Module - 26 Operating Exposure Measurement

Transcription

1 NPTEL Vinod Gupta School of Management, IIT. Kharagpur. Module - 26 Operating Exposure Measurement Developed by: Dr. Prabina Rajib Associate Professor Vinod Gupta School of Management IIT Kharagpur, prabina@vgsom.iitkgp.ernet.in Joint Initiative IITs and IISc Funded by MHRD - 1 -

2 Lesson - 26 Operating Exposure Measurement Highlights & Motivation: Change in the foreigner exchange risk affects firms in many other major ways. Change in foreign exchange not only affects individual transactions, it affects the firm value as a whole. Change in the exchange rate can affect the competitiveness of the firm and may have a bearing on the survival of the firm. The impact of change in foreign exchange rate on firm value is known as the operating exposure. Measuring operating exposure is quite difficult as anticipating how a company s sales, input prices will be affected due to change in the forex rate. More so quantifying how competitive scenario for the company will change due to exchange rate thus affecting future cash flow can be akin a gazing crystal ball!! Hence companies spend considerable time and effort to measure and manage the operating exposure. Learning Objectives: In this session, the following aspects have been dealt in greater detail: Understanding the meaning of operating exposure Sources of operating exposure Measurement of operating exposure and difficulties associated with the measurement Impact of operating exposure on firm s cash flow. Joint Initiative IITs and IISc Funded by MHRD - 2 -

3 26.1: Introduction. Sessions 22 and 23 deals with how change in foreign exchanges affects the contractual cash flows i.e. transaction exposure. Transaction exposure arises due to exchange loss or gain on foreign currency denominated short term contractual obligations like Borrowing or lending in foreign currency Purchasing and selling where payment/receipt is denominated in foreign currency. Lease/Rental payment in foreign currency Other contractual payments which a firm may have agreed to pay/receive before the change in exchange rate. Session 22 and 23 also focus on how companies manage various kinds of transaction exposure (hedge the risk emanating from change in foreign exchange rate) through forward and futures contracts, money market and through options contracts. Change in the foreigner exchange risk affects firms in many other major ways. Change in foreign exchange not only affects individual transactions, it affects the firm value as a whole. Change in the exchange rate can affect the competitiveness of the firm and may have a bearing on the survival of the firm. The impact of change in foreign exchange rate on firm value is known as the operating exposure. Translation exposure arises when companies report and consolidate its financial statements requiring conversion from foreign to local currency for foreign operations. In this session, how operating and translation exposure are measured and how firms manage these two exposures are discussed in detail. Joint Initiative IITs and IISc Funded by MHRD - 3 -

4 26.2: Defining Operating Exposure: Operating exposure measures the change the present value of the company due to change in future cash flows caused by any unexpected change in the foreign exchange rate. The cash flow pertains to the long-term cash flows which are yet to contracted but would occur as part of the normal course of the firm s operation. In other words, operating exposure measures the changes in long-term cash flows that have not been contracted for but would be expected in the normal course of future business. Let us elaborate little more on this aspect even though these have been discussed in greater detail in Session 22 and 23. Transaction exposure involves with the cash flows which a company has already contracted but the value of these cash flows has changed due to change in foreigner exchange. For example, an Indian company has agreed to supply 2000 units (within in coming 12 months) of bed linen to Wal-Mart. Wal-Mart has agreed to pay USD20 per piece. On the date of the contract, the spot rate is INR 45 per USD. It translates to INR 900 per piece. Direct cost per unit of linen is INR 700. The fixed cost is INR 300,000 per year. For every 1 unit of bed linen the Indian exporter sells, the contribution margin is Rs Hence it takes 1500 units to cover the fixed cost. With a sales figure of 200, 000 units, the Indian company is making a profit of INR 100,000 (INR 200 per unit * 500 units). Indian company is happy to receive a gross profit of INR 200 per unit. Indian exporter buys all raw materials from other Indian companies. Suppose after supply one lot of 5,000 units, Indian company receives USD 125,000 on 25 th day from agreement. On this date, suppose INR has appreciated to INR 40 per USD. With this rate, Indian company gross profit reduces to INR 100. Suppose INR still appreciate to INR 37 USD by the time Indian company receives the payment for second lot export. Indian company is incurring a loss of INR 60 per piece of bed linen it exports. Transaction exposure measures the effect of change in cash flow for such kind of transactions. These cash flows are easy to identify, measure hence manage. Joint Initiative IITs and IISc Funded by MHRD - 4 -

5 However, operating exposure measures the impact of foreign exchange on future cashflows Operating exposure is also known as competitive or strategic exposure. Unexpected change in exchange rate shifts competitive scenario for a company (may make it more or less competitive) vis-à-vis its competitors. Hence past cash flows cannot be used as a reference point to identify and quantify future cash flows. Hence measuring operating exposure is not straight forward like the measurement of transaction exposure. Operating exposure is also known as strategic exposure as management of operating exposure requires a reorientation at a strategic level. Let us go back to the previous example of Indian exporter exporting bed linen to Wal-Mart. With INR appreciating, exporting is becoming an unviable proposition for Indian company. The Indian company may renegotiate raw material price it pays to its suppliers. However, they may agree provided these suppliers are making enough profit at the renegotiated price. Indian company may consider revising the price, but there could be some other company from Bangladesh which is happy to export to Wal-Mart at USD 20. So increasing price it charges to Wal-Mart is not an option as it makes the Indian exporter uncompetitive. Indian exporter may start sourcing raw material from other countries. For this it may have to scout for different vendors, check their quality standard, check whether they have capacity to deliver raw material as per the requirement. The Indian company also has to consider the customs duties levied by Indian government to import raw-material to India and political relationship between the two countries. On top of this Indian exporter will be exposed to foreign exchange risk from the input side if it changes the vendor from Bangladesh to let us say Pakistan. Indian company may consider exporting to another company rather than to Wal-mart. All these changes may require change in manufacturing process, raw material sourcing process, getting hang of design trend, basically competing with another set of competitors who may be having formidable brand names in curtains and durries segment. The kind of change the Indian exporter decides to bring in requires reorientation at strategic level and requires a relook at the way the Indian exporter is doing business. Unlike transaction exposure, which is predominantly managed by the firm s finance division (of course with a broad policy direction regarding the types of hedging instruments to be chosen and the quantum of foreign exposure to be hedged), operating exposure requires involvement of each and every unit of the firm i.e, marketing, finance, purchase, sales, manufacturing etc. As the changes required to tackle operating exposure is multifaceted, projecting future cash flow becomes an extremely difficult proposition if not impossible. Joint Initiative IITs and IISc Funded by MHRD - 5 -

6 From the above discussion it is amply clear that quantifying operating exposure is difficult to measure as well as manage as change in exchange rate affects future cash flows of the company. Also management of operating exposure is done at operational level as well as at strategic level. Operating cash flows can be categorized into two categories i.e, cash flows arise from intercompany and intracompany receivables and payables, lease, rent and royalty payments and receipts and financing cash flows. Financing cash flows involve payment and receipt of loans, equity investments and dividend payments and receipts. The cash flows occurring between Indian exporter and Wal-mart are categorized as intercompany cash flow. Suppose Indian company has joint venture with a Srilankan company and Srilankan Company exports raw material to the Indian company with invoice being in Srilankan Rupees. When the exchange rate between INR and Srilankan Rupees changes, it also affects the Indian exporter. This will be an example of intracomapny transfer or intracompany cashflows. To sum up, operating exposure measurement requires a company to analyze the following aspect of its operation. From which country/currency the company is generating revenue. Who are the main competitors? Are they going to be affected by the currency risk similar way or not? For example, if the Indian Exporter s main competitors are also from India, these competitors are also facing the similar kind of risk. Competitors will also be affected by the exchange rate movement in a similar fashion. But if competitors are from other countries, then Indian company is facing a bigger hurdle. How sensitive is the company s sales volume to price? Can Indian exporter afford to pass on the exchange rate risk to Wal-mart? If the bed-linen demand is sensitive to price, then Indian exporter will loose the sales revenue if it increases the price. In that case what should be the strategy of Indian exporter? In which currency the company s expenses are? Where does the company produce its goods, source its raw materials? How the input costs change with the change in exchange rate? Joint Initiative IITs and IISc Funded by MHRD - 6 -

7 Now let us focus on what is meant buy unexpected change in exchange rate. As we know, in an efficient market, that forward rate is an unbiased predictor of futures spot market. Hence the forward rate can throw light on what is going to be future spot rate. Knowledge about the futures spot rate would help the companies to plan their pricing and sourcing strategies to the best possible manner. If exchange rate changes can be anticipated, then companies plan accordingly. Unexpected changes in exchange rates are what companies are worried about. For example on July 12 th 2007, Infosys top executives gave the following guidelines ( details given in Box 26.1) for the financial year ending Expecting appreciation of INR, Infosys has hedged USD revenue at a price of INR Box 26.1: Rupee impact: Infosys cuts earnings guidance. m Stung by the sharp rise of rupee against dollar, Infosys Technologies Ltd for the first time ever reduced its profit and revenue outlook for the fiscal The sharp appreciation of the rupee against all major currencies impacted our operating margins, said Mr V. Balakrishnan, Chief Financial Officer. However, our robust and flexible operating and financial model enabled us to maintain our net margins while absorbing the impact of appreciating currency, higher wages and visa costs, he said. Further, Mr Balakrishnan said The downward revision of the earnings guidance reflects the change in environment caused by the rupee appreciation. The rupee rose by 7 per cent against dollar this quarter from to as of end-june Infosys was assuming a rate of Rs to a dollar in its forecast and has not factored any large deals. It has hedged $925 million at Rs 40.58, and if required we will increase the hedging Mr Balakrishnan said. Hence it can be concluded here that if a company knows that fluctuations in currency rates is going to affect the firm negatively, the company will be able to take proactive action to protect against such fluctuations. Joint Initiative IITs and IISc Funded by MHRD - 7 -

8 26.3: Operating Exposure: Impact on cash flows Measurement of operating exposure can be done for different scenarios. Let us go back to the example of Indian exporter exporting to Wal-mart USA. As mentioned earlier, an Indian company has agreed to supply 2000 units (within in coming 12 months) of bed linen to Wal-Mart. Wal-Mart has agreed to pay USD20 per piece. On the date of the contract, the spot rate is INR 45 per USD. It translates to INR 900 per piece. Direct cost per unit of linen is INR 700. The fixed cost is INR 300,000 per year. For every 1 unit of bed linen the Indian exporter sells, the contribution margin is Rs Hence it takes 1500 units to cover the fixed cost. With a sales figure of 200, 000 units, the Indian company is making a profit of INR 100,000 (INR 200 per unit * 500 units). Let us term this as base case. With INR appreciating there could be three scenarios. The Indian exporter can 1. Increase per unit USD price and the company knows that price increase will not have any impact on volume sales. (Case 1). 2. Increase per unit USD price and the company knows that price increase will negatively affect the unit sales (Case 2). 3. Decrease price and the company knows price decrease will be accompanied by volume increase (Case 3). Table 26.1 : Indian exporter s profit from different scenarios. Base Case Case (1) Price increased & Volume unchanged Case (2) Price increased & volume decreased ( Case 3) Price decreased & volume increased Unit sales 2, Unit Price (USD) Exchange Rate Per Unit Revenue realized(inr) Direct Cost Unit ( INR) Contribution Margin Total Fixed cost 300, , , ,000 Breakeven Sales Total Profit 100,000 60,000 24,000 (256,000) Joint Initiative IITs and IISc Funded by MHRD - 8 -

9 Table 26.1 clearly shows profit of Indian exporter can vary from INR 60,000 to a loss of INR for the coming year. Depending upon the exchange rate movement, competitive scenario, cash flows of the company for future years will also be affected. The impact of foreign exposure will have a multiple dimension if we modify the example of Indian exporter slightly. The Indian exporter has foreign currency earnings but all other expenses are incurred in domestic currency i.e. Indian Rupees. Suppose the Indian exporter not only exports to Wal-mart at USA and to Yaohan, the Japanese retail chain. Indian exporter receives the export proceedings from in USD and Japanese Yen. Indian exporter sources the raw material from Srilankan subsidiary and pays in Srilankan Rupee. It sources special dye from Bangladesh but pays in INR. The Indian exporter has borrowed Euro to fund its business. Interest and principal payment I has to be done in Euro. The Indian exporter s profitability will now be governed by INR/USD, INR/YEN, INR/Srilankan Rupee and INR/Euro exchange rate movement. If the Bangladeshi Dye maker demands its payment to be made in Bangladeshi Taka, it adds another dimension to operating exposure. Indian exporter s profitability now gets governed by INR/USD, INR/YEN, INR/Srilankan Rupee, INR/Euro and INR/BTK exchange rate movement. The impact of foreign exposure will have a multiple dimension if we modify example of Indian exporter. The Indian exporter has foreign currency earnings but all other expenses are incurred in domestic currency i.e. Indian Rupees. Suppose the Indian exporter not only exports to Wal-mart at USA and to Yaohan, the Japanese retail chain. Indian exporter receives the export proceedings from in USD and Japanese Yen. Indian exporter sources the raw material from Srilankan subsidiary and pays in Srilankan Rupee. It sources special dye from Bangladesh but pays in INR. The Indian exporter has borrowed Euro to fund its business. Interest and principal payment I has to be done in Euro. The Indian exporter s profitability will now be governed by INR/USD, INR/YEN, INR/Srilankan Rupee and INR/Euro exchange rate movement. If the Bangladeshi Dye maker demands its payment to be made in Bangladeshi Taka, it adds another dimension to operating exposure. Indian exporter s profitability now gets governed by INR/USD, INR/YEN, INR/Srilankan Rupee, INR/Euro and INR/BTK exchange rate movement. The enormity of the foreign exchange exposure increases manifold when a company operates in multiple countries i.e, selling, raw material sourcing, borrowing, lending, and having subsidiaries in many countries. In fact, operating exposure management becomes a big challenge for MNC operating in many countries. The following box, Box 26.2 indicates some interesting facts about Nestle s global presence, scale of operations and can throw light on the degree of foreign exchange exposure faced by Nestlé. Joint Initiative IITs and IISc Funded by MHRD - 9 -

10 Box 26.2: Nestle s global operation Source: BEE FE5E8 Nestlé is a Swiss company, founded in 1866 by Henri Nestlé. Nestlé markets its products in 130 countries across the world. Nestlé manufactures around 10,000 different products and employs some 250,000 people. Around 3,500 people from over 50 countries work in Nestlé s worldwide network of 17 research, development and product testing centers. To the average number of employees in Nestlé s factories is 270, and the average number of employees in any single country is around 3,000. Although Nestlé s doesn t have control over the farms, it supports sustainability in the supply of agricultural raw materials and agricultural best practices. \ To put these words into action, Nestlé s has 800 of its own agronomists, technical advisers and field technicians. Their job is to provide technical assistance to more than 400,000 farmers throughout the world to improve their production quality, as well as their output and efficiency. They do this on a daily basis in as many as 40 countries including Inner Mongolia, China, Pakistan, Ethiopia and Colombia. Above all, Nestlé is genuinely international. One simple example is that around 80 different nationalities are represented among the 1,600 people in Nestlé Head Office. To summarize, change in foreign exchange rate not only affects a firm s already committed foreign currency payables or receivables, but also has a bigger ramification by affecting the firm s competitiveness in the long run. Change in foreign exchange rate affects the present and future cash flows of the company, thus affecting a very survival of a company. Firms have to continuously evaluate their operating and financing strategy to tackle the negative impact of forex movement on the firms competitiveness. These aspects are discussed in Sessions 27 and Session 28. Joint Initiative IITs and IISc Funded by MHRD

11 Questions: True/False Questions 1. A purely domestic firm with no operations abroad does not face any operating exposure. 2. Only when a company exports and competes against foreign companies exporting from other countries face operating exposure. 3. If a firms all payables and receivable, borrowing and lending are denominated in home currency, it does not face operating exposure. 4. Firms enjoying monopolistic power have lesser operating exposure as these firms can change their pricing policy keeping suiting the exchange arte movement. 5. Firms enjoying monopolistic power have lesser operating exposure if their product is price inelastic. Multiple choice questions: 1. The three main types of foreign exchange risk are a) operating, transaction, and translation. b) translation, accounting, and operating. c) transaction, accounting, and translation. d) operating, currency, and market. 2. Operating exposure is also known as exposure. a) economic b) competitive c) strategic d) all of the above 3. Risk exposure that measures the change in net present value of a firm due to changes in future operating cash flows is known as a) transaction exposure b) operating exposure c) translation exposure d) None of the above 4. If a company believes in efficient market, the company uses exchange rate as an unbiased predictor of future spot rates to plan for its forex management activities. a) the current spot b) the forward rate c) he futures market d) none of the above Joint Initiative IITs and IISc Funded by MHRD

12 Answers to TURE/FALSE Questions: 1. False, A purely domestic firm also faces operating exposure as with the change in exchange rate, it may turn less/more competitive in domestic market. 2. False. Even without exporting the country faces operating exposure. 3. False, A purely domestic firm faces operating exposure. 4. False. Monopolistic power need not necessarily help in reduction of operating exposure as even while enjoying this power a company may not be able increase the price, if the product demand is elastic in nature. 5. True, with a price inelastic product, the company will be able to increase the price if exchange rate moves adversely. Answers to Multiple Choice Questions: 1. a 2. d 3. b 4. b References: 1. Operating Exposure, Multinational Business Finance, Eiteman, Moffett, Stonehill and Pandey, 10 th Edition, Pearson Education, ISBN, Techniques for managing economic exposure, class note by Prof. Gordon Bodnar, 3. Rupee impact: Infosys cuts earnings guidance Nestle s global operation, Source: 5. Currency Swap deals by Maruti Udyog Limited,Source: Annual report Greece facing Goldman Sachs debt deal scrutiny 7. Japan, India agree on $6 bn currency swap deal Joint Initiative IITs and IISc Funded by MHRD