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International Corporate Finance

March 22, 2011

Managing Operating Exposure

Chapter 12Suggested Exercises: 1, 4, 6

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Operating Exposure

Operating exposure measures any change in

the present value of a firm resulting from

changes in future operating cash flows caused

by an unexpected change in exchange rates.

Also called:

economic exposure,

competitive exposure,

strategic exposure.

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Operating & Financing Cash Flows

The cash flows of the MNE can be divided into: operating cash flows, and

financing cash flows.

Operating cash flows arise from intercompany (betweenunrelated companies) and intracompany (between unitsof the same company) receivables and payables, rent andlease payments, royalty and license fees and assortedmanagement fees.

Financing cash flows are payments for loans (principaland interest), equity injections and dividends.

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Expected Versus Unexpected Changes in Cash

Flows

An expected change in exchange rates is not included

in the definition of operating exposure

Management and investors should have factored this into

their analysis of anticipated market value

Management should use forward exchange rates when

preparing the operating budgets, rather than assuming

that the spot exchange rates will not change.

Rem

em

ber: Forward rate is an unbiased estim

ator offuture spot rates

Therefore, only unexpected changes in exchange rates

should cause market value to change.

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CASE STUDY: Trident Corporation and Its European Subsidiary:

Operating Exposure of the Parent and Its Subsidiary

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Trident Corporation and Its European Subsidiary:

Operating Exposure of the Parent and Its Subsidiary

Base Case:

Trident Europe manufactures in Germany using European

material and labor.

Half of its production is sold within Europe for euros and halfis exported to non-European countries.

All sales are invoiced in euros.

Accounts receivable are one-fourth of annual sales

i.e. average collection period is 90 days. Inventory is equal to 25% of annual direct costs

Depreciation on plant and equipment is Euro600,000 per year

Corporate income tax is 34%

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Trident Corporation and Its European Subsidiary:

Operating Exposure of the Parent and Its Subsidiary

On January 1, 2011, the Euro unexpectedly drops by

16.67% in value, from $1.2/ to $1.0/ .

We need to predict: What will happen to the sales

volume, sales price, and operating costs? The answer will depend on Trident Europes, its customers

and suppliers reaction to the devaluation.

Case 1: No change in any variable

Case 2: Sales volum

e in Europe and export volum

e doublebecause German-made telecom components are nowmore

competitive with imports (lower prices). Other variables remain

constant

Case 3: The Euro sales price increase from 12.80 to 15.36 tomaintain the same U.S. dollar-equivalent price (exchange rate pass

through). Other variables remain constant.

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BALANCE SHEETEnd of Fiscal 2010

Assets Liabilities and net worth

Cash 1,600,000 Accounts payable 800,000

Accounts receivable 3,200,000 Short-term bank loan 1,600,000

Inventory 2,400,000 Long-term debt 1,600,000

Net plant and equipment 4,800,000 Common stock 1,800,000

Retained earnings 6,200,000

Sum 12,000,000 Sum 12,000,000

Important Ratios to be Maintained and Other Data

Accounts receivable, as percent of sales 25.00%

Inventory, as percent of annual direct costs 25.00%

Cost of capital (annual discount rate) 20.00%

Income tax rate 34.00%

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Base Case Case 1 Case 2 Case 3

Assumptions

Exchange rate, $/ 1.2000 1.0000 1.0000 1.0000

Sales volume (units) 1,000,000 1,000,000 2,000,000 1,000,000

Sales price per unit 12.80 12.80 12.80 15.36

Direct cost per unit 9.60 9.60 9.60 9.60

Annual Cash Flows before Adjustments

Sales revenue 12,800,000 12,800,000 25,600,000 15,360,000

Direct cost of goods sold 9,600,000 9,600,000 19,200,000 9,600,000

Cash operating expenses (fixed) 890,000 890,000 890,000 890,000

Depreciation 600,000 600,000 600,000 600,000

Pretax profit 1,710,000 1,710,000 4,910,000 4,270,000

Income tax expense 581,400 581,400 1,669,400 1,451,800

Profit after tax 1,128,600 1,128,600 3,240,600 2,818,200

Add back depreciation 600,000 600,000 600,000 600,000

Cash flow from operations, in euros 1,728,600 1,728,600 3,840,600 3,418,200

Cash flow from operations, in dollars $ 2,074,320 $ 1,728,600 $ 3,840,600 $ 3,418,200

Adjustments to Working Capital for 2011 and 2015 Caused by Changes in Conditions

Accounts receivable 3,200,000 3,200,000 6,400,000 3,840,000

Inventory 2,400,000 2,400,000 4,800,000 2,400,000

Sum 5,600,000 5,600,000 11,200,000 6,240,000

Change from base conditions in 2011 - - 5,600,000 640,000

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Year Year-End Cash Flows

1 (2011) $ 2,074,320 $ 1,728,600 $ (1,759,400) $ 2,778,200

2 (2012) $ 2,074,320 $ 1,728,600 $ 3,840,600 $ 3,418,200

3 (2013) $ 2,074,320 $ 1,728,600 $ 3,840,600 $ 3,418,200

4 (2014) $ 2,074,320 $ 1,728,600 $ 3,840,600 $ 3,418,200

5 (2015) $ 2,074,320 $ 1,728,600 $ 9,440,600 $ 4,058,200

Year Change in Year-End Cash Flows from Base Conditions

1 (2011) na $ (345,720) $ (3,833,720) $ 703,880

2 (2012) na $ (345,720) $ 1,766,280 $ 1,343,880

3 (2013) na $ (345,720) $ 1,766,280 $ 1,343,880

4 (2014) na $ (345,720) $ 1,766,280 $ 1,343,8805 (2015) na $ (345,720) $ 7,366,280 $ 1,983,880

Present Value of Incremental Year-End Cash Flows

na $ (1,033,914) $ 2,866,106 $ 3,742,892

Base Case Case 1 Case 2 Case 3

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Measuring the Impact of Operating Exposure

Short-run: One year operating budget.

The prices and costs are rigid for the existing obligations,

they cannot be changed according to the market

conditions.

Medium-run: 2-5 year budgets.

If the parity conditions among foreign exchange rates,

nominal interest rates and inflation rates hold, there would

be no operating exposure (estimated cash flows = actual

cash flows)

If the markets are in disequilibrium, the firm is exposed to

the operating risk.

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Strategic Management of Operating

Exposure

Objective

To anticipate and influence the effect of

unexpected changes in exchange rates on a firms

future cash flows How to meet this objective?

Recognize a disequilibrium in foreign exchange

markets (e.g. Divergence from international parity

conditions)

Diversify internationally firms operating base

Diversify internationally firms financing base

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Diversifying Operations

Diversify

Location of sales

Location of production facilities

Location of raw material sources Benefits

If a firm is diversified, management can recognize

disequilibrium when it occurs and react competitively.

Recognizing a temporary change in worldwidecompetitive conditions permits management to make

changes in operating and financial strategies

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Diversifying Financing

Diversify by

Raising funds in more than one capital market

Raising funds in more than one currency

Establishing banking relationships in more than

one country

Benefits

Reduce the variability of future cash flows dueto domestic business cycles

Increase the availability of capital, and reduce

cost of capital

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Proactive Management of Operating Exposure

The six most commonly employed proactive policies are

1. Matching currency cash flows2. Risk-sharing agreements

3. Back-to-back or parallel loans

4. Currency swaps

5. Leads and lags

6. Reinvoicing center

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1. Matching Currency Cash Flows

Use when cash flows in foreign currency arerelatively constant and predictable over time.

One way to offset an anticipated continuous long

exposure to a particular currency is to acquire

debt denominated in that currency. This policy results in a continuous receipt of

payment and a continuous outflow in the same

currency.

This can sometimes occur through the conduct of

regular operations (eg. buy rawmaterials in a

country from where the company expects

revenues) and is referred to as a natural hedge.

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Matching Currency Cash Flows

U.S.

Corporation

Canadian

Corporation(buyer of goods)

Exports

goods toCanada

Payment for goods

in Canadian dollars

Principal and interest

payments on debt

in Canadian dollars

Canadian

Bank(loans funds)

US Corp borrows

Canadian dollar debtfrom Canadian Bank

Exposure: The sale of goods to Canada creates a foreign currency

exposure from the inflow of Canadian dollars

Hedge: The Canadian dollar debt payments act as a financial hedge by

requiring debt service, an outflow of Canadian dollars

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2. Risk-sharing

Risk-sharing is a contractual arrangement in whichthe buyer and seller agree to share or split currency

movement impacts on payments

This agreement is intended to smooth the impact onboth parties of volatile and unpredictable exchange

rate movements

Example Ford purchases from Mazda in Japanese yen at the current

spot rate as long as the spot rate is between 115/$ and

125/$.

If the spot rate falls outside of this range, Ford and Mazda

will share the difference equally

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If on the date of invoice, the spot rate is 110/$,

(i.e. yen appreciated), Fords costs of purchasingrises.

Fords payment to Mazda would be:

22.222,222$112.50/$

025,000,00

2

5.00/$-115.00/$

025,000,00!!

Note that this movement is in Fords favor, however

if the yen depreciated to 130/$, Mazda would be

the beneficiary of the risk-sharing agreement

What is Japanese yen is continuously appreciating?

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3. Back-to-Back Loan

(Parallel Loan; Credit Swap)

Two firms in different countries arrange to borrow each

others currency for a specific period of time

The operation is conducted outside the FOREX markets, although

spot quotes may be used

The two loans would be for equal values at the current spot rate

for a specified maturity. But there may be additional clauses for

extreme unexpected changes in the future spot rates.

This swap creates a covered hedge against exchange loss, since

each company, on its own books, borrows the same currency it

repays

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Back-to-Back Loans

The back-to-back loan provides a method for parent-subsidiary cross border

financing without incurring direct currency exposure.

Impediments: (i) Finding a counterparty. (ii) counterparty risk

Indirect

Financing

British parent

firm

1. British firm wishes to invest fundsin its Dutch subsidiary

Dutch firms

British subsidiary

3. British firm loans British pounds

directly to the Dutch firms British

subsidiary

Direct loan

in pounds

Dutch parent

firm

2. British firm identifies a Dutch firm wishingto invest funds in its British subsidiary

British firms

Dutch subsidiary

4. British firms Dutch subsidiary loans

euros to the Dutch parent

Direct loan

in euros

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4. Currency Swaps

In a currency swap, a firm and a swap dealer or swap

bank agree to exchange an equivalent amount of two

different currencies for a specified amount of time.

Currency swaps can be negotiated for a wide range of

maturities

A typical currency swap requires two firms to borrow funds

in the markets and currencies in which they are best known

or get the best rates

The swap dealer, or the swap bank acts as the middleman in

setting up the swap agreement

Do not appear on a firms balance sheet

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Currency Swaps

Wishes to enter into a swap to

pay dollars and receive yen

Japanese

Corporation

Assets Liabilities & Equity

Debt in yenSales to US

Swap Dealer

Receivedollars

Pay

dollars

Pay

yen

Receive

yen

Wishes to enter into a swap to

pay yen and receive dollars

United States

Corporation

Debt in US$

Assets Liabilities & Equity

Sales to Japan

Inflow

of yen

Inflow

of US$

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5. Leads and Lags

Retiming the transfer of funds Firms can reduce both operating and transaction exposure

by accelerating or decelerating the timing of payments

that must be made or received in foreign currencies.

To lead is to pay early. A firm holding soft currency and having debts denominated in

hard currency will pay the hard currency debt as soon as possible.

The objective is to pay currency debts before the currency drops in

value.

To lag is to pay late.

A firm holding a hard currency and having debts denominated in

soft currency will lag by paying the debt late. (less currency will be

needed if soft currency depreciates)

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6. Reinvoicing Centers

A subsidiary or department of a multinational

corporation where all intrafirm transactions are

centralized and foreign currency related receivables

and liabilities are netted. There are three basic benefits arising from the

creation of a reinvoicing center:

Managing foreign exchange exposure

Guaranteeing the exchange rate for future orders

Managing intrasubsidiary cash flows

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Use of a Reinvoicing Center

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Managing Translation Exposure

Chapter 13

Suggested Exercises:1, 2, 3, 4

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Translation (Accounting) Exposure

Translation exposure is the risk of adverse effects on a firm`s

financial statements that may arise from changes in exchange

rates.

Translation exposure results from translating foreign currency

denominated financial statements into the parents consolidated

reporting currency.

Translation exposure is the potential for an increase or decrease in the

parents net worth or reported net income caused by a change in

exchange rates since the last translation.

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Overview ofTranslation

Main cause: Different exchange rates are usedin translating different line items in accounting

statements.

Historical exchange rates are used for certainequity accounts, fixed assets, and inventory items,

Current exchange rates are used for current

assets, current liabilities, income, and expense

items.

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Translation Methods

Translationmethods differ by country along two

dimensions:

Degree of independence from the parent

company

Integrated foreign entity

Self-sustaining foreign entity

Functional Currency

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Categorizing the Foreign Subsidiaries

Most countries today specify the translationmethod used by a foreign subsidiary based on thesubsidiarys business operations (subsidiarycharacterization).

A foreign subsidiarys business can be categorized aseither an integrated foreign entityor a self-sustaining

foreign entity.

An integrated foreign entity is one that operates as anextension of the parent, with cash flows and businesslines that are highly interrelated.

A self-sustaining foreign entity is one that operates inthe local economic environment independent of theparent company.

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Functional Currency

A foreign affiliates functional currency is the

currency of the primary economic environment in

which the subsidiary operates

The geographic location of a subsidiary and itsfunctional currency can be different

Example: US subsidiary located in Singapore may find that

its functional currency could be

U.S. dollars (integrated subsidiary)

Singapore dollars (self-sustaining subsidiary)

British pounds (self-sustaining subsidiary)

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Economic Indicators

forDetermining the

Functional Currency

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Translation Methods

There are two basic methods for the translation of

foreign subsidiary financial statements:

The current rate method

The temporal method

Either method designates:

(1) The exchange rate at which individual balance sheet and

income statement items are remeasured

(2) Where any imbalances are to be recorded

balance sheet ?

income statement ?

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Current Rate Method

The current rate methodis the most prevalent in the world

today.

Assets and liabilities are translated at the current rate of exchange on

the day of the statement.

Income statement items are translated at the exchange rate on the

dates they were recorded, or at an appropriately weighted average

rate for the period.

Dividends (distributions) are translated at the rate in effect on the date

of paym

ent. Common stock and paid-in capital accounts are translated at historical

rates.

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Current Rate Method

Gains or losses caused by translation adjustments are not included in the

calculation of consolidated net income.

Rather, translation gains or losses are reported separately and

accumulated in a separate equity reserve account (on the B/S) with a title

such as cumulative translation adjustment(CTA).

The biggest advantage of the current rate method is that the gain or loss

on translation does not pass through the income statement but goes

directly to a reserve account (reducing variability of reported earnings).

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Current Rate Method: Summary

Item Translation Rate

Assets and Liabilities Balance Sheet Date

Income StatementItems

Either the actual exchange rate on the datesthe various revenues, expenses, gains and

losses were incurred or at a weightedaverage exchange rate for the period

Dividends Date of payment

Common Stock Historical Rate

Paid-in Capital Historical Rate

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Temporal Method

Under this method, specific assets and liabilities are

translated at exchange rates consistent with the timing of the

items creation.

The temporal method assumes that items such as inventories

and net plant and equipment are restated to reflect market

value.

Gains or losses resulting from remeasurement are carried

directly to current consolidated income, and not to equity

reserves (increased variability of consolidated earnings).

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Temporal Method: Summary

Item Translation RateMonetary Assets Current Exchange Rates

Monetary Liabilities Current Exchange Rates

Nonmonetary Assets Historical Exchange Rates

Income Statement Items Average Exchange Rate

Depreciation Historical Exchange Rates

Cost of Goods Sold Historical Exchange Rates

Dividends Exchange Rate on Payment Date

Common Stock, Paid-inCapital

Historical Exchange Rates

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Temporal Method

Any gains or losses from remeasurement are

carried directly to current consolidated

income and not to equity reserves.Foreign exchange gains and losses arising from

the translation process creates earnings

volatility.

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U.S.Translation Procedures

Governed by Financial Accounting Standards Number 52 (FAS52)

The US differentiates foreign subsidiaries on the basis of

functional currency, not subsidiary characterization

If the statem

ents arem

aintained in the local currency, and the localcurrency is the functional currency, they are translated by the current

rate method

If the statements are maintained in local currency, and the US dollar is

the functional currency, they are remeasured by the temporal method

If the statements are in local currency and neither the local currencyor the US dollar is the functional currency, the statements must first

be remeasured into the functional currency by the temporal method,

and then translated into US dollars by the current rate method

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Yes

Translatedtodollars

(currentrate method)

Remeasuretodollars

(temporal method)

YesRemeasure from foreign

currencyto functional

(temporal method)

andtranslatetodollars

(currentrate method)

No

Ifthe financialstatementsofthe foreignsubsidiaryareexpressed

ina foreigncurrency, the followingdeterminationsneedtobe

made:Isthelocalcurrencythe

functionalcurrency?No

Isthedollarthe

functionalcurrency?

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Hyperinflation Countries

Hyperinflation: Cumulative inflation has been 100% or more for over a

three-year period

Financial statements of the subsidiaries must be translated

using the temporal method

The rationale is to correct the problem of the disappearing

asset

If the current rate method were used, depreciation would be

overstated in real terms and the book value of the physical

assets would disappear from the balance sheet

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Translation Example

The functional currency of the subsidiary is the euro

The currency of the parent is US dollars

Euro

December 2002: $1.200/

January 2003: $1.000/16.67% depreciation

PP&E, common stock, and long-term debt were acquired at a past rate of

$1.2760/

Inventory on hand was purchased orm

anufactured when the averageexchange rate was $1.2180/

The example will also look at the consequences had the euro appreciated

to $1.3200/

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Managerial Implications

The translation loss or gain is larger under thecurrent rate method because inventory and

PP&E as well as monetary assets are deemed

exposed

The managerial implications are

Ifmanagement expects a currency to depreciate, it

couldminimize translation exposure by reducing net

exposed assets

Ifmanagement expects appreciation, it should

increase net exposed assets to benefit from the gain

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Should Firms Hedge Translation Exposure?

No

The value of the firm is the

PV of cash flows

Translation exposuredoesnt effect cash flows, so

ignore it

Yes

Investors dont have enough

information to estimate

cash flows and instead must

rely on reported earnings.

If reported earnings are

distorted by translation

issues, investors will

misvalue the firm.

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Managing Translation Exposure

Balance Sheet Hedge Requires an equal amount ofexposedforeign

currency assets and liabilities on a firms

consolidated balance sheet

A change in exchange rates will change the value

of exposed assets but offset that with an opposite

change in liabilities

T

his is term

edm

onetary balance The cost of this method depends on relative

borrowing costs in the varying currencies

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Trident Europe, Balance Sheet Exposure

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Balance Sheet Hedge

To achieve a balance sheet hedge:

Reduce exposed euro assets

Increase exposed euro liabilities

Exchange existing euro cash for dollars

Borrow euros, and exchange the borrowed

euros for dollars

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When is a balance sheet hedge justified?

The foreign subsidiary is about to be liquidated so

that the value of its cumulative translationadjustment would be realized

The firm has debt covenants or bank agreements that

state the firms debt/equity ratios will be maintained

within specific limits

Management is evaluated on the basis of certain

income statement and balance sheet measures that

are affected by translation losses or gains The foreign subsidiary is operating in a

hyperinflationary environment

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Which Exposure to Minimize?

Firms seeking to reduce transaction and

translation exposures typically reduce

transaction exposure first.

They then recalculate translation exposure

and then decide if any residual translation

exposure can be reduced without creating

more transaction exposure.