FINANCIAL CONTROL Any business firm must evaluate its operations periodically to better

FINANCIAL CONTROL Any business firm must evaluate its operations periodically to better

allocate resources and increase income. The financial management of a multinational firm involves exercising control over foreign operations. The responsible individuals at the parent office or headquarters review financial reports from foreign subsidiaries with a view toward modifying operations and assessing the performance of foreign managers.

Typical control systems are based on setting standards with regard to sales, profits, inventory, or other specific variables and then examining financial statements and reports to evaluate the achievement of such goals.

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foreign subsidiary profits be measured and evaluated in foreign currency or in the domestic currency of the parent firm? The answer to this question depends on whether foreign managers are to be held responsible for currency translation gains or losses.

If top management wants foreign managers to be involved in currency management and international financing issues, then the domestic currency of the parent would be a reasonable choice. On the other hand, if top management wants foreign managers to concern themselves with production operations and behave as other managers in companies in the foreign country would, then the foreign currency would be the appropri- ate currency for evaluation.

Some multinational firms prefer a decentralized management structure in which each subsidiary has a great deal of autonomy and makes most financing and production decisions subject only to general parent-company guidelines. In this management setting, the foreign manager may be expected to operate and think as the stockholders of the parent firm would want, so the foreign manager makes decisions aimed at increasing the parent’s domestic currency value of the subsidiary. The control mechanism in such firms is to evaluate foreign managers based on their ability to increase that value.

Other firms prefer more centralized management in which financial managers at the parent make most of the decisions. They choose to move funds among divisions based on a system-wide view rather than what is best for a single subsidiary. A highly centralized system would have foreign managers evaluated on their ability to meet goals established by the parent for key variables like sales or labor costs. The parent-firm managers assume responsibility for maximizing the value of the firm, with foreign managers basically responding to directives from the top. We see then that the appropriate control system is largely determined by the management style of the parent.

Considering the discussion to this point, it is clear that managers at foreign subsidiaries should be evaluated only on the basis of things they control. Foreign managers often may be asked by the parent to follow poli-

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no fault of the foreign manager. The message to parent-company managers is to place blame fairly where the blame lies. In a dynamic world, corporate fortunes may rise and fall because of events entirely beyond any manager’s control.

CASH MANAGEMENT Cash management involves using the firm’s cash as efficiently as possible.

Given the daily uncertainties of business, firms must maintain some liquid resources. Liquid assets are those that are readily spent. Cash is the most liquid asset. But since cash (and the traditional checking account) earns no interest, the firm has a strong incentive to minimize its holdings of cash. There are highly liquid short-term securities that serve as good substitutes for actual cash balances and yet pay interest. The corporate treasurer is concerned with maintaining the correct level of liquidity at the minimum possible cost.

The multinational treasurer faces the challenge of managing liquid assets denominated in different currencies. The challenge is compounded by the fact that subsidiaries operate in foreign countries where financial market regulations and institutions differ.

When a subsidiary receives a payment and the funds are not needed immediately by this subsidiary, the managers at the parent headquarters must decide what to do with the funds. For instance, suppose a U.S. mul- tinational’s Mexican subsidiary receives 500 million pesos. Should the pesos be converted to dollars and invested in the United States, or placed in Mexican peso investments, or converted into any other currency in the world? The answer depends on the current needs of the firm as well as the current regulations in Mexico. If Mexico has strict foreign exchange controls in place, the 500 million pesos will have to be kept in Mexico and invested there until a future time when the Mexican subsidiary will need them to make a payment.

Even without legal restrictions on foreign exchange movements, we

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to another currency now and then going back to pesos in 30 days. In any case, we would never let the funds sit idly in the bank for 30 days.

There are times when the political or economic situation in a country is so unstable that we keep only the minimum possible level of assets in that country. Even when we will need pesos in 30 days for the Mexican subsidiary’s payable, if there exists a significant threat that the government could confiscate or freeze bank deposits or other financial assets, we would incur the transaction costs of currency conversion to avoid the political risk associated with leaving the money in Mexico.

Multinational cash management involves centralized management. Subsidiaries and liquid assets may be spread around the world, but they are managed from the home office of the parent firm. Through such cen- tralized coordination, the overall cash needs of the firm are lower. This occurs because subsidiaries do not all have the same pattern of cash flows. For instance, one subsidiary may receive a dollar payment and finds itself with surplus cash, while another subsidiary faces a dollar payment and must obtain dollars. If each subsidiary operated independently, there would be more cash held in the family of multinational foreign units than if the parent headquarters directed the surplus funds of one subsidiary to the subsidiary facing the payable.

Centralization of cash management allows the parent to offset subsidiary payables and receivables in a process called netting. Netting involves the consolidation of payables and receivables for one cur- rency so that only the difference between them must be bought or sold. For example, suppose Oklahoma Instruments in the United States sells C$2 million worth of car phones to its Canadian sales subsidiary and buys C$3 million worth of computer frames from its Canadian manufacturing subsidiary. If the payable and receivable both are due on the same day, then the C$2 million receivable can be used to fund the C$3 million payable, and only C$1 million must be bought in the foreign exchange market. Rather than buy C$3 million to settle the payable and sell the C$2 million to convert the receivable into dollars, incurring transaction costs twice on the full

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netting requires accurate and timely reporting of transactions by all divisions of the firm.

As an example of intrafirm netting, let us consider a U.S. parent firm with subsidiaries in Canada, the United Kingdom, Germany, and Mexico. Table 9.1 sets up the report for the week of January 15. We assume that netting occurs weekly. Each division’s scheduled payments and receipts are converted to dollars so that aggregation across all units can occur. Table 9.1 indicates that the Canadian subsidiary will pay $0.7 million (total of column 2) and receive $3.2 million (total of row 1), so it will have a cash surplus of $2.5 million. The U.K. subsidiary will pay $1.3 million and receive $1.2 million, so it will have a cash shortage of $0.1 million. The German subsidiary will pay $3.1 million and receive $0.5 million, so it has a shortage of $2.6 million, and, finally, the Mexican subsidiary will pay $0.1 million and receive $0.3 million, so it has a sur- plus of $0.2 million. The parent financial managers determine the net payer or receiver position of each subsidiary for the weekly netting. Only these net amounts are transferred within the firm. The firm does not have to change $0.7 million worth of Canadian dollars into the currencies of Germany and Mexico to settle the payable of the Canadian subsidiary and then convert $3.2 million worth of pounds, euros, and pesos into Canadian dollars. Only the net cash surplus flowing to the Canadian subsidiary of $2.5 million must be converted into Canadian dollars.

So far we have considered netting when the currency flows occur at the same time. What if the payments and receipts are not for the same date? Suppose in our Oklahoma Instruments example that the C$3 million payable is due on October 1, and the C$2 million receivable is due September 1. Netting could still occur by leading or lagging currency flows. The sales subsidiary could lag its C$2 million payment by one month, or the C$3 million could lead one month and be paid on September 1.

Table 9.1 Intrafirm Payments for Netting Million-Dollar Values (Week of January 15)

Payments

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Leads and lags increase the flexibility of parent financial managers, but require excellent information flows between all divisions and headquarters.