Transcript Ch12 - NTU

Chapter 12
Operating Exposure
The Goals of Chapter 12
• Define and study the attributes of operating
exposure, which is the risk that the future levels of
operating income and costs denominated in foreign
currencies could be influenced by exchange rate
changes
• Discuss the impact of the operating exposure on
firms’ expected cash flows in different time horizons
• Illustrate the operating exposure by a case of the
hypothetical firm, Trident Germany
• Discuss how to manage operating exposure
12-2
Definition and Attributes
of Operating Exposure
12-3
Definition of Operating Exposure
• Operating exposure, also called economic exposure,
competitive exposure, or strategic exposure,
measures any change in the present value of a firm
resulting from changes in future operating cash flows
caused by any unexpected change in exchange rates
• Therefore, operating exposure analysis accesses the
impact of changing exchange rates on a firm’s
operations over the following years and on its
competitive position vis-à-vis other firms
• The goal of operating exposure analysis is to identify
possible strategic actions or operating techniques that
the firm might adopt to enhance its market value for
unexpected exchange rate changes
12-4
Attributes of Operating Exposure
• Measuring the operating exposure of a firm requires
forecasting and analyzing the firm’s future foreign
exchange exposures together with the future foreign
exchange exposures of all the firm’s competitors and
potential competitors
– The response to the exchange rate changes from competitors
could affect the relative competitiveness of market participants
• Future exchange rate changes not only alter the
domestic currency value of the firm’s foreign
currency cash flows, but also change the quantity of
foreign currency cash flows
– The change of the quantity of foreign currency cash flows may
due to the change of the competiveness of the firm in various
market worldwide
– For transactions exposure, the quantity of foreign currency
remains unchanged
12-5
Attributes of Operating Exposure
• From a broader perspective, operating exposure is not
just the sensitivity of a firm’s future cash flows to
unexpected changes in foreign exchange rates, but
also to other key macroeconomic variables
– Taking a car producer for example, not only exchange rates
but also interest rates and various prices affect the
competitiveness and thus future operating cash flows
• A depreciating domestic dollar will enhance the firm’s
competitiveness and improve its cash flows worldwide
• A reduction in interest rates in foreign countries improves the
firm’s cash flows due to increased demand for its cars
• A increase in product prices of competitors located in foreign
countries will improve the firm’s cash flow
※Since exchange rates are highly associated with other
macroeconomic variables, the combined effect of exchange
rates and other macroeconomic variables should be
considered
12-6
Attributes of Operating Exposure
• The cash flows of the MNE can be divided into
operating cash flows and financing cash flows
• Operating cash flows arise from intercompany
(between unrelated companies) and intracompany
(between parent company and subsidiaries)
receivables and payables, rent and lease payments,
royalty and license fees, and management fees
• Financing cash flows are payments for intercompany
and intracompany loans (principal and interest) and
stockholder equity (new equity investments and
dividends)
• Intracompany cash flow possibilities are summarized
in Exhibit 12.1
12-7
Exhibit 12.1 Financial & Operating Cash
Flows Between Parent & Subsidiary
12-8
Attributes of Operating Exposure
• Operating exposure is far more important for the
long-run health of a business than changes caused
by transaction or accounting exposure
• Operating exposure is inevitably subjective,
because it depends on the views to estimate future
cash flow changes over an arbitrary time horizon
• Planning for operating exposure is a total
management responsibility because it depends on
the interaction of strategies in finance, marketing,
purchasing, and production
12-9
Attributes of Operating Exposure
• An expected change in foreign exchange rates is not
included in the definition of operating exposure
– This is because both the management and investors should
have factored this information into their evaluation of
anticipated operating results and market value of the firm
• For the management, the forward rate can be used
when preparing the operating budgets, rather than
assume that the spot rate would remain unchanged
• From investors, if the foreign exchange market is
efficient, information about expected changes in
exchange rates should be already reflected in a firm’s
market value
• Only unexpected changes in exchange rates should
cause market value of a firm to change
12-10
Impact of the Operating
Exposure
1211
Impact of Operating Exposure
• An unexpected change in exchange rates impacts a
firm’s expected cash flows at four levels, depending on
different time horizons:
– Short run (< 1 year)
• It is difficult to change sales prices or renegotiate factor costs
• Since the quantity of realized foreign currency will not change
substantially, its value in domestic dollars will differ from those
expected in the budget only due to different exchange rates
– Medium run (2-5 years): Equilibrium case
• If parity conditions hold among exchange rates, national inflation
rates, and national interest rates, the firm should be able to adjust
prices and factor costs over time to maintain the expected level of
cash flows
• For instance, if id – if = –4%, according to the international Fisher
effect, the domestic currency will appreciate by 4%, the firm can
increase product prices in foreign currency by 4% and thus will
receive the same expected cash flows at the end of this year
12-12
Impact of Operating Exposure
• If equilibrium exists continuously and a firm is free to adjust its
prices and costs to maintain its expected competitive position in
that industry, the firm’s operating exposure may be zero
• If the firm is unable to adjust operations to the new competitive
environment, the firm would experience operating exposure
– Medium run (2-5 years): Disequilibrium case
• Under disequilibrium condition, the firm may not be able to
adjust prices and costs in advance to reflect the new competitive
realities caused by a change in exchange rates
• Thus the firm’s realized cash flows will differ from its expected
cash flows, so the firm’s value today may change due to the
unanticipated results in exchange rates
– Long run (> 5 years)
• Since all firms have foreign exchange operating exposure, their
adjustments in prices and costs to reflect exchange rate changes
will affect the relative competitiveness among them
• A firm’s cash flows will be influenced by the reactions of existing
and potential competitors to exchange rate changes
12-13
Operating Exposure:
Trident Corporation
1214
Illustration of Operating Exposure:
Trident Corporation
• Trident corporation, is a hypothetical U.S.-based
MNE with headquarters in Los Angeles, and it has
100%-owned manufacturing, sales, and service
subsidiaries in Hamburg, Germany
• Exhibit 12.2 on the next slide presents the dilemma
facing Trident as a result of an unexpected change in
the value of the euro, which is the currency of
economic consequence for the German subsidiary
• More specifically, there is concern over how the
subsidiaries revenues (prices and volumes in euro
terms), costs (input costs in euro terms), and
competitive landscape will change with a fall in the
value of the euro
12-15
Exhibit 12.2 Trident Corporation
and Trident Germany
※ An unexpected depreciation or appreciation in the value of the euro alters both the
competitiveness of the subsidiary and the financial results which are consolidated with
the parent company
1-16
Illustration of Operating Exposure:
Trident Corporation
• The basic information about Trident Germany
– It uses European material and labor to produce
– Half of production is sold within Europe for euros, and half
is exported to non-European countries, but all sales are
invoiced in euros
– Accounts receivable are equal to one-fourth of annual sales
– Inventory is equal to 25% of annual direct costs
– It can expand or contract production volume without any
significant change in per-unit direct costs or in overall
general and administrative expenses
– Depreciation on plant and equipment is €600,000 per year
– The corporate income tax in Germany is 34%
– The cost of capital for Trident Germany is 20% (to calculate
the present value of the change of future operating cash
flows)
12-17
Illustration of Operating Exposure:
Trident Corporation
• Operating exposure depends on whether an unexpected
change in exchange rates causes unanticipated changes
in sales volume, sales prices, or operating costs
• Possible actions adopted by Trident Germany if the
exchange rate depreciates from $1.2/€ to $1.0/€:
– Since competing imported products are now priced higher in
Europe zone and products of Trident Germnay are now
cheaper in non-European countries,
• if Trident Germany maintains constant sales prices  the sales
volume will increase both domestically and internationally
• depending on the management’s opinion about the price
elasticity of demand, Trident Germany might choose to raise
product prices in euros. If the competitive position of Trident
Germany can maintain the same, it is possible to have little
influence on the market share of Trident Germany
12-18
Illustration of Operating Exposure:
Trident Corporation
– On the cost side, the increase of the price level in Germany
might raise the cost of Trident Germany,
• because of more expensive imported raw material or
components
• because labor is now demanding higher wages to compensate
for inflation in Germany
– In practice, the favorable effect of a euro depreciation on
comparative prices (appears in the shorter term) will not be
immediately offset by higher domestic inflation (appears in
the longer term)
12-19
Illustration of Operating Exposure:
Trident Corporation
• Three possible scenarios on Trident Germany’s
operating exposure for the depreciation from $1.2/€ to
$1.0/€
– Case 1: no change in other variables
– Case 2: increase in sales volume; other variables remain
constant
• The sales price is kept constant in euro terms, because
management of Trident Germany has not observed any change
in local German operating costs or because it sees an
opportunity to increase market share
– Case 3: increase in sales price; other variables remain
constant
• Assume that the euro sales price is raised from €12.8 to €15.36
per unit to maintain the same U.S. dollar-equivalent price
• The expected cash flow statements of the three cases
for the future 5 years are shown in Exhibit 12.3
12-20
Exhibit
12.3
The investment in inventory
is still $2,400,000, because
annual direct costs will not
change
A double sales volume will
require additional
investment in accounts
receivable and in inventory
$3,418,200 – $640,000
$3,840,600 – $5,600,000
※ In fact, there are infinitely
many combinations of
volume, price, and cost
following the depreciation.
Here are just three
examples to show how to
measure the operating
exposure
At the end of
the fifth year
(2015), the
cash
outflows for
working
capital
should be
recaptured
12-21
Management of the
Operating Exposure
12-22
Strategic Management of
Operating Exposure
• The objective of operating exposure management is
to anticipate and neutralize the impact of unexpected
changes in exchange rates on a firm’s future cash
flows
• To meet this objective, management can diversify
the firm’s operating and financing base
– Diversifying operating base means diversifying sales,
location of production facilities, and raw material sources
– Diversifying the financing base means raising funds in
more than one capital market and in more than one
currency
※Once the international diversification is achieved, the firm
can adopt different operating or financing strategies to
manage the operating exposure
12-23
Strategic Management of
Operating Exposure
• If a firm’s operations are diversified internationally,
management is prepositioned both to recognize
disequilibrium when it occurs and to react
competitively
– That is, for MNEs, management can recognize disequilibrium
by comparing the data from subsidiaries in different countries
• Recognizing a temporary change in worldwide
competitive conditions permits management to make
changes in operating strategies
– Management might make marginal shifts in sourcing raw
materials, capacity of production, or the marketing effort in
different markets to manage operating exposure
– E.g., the marketing effort can be strengthened in export
markets where the firm faces more price competitive due to
exchange rate changes
12-24
Strategic Management of
Operating Exposure
• Even if management does not actively distort normal
operations when exchange rates change,
– the variability of the MNE’s cash flows can be reduced by
international diversification of its production, sourcing, and
sales because exchange rate changes are likely to increase
the firm’s competitiveness in some markets while
reducing it in others
• Due to the inability of diversifying operations
internationally, 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
12-25
Strategic Management of
Operating Exposure
• If a firm’s financing sources are diversified, it will be
prepositioned to take advantage of temporary deviations
from the international Fisher effect
– More specifically, if interest rate differentials do not equal
expected change in exchange rates, opportunities to lower a
firm’s cost of capital will exist
– However, to switch financing sources, a firm must already be
well-known in the international capital market
• Ch14 will demonstrate that diversifying sources of
financing, regardless of the currency of denomination,
can lower a firm’s cost of capital and increase its
availability of capital
– But this would not be an option for a domestic firm that has
limited its financing to one capital market
12-26
Strategic Management of
Operating Exposure
• International diversification not only is useful for
foreign exchange risk management but also has
potentially favorable impact on other risks as well
– It could reduce the variability of future cash flows due to
domestic business cycles, provided that these are not
perfectly correlated with international cycles
– It could diversify political risks of individual countries
– It could reduce portfolio risk in the context of the capital
asset pricing model
12-27
Proactive Management of
Operating Exposure
• Operating exposure (as well as transaction exposure)
can be partially managed by adopting operating or
financing policies that offset anticipated foreign
exchange exposures
• The six most commonly employed proactive (前瞻
性、預測性) policies are:
1. Matching currency cash flows
2. Risk-sharing agreements
3. Back-to-back or parallel loans
4. Currency swaps
5. Leads and lags
6. Reinvoicing center
※The above policies are also called the operating hedge
methods mentioned in Ch11
12-28
Proactive Management of
Operating Exposure
• Here an example is considered, in which a U.S. firm
has continuing export sales to Canada
• In order to compete effectively in Canadian markets,
the firm invoices all export sales in Canadian dollars
• This policy results in a continuing receipt of Canadian
dollars month after month
• This endless series of transaction exposures could be
continually hedged with forwards or other contractual
agreements, as discussed before
• If the firm does not want to actively manage the
exposure with contractual financial instruments, can
the firm seek out a continual use, an outflow, for its
continual inflow of Canadian dollars?
12-29
Proactive Management of
Operating Exposure
1. Matching currency cash flows
– First and the most common way is the use of the financial
hedge to offset an anticipated continuous operating exposure
by acquiring part of the firm’s debt-capital in that currency
(see Exhibit 12.4)
• This form of hedging is effective in eliminating currency risk
when the exposed cash flow is relatively constant and
predictable over time
– Another alternative would be for the U.S. firm to seek out
potential suppliers of raw materials or components in Canada
as a substitute for U.S. or other foreign firms
• If the receivable and payable cash flows were roughly the same
in magnitude and timing, this strategy forms a natural hedge
– A third alternative for the company is to engage in currency
switching, in which the U.S. firm would pay foreign suppliers
(e.g., Mexican) with Canadian dollars
12-30
Exhibit 12.4 Matching: Debt Financing
as a Financial Hedge
1-31
Proactive Management of
Operating Exposure
2. Risk-sharing agreements
– An alternate method for managing a long-term cash flow
exposure between firms is via risk sharing agreement
– 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 smoothes the impact of volatile and
unpredictable exchange rate movements on both parties
– The example for Ford and Mazda
• Ford imports automotive parts form Mazda, so swings in
exchange rates can benefit one party at the expense of the other
• One risk-sharing solution is that if the EX rate on the payment
date is between ￥115/$ and ￥125/$, Ford pays at that EX rate,
but if the EX rate falls outside this range on the payment date,
Ford and Mazda will share the difference equally
• That is, for ￥110/$ (￥130/$), the effective exchange rate for
12-32
Ford will be ￥112.5/$ (￥127.5/$)
Proactive Management of
Operating Exposure
3. Back-to-Back 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
– The structure of a typical back-to-back loan for parentsubsidiary cross-border financing is in Exhibit 12.5
– The default risk is minimized, because each loan can be viewed
as the cash collateral in the event of default for the other loan
• A further agreement can provide to maintain principal parity, e.g., if ￡
dropped by 6% for as long as 30 days, the British parent firtmmight have
to advance additional pounds to the Dutch subsidiary to bring the
principal value of the two loans back to parity
– However, it is difficult for a firm to find a partner, termed a
counterparty, for the desired currency amount and timing
– So, it causes the development of the currency swap
12-33
Exhibit 12.5 Using a Back-to-Back
Loan for Currency Hedging
※ At an agreed terminal date, both subsidiaries return the borrowed currencies
※ Thus, the back-to-back loan provides a method for parent-subsidiary crossborder financing without incurring direct currency exposure
12-34
Proactive Management of
Operating Exposure
4. Currency Swaps (or Cross Currency Swap, CCS):
– 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 time period
– For a Japanese (American) corporation, it exports to the U.S.
(Japan) and earns U.S. dollars (Japanese yen), the cross
currency swap is illustrated in Exhibit 12.6
– Swap dealer arrange most swap on a blind basis, meaning that
the initiating firm does not know its counterparty
– A currency swap is similar to a back-to-back loan except that it
does not affect the capital structure in the balance sheet
• Accountants in the U.S. treat the currency swap as a foreign
exchange transaction rather than as a debt and treat the
obligation to pay back the principal at maturity as a forward
exchange contract, which are entered into a firm’s footnotes
rather than as balance sheet items
• Thus, there is no translation exposures for CCS
12-35
Exhibit 12.6 Using a Cross Currency
Swap to Hedge Currency Exposure
※ Initially, Japanese corporation (U.S. corporation) pays yen principal (dollar
principal) and receives dollar principal (yen principal)
※ During the contract period, Japanese firm can “pay dollars” and “receive yen”
※ At the end of the cross currency swap, they return the dollar and yen principal
to each other
12-36
Proactive Management of
Operating Exposure
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 (lag) is to pay or receive earlier (later)
– A firm that holds the soft (hard) currency and has debts in
hard (soft) currency will lead (leg) by using the soft (hard)
currency to pay the hard (soft) currency debts as soon (late)
as possible
• Soft (hard) currency indicates the currency that is inclined to
depreciate (appreciate)
– For receivables, on the contrary, firms tend to collect soft
foreign currency receivables early and collect hard foreign
currency receivables later
– Leading or lagging payments will change the cash position
of one firm, with the reverse effect on the other firm
12-37
Proactive Management of
Operating Exposure
– Intercompany leads and lags is difficult to be achieved,
because the time preference of one firm imposes the
detriment of the other firm
– Intracompany leads and lags is more feasible as related
companies presumably embrace a common set of goals for
the consolidated group
– Because the use of leads and lags can both minimize foreign
exchange exposure and shift the burden of financing, many
governments impose restrictions on the allowed range
• E.g., the restriction of180-day lag on trade receivables: after 180 days,
the receivables should be classified as noncollectable receivables
12-38
Proactive Management of
Operating Exposure
6. Reinvoicing centers:
– A recivoicing center is a separate corporate subsidiary that
serves as a type of “middleman” among the parent company
and all foreign subsidiaries
– Manufacturing subsidiaries sell goods to distribution
subsidiaries by selling first to a reinvoicing center, which in
turn resells to the distribution subsidiary, and all
subsidiaries trade with the reinvoicing center with their
domestic currencies (see Exhibit 12.7)
12-39
Exhibit 12.7 Use of a Reinvoicing
Center
12-40
Proactive Management of
Operating Exposure
– Benefits from the creation of a reinvoicing center:
• Managing foreign exchange exposure centrally
– This center allows the management of all foreign exchange
transaction exposure for intracompany sales to be located in one
place
– Reinvoicing center can focus on developing a specialized expertise
to hedge foreign exchange exposure
• Guaranteeing the exchange rate for future orders
– The reinvoicing center can set local currency prices or costs in
advance such that subsidiaries can make bids for final customers
in advance
– Manufacturing (sales) subsidiaries can focus on their
manufacturing (marketing) activities and their performance is
judged without distortion from exchange rate changes
• Managing intrasubsidiary cash flows, e.g., leads and lags of
payment
12-41
Proactive Management of
Operating Exposure
– Disadvantages for a reinvoicing center:
• Additional expense for a firm and high initial setup cost
– Due to one additional corporate unit created and the costs of
personnel to operate the reinvoicing center, it will increase the
expense for a firm
– In addition, the initial setup cost is high because all existing orderprocessing procedures must be reprogrammed
• To bring increased scrutiny by tax authorities
– Since the reinvoicing center will have an impact on the tax status
and customs duties of all subsidiaries, it will attract more focus
from tax authorities to ensure that it is not functioning as a tax
haven
• A variety of professional costs will be incurred for tax and legal
advice
12-42
Proactive Management of
Operating Exposure
• Some MNEs now attempt to hedge their operating
exposure with contractual hedges
• Merck and Eastman Kodak have undertaken longterm currency option positions hedges designed to
offset lost earnings from adverse exchange rate
changes
• The possibilities to hedge the “unhedgeable”
operating cash flows are dependent on two abilities:
– The ability to predict the firm’s future cash flows
– The ability to predict the firm’s competitor’s responses to
exchange rate changes
12-43
Proactive Management of
Operating Exposure
• Merck example
– Merck, as a U.S.-based pharmaceutical exporter, is capable of
making the prediction of long-run revenues, because the
product prices are often regulated by governments and
relatively predictable
– The research-oriented feature lets it highly centralized for
production, operation, and financing
– Due to the fact that operation or financing diversifications are
difficult to achieve, Merck purchases long-term put options
on foreign currencies versus the US$ as insurance against
potential loss from exchange rate changes
– If a firm wishes to insure the net earnings from exchange
rate-induced losses, the option position would be smaller than
a position attempting to replace gross sales revenues, i.e., it
is cheaper to hedge only for the net earnings
12-44