Chapter 8 Valuation of Acquisitions and Mergers



Chapter 13 The Role of the Treasury Function in Multinationals

|LEARNING OBJECTIVES |

| |

|1. Discuss the role of the treasury management function within: |

|(a) The short term management of the organization’s financial resources |

|(b) The longer term maximization of shareholder value |

|(c) The management of risk exposure |

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1. Financial Markets

1.1 Concept of financial markets

1.1.1 A financial market brings a firm into direct contact with its investors. The trend to borrowing directly from investors is sometimes called disintermediation.

1.1.2 Financial markets are split into those that provide short-term finance (money markets) and those that provide long-term finance (capital markets).

1.2 Money markets

1.2.1 Money markets – If a company or a government needs to raise funds for short-term (usually less than one year), they can access the money markets and issue:

|Increasing risk to the |[pic] |(a) Treasury bills (issued by governments) |

|investor | | |

| | |(b) Certificates of deposit (issued by companies) |

| | |(c) Commercial paper (issued by companies with a high credit rating) |

| | |(d) Bills of exchange |

1.3 Capital markets

1.3.1 Capital markets – If a company needs to raise funds for the long-term, it can access the capital markets; this is a market on which the following are traded:

|Increasing risk to the |[pic] |(a) Debentures/loan notes (secured on an asset or by covenants) |

|investor | | |

| | |(b) Junk bonds (unsecured) |

| | |(c) Shares traded on the main stock market |

| | |(d) Shares in Alternative Investment Market |

1.3.2 Primary markets enable organizations to raise new finance, by issuing new shares or new bonds. In the UK, a company must have public company status to be allowed to raise finance from the public on a capital market.

1.3.3 Secondary markets enable investors to buy and sell existing investments to each other.

1.3.4 Secondary markets may be organized on exchanges or may consist of over the counter (OTC) transactions.

1.4 Other financial markets

1.4.1 Commodity markets – which facilitate the trading of commodities (e.g. oil, metals and agricultural produce).

1.4.2 Derivatives markets – which provide instruments for the management of financial risk, such as options and futures contracts.

1.5 International money and capital markets

1.5.1 Larger companies are able to borrow funds on the eurocurrency markets (which are international money markets) and on the markets for eurobonds (international capital markets)

1.5.2 Eurocurrency is currency which is held by individuals and institutions outside the country of issue of that currency. For example, if a UK company borrows US$50,000 from its bank, the loan will be a ‘eurodollar’ loan. London is a major centre of eurocurrency lending and companies with foreign trade might choose to borrow from their bank in another currency.

1.5.3 Eurocurrency markets – Eurocurrency is money deposited with a bank outside its country of origin, e.g. money in a US dollar account with a bank in London is Eurodollars.

Note that these deposits need not be with European banks, although originally most of them were.

1.5.4 Eurobond market – A Eurobond is a bond denominated in a currency which often differs from that of the country of issue. It is long-term loans raised by international companies or other institutions and sold to investors in several countries at the same time. The term of a Eurobond issue is typically 10 to 15 years.

2. Treasury Management Function

2.1 Treasury management

2.1.1 Large companies rely heavily for both long-term and short-term funds on the financial and currency markets. To manage cash (funds) and currency efficiently, many large companies have set up a separate treasury department.

2.1.2 A treasury department, even in a large company, is likely to be quite small, with perhaps a staff of three to six qualified accountants, bankers or corporate treasurers working under a Treasurer, who is responsible to the Finance Director.

2.1.3 In some cases, where the company or organisation handles very large amounts of cash or foreign currency dealings, and often has large cash surpluses, the treasury department might be larger.

2.2 The role of the treasurer

2.2.1 Liquidity management – making sure the company has the liquid funds it needs, and invests any surplus funds, even for very short terms.

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2.2.2 Funding management – It is concerned with all forms of borrowing, and alternative sources of funds, such as leasing and factoring.

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2.2.3 Currency management – Currency dealings can save or cost a company considerable amounts of money, and the success or shortcomings of the corporate treasurer can have a significant impact on the statement of profit or loss of a company which is heavily involved in foreign trade.

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2.2.4 Corporate finance – The treasury department has a role in all levels of decision-making within the company. It is involved with strategic decisions such as dividend policy or the raising of capital, tactical decisions such as risk management, and operational decisions such as the investment of surplus funds.

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2.3 Treasury policy

2.3.1 All treasury departments should have a formal statement of treasury policy and detailed guidance on treasury procedures. The aims of a treasury policy are to enable managers to establish direction, specify parameters and exercise control, and also provide a clear framework and guidelines for decisions.

2.3.2 The guidance needs to cover the roles and responsibilities of the treasury function, the risks requiring management, authorization and dealing limits.

2.3.3 The areas that might be covered include:

(a) Counterparty exposure including limits for each counterparty and monitoring of exposures in relation to the limits

(b) Currency and interest rate risk such as hedging methods, authorised instruments and exposure limits

(c) Funding risk including limits and targets for different sources of funding

(d) Liquidity management including permitted banks, netting and inter-group procedures

(e) Investment management covering sources of funds, authorised counterparties and instruments, and inter-company funding

(f) Bank relationships specifying criteria for the choice of bank

3. Centralisation and Decentralisation of Treasury Department

3.1 Centralisation and decentralization

3.1.1 A large company may have a number of subsidiaries and divisions. In the case of a multinational, these will be located in different countries. It will be necessary to decide whether the treasury function should be centralised.

3.1.2 With centralised cash management, the central Treasury department effectively acts as the bank to the group. The central Treasury has the job of ensuring that individual operating units have all the funds they need at the right time.

3.2 Advantages of centralised treasury department

(Dec 14)

3.2.1 Advantages of having a treasury function which is centralised are as follows.

(a) Centralised liquidity management avoids mixing cash surpluses and overdrafts in different localized bank accounts.

(b) Bulk cash flows allow lower bank charges to be negotiated.

(c) Larger volumes of cash can be invested, giving better short-term investment opportunities.

(d) Borrowing can be agreed in bulk, probably at lower interest rates than for smaller borrowings.

(e) Currency risk management should be improved, through matching of cash flows in different subsidiaries. There should be less need to use expensive hedging instruments such as option contracts.

(f) A specialist department can employ staff with a greater level of expertise than would be possible in a local, more broadly based, finance department.

(g) The company will be able to benefit from the use of specialised cash management software.

(h) Access to treasury expertise should improve the quality of strategic planning and decision making.

3.3 Advantages of decentralized cash management

(Dec 14)

3.3.1 Advantages of decentralization:

(a) Sources of finance can be diversified and can be matched with local assets.

(b) Greater autonomy can be given to subsidiaries and divisions because of the closer relationships they will have with the decentralised cash management function.

(c) The decentralised treasury function may be able to be more responsive to the needs of individual operating units.

3.4 Centralised cash management in the multinational firm

3.4.1 If cash management within a multinational firm is centralised, each subsidiary holds only the minimum cash balance required for transaction purposes. All excess funds will be remitted to the central Treasury department.

3.4.2 Funds held in the central pool of funds can be returned quickly to the local subsidiary by telegraphic transfer or by means of worldwide bank credit facilities. The firm's bank can instruct its branch office in the country in which the subsidiary is located to advance funds to the subsidiary.

4. Treasury Department as Cost Centre or Profit Centre

4.1 A treasury department might be managed either as a cost centre or as a profit centre. For a group of companies, this decision may need to be made for treasury departments in separate subsidiaries as well as for the central corporate treasury department.

4.2 In a cost centre, managers have an incentive only to keep the costs of the department within budgeted spending targets. The cost centre approach implies that the treasury is there to perform a service of a certain standard to other departments in the enterprise. The treasury is treated much like any other service department.

4.3 However, some companies (including BP, for example) are able to make significant profits from their treasury activities. Treating the treasury department as a profit centre recognises the fact that treasury activities such as speculation may earn revenues for the company, and may as a result make treasury staff more motivated. It also means that treasury departments have to operate with a greater degree of commercial awareness, in for example the management of working capital.

4.4 However, as a profit centre, the following points should be noted:

(a) A treasury engaged in speculation must be properly controlled by the company’s board of directors. Millions of dollars can be committed in one telephone call by a treasurer, so it is crucial that limits are set on traders’ risk exposure and that these limits are monitored scrupulously.

For example, in 1993 the German oils and metals company Metallgesellschaft managed to lose $1 billion after becoming over-exposed to oil derivative contracts.

(b) Treasury staff must be well trained and probably well paid, so that staff of the right caliber can be secured.

(c) The low volume of foreign currency transactions undertaken by a small company would probably make a profit centre approach unviable. A regular flow of large foreign transactions is needed before the cost centre approach is abandoned.

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