Managing Economic Exposure And Translation Exposure. J. Gaspar: Adapted from Jeff Madura, International Financial Management

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1 Chapter 12 Managing Economic Exposure And Translation Exposure J. Gaspar: Adapted from Jeff Madura, International Financial Management 12. 1

2 Chapter Objectives To explain how an MNC s economic exposure can be managed/hedged; and To explain how an MNC s translation exposure can be managed/hedged

3 Economic Exposure Economic exposure refers to the impact exchange rate fluctuations can have on a firm s Present Value of future cash flows. Recall that corporate cash flows can be affected by exchange rate movements in ways not directly associated with foreign transactions, i.e., a purely domestic firm that faces international competition

4 Economic Exposure The economic impact of currency exchange rates on us is complex because such changes are often linked to variability in real growth, inflation, interest rates, governmental actions, and other factors. These changes, if material, can cause us to adjust our financing and operating strategies. PepsiCo 12. 4

5 Income Statement Analysis to Assess Economic Exposure MNCs can determine the impact of FX exposure by assessing the sensitivity of their cash inflows and outflows to various possible exchange rate scenarios. The MNC can then minimize its FX exposure by restructuring its operations to reduce its net exchange-rate-sensitive cash flows. Use spreadsheets to facilitate analysis

6 Base Case: Impact of Exchange Rate Movements on Earnings of Madison, Inc. (In Millions) 12. 6

7 Managing Madison Inc. s Economic Exposure Madison Inc. s Net FX Exposure: C$206 m outflow Madison s earnings before taxes is inversely related to the Canadian dollar s strength, since the higher expenses more than offset the higher revenue when the Canadian dollar strengthens. Madison may reduce its exposure by increasing Canadian sales, reducing orders of Canadian materials, and borrowing less in Canadian dollars

8 How to Minimize Economic Exposure Restructuring can reduce economic exposure by shifting the sources of costs or revenue to other locations in order to match cash inflows and outflows in foreign currencies. The new structure is then evaluated by assessing how the revised cash flows are sensitive to various possible exchange rate scenarios

9 Impact of Possible Exchange Rate Movements on Earnings: Before and After Corporate Restructuring (in Millions) 12. 9

10 Economic Exposure Based on the Original and Proposed Operating Structures

11 Crucial Issues Involved in the Restructuring Decisions Restructuring operations is a long-term solution to reducing economic exposure. It is a much more complex task than hedging any foreign currency transaction. MNCs must be very confident about the long-term potential benefits before they proceed to restructure their operations, because of the high reversal costs

12 Strategies for Restructuring Restructuring may involve: increasing/reducing sales in new or existing foreign markets, increasing/reducing dependency on foreign suppliers, establishing/eliminating production facilities in foreign markets, and/or increasing/reducing the level of debt denominated in foreign currencies

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14 A Case Study in Hedging Economic Exposure Savor Co., a U.S. firm, has three independent units that conduct business in the Eurozone. It is concerned about its exposure to the euro. To determine whether it is exposed and the source of the exposure, Savor applies a series of regression analysis to its cash flows and the euro s movements

15 An Analysis of Savor Co. s Cash Flows and the Euro s Movements

16 A Case Study in Hedging Economic Exposure Assessment of Savor s Exposure: % TotalCashFlow t = a 0 + a 1 % euro t + t The slope coefficient, a 1, is found by regression analysis to be positive and statistically significant. Savor is exposed to the euro s movements

17 A Case Study in Hedging Economic Exposure Assessment of Each Unit s Exposure: % UnitCashFlow t = a 0 + a 1 % euro t + t Unit C is exposed to the euro s movements

18 A Case Study in Hedging Economic Exposure Identifying the Source of Unit C s Exposure: Savor believes that Unit C s cash flows are mainly affected by income statement items. Savor thus applies regression analysis to each income statement item, and finds a significant positive relationship between Unit C s revenue and the euro s value. Savor s economic exposure could be due to foreign competition

19 A Case Study in Hedging Economic Exposure Possible Hedging Strategies: Pricing policy Reduce prices when the euro depreciates. Hedging with forward contracts Sell euros forward to hedge against the adverse effects of a weak euro. Purchasing foreign supplies Costs will be reduced during a weak-euro period

20 A Case Study in Hedging Economic Exposure Possible Hedging Strategies: Financing with foreign funds Costs will be reduced during a weak-euro period. Revising the operations of other units So as to offset the exposure of Unit C

21 Hedging Exposure to Fixed Assets When an MNC has fixed assets (such as buildings or machinery) in a foreign country, the cash flows to be received from the sale of these assets is subject to exchange rate risk. A sale of fixed assets can be hedged by creating a liability that matches the expected value of the assets at the point in the future when they will be sold

22 Translation Exposure Translation exposure results when an MNC translates each subsidiary s financial data from its host country (operating) currency to home country (reporting) currency for consolidated financial reporting. MNCs like Coca Cola, GE, etc. deal with over a hundred operating currencies. Translation exposure does not directly affect cash flows, but some firms are concerned because of its potential impact on reported consolidated earnings

23 Translation Exposure Management A simple example of earnings and balance sheet translation Earnings Translation Management Columbus, Inc., a US-based MNC has a subsidiary in France that is forecast to have an after tax earnings of 20 million during after tax earnings: 20 million Case#1: Repatriate earnings Case of transactions exposure Case#2: Reinvest earnings in France Case of translation exposure Exchange rate Jan 1, 2015 Dec 31, 2015 rate Ave Forward Rate (sell ) quote provided on Jan 1, 2015 $1.30/ spot $1.40/ spot $1.35/ $1.50/ (Dec 31, 2015 delivery) Case#2: Reinvest 20 million earnings in France Strategy #1: No hedging of translation exposure Per FASB-52, Translation of 20 French earning to $ (reporting currency) on Dec 31, 2015 = = $27 million Earnings after translation = $27 million Strategy #2: Hedging translation exposure by selling euros forward at a stronger rate than the actual future spot rate of $1.40/ recorded on December 31, Profit from executing forward contract = Sell euros forward buy euros spot on Dec 31, 2015 = 20 million ( ) = = $2 million Earnings after translation = $27 million + $2*(1-French corporate tax rate) million Strategy #3: Hedging translation exposure by selling euros forward at a weaker rate than the actual future spot rate (say, $1.36/ instead of the recorded $1.40/ spot rate). A loss will be incurred while executing the forward contract, since euros will need to be purchased at say, $1.40/ (future spot rate on December 31, 2015) and the euro sold at a lower forward rate of $1.36/. Loss= 20 million ( ) = 20 x = -$0.8 mn Earnings after translation = $27 million (1.35x20) $0.8 million = $26.2 million Balance Sheet Translation Management Balance Sheet Translation Exposure relates to consolidation of Balance Sheet items in different currencies to reporting currency and can be managed by minimizing Net Exposed Assets Columbus Net exposed assets = Assets Liabilities (i.e., net assets exposed to change in the value of v. $, i.e. from operating currency to reporting currency). J. Gaspar 5/4/

24 Limitations of Hedging Translation Exposure Inaccurate earnings forecasts Inadequate forward contracts for some currencies Accounting distortions Translation gains/losses are based on the average exchange rate (which is unlikely to be the same as the forward rate). Translation losses are also not tax deductible