Chapter 19 Managing Net Working Capital Slides prepared

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Chapter 19 Managing Net Working Capital Slides prepared by April Knill, Ph. D. , Florida State University

19. 1 The Purpose of Net Working Capital • Working capital – current assets (i. e. , cash, marketable securities, accounts receivable, and inventories) held by a firm at any point in time • Net working capital (NWC) = working capital – firm’s current liabilities (i. e. , short-term debt and accounts payable) – Necessary but if firm’s can work with less they can pay out cash to shareholders – Used to smooth production 19 -2 © 2012 Pearson Education, Inc. All rights reserved.

19. 1 The Purpose of Net Working Capital • Inventories as assets – Increases seen as an investment for future cash – Includes raw materials, goods that represent work-inprogress, and finished goods – Cost of production are lower if production is smoothed over time • Other current assets – Increases in cash marketable securities and accounts receivable should also be viewed as investment for future cash • Short-term liabilities – May be used to buy e. g. , raw materials without changing NWC 19 -3 © 2012 Pearson Education, Inc. All rights reserved.

19. 2 International Cash Management • Constraints – Government restrictions on the transfers of funds • Blocked funds • Unattractive foreign exchange rates – Taxes that depend on the type of fund transfer – Transaction costs in the foreign exchange market – Problems maintaining the liquidity of all foreign affiliates 19 -4 © 2012 Pearson Education, Inc. All rights reserved.

19. 2 International Cash Management • Cash management with a centralized pool – Transactions demand for money – arises because a firm realizes that it has some expenditure that will be incurred in the near future. – Precautionary demand for money – arises because a firm may need to purchase something due to unanticipated change in its environment – MNCs can reduce transaction costs by centralizing the management of short-term cash balances of its foreign affiliates 19 -5 © 2012 Pearson Education, Inc. All rights reserved.

19. 2 International Cash Management • Managing surpluses and deficits – Surpluses can be invested in short-term money market instruments – Deficits can be borrowed through banks or in the commercial paper market • Forecasts of cash flows – Five-day rolling forecasts (see, e. g. , Exhibit 19. 3, page 647) – Can be checked for accuracy – Enables assessment of short-term needs of each affiliate in light of forecasted movements in exchange rate – Used to generate overall forecasts of the net cash flows 19 -8 © 2012 Pearson Education, Inc. All rights reserved.

Exhibit 19. 3 Consolidated 5 -Day Cash Forecasts of an MNC’s European Affiliates (in thousands of euros) Multilateral netting systems – method for firms to save on transaction costs 19 -9 © 2012 Pearson Education, Inc. All rights reserved.

Exhibit 19. 4 The Cash Flows of an MNC’s Affiliates Before Multilateral Netting (in thousands of euros) Multilateral netting systems – method for firms to save on transaction costs 19 -10 © 2012 Pearson Education, Inc. All rights reserved.

Exhibit 19. 5 Cash Flows After Multilateral Netting (in thousands of euros) Multilateral netting systems – method for firms to save on transaction costs 19 -11 © 2012 Pearson Education, Inc. All rights reserved.

19. 2 International Cash Management • Using a centralized cash management system to reduce precautionary cash demands – Can use probability distributions to help the firm manage the cash • Normal distribution firm can feel 97. 5% sure that the cash demands will not exceed the mean plus two times the standard deviation • This can be done at a specific location or even by region – Limits – MNCs must diversify across banks because, as the 2007 -2010 global financial crisis has taught us, even the largest banks have the potential to default 19 -12 © 2012 Pearson Education, Inc. All rights reserved.

19. 3 Cash Transfers from Affiliates to Parents • Dividends – Most common - >50% of transfers – Tax planning – policy/timing should minimize taxes – Dealing with political risk – to avoid questions from foreign governments, it is advantageous to have dividend policies in place – Foreign exchange risk – timing may be used to maximize benefit or minimize loss – Other factors, e. g. , joint venture relationships • Royalties and management-fees – Royalties – payments to owners of technology, patent or trademark for its use – Fees for management or consulting services 19 -14 © 2012 Pearson Education, Inc. All rights reserved.

19. 3 Cash Transfers from Affiliates to Parents • Royalties and management-fees (cont. ) – Repatriation in a joint venture – important to ensure that there is no confusion about future payments – Tax advantages of royalties and fees – not taxes in some countries – Paid out of pretax income, which reduces withholding taxes of other repatriated funds • Transfer pricing and cash flows – set prices for goods being sold to firm’s affiliates – Not always easy to determine if these prices are fair value (especially for semi-finished goods, which have no market) – High transfer pricing shifts income/tax payments from the affiliate paying to the affiliate receiving – governments don’t like this! 19 -15 © 2012 Pearson Education, Inc. All rights reserved.

19. 3 Cash Transfers from Affiliates to Parents • Transfer pricing regulations – establishes what is an appropriate price – In U. S. this is one which reflects an “arm’slength price” • Methods to calculate this (for U. S. and OECD member nations) include: 1. The comparable uncontrolled price method 2. The resale price method 3. The cost-plus method 4. The comparable-profits method 5. Other acceptable methods 19 -18 © 2012 Pearson Education, Inc. All rights reserved.

19. 3 Cash Transfers from Affiliates to Parents • How transfer prices affect managers’ incentives – Makes in more difficult to evaluate management since it makes it appear that some locations are more profitable than others artificially • Using transfer prices to offset tariffs – can offset tariffs by imposing a low transfer price – Increase gross income of the purchasing affiliate, which will result in higher income taxes 19 -19 © 2012 Pearson Education, Inc. All rights reserved.

19. 3 Cash Transfers from Affiliates to Parents • Using transfer pricing to deal with foreign exchange quotas – similar to offsetting tariffs, quotas push up the value of each unit so affiliates can offset this with lower transfer prices • Transfer pricing in joint ventures – more difficult since partner is from another country and incentives are different • Strategies for dealing with blocked funds – Fronting loans – parent-to-affiliate loan that uses a large international bank as a financial intermediary – Reinvest working capital locally – Alter terms of trade 19 -21 © 2012 Pearson Education, Inc. All rights reserved.

19. 4 Managing Accounts Receivable • Any firm that decides to issue trade credit must perform five tasks – Assess credit risk of customer – Determine terms of credit (term length and interest penalties for late payments) – Finance the receivable between the production and the receipt of funds from the sale – Collect the receivable – Bear the default risk of the companies that are extended credit • Currency – Exports in currencies most likely to appreciate – Imports in currencies most likely to depreciate 19 -22 © 2012 Pearson Education, Inc. All rights reserved.

19. 4 Managing Accounts Receivable Pricing airplanes for British Airways will have to pay Boeing $100 M in 1 year when they deliver the planes. If the spot and forward rates are as follows: Spot: $1. 65/£; 1 -yr Forward: $1. 60/£ Using the forward contract, BA would pay $100 M/($1. 60/£) = £ 62. 5 M They are therefore indifferent between paying £ 62. 5 M or hedging $100 M. 19 -23 © 2012 Pearson Education, Inc. All rights reserved.

19. 4 Managing Accounts Receivable Pricing airplanes for Bangkok Airways Spot = THB 25/$ with no forward market; 50% chance spot will remain and 50% the baht will fall THB 40/$ Price of plane = $100 M in 1 year BA can buy $ today and invest or just bear the risk for a year: E[F] = [0. 5 * (THB 25/$)] + [0. 5 * (THB 40/$)] = THB 32. 5/$ Boeing thinks THB 40/$ will occur with 55% probability: E[F] = [0. 45 * (THB 25/$)] + [0. 55 * (THB 40/$)] = THB 33. 25/$ so it could charge this price in THB if they wanted to if this happened though, BA would prefer to be invoiced in $’s since THB 32. 5 < THB 33. 25! 19 -24 © 2012 Pearson Education, Inc. All rights reserved.

19. 4 Managing Accounts Receivable • Timing of payments can affect liquidity of an MNC’s affiliates – Leading payment – payment made earlier than usual – Lagging payment – payment made later than usual – Cost must be considered • Funds should be moved from affiliates that have low opportunity costs of NWC to affiliates with high opportunity costs 19 -25 © 2012 Pearson Education, Inc. All rights reserved.

19. 4 Managing Accounts Receivable Different borrowing and lending rates for different affiliates U. S. parent 8% borrowing rate; 7% lending rate British affiliate 8. 2% borrowing rate; 6. 9% lending rate • The U. S. parent has surplus funds and British affiliate must borrow – parent should lend funds to the affiliate $1 M * (8. 2 – 7)/100 * (90/360) = $3, 000 1. The U. S. parent must borrow and affiliate has surplus – the affiliate should lend to the parent $1 M * (8. 0 -6. 9)/100 * (90/360) = $2, 750 19 -26 © 2012 Pearson Education, Inc. All rights reserved.

19. 4 Managing Accounts Receivable 1. Both the parent and the affiliate have surplus – parent can earn more so the affiliate should flow funds to parent $1 M * (7 -6. 9)/100 * (90/360) = $250 1. Both parent and affiliate must borrow – since the parent borrows at a lower cost, funds should flow from parent to affiliate. $1 M * (8. 2 – 8. 0)/100 * (90/360) = $500 19 -27 © 2012 Pearson Education, Inc. All rights reserved.

19. 4 Managing Accounts Receivable • Credit terms – terms of payments for an MNC’s customers – Increasing the term of an A/R and reducing the interest charge until MB = MC – The longer the term, the more extensive the creditworthiness investigation – If an MNC has a lower cost of capital than its local customers, it can increase its profits by extending long credit terms and charging financing fees • Makes sense if the fees here are less than what the customer could get at a bank • Collateral used to secure loan may be worth more to the MNC than it does to a bank 19 -28 © 2012 Pearson Education, Inc. All rights reserved.

19. 5 Inventory Management • Inventory kept to smooth the production process • Inventory is costly though! – If a firm’s cost of capital = 15%, $100 M of inventory costs them $15 M – Firm exposed to losses if inventory is stolen, destroyed or becomes obsolete (insurance can be bought for this but that costs money too) • Optimal inventory theory – MB of production smoothing = MC of holding inventory – Devaluation or depreciation risk at foreign subsidiaries 19 -29 © 2012 Pearson Education, Inc. All rights reserved.