Module 5 If Notes.docx

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, 1

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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 3

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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% 5

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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 6

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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, 7

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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 tradeoff has to be skillfully made.

An investment proposal can be evaluated using two types of method nondiscounting 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 11

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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 13

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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 shortterm 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 14

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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. 15

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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 16

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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 18

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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 19

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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. 20

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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 22

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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 25

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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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