International Financial Management - Bekaert 2e - Solutions - Ch19
Chapter 19 Managing Net Working Capital
QUESTIONS
1.What is net working capital? Why should it be considered an investment that a firm
must make to increase its future profitability?
Answer: Every corporation maintains a stock of current assets and current liabilities to buffer the inflows and outflows of cash generated by the firm’s business. The term working capital refers to the stock of current assets consisting of cash, marketable securities, accounts receivable, and inventories held by a firm at any point in time. By subtracting the value of a firm’s current liabilities, which are the corporation’s short-term debts and its accounts payable, from its stock of working capital, we arrive at its net working capital. To the extent that a firm can be managed with a smaller stock of net working capital, cash can be paid to shareholders. Thus, one goal of management is to run a corporation efficiently in order to minimize the need for net working capital.
Increases in net working capital are investments that a firm makes to produce cash in the future because they use cash that could otherwise be distributed to shareholders. If the cash that is invested in net working capital does not earn the weighted average cost of capital, it should be paid to the firm’s investors.
2.What distinguishes international cash management from purely domestic cash
management? In particular, what constraints arise in the international environment?
Answer: The goals of an international money manager of a multinational corporation are (1) to establish control over the cash resources of the organization, (2) to invest excess short-term funds in an optimal way, and (3) to obtain short-term financing at the lowest cost.
Establishing control over the cash resources of an organization necessitates creating a reporting system that provides timely and accurate information. When the information is available, the international cash manager can try to improve upon the cash disbursements to and collections from its foreign affiliates. By synchronizing the flows of funds, the international cash manager can lower the cost of moving funds among them. These goals are no different than those of a purely domestic cash manager who transfers money from one account to another (or from one subsidiary to another) so that the firm has an optimal amount of working capital. However, there are constraints on international cash management that domestic managers do not face. These constraints include government restrictions on the transfers of funds, taxes that depend on the type of fund transfer, transaction costs in the foreign exchange market, and problems maintaining the liquidity of all foreign affiliates.
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3.Why is it important for a foreign affiliate to have a well-defined dividend policy for
repatriating profits to its parent corporation?
Answer: It is often advantageous for a multinational corporation to have an established dividend policy that it can easily defend if government officials of the host country question it to avoid problems repatriating profits from abroad. Without such a policy or a history of dividend payments, an MNC may have difficulty explaining the reason for any given year’s dividend payment.
If the host country is having difficulty financing its balance of payments, it may appear to the government that the MNC’s dividend payment is actually an attempt by the company to export capital from the country in a time of crisis. Even if a government blocks the dividends and no transfers can be made, many firms find it to their advantage to at least declare a dividend in order to establish its validity in case the government later relaxes its foreign exchange restrictions.
Some corporations also set a ―common‖ dividend repatriation rate for all their foreign affiliates in different countries. This approach establishes that the shareholders of the parent corporation demand a certain share of the earnings of all of the corporation’s foreign subsidiaries and are not merely trying to take capital out of one particular country.
4.What is the difference between a royalty and a fee?
Answer: Royalties are payments made to the owners of a technology, a patent, or a trademark for the use of the technology or the right to manufacture under the patent or the trademark.
As such, royalty payments are pure profits in the sense that the firm receiving them performs no current services and incurs no current costs to receive the payment. Thus, royalties can be
a substantial source of income for the firm that is receiving them.
Parent corporations also assess fees for the services they provide to their affiliates, including management and technical consulting services and fees to recover overhead costs associated with day-to-day operations the parent performs for the foreign affiliate. These costs include the for eign affiliate’s share of the research and development of the organization, its share of legal and accounting costs for the entire enterprise, its share of the salaries of the general corporate management, and other costs, such as general corporate advertising and public relations. Often, the fees associated with the parent’s overhead are based on the affiliate’s sales. In other circumstances, the overhead charges are based on a pro rata sharing of all the MNC’s fixed costs.
5.What are the determinants of leading and lagging payments between related
international affiliates?
Answer: A leading payment is a payment made earlier than usual; while a lagging payment is
a payment made later than usual. By shortening and lengthening the payment cycle of
payments between related affiliates, an MNC can affect the liquidity of its affiliates around the world.
Chapter 19: Managing Net Working Capital 3 The foremost determinant of leading and lagging by an MNC is the nature of the relevant opportunity costs associated with the net working capital of each of its affiliates.
This interest rate must be based on a common currency, such as the dollar, and it should be calculated on an after-tax basis. Funds should then be moved from affiliates that have a low opportunity cost of net working capital to affiliates that have a high opportunity cost of net working capital.
Leading and lagging payments can also be done to transfer funds into countries whose currencies are expected to appreciate and out of countries whose currencies are expected to depreciate.
6.What principles determine the appropriateness of transfer prices under U.S.
regulations?
Answer: Transfer prices are the prices a firm charges its affiliates when selling goods and services to them. These prices are set internally within a firm and thus are not directly determined by market forces. In the United States, the Internal Revenue Service (IRS) specifies that an appropriate transfer price is one that reflects an ―arm’s-length price‖—that is, one that would be observed in a sale of the good or the service to an unrelated customer. The IRS recognizes five methods that can be used to establish an arm’s-length price. The methods, in decreasing order of general acceptance to tax authorities, are the following:
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
7.How can transfer pricing be used to shift income around the world?
Answer: Setting a low transfer price increases the income of the affiliate that is purchasing the good because it lowers the cost of the good. The affiliate that is selling the good has lower revenue and hence lower income. Setting a high transfer price decreases the income of the affiliate that is purchasing the good because it increases the cost of the good. The affiliate that is selling the good has higher revenue and hence higher income.
8.How can transfer pricing be used to avoid tariffs?
Answer: Tariffs, also called import duties, are taxes that are levied on the value of imported goods. Most tariffs consist of ad valorem duties, which increase the price of imported products by a certain percentage, depending on the size of the tariff. To lower the incidence of these taxes to the importing affiliate, a multinational corporation could set a low transfer price. This does not completely avoid the tariff, but it reduces the base on which the tariff is calculated which lowers the revenue of the government imposing the tariff.
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9.What are blocked funds? How can a corporation structure its foreign affiliates to
mitigate problems with blocked funds?
Answer: Blocked funds arise when the government of a foreign country makes the nation’s currency completely inconvertible. Foreign exchange controls that impose unattractive foreign exchange rates can also constrain a firm. One technique is for the parent to lend to the affiliate with a fronting loan, which is explained in the answer to Question 10.
If the profits from the local affiliate cannot be repatriated, the local managers should be given the power to invest in any zero net present value investments. These investments include the commercial bonds and the equities of other firms. If none of these investments appear to be attractive, the firm can engage in additional direct investment in the country by purchasing local real estate, either land or buildings. The firm can also pursue other real investments, including commodities, either for export or to add to its existing inventory, or it might construct additional facilities. Another way for a multinational corporation to use its working capital is to have a local affiliate contract with other firms operating in the country to supply goods or to perform services for the parent or its other affiliates. For example, an architectural firm in a country with blocked funds could be hired to design a factory slated to be built by the parent.
10.What is a fronting loan? How does its structure potentially create value for a
multinational corporation?
Answer: A fronting loan is a parent-to-affiliate loan that uses a large international bank as a financial intermediary. Rather than have the parent corporation make a loan directly to its foreign affiliate, the parent instead makes a deposit with an international bank. The bank, in turn, makes a loan to the foreign affiliate that is equivalent to 100% of the deposited funds.
From the bank’s perspective, a fronting loan is risk free because the loan is fully collateralized by the deposit of the parent. The bank willingly participates for a small fee, earned in the form of a spread between the deposit rate that is paid to the parent and the rate that is charged to the foreign affiliate. The primary reason for involving the international bank is to try to avoid the adverse impact of a blocked-funds situation. When a country rations foreign exchange, it often allows businesses to make some payments but not others.
Interest and principal payments on intracompany loans from the foreign affiliate of an MNC operating in the country to its parent are generally given a lower priority by the government than interest and principal payments from the same foreign affiliate to an international bank in a neutral country. Although halting the payments made to large MNCs does have costs, the perceived costs are smaller than those incurred when a country stops allowing payments to be made to major international banks.
International banks can refuse to finance a country’s international trade or can hamper the government’s ability to borrow funds, whereas MNCs can do little more than threaten not to invest in the country in the future. Fronting loans can also give an MNC a tax advantage. If the local government allows the foreign affiliate to take a tax deduction for interest paid on a
Chapter 19: Managing Net Working Capital 5 bank loan but does not allow a tax deduction for interest paid on an intracompany loan, the use of a fronting loan creates a valuable tax shield.
11.Why is the threat of devaluation an insufficient reason for a firm to build up its stocks
of inventories?
Answer: The prospects of a depreciation of a local currency are insufficient in and of themselves to warrant an increase in inventories. Only by balancing the anticipated marginal benefits and anticipated marginal costs of holding the inventory can we arrive at the optimal stock. What will happen to future retail prices and whether nominal interest rates accurately and rationally reflect the probabilities of devaluation are equally as important as the fact that the local currency is expected to depreciate.
12.What are the five tasks involved in issuing trade credit?
Answer: Any firm that decides to issue trade credit must perform five tasks within the firm or hire an outside firm to do so. First, the credit risk of the customer must be assessed. Second, the terms of the credit must be determined. These terms include the length of time between the sale and the payment and any interest penalties for late payments. Third, the receivable must be financed between the production and receipt of funds from the sale. Fourth, the receivable must be collected. Fifth, the firm must bear the risk that the companies to which it extends credit will default.
Like purely domestic companies, MNCs commonly extend credit to their customers.
However, the problems related to managing the company’s accounts receivable are more complex for the MNC. In addition to the five tasks just mentioned, the MNC also must decide the currency of denomination of its accounts receivable.
13.What is wrong with the rule that firms should invoice their customers in hard
currencies?
Answer: Invoicing in hard currencies forces the customer to assess the probability distribution of future exchange rates between the customer’s currency and the hard currency.
If the MNC can do this better or assess it more rationally, then the MNC can increase sales to those who would otherwise not purchase the product. Invoicing in hard currencies also shifts the foreign exchange risk to the customer who may be less sophisticated and less able to manage the risk.
14.Why does it make sense for a multinational corporation to allow its foreign customers
to pay on credit if there is rationing in the foreign credit market?
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Answer: The MNC must balance the increase in sales that arises from granting credit with the costs that arise from the situation giving rise to the blocked funds and the possibility that the MNC will not get sufficient value in the future. If the situation is considered somewhat temporary, it may make sense to grant customers credit with the understanding that they will be able to pay after the blocked funds situation is resolved.
PROBLEMS
1.Euroshipping Corporation maintains separate production and distribution facilities in
Sweden, France, Spain, and Italy. The corporate headquarters is in France. As a consultant to the treasurer of Euroshipping, you have been asked to estimate how much money the firm could save by creating a centralized cash management pool.
Currently, each affiliate maintains precautionary cash balances equal to 3 standard deviations above its expected demand for cash.
Affiliate Mean Demand for
Money 1 Standard Deviation
Swedish €25,000,000€7,000,000
French €50,000,000€13,000,000
Italian €35,500,000€10,000,000
Spanish €20,000,000€6,000,000
By how much could Euroshipping reduce its overall demand for cash if it were to create a centralized cash pool for the four affiliates? (Assume that the cash needs are normally distributed and are independent of each other.)
Answer: Currently, each of the four affiliates is holding cash equal to the mean of their perceived demand plus three standard deviations. The total demand for cash by each affiliate is therefore
Swedish = €25,000,000 + 3 ?€7,000,000 = €46,000,000
French = €50,000,000 + 3 ?€13,000,000 = €89,000,000
Italian = €35,500,000 + 3 ?€10,000,000 = €65,500,000
Spanish = €20,000,000 + 3 ?€6,000,000 = €38,000,000
The total demand for cash sums these demands to give €238,500,000.
If we centralize the cash management, we would want to know the distribution of the sum of the demands for cash. The mean of the sum would be the sum of the means, and the variance of the sum would be the sum of the variances, because the demands are independent of each other. Thus, the mean demand for cash of centralized cash pool is
€25,000,000 + €50,000,000 + €35,500,000 + €20,000,000 = €130,500,000
The variance of the demand for cash of centralized cash pool is
€7,000,0002+ €13,000,0002+ €10,000,0002+ €6,000,0002= €18,814,8882
Thus, the total demand for cash by the centralized cash pool is
€130,500,000 + 3 ?€18,814,888 = €186,944,664
Chapter 19: Managing Net Working Capital 7 The demand for cash from the centralized cash pool is €51,555,336 = €238,500,000 - €186,944,664 less than the total demands for cash from the separate affiliates. This cash can be distributed to shareholders.
2.Euroshipping is also considering developing a multilateral netting system.
a.Given the cumulative monthly payments in the following payments matrix,
derive the minimum transfers that could be made.
Euroshipping Intracompany Payments Matrix (millions of euros)
Paying Affiliate
Swedish French Italian Spanish
Receiving
Affiliate
Swedish —16 14 18
French 19 —12 15
Italian 22 7 —11
Spanish 9 15 3 —
Answer: If we add the total payments for each affiliate, we find the following:
Swedish: 19 + 22 + 9 = 50
French: 16 + 7 + 15 = 38
Italian: 14 + 12 + 3 = 29
Spanish: 18 + 15 + 11 = 44
With no netting system, total payments would be 50 + 38 + 29 + 44 = 161.
If we add the total receipts for each affiliate, we find the following:
Swedish: 16 + 14 + 18 = 48
French: 19 + 12 + 15 = 46
Italian: 22 + 7 + 11 = 40
Spanish: 9 + 15 + 3 = 27
With no netting system, total receipts would therefore be 48 + 46 + 40 + 27 = 161.
If we subtract each affiliate’s total receipts from its total payments, we find the net
payments that must be made by a multilateral netting system:
Swedish: 50 – 48 = 2
French: 38 – 46 = -8
Italian: 29 – 40 = -11
Spanish: 44 – 27 = 17
Clearly, a total of €19 million must be transferred among the affiliates. This can be
achieved by having the Swedish affiliate pay €2 milli on to Italian affiliate, and the
Spanish affiliate pay €9 million to the Italian affiliate and €8 million to the French
affiliate.
b.If the transaction costs on these fund transfers are 0.45%, how much would the
company save by switching to a multilateral netting system?
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Answer: The difference in the total amount transferred without and with a multilateral
netting system is €161 million - €19 million = €142 million. If the transactions cost is
0.45% of the amount transferred, the total savings is
€142 mill ion ?0.0045 = €0.639 million
3.Suppose the euro borrowing and lending rates for a German parent and its Spanish
affiliate for a 90-day period are as follows:
Borrowing Rate (in percent per annum)
Lending Rate (in percent per annum)
German parent 9.3 8.1
Spanish affiliate 9.6 7.9
In each of the following cases, determine the direction funds should flow and the return to the MNC of transferring EUR1,000,000:
a.The German parent has positive funds; the Spanish affiliate has negative funds.
Answer: The German parent should lend to the Spanish affiliate. The return to the MNC is
(0.096 – 0.081) ?€1,000,000 = €15,000
b.The German parent has negative funds; the Spanish affiliate has positive funds.
Answer: The Spanish affiliate should lend to the German parent. The return to the MNC is
(0.093 – 0.079) ?€1,000,000 = €14,000
c.The German parent has positive funds; the Spanish affiliate has positive funds.
Answer: The Spanish affiliate should lend to the German parent. The return to the MNC is
(0.081 – 0.079) ?€1,000,000 = €2,000
d.The German parent has negative funds; the Spanish affiliate has negative funds.
Answer: The German parent should lend to the Spanish affiliate. The return to the MNC is
(0.096 – 0.093) ?€1,000,000 = €3,000
4.Consider a situation in which a manufacturing affiliate is selling to a distribution
affiliate. The relevant tax information, operating expenses, and cost of goods sold are given in the following table. Fill out the entries in the table and determine how the overall income of the consolidated company would change if it were to increase the transfer price by $500:
Chapter 19: Managing Net Working Capital 9
Manufacturing Affiliate (35% tax rate)
Distribution
Affiliate
(55% tax rate)
Consolidated
Company
Sales $4,500 $5,700 Less cost of goods sold 2,600
Less operating expenses 1,000 450 Taxable income
Less income taxes
Net income
Answer: The filled out table looks like this:
Manufacturing Affiliate (35% tax rate)
Distribution
Affiliate
(55% tax rate)
Consolidated
Company
Sales $4,500 $5,700 $10,200 Less cost of goods sold 2,600 4,500 7,100 Less operating expenses 1,000 450 1,450 Taxable income 900 750 1,650 Less income taxes 315 412.5 727.5 Net income 585 337.5 922.5 If we increase the transfer price by $500, the filled out table looks like this:
Manufacturing Affiliate (35% tax rate)
Distribution
Affiliate
(55% tax rate)
Consolidated
Company
Sales $5,000 $5,700 $10,700
Less cost of goods sold 2,600 5,000 7,600
Less operating expenses 1,000 450 1,450 Taxable income 1,400 250 1,650
Less income taxes 490 137.5 627.5
Net income 910 112.5 1,022.5 By increasing the transfer price by $500, we increase the income of the Manufacturing Affiliate by $500, which is subject to a 35% tax rate. We also decrease the income of the Distribution Affiliate by $500, and this income was taxed at 55%. The tax savings is 20% of $500, or $100, which is the increase in the income of the Consolidated Company.
5.If a manufacturing affiliate faces a 55% income tax rate, and its distribution affiliate
faces a 40% income tax rate and a 15% import tariff, should transfer prices be high or low?
Answer: Let τ be the tariff rate in the distribution country, which is 15% in our example. Let τm be the income tax rate on the manufacturing affiliate, which is 55% in our example, and
Chapter 19: Managing Net Working Capital
10 let τd be the income tax rate on the distribution affiliate, which is 15% in our example. First, notice that each dollar increase in the transfer price increases the manufacturing affiliate’s net-of-tax profit by 1 – τm dollars per unit sold. Second, a dollar of cost to the distribution affiliate is increased by 1 + τ because of the tariff. The overall increase in the cost to the distribution affiliate reduces its profitability because it keeps 1 – τd of its income. Thus, each dollar increase in transfer price decreases the distribution affiliate’s net -of-tax profit by (1 + τ) × (1 – τd ) dollars per unit sold. Therefore, a high-transfer-price policy is optimal for the consolidated company as long as 1 minus the tax rate on the manufacturing affiliate, 1 – τm , is larger than 1 plus the tariff rate times 1 minus the tax rate on the distribution affiliate, (1 + τ) × (1 – τd ). Algebraically, if
(1 – τm ) > (1 + τ) × (1 – τd )
a high-transfer-price policy is desirable from the perspective of the consolidated company because it increases the consolidated income. If
(1 – τm ) < (1 + τ) × (1 – τd )
then a low-transfer-price policy maximizes the income of the consolidated company.
In our example,
(1 – τm ) = (1 – 0.55) = 0.45
and
(1 + τ) × (1 – τd ) = (1 + 0.15) × (1 – 0.40) = 0.69
Therefore, a low transfer price is optimal because even though the distribution affiliate must pay the tariff, its tax rate is lower, and the tariff is a deductible cost.
6. Caterpillar is selling earthmoving equipment to an Indonesian construction company.
Caterpillar must choose whether to denominate the contract in U.S. dollars or in Indonesian rupiah. Suppose that the spot exchange rate is IDR9150/$ and that there is no forward market. Suppose, too, that there is a possibility that the rupiah will be devalued relative to the dollar during the next year. If Caterpillar prices the contract in dollars, it will charge $15,000,000 and will expect to be paid in 1 year. It is also willing to discuss pricing the machines in rupiah. The Indonesian firm thinks that there is a 60% chance the exchange rate will remain the same and a 40% chance it will increase to IDR9300/$. Caterpillar thinks that there is a 65% probability of the exchange rate remaining the same and a 35% probability that it will increase to ID9450/$. How should the deal be priced, and who will bear the risk of devaluation of the rupiah?
Answer: The Indonesian construction company thinks that the expected future spot rate is
IDR9,150IDR9,300IDR9,2100.60 ? + 0.40 ? = $$$???? ? ?????
Caterpillar, on the other hand, thinks that the probability of devaluation of the rupiah is lower, but if the rupiah devalues, the increase in the exchange rate will be more severe. Caterpillar’s expected future spot rate is
IDR9,150IDR9,450IDR9,2550.65 ? + 0.35 ? = $$$???? ? ?????
Since Caterpillar’s intensity of the devaluation is greater, it has a higher expected future spot rate. To get $15,000,000 as the expected cost for the equipment, Caterpillar would charge
Chapter 19: Managing Net Working Capital 11
IDR9,255
$15,000,000 ? = IDR138,825,000
$
On the other hand, if Caterpillar charges in dollars, the Indonesian construction company would perceive an expected cost of only
IDR9,210
$15,000,000 ? = IDR138,150,000
$
The deal should be priced in dollars, and the Indonesian company will bear the foreign exchange risk.
7.Web Question: Go to the PwC Web site related to transfer pricing at
https://www.360docs.net/doc/127181372.html,/gx/en/international-transfer-pricing and download the latest version of their manual on international transfer pricing. Determine how Venezuela handles transfer pricing and what the penalties are for non-compliance.
Answer: The document states (p.830) the following:
The transfer pricing methods specified in the 2001Venezuelan Income Tax Law are basically the same as those contained in the OECD Guidelines:
?Comparable uncontrolled price method;
?Resale price method;
?Cost plus method;
?Profit split method; and
?Transactional net margin method.
The penalties for non-compliance with the transfer pricing laws range from 25% to 200% of the omitted tax to 6 months to 7 years in prison for fraud. These latter penalties can be increased by ? to 2/3 for hiding investments in low tax jurisdictions.