Managing Economic Exposure And Translation Exposure 12 LECTURE Managing Economic Exposure And Translation Exposure

Chapter Objectives To explain how an MNC’s economic exposure can be hedged; and To explain how an MNC’s translation exposure can be hedged.

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.

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

Use of the Income Statement to Assess Economic Exposure An MNC can determine its exposure by assessing the sensitivity of its cash inflows and outflows to various possible exchange rate scenarios. The MNC 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.

Original Impact of Exchange Rate Movements on Earnings: Madison, Inc Original Impact of Exchange Rate Movements on Earnings: Madison, Inc. (In Millions)

Managing Madison Inc.’s Economic Exposure 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.

How Restructuring Can Reduce Economic Exposure Restructuring to reduce economic exposure involves shifting the sources of costs or revenue to other locations in order to match cash inflows and outflows in foreign currencies. The proposed structure is then evaluated by assessing the sensitivity of its cash inflows and outflows to various possible exchange rate scenarios.

Impact of Possible Exchange Rate Movements on Earnings under Two Alternative Operational Structures (in Millions)

Economic Exposure Based on the Original and Proposed Operating Structures

Issues Involved in the Restructuring Decision 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.

Issues Involved in the Restructuring Decision 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.

Recommended Action When a Foreign Currency Has a Greater Impact on How to Restructure Operations to Balance the Impact of Currency Movements on Cash Inflows and Outflows Recommended Action When a Foreign Currency Has a Greater Impact on Type of Operation Cash Inflows Cash Outflows Sales in foreign Reduce foreign Increase foreign currency units sales sales Reliance on Increase foreign Reduce foreign foreign supplies supply orders supply orders Proportion of Restructure debt Restructure debt foreign debt to increase debt to reduce debt payments in payments in foreign currency foreign currency

A Case Study in Hedging Economic Exposure Savor Co., a U.S. firm, has three independent units that conduct some business in Europe. 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.

Assessment of Savor Co.’s Cash Flows and the Euro’s Movements

A Case Study in Hedging Economic Exposure Assessment of Savor’s Exposure: %TotalCashFlowt = a0 + a1%eurot + t The slope coefficient, a1, is found by regression analysis to be positive and statistically significant.  Savor is exposed to the euro’s movements.

A Case Study in Hedging Economic Exposure Assessment of Each Unit’s Exposure: %UnitCashFlowt = a0 + a1%eurot + t Unit Slope Coefficient R-squared Statistic A Not significant 6.8% B Not significant 6.7% C Statistically significant 93%  Unit C is exposed to the euro’s movements.

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.

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.

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.

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.

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.

Use of Forward Contracts to Hedge Translation Exposure 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.

Use of Forward Contracts to Hedge Translation Exposure Example: A U.S.-based MNC has a British subsidiary. The forecasted British earnings of £20 million (to be entirely reinvested) will be translated at the weighted average £ value over the year. To hedge this expected earnings, the MNC sells £20 million one year forward. If the £ depreciates, the gain generated from the forward contract position will help to offset the translation loss.

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.

Limitations of Hedging Translation Exposure Increased transaction exposure If the foreign currency appreciates during the fiscal year, the transaction loss generated by a forward contract position will somewhat offset the translation gain. The translation gain is simply a paper gain, while the loss resulting from the hedge is a real loss.

Source: Adopted from South-Western/Thomson Learning © 2006