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
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.
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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
7. How can transfer pricing be used to shift income around the world?
8. How can transfer pricing be used to avoid tariffs?
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11. Why is the threat of devaluation an insufficient reason for a firm to build up its stocks
of inventories?
12. What are the five tasks involved in issuing trade credit?
13. What is wrong with the rule that firms should invoice their customers in hard
currencies?
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?
Chapter 19: Managing Net Working Capital
6
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
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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
Receiving
Affiliate
Swedish
French
Italian
Spanish
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
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?
Chapter 19: Managing Net Working Capital
8
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
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
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
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 $500, we increase the income of the Manufacturing
5. If a manufacturing affiliate faces a 55% income tax rate, and its distribution affiliate
faces a 40% income tax rate and a 15% import tariff, should transfer prices be high or
low?
Answer: Let τ be the tariff rate in the distribution country, which is 15% in our example. Let
τm be the income tax rate on the manufacturing affiliate, which is 55% in our example, and
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6. Caterpillar is selling earthmoving equipment to an Indonesian construction company.
Caterpillar must choose whether to denominate the contract in U.S. dollars or in
Indonesian rupiah. Suppose that the spot exchange rate is IDR9150/$ 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
IDR9,150 IDR9,300 IDR9,210
0.60 × + 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
IDR9,150 IDR9,450 IDR9,255
0.65 × + 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
©2017 Cambridge University Press
7. Web Question: Go to the PwC Web site related to transfer pricing at
www.pwc.com/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 2015-2016 document states (p.1113) the following:
The transfer pricing methods specified in the Venezuelan Income Tax Law are basically
the same as those contained in the OECD Guidelines: