INTERNATIONAL FINANCIAL MANAGEMENT | 11.

CHAPTER –11 INTERNAITOLNAL FINANCIAL MANAGEMENT

CHAPTER 11
INTERNATIONAL FINANCIAL
MANAGEMENT
LEARNING OUTCOMES
After going through the chapter student shall be able to understand
 International Capital Budgeting
 International Sources of Finance
 International Working Capital Management
(a) International Working Capital Management
(b) Multinational Cash Management
(c) Multinational Receivable Management
(d) Multinational Inventory Management
(1) INTERNATIONAL CAPITAL BUDGETING
1. Complexities Involved
 Multinational Capital Budgeting has to take into consideration the different
factors and variables which affect a foreign project and are complex in nature
than domestic projects.

 The factors crucial in such a situation are:

(a) Cash flows from foreign projects have to be converted into the currency of the
parent organization.
(b) Parent cash flows are quite different from project cash flows
(c) Profits remitted to the parent firm are subject to tax in the home country as
well as the host country
(d) Effect of foreign exchange risk on the parent firm’s cash flow
(e) Changes in rates of inflation causing a shift in the competitive environment
and thereby affecting cash flows over a specific time period
(f) Restrictions imposed on cash flow distribution generated from foreign
projects by the host country
(g) Initial investment in the host country to benefit from the release of blocked
funds
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(h) Political risk in the form of changed political events reduce the possibility of
expected cash flows
(i) Concessions/benefits provided by the host country ensures the upsurge in
the profitability position of the foreign project
(j) Estimation of the terminal value in multinational capital budgeting is
difficult since the buyers in the parent company have divergent views on
acquisition of the project.

2. Problems Affecting Foreign Investment Analysis

The various types of problems faced in International Capital Budgeting analysis are as
follows:
(i) Foreign exchange risk

 Multinational companies investing elsewhere are subjected to foreign exchange

risk in the sense that currency appreciates/ depreciates over a span of time.

 To include foreign exchange risk in the cash flow estimates of any project, it is
necessary to forecast the inflation rate in the host country during the lifetime of
the project.

 Adjustments for inflation are made in the cash flows depicted in local currency. The
cash flows are converted in parent country’s currency at the spot exchange rate
multiplied by the expected depreciation rate obtained from purchasing power parity.
(ii) Restrictions

 Due to restrictions imposed on transfer of profits, depreciation charges and

technical differences exist between project cash flows and cash flows obtained by the
parent organization.

 Such restriction can be diluted by the application of techniques viz internal transfer
prices, overhead payments.

 Adjustment for blocked funds depends on its opportunity cost, a vital issue in capital
budgeting process.
(iii) Presence of two tax regimes

 In multinational capital budgeting, after tax cash flows need to be considered for
project evaluation.

 The presence of two tax regimes along with other factors such as remittances to
the parent firm in the form of royalties, dividends, management fees etc, tax
provisions with held in the host country, presence of tax treaties, tax discrimination
pursued by the host country between transfer of realized profits vis-à-vis local re-
investment of such profits cause serious impediments to multinational capital
budgeting process.
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 MNCs are in a position to reduce overall tax burden through the system of transfer
pricing.

 For computation of actual after tax cash flows accruing to the parent firm, higher of
home/ host country tax rate is used.

 If the project becomes feasible then it is acceptable under a more favourable tax
regime. If not feasible, then, other tax saving aspects need to be incorporated in
order to find out whether the project crosses the hurdle rate
3. Project vis-a-vis Parent Cash Flows
 There exists a big difference between the project and parent cash flows due to tax
rules, exchange controls.

 Management and royalty payments are returns to the parent firm.

 The basis on which a project shall be evaluated depend on one’s own cash flows,
cash flows accruing to the parent firm or both.
 Evaluation of a project on the basis of own cash flows entails that the project
should compete favourably with domestic firms and earn a return higher than the
local competitors.
 If not, the shareholders and management of the parent company shall invest in the
equity/government bonds of domestic firms. A comparison cannot be made since
foreign projects replace imports and are not competitors with existing local firms.
Project evaluation based on local cash flows avoid currency conversion and
eliminates problems associated with fluctuating exchange rate changes.
 For evaluation of foreign project from the parent firm’s angle, both operating and
financial cash flows actually remitted to it form the yardstick for the firm’s
performance and the basis for distribution of dividends to the shareholders and
repayment of debt/interest to lenders.
 An investment has to be evaluated on basis of net after tax operating cash flows
generated by the project. As both types of cash flows (operating and financial) are
clubbed together, it is essential to see that financial cash flows are not mixed up with
operating cash flows.
4. Discount Rate and Adjusting Cash Flows
 An important aspect in multinational capital budgeting is to adjust cash flows or the
discount rate for the additional risk arising from foreign location of the project.

 Earlier MNCs adjusted the discount rate upwards for riskier projects as they
considered uncertainties in political environment and foreign exchange fluctuations.

 The MNCs considered adjusting the discount rate to be popular as the rate of return of
a project should be in conformity with the degree of risk.
 INTERNATIONAL FINANCIAL MANAGEMENT | 11.4

 It is not proper to combine all risks into a single discount rate. Political
risk/uncertainties attached to a project relate to possible adverse effects which might
occur in future but cannot be foreseen at present. So adjusting discount rates for
political risk penalises early cash flows more than distant cash flows. Also
adjusting discount rate to offset exchange risk only when adverse exchange rate
movements are expected is not proper since a MNC can gain from favourable
currency movements during the life of the project on many occasions.

 Instead of adjusting discount rate while considering risk it is worthwhile to adjust

cash flows.

 The annual cash flows are discounted at a rate applicable to the project either at
that of the host country or parent country.
Probability with certainty equivalent method along with decision tree analysis are used for
economic and financial forecasting. Cash flows generated by the project and remitted to the
parent during each period are adjusted for political risk, exchange rate and other
uncertainties by converting them into certainty equivalents.
5. Adjusted Present Value (APV)
 APV is used in evaluating foreign projects.

 The APV model is a value additive approach to capital budgeting process i.e. each
cash flow is considered individually and discounted at a rate consistent with
risk involved in the cash flow.

 Different components of the project’s cash flow have to be discounted separately.

 The APV method uses different discount rates for different segments of the total
cash flows depending on the degree of certainty attached with each cash flow.
The APV model is represented as follows.

n n n
Xt Tt St
–I0      
t 1 (1  k ) t 1 (1  i d ) t 1 1  i d 
* t t t

Where I 0  Present Value of Investment Outlay

Xt
 Present Value of Operating Cash Flow
1  k * t

Tt
 Present Value of Interest Tax Shields
1  id 
t
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St
 Present Value of Interest Subsidies
1  id 
t

Tt  Tax Saving in year t due to financial mix adopted

St  Before tax value of interests subsidies (on home currency) in year t due to project
specific financing

i t  Before tax cost of dollar dept (home currency)

 The initial investment will be net of any ‘Blocked Funds’ that can be made use of by
the parent company for investment in the project.

 ‘Blocked Funds’ are balances held in foreign countries that cannot be remitted to
the parent due to Exchange Control regulations. These are ‘direct blocked funds’.
 Apart from this, it is quite possible that significant costs in the form of local taxes or
withholding taxes arise at the time of remittance of the funds to the parent country.
Such ‘blocked funds’ are indirect.
 If a parent company can release such ‘Blocked Funds’ in one country for the
investment

 A foreign company is investing in India

 An Indian Company is investing in foreign country by raising fund in the same country
 An Indian Company is investing in foreign country by raising fund in different country
through the mode of Global Depository Receipts (GDRs)

INTERNATIONAL SOURCES OF FINANCE

Indian companies have been able to tap global markets to raise foreign currency funds by
issuing various types of financial instruments which are discussed as follows:
1. Foreign Currency Convertible Bonds (FCCBs)
 A type of convertible bond issued in a currency different than the issuer's
domestic currency. In other words, the money being raised by the issuing
company is in the form of a foreign currency.

 A convertible bond is a mix between a debt and equity instrument.

 It acts like a bond by making regular coupon and principal payments, but
 these bonds also give the bondholder the option to convert the bond into
stock.
 INTERNATIONAL FINANCIAL MANAGEMENT | 11.6

 These types of bonds are attractive to both investors and issuers.

 The investors receive the safety of guaranteed payments on the bond and are
also able to take advantage of any large price appreciation in the company's
stock. (Bondholders take advantage of this appreciation by means of warrants
attached to the bonds, which are activated when the price of the stock reaches a
certain point.)
 Due to the equity side of the bond, which adds value, the coupon payments
on the bond are lower for the company, thereby reducing its debt-financing
costs.
Advantages of FCCBs
(i) The convertible bond gives the investor the flexibility to convert the bond into equity
at a price or redeem the bond at the end of a specified period, normally three years if
the price of the share has not met his expectations.
(ii) Companies prefer bonds as it leads to delayed dilution of equity and allows
company to avoid any current dilution in earnings per share that a further issuance
of equity would cause.
(iii) FCCBs are easily marketable as investors enjoys option of conversion into equity if
resulting to capital appreciation. Further investor is assured of a minimum fixed interest
earnings.
Disadvantages of FCCBs
(i) Exchange risk is more in FCCBs as interest on bonds would be payable in foreign
currency. Thus companies with low debt equity ratios, large forex earnings potential only
opt for FCCBs.
(ii) FCCBs mean creation of more debt and a forex outgo in terms of interest which is in
foreign exchange.
(iii) In the case of convertible bonds, the interest rate is low, say around 3–4% but
there is exchange risk on the interest payment as well as re-payment if the bonds are not
converted into equity shares.

The only major advantage would be that where the company has a high rate of growth
in earnings and the conversion takes place subsequently, the price at which shares
can be issued can be higher than the current market price.
2. American Depository Receipts (ADRs)
 Depository receipts issued by a company in the United States of America (USA) is
known as American Depository Receipts (ADRs).

 Such receipts must be issued in accordance with the provisions stipulated by the
Securities and Exchange Commission of USA (SEC) which are very stringent.
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 An ADR is generally created by the deposit of the securities of a non-United States company
with a custodian bank in the country of incorporation of the issuing company. The
custodian bank informs the depository in the United States that the ADRs can be issued.

 ADRs are United States dollar denominated and are traded in the same way as are
the securities of United States companies.

 The ADR holder is entitled to the same rights and advantages as owners of the
underlying securities in the home country.

 Several variations on ADRs have developed over time to meet more specialized
demands in different markets. One such variation is the GDR which are identical in
structure to an ADR, the only difference being that they can be traded in more than one
currency and within as well as outside the United States.
3. Global Depository Receipts (GDRs)
 A depository receipt is basically a negotiable certificate, denominated in a
currency not native to the issuer, that represents the company's publicly - traded
local currency equity shares.

 Most GDRs are denominated in USD, while a few are denominated in Euro and Pound
Sterling.

 The Depository Receipts issued in the US are called American Depository Receipts
(ADRs), which anyway are denominated in USD and outside of USA, these are called
GDRs.

 In theory, though a depository receipt can also represent a debt instrument, in

practice it rarely does.

 DRs (depository receipts) are created when the local currency shares of an Indian
company are delivered to the depository's local custodian bank, against which the
Depository bank (such as the Bank of New York) issues depository receipts in US
dollar.

 These depository receipts may trade freely in the overseas markets like any other
dollar-denominated security, either on a
 foreign stock exchange, or
 in the over-the-counter market, or
 among a restricted group such as Qualified Institutional Buyers (QIBs).

 Indian issues have taken the form of GDRs to reflect the fact that they are
marketed globally, rather than in a specific country or market.

 Through the issue of depository receipts, companies in India have been able to tap
global equity market to raise foreign currency funds by way of equity. Quite apart
from the specific needs that Indian companies may have for equity capital in preference
 INTERNATIONAL FINANCIAL MANAGEMENT | 11.8

to debt and the perceived advantages of raising equity over debt in general (no
repayment of "principal" and generally lower servicing costs, etc.) the fact of the matter
is quite simple, that no other form of term foreign exchange funding has been available.

 In addition, it has been perceived that a GDR issue has been able to fetch higher
prices from international investors (even when Indian issues were being sold at a
discount to the prevailing domestic share prices) than those that a domestic public issue
would have been able to extract from Indian investors.

 Impact of GDRs on Indian Capital Market

Since the inception of GDRs a remarkable change in Indian capital market has been
observed as follows:
(i) Indian stock market to some extent is shifting from Bombay to Luxemburg.
(ii) There is arbitrage possibility in GDR issues.
(iii) Indian stock market is no longer independent from the rest of the world.
This puts additional strain on the investors as they now need to keep updated
with world wide economic events.
(iv) Indian retail investors are completely sidelined. GDRs/Foreign Institutional
Investors' placements + free pricing implies that retail investors can no longer
expect to make easy money on heavily discounted rights/public issues.
(v) As a result of introduction of GDRs a considerable foreign investment has flown
into India.
Markets of GDRs
(i) GDR's are sold primarily to institutional investors.
(ii) Demand is likely to be dominated by emerging market funds.
(iii) Switching by foreign institutional investors from ordinary shares into GDRs is
likely.
(iv) Major demand is also in UK, USA (Qualified Institutional Buyers), South East Asia
(Hong kong, Singapore), and to some extent continental Europe (principally France
and Switzerland).

 Mechanism of GDR: The mechanics of a GDR issue may be described with the
help of following diagram.
Company issues

Ordinary shares

Kept with Custodian/depository banks

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against which GDRs are issued


to Foreign investors

 Characteristics
(i) Holders of GDRs participate in the economic benefits of being ordinary
shareholders, though they do not have voting rights.
(ii) GDRs are settled through CEDEL & Euro-clear international book entry
systems.
(iii) GDRs are listed on the Luxemburg stock exchange.
(iv) Trading takes place between professional market makers on an OTC (over
the counter) basis.
(v) The instruments are freely traded.
(vi) They are marketed globally without being confined to borders of any
market or country as it can be traded in more than one currency.
(vii) Investors earn fixed income by way of dividends which are paid in issuer
currency converted into dollars by depository and paid to investors and hence
exchange risk is with investor.
(viii) liquidation of GDRs
o As far as the case of liquidation of GDRs is concerned, an investor
may get the GDR cancelled any time after a cooling off period of 45
days.
o A non-resident holder of GDRs may ask the overseas bank
(depository) to redeem (cancel) the GDRs
o In that case overseas depository bank shall request the domestic
custodians bank to cancel the GDR and to get the corresponding
underlying shares released in favour of non-resident investor.
o The price of the ordinary shares of the issuing company
prevailing in the Bombay Stock Exchange or the National Stock
Exchange on the date of advice of redemption shall be taken as
the cost of acquisition of the underlying ordinary share.

4. Euro-Convertible Bonds (ECBs)

 A convertible bond is a debt instrument which gives the holders of the bond an
option to convert the bond into a predetermined number of equity shares of the
company.

 Usually, the price of the equity shares at the time of conversion will have a
premium element.
 INTERNATIONAL FINANCIAL MANAGEMENT | 11.10

 The bonds carry a fixed rate of interest.

 If the issuer company desires, the issue of such bonds may carry two options viz.
(i) Call Options: (Issuer's option) –
o where the terms of issue of the bonds contain a provision for call option, the
issuer company has the option of calling (buying) the bonds for redemption
before the date of maturity of the bonds.
o Where the issuer's share price has appreciated substantially, i.e. far in excess of
the redemption value of the bonds, the issuer company can exercise the option.
o This call option forces the investors to convert the bonds into equity. Usually,
such a case arises when the share prices reach a stage near 130% to 150% of the
conversion price.
(ii) Put options –
o A provision of put option gives the holder of the bonds a right to put (sell)his
bonds back to the issuer company at a pre-determined price and date.
o In case of Euro-convertible bonds, the payment of interest on and the redemption
of the bonds will be made by the issuer company in US dollars.

5. Other Sources
(i) Euro Bonds:
o Plain Euro-bonds are nothing but debt instruments.
o These are not very attractive for an investor who desires to have
valuable additions to his investments.
(ii) Euro-Convertible Zero Bonds:
o These bonds are structured as a convertible bond.
o No interest is payable on the bonds.
o But conversion of bonds takes place on maturity at a pre- determined price.
o Usually there is a 5 years maturity period and they are treated as a deferred
equity issue.
(iii) Euro-bonds with Equity Warrants:
o These bonds carry a coupon rate determined by the market rates.
o The warrants are detachable.
o Pure bonds are traded at a discount.
o Fixed income funds' managements may like to invest for the purposes of
regular income.
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(iv) Syndicated bank loans:

o One of the earlier ways of raising funds in the form of large loans from banks
with good credit rating, can be arranged in reasonably short time and with few
formalities.
o The maturity of the loan can be for a duration of 5 to 10 years.
o The interest rate is generally set with reference to an index, say, LIBOR plus a
spread which depends upon the credit rating of the borrower.
o Some covenants are laid down by the lending institution like maintenance of key
financial ratios.
(v) Euro-bonds:
o These are basically debt instruments denominated in a currency issued
outside the country of that currency for examples Yen bond floated in France.
o Primary attraction of these bonds is the refuge from tax and regulations and
provide scope for arbitraging yields.
o These are usually bearer bonds and can take the form of
 Traditional fixed rate bonds.
 Floating rate Notes.(FRNs)
 Convertible Bonds.
(vi) Foreign Bonds:
o Foreign bonds are denominated in a currency which is foreign to the borrower
and sold at the country of that currency.
o Such bonds are always subject to the restrictions and are placed by that country on
the foreigners funds.
(vii) Euro Commercial Papers:
o These are short term money market securities usually issued at a discount, for
maturities less than one year.
o Credit Instruments:
o The foregoing discussion relating to foreign exchange risk management and
international capital market shows that foreign exchange operations of banks
consist primarily of purchase and sale of credit instruments.

(3) INTERNATIONAL WORKING CAPITAL MANAGEMENT

1. International Working Capital
The management of working capital in an international firm is much more complex as
compared to a domestic one. The reasons for such complexity are:
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(i) A multinational firm has a wider option for financing its current assets. A
MNC has funds flowing in from different parts of international financial markets.
Therefore, it may choose to avail financing either locally or from global financial
markets. Such an opportunity does not exist for pure domestic firms.
(ii) Interest and tax rates vary from one country to the other. A Treasurer 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 firm limit their operations within
the country and do not face such problems.
(iv) 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 firm limit their operations within the country and do not
face such problems.
(v) With limited knowledge of the politico-economic conditions prevailing in
different host countries, a Manager of a multinational firm 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.
(vi) In countries which operate on full capital convertibility, a MNC can move its funds
from one location to another and thus mobilize and ‘position’ the funds in the most
efficient way possible. Such freedom may not be available for MNCs operating in
countries that have not subscribed to full capital convertibility (like India).
2. Multinational Cash Management
 MNCs are very much concerned with effective cash management. International
money managers follow the traditional objectives of cash management viz.
o effectively managing and controlling cash resources of the company as
well as
o achieving optimum utilization and conservation of funds.
 The former objective can be attained by improving cash collections and
disbursements and by making an accurate and timely forecast of cash flow
pattern.

 The latter objective can be reached by making money available as and when
needed, minimising the cash balance level and increasing the risk
adjusted return on funds that is to be invested.
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 International Cash Management requires Multinational firms to adhere to

the extant rules and regulations in various countries that they operate in.
Apart from these rules and regulations, they would be required to follow the
relevant forex market practices and conventions which may not be practiced in
their parent countries.

 A host of factors curtail the area of operations of an international money

manager e.g. restrictions on FDI, repatriation of foreign sales proceeds to
the hinder the movement of funds across national borders and the manager has to
plan beforehand the possibility of such situation arising on a country to country
basis.

 Other complications in the form of multiple tax jurisdictions and currencies

and absence of internationally integrated exchange facilities result in
shifting of cash from one location to another to overcome these difficulties.

The main objectives of an effective system of international cash

management are:
(i) To minimise currency exposure risk.
(ii) To minimise overall cash requirements of the company as a whole without
disturbing smooth operations of the subsidiary or its affiliate.
(iii) To minimise transaction costs.
(iv) To minimise country’s political risk.
(v) To take advantage of economies of scale as well as reap benefits of superior
knowledge.
The objectives are conflicting in nature as minimising of transaction costs
require cash balance to be kept in the currency in which they are received
thereby contradicting both currency and political exposure requirements.

A centralized cash management

 A centralized cash management group is required to monitor and manage parent
subsidiary and inter-subsidiary cash flows.
 Centralization needs centralization of information, reports and decision making
process relating to cash mobilisation, movement and investment. This system benefits
individual subsidiaries which require funds or are exposed to exchange rate risk.
 A centralised cash system helps MNCs as follows:
(a) To maintain minimum cash balance during the year.
(b) To manage judiciously liquidity requirements of the centre.
(c) To optimally use various hedging strategies so that MNC’s foreign exchange
exposure is minimized.
 INTERNATIONAL FINANCIAL MANAGEMENT | 11.14

(d) To aid the centre to generate maximum returns by investing all cash resources
optimally.
(e) To aid the centre to take advantage of multinational netting so that transaction
costs and currency exposure are minimised.
(f) To make maximum utilization of transfer pricing mechanism so that the firm
enhances its profitability and growth.
(g) To exploit currency movement correlations:
(h) Payables & receivables in different currencies having positive correlations
(i) Payables of different currencies having negative correlations
(j) Pooling of funds allows for reduced holding – the variance of the total cash flows
for the entire group will be smaller than the sum of the individual variances

International Cash Management has two basic objectives:

1) Optimising Cash Flow movements.
2) Investing excess cash.

There are numerous ways of optimising cash inflows:

1) Accelerating cash inflows.
2) Managing blocked funds.
3) Leading and Lagging strategy.
4) Minimizing tax on cash flow through international transfer pricing.
5) Using netting to reduce overall transaction costs by eliminating number of
unnecessary conversions and transfer of currencies.
6) Investing excess cash

1) Accelerating Cash Inflows

 Faster recovery of cash inflows helps the firm to use them whenever required
or to invest them for better returns.

 Customers all over the world are instructed to send their payments to
lockboxes set up at various locations, thereby reducing the time and
transaction costs involved in collecting payments.

 Also, through pre-authorized payment, an organization may be allowed to

charge the customer’s bank account up to some limit.
2) Managing Blocked Funds
 The host country may block funds of the subsidiary to be sent to the parent or
make sure that earnings generated by the subsidiary be reinvested locally before
being remitted to the parent so that jobs are created and unemployment reduced.
 INTERNATIONAL FINANCIAL MANAGEMENT | 11.15

 The subsidiary may be instructed to obtain bank finance locally for the
parent firm so that blocked funds may be utilised to pay off bank loans.

 The parent company has to assess the potential of future funds blockage in a
foreign country.

 MNCs have to be aware of political risks cropping up due to unexpected

blockage of funds and devise ways to benefit their shareholders by using different
methods for moving blocked funds through transfer pricing strategies, direct
negotiations, leading and lagging and so on.
3) Leading and Lagging
 This technique is used by subsidiaries for optimizing cash flow movements
by adjusting the timing of payments to determine expectations about future
currency movements.

 MNCs accelerate (lead) or delay (lag) the timing of foreign currency

payments through adjustment of the credit terms extended by one unit to
another.

 The technique helps to reduce foreign exchange exposure or to increase

available working capital.

 Firms accelerate payments of hard currency payables and delay payments of

soft currency payables in order to reduce foreign exchange exposure.

 A MNC in the USA has subsidiaries all over the world. A subsidiary in India
purchases its supplies from another subsidiary in Japan. If the Indian subsidiary
expects the rupee to fall against the yen, then it shall be the objective of that firm
to accelerate the timing of its payment before the rupee depreciates. Such a
strategy is called Leading.

 On the other hand, if the Indian subsidiary expects the rupee to rise against
the yen then it shall be the objective of that firm to delay the timing of its
payment before the rupee appreciates. Such a strategy is called Lagging. MNCs
should be aware of the government restrictions in such countries before availing
such strategies.

4) Minimising Tax on Cash Flows through Transfer Pricing

Mechanism
 Large entities having many divisions require goods and services to be
transferred frequently from one division to another.

 The profits of different divisions are determined by the price to be charged

by the transferor division to the transferee division.
 INTERNATIONAL FINANCIAL MANAGEMENT | 11.16

 The higher the transfer price, the larger will be the gross profit of the
transferor division with respect to the transferee division.

 The position gets complicated for MNCs due to exchange restrictions,

inflation differentials, import duties, tax rate differentials between two
nations, quotas imposed by host country, etc.

5) Netting
 It is a technique of optimising cash flow movements with the combined
efforts of the subsidiaries thereby reducing administrative and transaction
costs resulting from currency conversion.

 There is a co-ordinated international interchange of materials, finished

products and

 parts among the different units of MNC with many subsidiaries buying
/selling from/to each other.

 Netting helps in minimising the total volume of inter-company fund flow.

Advantages derived from netting system includes:

1) Reduces the number of cross-border transactions between subsidiaries thereby
decreasing the overall administrative costs of such cash transfers
2) Reduces the need for foreign exchange conversion and hence decreases
transaction costs associated with foreign exchange conversion.
3) Improves cash flow forecasting since net cash transfers are made at the end of
each period
4) Gives an accurate report and settles accounts through co-ordinated efforts
among all subsidiaries

There are two types of Netting:

1) Bilateral Netting System –

 It involves transactions between the parent and a subsidiary or between

two subsidiaries.

 If subsidiary X purchases $ 20 million worth of goods from subsidiary Y and

subsidiary Y in turn buy $ 30 million worth of goods from subsidiary X, then the
combined flows add up to $ 50 million. But in bilateral netting system
subsidiary Y would pay subsidiary X only $10 million.

 Thus, bilateral netting reduces the number of foreign exchange

transactions and also the costs associated with foreign exchange
conversion.
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2) Multilateral Netting System

 Each affiliate nets all its inter affiliate receipts against all its disbursements.
 It transfers or receives the balance on the position of it being a net receiver or
a payer thereby resulting in savings in transfer / exchange costs.
 For an effective multilateral netting system, these should be a centralised
communication system along with disciplined subsidiaries. This type of system
calls for the consolidation of information and net cash flow positions for each
pair of subsidiaries.

6) Investing Excess Cash

 Euro Currency market accommodates excess cash in international money
market.

 Euro Dollar deposits offer MNCs higher yield than bank deposits in US.

 The MNCs use the Euro Currency market for temporary use of funds, purchase of
foreign treasury bills / commercial paper. Through better telecommunication
system and integration of various money markets in different countries, access to the
securities in foreign markets has become easier.
 Through a centralized cash management strategy, MNCs pool together excess
funds from subsidiaries enabling them to earn higher returns due to the larger
deposits lying with them.
 Sometimes a separate investment account is maintained for all subsidiaries so
that short term financing needs of one can be met by the other subsidiary without
incurring transaction costs charged by banks for exchanging currencies. Such an
approach leads to an excessive transaction costs.
 The centralized system helps to convert the excess funds pooled together into a
single currency for investments thereby involving considerable transaction cost
and a cost benefit analysis should be made to find out whether the benefits
reaped are not offset by the transaction costs incurred.
 A question may arise as to how MNCs will utilise their excess funds once they have
used them to meet short term financing needs. This is vital since some currencies may
provide a higher interest rate or may appreciate considerably. So deposits made in such
currencies will be attractive.
 Again MNCs may go in for foreign currency deposit which may give an effective
yield higher than domestic deposit so as to overcome exchange rate risk.
Forecasting of exchange rate fluctuations need to be calculated in this respect so that a
comparative study can be effectively made.
 Lastly an MNC can go for a diversification of its portfolio in different countries
having different currencies because of the exchange rate fluctuations taking place
and at the same time avoid the possibility of incurring substantial losses that may arise
due to sudden currency depreciation.
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2. 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 a firm get a large part of their inventory from sister units
in different countries. This is possible in a vertical set up.

 For political disturbance there will be bottlenecks in import. If the currency of the
importing country depreciates, imports 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 the port in time, a lot of
customs formalities have to be carried out. Due to these factors, re-order point for
international firm lies much earlier.

 The final decision depends on the quantity of goods to be 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 set up.

3. International Receivables Management

 Credit Sales lead to the emergence of account receivables. There are two types of
such sales viz. Inter firm Sales and Intra firm Sales in the global aspect.
 In case of Inter firm Sales,:
 the currency in which the transaction should be denominated and the
terms of payment need proper attention.
 With regard to currency denomination, the exporter is interested to
denominate the transaction in a strong currency while the importer wants
to get it denominated in weak currency.
 The exporter may be willing to invoice the transaction in the weak currency
even for a long period if it has debt in that currency. This is due to sale
proceeds being used to retire debts without loss on account of exchange rate
changes.
 With regard to terms of payment, the exporter does not provide a longer
period of credit and ventures to get the export proceeds quickly in order to
invoice the transaction in a weak currency.
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 If the credit term is liberal the exporter is able to borrow currency from the
bank on the basis of bills receivables.
 Also credit terms may be liberal in cases where competition in the market is
keen compelling the exporter to finance a part of the importer’s inventory.
Such an action from the exporter helps to expand sales in a big way.

 In case of Intra firm sales,

 the focus is on global allocation of firm’s resources.
 Different parts of the same product are produced in different units
established in different countries and exported to the assembly units leading
to a large size of receivables.
 The question of quick or delayed payment does not affect the firm as both
the seller and the buyer are from the same firm though the one having
cash surplus will make early payments while the other having cash crunch will
make late payments.
 This is a case of intra firm allocation of resources where leads and lags
explained earlier will be taken recourse to.

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