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Fundamentals of Multinational Finance Sixth Edition

Chapter 12 Operating Exposure

Learning Objectives 12.1 Examine how operating exposure arises in a multinational firm through unexpected changes in corporate cash flows

12.2 Analyze how to measure operating exposure’s impact on a business unit through the sequence of volume, price, cost, and other key variable changes

12.3 Evaluate strategic alternatives to managing operating exposure

12.4 Detail the proactive policies firms use in managing operating exposure

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A Multinational’s Operating Exposure (1 of 7) • Operating Exposure

– aka Competitive Exposure or Strategic Exposure – Measures changes in present value of a firm resulting

from changes in future operating cash flows caused by unexpected changes in exchange rates

Exhibit 12.1: Ganado Corporation: Structure and Operations

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A Multinational’s Operating Exposure (2 of 7) • Static Versus Dynamic Operating Exposure

– Example: Assume the dollar starts depreciating against the euro § Ganado China

– Sales in U.S. dollars will result in fewer renminbi proceeds in the immediate period

– Sales in euros may stay roughly the same in renminbi proceeds depending on the relative movement of the Rmb against the euro General profitability will fall in the short run

– In the longer term, depending on the markets for its products and the nature of competition, it may need to raise the price at which it sells its export products, even to its U.S. parent company

A Multinational’s Operating Exposure (3 of 7) • Static Versus Dynamic Operating Exposure

– Example: Assume the dollar starts depreciating against the euro

§ Ganado Germany

– Since this business unit’s cash inflows and outflows are all in euros, there is no immediate transaction exposure or change

– It may suffer some rising input costs in the future if Ganado China does indeed push through price increases of component sales

– Profitability is unaffected in the short term

§ Ganado U.S.

– Ganado U.S. has all local currency cash inflows and outflows

– A fall in the value of the dollar will have no immediate impact, but may change over the medium to long term, because input costs from China may rise over time as the Chinese subsidiary tries to regain prior profit margins

– Short-term profitability is unaffected

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A Multinational’s Operating Exposure (4 of 7) • Static Versus Dynamic Operating Exposure

– Example: Assume the dollar starts depreciating against the euro § The net result for Ganado is possibly a fall in the total

profitability of the firm in the short term, primarily from the fall in profits of the Chinese subsidiary

§ The fall in the dollar in the short term, however, is likely to have a positive impact on translation exposure, as profits and earnings in renminbi and euros translate into more dollars

A Multinational’s Operating Exposure (5 of 7) • Operating and Financing Cash Flows

– Operating Cash Flows § Arise from intercompany and intracompany receivables

and payables – Financing Cash Flows

§ Payments for the use of intercompany and intracompany loans and stockholder equity

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Exhibit 12.2: Financial and Operating Cash Flows Between Parent and Subsidiary

A Multinational’s Operating Exposure (6 of 7) • Expected Versus Unexpected Changes in Cash Flow

– Expected Change § From a management perspective, budgeted financial statements

already reflect information about the effect of an expected change in exchange rates

§ From a debt service perspective, expected cash flow to amortize debt should already reflect the international Fisher effect

§ From an investor’s perspective, if the foreign exchange market is efficient, information about expected changes in exchange rates should be widely known and reflected in market value

§ From a broader macroeconomic perspective, operating exposure is not just the sensitivity of a firm’s future cash flows to unexpected changes in foreign exchange rates, but also its sensitivity to other key macroeconomic variables

– This factor has been labeled as macroeconomic uncertainty

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A Multinational’s Operating Exposure (7 of 7) • Measuring Operating Exposure

– Short Run – Medium Run: Equilibrium – Medium Run: Disequilibrium – Long Run

Exhibit 12.3: Operating Exposure’s Phases of Adjustment and Response

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Measuring Operating Exposure: Ganado Germany (1 of 7) • The Base Case

– Ganado Germany manufactures in Germany, sells domestically, and exports; and all sales are invoiced in euros

– Exhibit 12.5 summarizes the current baseline forecast for Ganado Germany income and operating cash flows

Exhibit 12.4: Ganado and Ganado Germany

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Exhibit 12.5: Ganado Germany’s Valuation: Baseline Analysis

Measuring Operating Exposure: Ganado Germany (2 of 7) • Case 1: Depreciation—All Variables Remain Constant

– Assume that in the coming five years no changes occur in sales volume, sales price, or operating costs

– Profits for the coming year in euros will be as expected, and cash flow from operations will still be €1,805,550

– There is no change in net working capital – The exchange rate change, however, means that operating

cash flows measured in U.S. dollars decline to $1,805,550 – The present value of this series of operating cash flows is

$6,052,483, a fall in Ganado Germany’s value of $1,210,497

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Measuring Operating Exposure: Ganado Germany (3 of 7) • Case 2: Volume Increases—Other Variables Remain Constant

– Assume that, following the depreciation in the euro, sales within Europe increase by 40%, to 1,400,000 units (all other variables remain constant)

– The depreciation has now made German-made telecom components more competitive with imports

– Additionally, export volume increases because German-made components are now cheaper in countries whose currencies have not weakened

– The sales price is kept constant in euro terms because management of Ganado Germany has not observed any change in local German operating costs and because it sees an opportunity to increase market share

– Ganado Germany’s net income rises to €2,107,950, and operating cash flows the first year rise to €2,504,553 after a one-time increase in net working capital of €203,397

– Operating cash flow is €2,707,950 per year for the following four years

– The present value of Ganado Germany has risen by $1,637,621 over baseline to $8,900,601

Measuring Operating Exposure: Ganado Germany (4 of 7) • Case 3: Sales Price Increases—Other Variables Remain Constant

– Assume the euro sales price is raised from €12.80 to €15.36 per unit to maintain the same U.S. dollar-equivalent price and that all other variables remain constant

– Also assume that volume remains constant in spite of this price increase; that is, customers expect to pay the same dollar- equivalent price, and local costs do not change

– Ganado Germany is now better off following the depreciation than it was before because the sales price, which is pegged to the international price level, increased and volume did not dropNet income rises to €3,010,350 per year, with operating cash flow rising to €3,561,254 in 2014 and €3,610,350 per year in the following four years

– Ganado Germany has now increased in value to $12,059,761

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Measuring Operating Exposure: Ganado Germany (5 of 7) • Case 4: Price, Cost, and Volume Increases

– Assume price increases by 10% to €14.08, direct cost per unit increases by 5% to €10.00, and volume rises by 10% to 1,100,000 units

– Revenues rise by more than costs, and net income for Ganado Germany rises to €2,113,590

– Operating cash flow rises to €2,623,683 in 2014, and is €2,713,590 for each of the following four years

– Ganado Germany’s present value is now $9,018,195

Exhibit 12.6: Ganado Germany: Case 4—Sales Price, Volume & Costs Increase

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Measuring Operating Exposure: Ganado Germany (6 of 7) • Other Possibilities

– If any portion of sales revenues were incurred in other currencies, the situation would be different

– Ganado Germany might leave the foreign sales price unchanged, in effect raising the euro-equivalent price

– It might leave the euro-equivalent price unchanged, thus lowering the foreign sales price in an attempt to gain volume

– Depending on elasticities and the proportion of foreign to domestic sales, total sales revenue might rise or fall

Measuring Operating Exposure: Ganado Germany (7 of 7) • Measurement of Loss

– In Case 1, in which the euro depreciates, Ganado’s German subsidiary’s value falls by the percent change in the exchange rate

– In Case 2, in which volume increased by 40%, the German subsidiary’s value increased 22.5%

– In Case 3, in which the change in the exchange rate was completely passed through to a higher sales price, the result is a massive 66% increase in subsidiary value

– In Case 4, which combined increases in price, cost and volume, the resulting change in subsidiary valuation of 24.2%

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Exhibit 12.7: Summary of Ganado Germany Value Changes to Depreciation of the Euro

Strategic Management of Operating Exposure (1 of 3) • The objective of both operating and transaction exposure

management is to anticipate and influence the effect of unexpected changes in exchange rates on a firm’s future cash flows, rather than merely hoping for the best

• To meet this objective, management can diversify the firm’s operating and financing base

• Management can also change the firm’s operating and financing policies

• A diversification strategy does not require management to predict disequilibrium, only to recognize it when it occurs

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Strategic Management of Operating Exposure (2 of 3) • Diversifying Operations

– If a firm’s operations are diversified internationally, management is pre-positioned both to recognize disequilibrium when it occurs and to react competitively

– Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

– Domestic firms may be subject to the full impact of foreign exchange operating exposure and do not have the option to react in the same manner as an MNE

Strategic Management of Operating Exposure (3 of 3) • Diversifying Financing

– If a firm’s financing sources are diversified, it will be pre- positioned to take advantage of temporary deviations from the international Fisher effect

– However, to switch financing sources, a firm must already be well-known in the international investment community

– This would not be an option for a domestic firm

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Proactive Management of Operating Exposure (1 of 5) • Matching Currency Cash Flows

– One way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

– An alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for U.S. or other foreign firms

– In addition, the company could engage in currency switching, in which the company would pay foreign suppliers with Canadian dollars

Exhibit 12.8: Debt Financing as a Financial Hedge

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Proactive Management of Operating Exposure (2 of 5) • Risk-Sharing Agreements

– An alternate method for managing a long-term cash flow exposure between firms is risk-sharing

– This is a contractual arrangement in which the buyer and seller agree to “share” or split currency movement impacts on payments between them

– This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

Proactive Management of Operating Exposure (3 of 5) • Back-to-Back or Parallel Loans

– A back-to-back loan, also referred to as a parallel loan or credit swap, occurs when two business firms in separate countries arrange to borrow each other’s currency for a specific period of time

– At an agreed terminal date they return the borrowed currencies – Such a swap creates a covered hedge against exchange loss, since each

company, on its own books, borrows the same currency it repays – There are two fundamental impediments to widespread use of the back-

to-back loan: § It is difficult for a firm to find a partner, termed a counterparty for the

currency amount and timing desired § A risk exists that one of the parties will fail to return the borrowed

funds at the designated maturity, although each party has 100% collateral (denominated in a different currency)

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Exhibit 12.9: Back-to-Back Loans for Currency Hedging

Proactive Management of Operating Exposure (4 of 5) • Cross-Currency Swaps

– A currency swap resembles a back-to-back loan except that it does not appear on a firm’s balance sheet

– 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

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Exhibit 12.10: Using Cross-Currency Swaps

Proactive Management of Operating Exposure (5 of 5) • Contractual Approaches: Hedging the Unhedgeable

– Some MNEs now attempt to hedge their operating exposure with contractual hedges

– Merck and Eastman Kodak have undertaken long-term currency option positions hedges designed to offset lost earnings from adverse exchange rate changes

– The ability to hedge the “unhedgeable” is dependent upon: § Predictability of the firm’s future cash flows § Predictability of the firm’s competitor’s responses to

exchange rate changes

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