Transcript Contents of the course - Solvay Brussels School of

International Finance
Part 2
International
Corporate Finance
Lecture n° 10
Repositioning funds and working
capital management
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Repositioning Funds
 As an MNE aims at maximizing the shareholder value,
one of its tasks is to reposition the profits as legally and
as practically as possible, in low tax environments.
 Repositioning profits is also useful to redeploy cash-flows
or fund in more value-creating activities, or to minimize
exposure to a currency collapse, or political crisis.
 To this end, it can use a variety of techniques :
Unbundling fund transfers
Dividend remittances
Payment of fees
Home overhead charges
 Example : Trident has operations in Brazil, China and
Europe, each with their own constraints and
opportunities for Trident to reposition funds
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Repositioning Funds
Trident Corporation
(Los Angeles, USA)
Country:
Currency: the dollar (US$)
Tax rate: 35%
Capital restrictions: None
Trident Europe
Trident Brazil
Trident China
(Hamburg, Germany)
(Sáo Paulo, Brazil)
(Shanghai, China)
Greenfield
Investment
Acquisition
Investment
Joint Venture
Investment
Country:
Currency: the euro (€)
Tax rate: 45%
Capital restrictions: None
Country:
Currency: the real (R$)
Tax rate: 25%
Capital restrictions: Some
Country:
Currency: the renminbi (Rmb)
Tax rate: 30%
Capital restrictions: Many
Subsidiary status:
Subsidiary status:
Subsidiary status:
Business: mature
Business: immediate growth
potential
Business: long-term growth
potential
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Repositioning Funds
The strategy for each subsidiary will be
Trident Europe – reposition profits from Germany to the
US while maintaining the value of the European market’s
maturity
Trident Brazil – reposition or in some way manage the
capital at risk subject to foreign exchange risk while still
providing adequate capital for growth
Trident China – reposition the quantity of funds in and
out of China to protect against transfer risk while
balancing the needs of the joint venture partner
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Repositioning Funds
Constraints on Positioning funds:
Political constraints : governments can block the
movement of funds (transfer risk).
Tax constraints : tax liabilities may prohibit fund
transfer; tax structures may be complex and possibly
contradictory.
Transaction costs : foreign exchange conversion and
fees for money transfers. Become significant for large or
frequent transfers. MNE avoid then unnecessary backand-forth transfers.
Liquidity needs : each subsidiary needs to maintain
adequate working capital.
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Conduits for Moving Funds
Foreign Subsidiary’s Income Statement
Payment to Parent Company
Sales
Cost of goods sold
Gross profit
Payments to parent
for goods or services
General & administrative expenses
License fees
Royalties
Management fees
Operating profit (EBITDA)
Payments for technology,
trademarks, copyrights,
management or other
shared services
Depreciation & amortization
Earnings before interest & taxes (EBIT)
Foreign exchange gains (losses)
Interest expenses
Earnings before tax (EBT)
Corporate income tax
Net income (NI)
Dividends
Retained earnings
Before-Tax
in the
Host Country
Payments of interest
to parent for intrafirm debt
Distribution of
dividends to parent
After-Tax
in the
Host Country
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Transfer Pricing
 Transfer pricing : pricing of goods and services
transferred to a foreign subsidiary from an affiliated
company.
 A parent wishing to reposition funds out of or into a
particular country can charge higher or lower prices on
goods sold among subsidiaries
This will affect the income statement of the subsidiary
and effectively raise or lower taxes, with an opposite
effect on the selling subsidiary.
Efficient conduit to avoid high taxation environments,
but subject to abuses and, therefore, controls by the
fiscal authorities. (see examples)
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Transfer Pricing
Methods of determining transfer prices
Comparable Uncontrolled Price Method
Regarded as the best evidence of arm’s length pricing
A market determined price
Resale Price Method
Subtracts appropriate markup for the distribution subsidiary from
the final selling price to an independent purchaser
Cost-Plus Method
Sets price by adding a appropriate profit markup to the seller’s full
cost
Often used where semi-finished products are sold between
subsidiaries
Other Pricing Methods
Some tax authorities allow low pricing for establishment of new
market so long as the cut price is passed on to final customer 8
License, Royalty Fees & Shared
Services
 License fees : remuneration paid to the owners of the
patents, technologies, trade names, etc.
Usually based on a percentage of the value of the product or the
volume of production
 Royalty fees : similar compensation paid for the use of
intellectual property
 Such fees are typically paid for identifiable services received
by the subsidiary
 Shared services : also referred to as distributed charges or
overhead, are charges to compensate the parent for costs
incurred in the general management of international
operations and other corporate services provided to the
subsidiary.
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Dividend Remittances
 The classic way in which funds are transferred from
subsidiary to parent
 Dividend payout policies have change over the years and
now incorporate several variables in determining the
payout strategy. These are :
Tax implications : dividends are very tax-inefficient
Political risk : incite firms to remit all funds locally generated that
are not necessary to locally.
Foreign exchange risk : if an FX loss is anticipated, the MNE will
speed the transfer of funds.
Distributions and cash flows : growth is not always accompanied
with liquidity, especially is working capital funding are high.
Joint venture factors : firms may be reluctant to vary the level of
dividends paid, and tying its obligations toward the partner. 10
Leads and Lags
 Firms can reduce both operating and transaction exposure
by accelerating or decelerating the timing of payments that
must be made or received in foreign currencies
 To lead is to pay early
A firm holding a “soft currency” or debts denominated in
“hard currency” will lead by using the soft currency to pay off
the debts before the soft currency loses value.
 To lag is to pay late
A firm holding a hard currency and debts denominated in
soft currency will lag by using the hard currency to pay off
the debts in hopes of having to use less of the hard currency
 Leading and lagging is more feasible within a related firm
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Reinvoicing Centers
 A reinvoicing center is a separate corporate subsidiary that
serves as an intermediary between the parent and all foreign
subsidiaries. Title of ownership and invoices pass through the
center but the physical movement of goods is direct.
 Advantages
Managing foreign exchange exposure is centrally located for all
subsidiaries allowing center to attain specialized expertise
Guaranteeing the exchange rate for future orders can be done
through the center by setting firm local currency costs in
advance
Managing intra-subsidiary cash flows, including leads and lags
of payments is better managed and allows center to hedge only
the net exposure of cash flows
 Disadvantage : that the cost of center may be greater than the
benefits attained.
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Working Capital Management
 The operating cycle of a business generates funding needs,
cash inflows and outflows – the cash conversion cycle – and
foreign exchange rate and credit risks.
 The funding needs generated by operations of the firm
constitute working capital.
 The cash conversion cycle is the period of time extending
between cash outflows for purchased inputs and cash inflow
from cash settlement.
 The entire process from stage t0 to t5 is the company’s
operating cycle.
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The Operating Cycle
Operating Cycle
Accounts
Payable
Period
Input
Sourcing
Period
Quotation
Period
Price
Quote
The
Firm
t0
Order
Placed
t1
Accounts
Receivable
Period
Inventory
Period
Inputs
Received
t2
Order
Shipped
t3
Payment
Received
t4
time
t5
Cash
Outflow
Cash
Intflow
Cash
Payment
for Inputs
Cash
Settlement
Received
Cash
Conversion Cycle
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Working Capital Funding
 Net Working Capital (NWC) is the net investment required of
the firm to support on-going sales. NWC components
typically grow as the firm buys inputs, produces product,
and sells finished goods.
Net working capital(NWC)  (A/R  Inventory)- (A/P)
 Days working capital is a common method used to calculate
the NWC of a firm :
This method is based on using a “days sales” basis : if
the value of A/R, inventories and A/P are divided by the
annual daily sales
The firm’s NWC can be summarized in the number of
days sales of NWC. These results vary among industries
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and countries.
Working Capital Financing
 Managing Receivables
A firm’s operating cash inflow is derived primarily from the collection
of receivables
There are several factors that go into the management of
receivables
Independent customers – requires decisions about currency of
denomination and payments terms
Payment terms
Self-liquidating bills – secured by physical inventory that has
been sold and the funds are lent based on the securitization
Other terms
 Inventory Management
Anticipating devaluation – management must decide whether to
build inventory of items that carry foreign exchange exposure
Anticipating price freezes
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International Cash Management
 International cash management is the set of activities
determining the levels of cash balances held throughout the
MNE, cash management, and the facilitation of its movement
cross border, settlements and processing
 Cash levels are determined independently of working capital
management decisions
Cash balances, including marketable securities, are held partly for dayto-day transactions (transaction motive) and to protect against
unanticipated variations from budgeted cash flows (precautionary
motive)
 Cash disbursed for operations is replenished from two sources
Internal working capital turnover
External sourcing, traditionally short-term borrowing
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International Cash Management
 All firms engage in some sort form of the following steps:
Planning – a financial manager anticipates cash flows over
future days, weeks, or months.
Collection – controlled through time lags between the
shipment date and the payment date.
Disbursement – steps included are avoiding unnecessary
early payment, maximizing float and selecting a disbursement
bank.
Covering cash shortages – anticipated cash shortages can
be managed by borrowing locally.
Investing surplus cash – if a subsidiary of an MNE
generates surplus cash, the MNE must decide whether to
handle its own short-term liquidity or whether surplus funds
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should be controlled centrally.
International Cash Settlements
 Four techniques for simplifying and lowering the cost of
settling cash flows between related and unrelated firms
Wire transfers : Variety of methods but two most
popular for cash settlements are CHIPS and SWIFT
Cash pooling
Payment netting
Electronic fund transfers
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International Cash Settlements
 Cash Pooling and Centralized Depositories
Businesses with widely dispersed operating subsidiaries
can gain operational benefits by centralizing cash
management.
Subsidiaries hold minimum cash for their own transactions
and no cash for precautionary purposes.
All excess funds are remitted to a central cash depository.
Information advantage is attained by central depository on
currency movements and interest rate risk.
Precautionary balance advantages as MNE can reduce pool
without any loss in level of protection.
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International Cash Settlements
 Multilateral Netting
Defined as the process that cancels via offset all, or
part, of the debt owed by one entity to another
related entity.
Netting of payments is useful primarily when a large
number of separate foreign exchange transactions
occur between subsidiaries.
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Financing Working Capital
 All firms need to finance working capital and most of the
short-term financing needs is done through the use of bank
credit lines.
 Banking sources available to MNEs are :
In-house Banks : set of functions performed by the
existing treasury department, providing banking services
to the various units of the firm.
Commercial Banking Offices :
Correspondent Banks with local banks across the world
Representative Offices established in a foreign country
Branch Banks and Affiliates
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