International Financial Management 6

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Chapter 6

Managing Economic Exposure And Translation Exposure

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Objectives

• This chapter shows how an MNC can restructure its operations to reduce economic exposure. Such a strategy is related to the firm’s long-run operations.

• It also briefly describes how an MNC’s translation exposure can be reduced. Yet, It is advised that the limitations of hedging translation exposure receives as much attention as the hedging strategy itself.

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Economic Exposure

• Economic exposure refers to the impact exchange rate fluctuations can have on a firm’s future cash flows.

• Recall that corporate cash flows can be affected by exchange rate movements in ways not directly associated with foreign transactions.

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Economic Exposure

• Exchange rate changes are often linked to variability in real growth, inflation, interest rates, governmental actions,… the changes may cause firms to adjust their financing and operating strategies.

• The importance of managing economic exposure can be seen from the case of the bankruptcy of Laker Airways, and from the the 1997-98 Asian crisis.

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How Financial Markets Affected Laker Airlines

Laker Airways is a British airline that generated much of its revenue in British pounds, a large proportion of its expenses (such as fuel, oil, and debt payments), however, were denominated in dollars. As the dollar strengthened in the foreign exchange market in 1981, Laker needed larger amounts in pounds to cover its dollar-denominated expenses. In January 1981, Laker borrowed $131 millions in the financial markets from a group of U.S. and European banks . The debt was denominated in U.S dollars and therefore had to be repaid in U.S. dollars. Laker’s decision

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How Financial Markets Affected Laker Airlines

to obtain dollar-denominated debt in the financial markets further increased its economic exposure. As the dollar continued to strengthen, the firm’s revenues could not adequately cover its dollar-denominated expenses. Consequently, Laker Airways went bankrupt. It might have avoided bankruptcy if it had reduced its economic exposure, either by reducing its dollar-denominated expenses or by increasing its dollar-denominated revenue. Overall, Laker’s performance was affected by conditions in the foreign exchange market along with its decision to borrow dollars in the debt market.

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Economic Exposure

• A firm can assess its economic exposure by determining the sensitivity of its expenses and revenues to various possible exchange rate scenarios.

• The firm can then reduce its exposure by restructuring its operations to balance its exchange-rate-sensitive cash flows.

• Note that computer spreadsheets are often used to expedite the analysis.

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Economic Exposure

• Restructuring may involve:increasing/reducing sales in new or existing

foreign markets,increasing/reducing dependency on foreign

suppliers,establishing or eliminating production facilities

in foreign markets, and/orincreasing or reducing the level of debt

denominated in foreign currencies.

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Economic Exposure

• MNCs must be very confident about the long-term potential benefits before they proceed to restructure their operations, because of the high costs of reversal.

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Managing Madison Inc.’s Economic Exposure (example)

• The amount of Madison’s earnings before taxes is inversely related to the strength of the Canadian dollar, since the higher expenses more than offset the higher revenue.

( Exhibit 6.1)• Madison may reduce its exposure by

increasing Canadian sales, reducing orders of Canadian materials, and/or borrowing

less from Canadian banks. ( Exhibit 6.2)

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Exhibit 6.1 Original Impact of Possible Exchange Rate Movements on Earnings of Madison, Inc. (in Millions)

Exchange Rate Scenario C$ = $.75 C$ = $.80 C$ = $.85 Sales: (1) U.S. $300.00 $304.00 $307.00 (2) Canadian C$4 = 3.00 C$4 = 3.20 C$4 = 3.40 (3) Total $303.00 $307.20 $310.40 Cost of goods sold: (4) U.S. $ 50.00 $ 50.00 $50.00 (5) Canadian C$200 = 150.00 C$200= 160.00 C$200 = 170.00 (6) Total $200.00 $210.00 $220.00 (7) Gross Profit $103.00 $ 97.20 $ 90.40 Operating expenses: (8) U.S.: Fixed $ 30.00 $ 30.00 $ 30.00 (9) U.S. Variable(10% of total sales) 30.30 30.72 31.04 (10) Total 60.30 60.72 61.04 (11) EBIT $ 42.70 $ 36.48 $ 29.36 Interest expense: (12) U.S. $ 3.00 $ 3.00 $ 3.00 (13) Canadian C$ 10 = 7.50 C$10 = 8.00 C$ 10 = 8.50 (14) Total $ 10.50 $ 11.00 $ 11.50 (15) EBT $ 32.20 $ 25.48 $ 17.86

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Exhibit 6.2 Managing Madison Inc.’s Economic Exposure (in Millions) (Proposed Structure)

C$=$.75 C$=$.80 C$=$.85Sales:

(1) U.S. $300.00 $304.00 $307.00(2) Canadian C$20= 15.00 C$20= 16.00 C$20= 17.00(3) Total $315.00 $320.00 $324.00

Cost of gods sold:(4) U.S. $ 140.00 $ 140.00 $140.00(5) Canadian C$100= 75.00 C$100= 80.00 C$100= 85.00(6) Total $215.00 $220.00 $225.00(7) Gross profit $100.00 $ 100.00 $ 99.00

Operating expenses:(8) U.S. - Fixed $ 32.00 $ 32.00 $ 32.00(9) U.S. – Variable 31.50 32.00 32.40(10) Total $ 63.50 $ 64.00 $ 64.40(11) EBIT $ 36.50 $ 36.00 $ 34.60

Interest expense:(12) U.S. $ 7.00 $ 7.00 $ 7.00

(13) Canadian C$5= 3.75 C$5= 4.00 C$5= 4.25(14) Total $ 10.75 $ 11.00 $ 11.25(15) EBT $ 25.75 $ 25.00 $ 23.35

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A Case Study in Hedging Economic Exposure

* Check the case of Savor Co. in your book.(P250-255)

* Find more cases by yourself .

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Translation Exposure

• Translation exposure results when an MNC translates each subsidiary’s financial data to its home currency for consolidated financial reporting.

• Translation exposure does not directly affect cash flows, but some firms are concerned about it because of its potential impact on reported consolidated earnings.

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• An MNC may attempt to avoid translation exposure by matching its foreign liabilities with its foreign assets.

• To hedge translation exposure, forward or futures contracts can be used. Specifically, an MNC may sell the currency that its foreign subsidiary receive as earnings forward, thus creating an offsetting cash outflow in that currency.

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• For example, a U.S.-based MNC that is concerned about the translated value of its British earnings may enter a one-year forward contract to sell pounds.

• If the pound depreciates during the fiscal year, the gain generated from the forward contract position will help to offset the translation loss.

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• Hedging translation exposure is limited by:– inaccurate earnings forecasts,– inadequate forward contracts for some

currencies,– accounting distortions (the choice of

the translation exchange rate, taxes, etc.), and

– increased transaction exposure (due to hedging activities).

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• Perhaps, the best way for MNCs to deal with translation exposure is to clarify how their consolidated earnings have been affected by exchange rate movements.

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Questions and Applications

1. Baltimore, Inc., is a U.S.-based MNC

that obtains 10 percent of its supplies

from European manufacturers, 60 percent

of its revenues are due to exports to Europe,

where its product is exported and invoiced in

euros. Explain how Baltimore can attempt to

reduce its economic exposure to exchange

rate fluctuations in the Euro.

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2. UVA Co. is a U.S.-based MNC that obtains 40 percent of its foreign supplies from Thailand. It also borrows Thailand’s currency (the baht) from Thai banks and converts the baht to dollar to support U.S. operations. It currently receives about 10 percent of its revenue from Thai customers. Its sales to Thai customers are denominated in baht. Explain how UVA Co. can reduce its economic exposure to exchange rate fluctuations.

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3. When an MNC restructures its operations to reduce its economic exposure, it may

sometimes forgo economies of scale. Explain. 4. Explain how a U.S.-based MNC’s consolidated earnings are affected during a period such as the Asian crisis. 5. Would a more established MNC or a less established MNC be better able to effectively hedge its given level of translation exposure? Why?

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6. Nelson Co. is a U.S. firm with annual export sales to Singapore worth about $800 million in Singapore dollars (S$). Its main competitor is Mez. Co., also based in the United States, with a subsidiary in Singapore that generates about S$800 million in annual sales. Any earnings generated by the subsidiary are reinvested to support its operations. Based on the information provided, which firm is subject to a higher degree of translation exposure? Explain.

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7. St.Paul Co. does business in the United States and New Zealand. In attempting to assess its economic exposure, it compiled the following information. a. St. Paul’s U.S. sales are somewhat affected by the value of the New Zealand dollar (NZ$) because it faces competition from New Zealand exporters. It forecasts the U.S. sales based on the following three exchange rate scenarios:

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Questions and Applications Exchange Rate Revenue from U.S. of NZ$ Business (in million) NZ$ = $.48 $100 NZ$ = $.50 $105 NZ$ = $.54 $110 b. Its New Zealand dollar revenue on sales to New Zealand invoiced in New Zealand dollars is expected to be NZ$600 million. c. Its anticipated cost of goods sold is estimated at $200million from the purchase of U.S. materials and NZ$100 million from the purchase of New Zealand materials. d. Fixed operating expenses are estimated at $30 million.

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Questions and Applications e. Variable operating expenses are estimated at 20 percent of total sales ( after including New Zealand sales, translated to a U.S. dollar amount). f. Interest expense is estimated at $20 million on existing U.S. loans, and the company has no existing New Zealand loans. Create a forecasted income statement for St. Paul Co. under each of

the three exchange rate scenarios. Explain how St. Paul’s projected earnings before taxes are affected by possible exchange rate movements. Explain how it can restructure its operations to reduce the sensitivity of its earnings to exchange rate movements without reducing its volume of business in New Zealand.

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International Financial Management 6