Lecture Multinational financial management: Lecture 12 - Dr. Umara Noreen

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.

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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.

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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
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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.

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

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

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Economic Exposure Based on the Original
and Proposed Operating Structures

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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.
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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.
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How to Restructure Operations
to Balance the Impact of Currency Movements
on Cash Inflows and Outflows
Type of
Operation

Recommended Action When a Foreign
Currency Has a Greater Impact on
Cash Inflows

Cash Outflows

Sales in foreign
currency units

Reduce foreign
sales

Increase foreign
sales

Reliance on
foreign supplies

Increase foreign
supply orders

Reduce foreign
supply orders

Proportion of
foreign debt

Restructure debt
to increase debt
payments in
foreign currency

Restructure debt
to reduce debt

payments in
foreign currency
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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.
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Assessment of
Savor Co.’s Cash Flows and the Euro’s Movements

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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.
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A Case Study in
Hedging Economic Exposure
Assessment of Each Unit’s Exposure:
% UnitCashFlowt =
Unit
A
B
C

a0 + a1% eurot +

t

Slope Coefficient
R-squared Statistic
Not significant
6.8%
Not significant

6.7%
Statistically significant
93%

Unit C is exposed to the euro’s
movements.
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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.
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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.
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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.

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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.
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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.

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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.

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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.
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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.
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