, a corporation may establish lockboxes around the world, which are post
office boxes to which customers are instructed to send payment. When set up in
appropriate locations, lockboxes can help reduce mailing time (mail float).

A bank usually processes incoming checks at a lockbox on a daily basis. Second,

cash inflows can be accelerated by using preauthorized payments, which allow a
corporation to charge a customer’s bank account up to some limit. Both
preauthorized payments and lockboxes are also used in a domestic setting.
Because international transactions may have a relatively long mailing time, these
methods of accelerating cash inflows can be quite valuable for an MNC.

Minimizing Currency Conversion Costs

Another technique for optimizing cash flow movements, netting, can be

implemented with the joint effort of subsidiaries or by the centralized cash
management group. This technique optimizes cash flows by reducing the
administrative and transaction costs that result from currency conversion. Over
time, netting has become increasingly popular because it offers several key
benefits. First, it reduces the number of cross-border transactions between

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subsidiaries, thereby reducing the overall administrative cost of such cash

transfers. Second, it reduces the need for foreign exchange conversion since
transactions occur less frequently, thereby reducing the transaction costs
associated with foreign exchange conversion.

Third, the netting process imposes tight control over information on transactions
between subsidiaries. Thus, all subsidiaries engage in a more coordinated effort
to accurately report and settle their various accounts. Finally, cash flow
forecasting is easier since only net cash transfers are made at the end of each
period, rather than individual cash transfers throughout the period. Improved
cash flow forecasting can enhance financing and investment decisions.

A bilateral netting system involves transactions between two units: between the
parent and a subsidiary, or between two subsidiaries. A multilateral netting
system usually involves a more complex interchange among the parent and
several subsidiaries. For most large MNCs, a multilateral netting system would be
necessary to effectively reduce administrative and currency conversion costs.
Such a system is normally centralized so that all necessary information is
consolidated. From the consolidated cash flow information, net cash flow
positions for each pair of units (subsidiaries, or whatever) are determined, and
the actual reconciliation at the end of each period can be dictated.

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The centralized group may even maintain inventories of various currencies so that
currency conversions for the end-of-period net payments can be completed
without significant transaction costs. MNCs commonly monitor the cash flows
between their subsidiaries with the use of an inter-subsidiary payments matrix. A
U.S.-based MNC will normally translate the payments into dollars (based on the
prevailing spot rate) so that the net payments can be easily determined. If the
Canadian subsidiary of the MNC normally makes payments to the French
subsidiary in Euros, but the French subsidiary normally makes payments to the
Canadian subsidiary in Canadian dollars, the payments need to be translated into
a common currency to determine the net payment owed. The amounts can be
translated into dollars to determine the net payment owed between each pair of
subsidiaries.

Managing Blocked Funds

Cash flows can also be affected by a host government’s blockage of funds, which
might occur if the government requires all funds to remain within the country in
order to create jobs and reduce unemployment. To deal with funds blockage, the
MNC may implement the same strategies used when a host country government
imposes high taxes. To make efficient use of these funds, the MNC may instruct
the subsidiary to set up a research and development division, which incurs costs
and possibly generates revenues for other subsidiaries. Another strategy is to use
transfer pricing in a manner that will increase the expenses incurred by the
subsidiary.

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A host country government is likely to be more lenient on funds sent to cover

expenses than on earnings remitted to the parent. When subsidiaries are
restricted from transferring funds to the parent, the parent may instruct the
subsidiary to obtain financing from a local bank rather than from the parent. By
borrowing through a local intermediary, the subsidiary is assured that its earnings
can be distributed to pay off previous financing. Overall, most methods of
managing blocked funds are intended to make efficient use of the funds by using
them to cover expenses that are transferred to that country.

Managing Inter-subsidiary Cash Transfers

Proper management of cash flows can also be beneficial to a subsidiary in need of

funds. The leading or lagging strategy can make efficient use of cash and thereby
reduce debt. Some host governments prohibit the practice by requiring that a
payment between subsidiaries occur at the time the goods are transferred. Thus,
an MNC needs to be aware of any laws that restrict the use of this strategy.

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