Ch12Managing Economic Exposure And Translation Exp

ManagingEconomicExposureAndTranslationExposure12ChapterSouth-Western/ThomsonLearning©2003C12-2ChapterObjectives•ToexplainhowanMNC’seconomicexposurecanbehedged;and•ToexplainhowanMNC’stranslationexposurecanbehedged.C12-3•Economicexposurereferstotheimpactexchangeratefluctuationscanhaveonafirm’sfuturecashflows.•Recallthatcorporatecashflowscanbeaffectedbyexchangeratemovementsinwaysnotdirectlyassociatedwithforeigntransactions.EconomicExposureC12-4•Exchangeratechangesareoftenlinkedtovariabilityinrealgrowth,inflation,interestrates,governmentalactions,…Ifmaterial,thechangesmaycausefirmstoadjusttheirfinancingandoperatingstrategies.•TheimportanceofmanagingeconomicexposurecanbeseenfromthecaseofthebankruptcyofLakerAirways,andfromthethe1997-98Asiancrisis.EconomicExposureC12-5•Afirmcanassessitseconomicexposurebydeterminingthesensitivityofitsexpensesandrevenuestovariouspossibleexchangeratescenarios.•Thefirmcanthenreduceitsexposurebyrestructuringitsoperationstobalanceitsexchange-rate-sensitivecashflows.•Notethatcomputerspreadsheetsareoftenusedtoexpeditetheanalysis.EconomicExposureC12-6•Restructuringmayinvolve:increasing/reducingsalesinneworexistingforeignmarkets,increasing/reducingdependencyonforeignsuppliers,establishingoreliminatingproductionfacilitiesinforeignmarkets,and/orincreasingorreducingthelevelofdebtdenominatedinforeigncurrencies.EconomicExposureC12-7•MNCsmustbeveryconfidentaboutthelong-termpotentialbenefitsbeforetheyproceedtorestructuretheiroperations,becauseofthehighcostsofreversal.EconomicExposureC12-8ManagingMadisonInc.’sEconomicExposure(inMillions)C$=$.75C$=$.80C$=$.85Sales:(1)U.S.$300.00$304.00$307.00(2)CanadianC$4=3.0C$4=3.20C$4=3.40(3)Total$303.00$307.20$310.40Costofgodssold:(4)U.S.$50.00$50.00$50.00(5)CanadianC$200=150.00C$200=160.00C$200=170.00(6)Total$200.00$210.00$220.00(7)Grossprofit$103.00$97.20$90.40Operatingexpenses:(8)U.S.-Fixed$30.00$30.00$30.00(9)U.S.-Variable30.3030.7231.04(10)Total$60.30$60.72$61.04(11)EBIT$42.70$36.48$29.36Interestexpense:(12)U.S.$3.00$3.00$3.00(13)CanadianC$10=7.50C$10=8.00C$10=8.50(14)Total$10.50$11.00$11.50(15)EBT$32.20$25.48$17.86C12-9ManagingMadisonInc.’sEconomicExposure•TheamountofMadison’searningsbeforetaxesisinverselyrelatedtothestrengthoftheCanadiandollar,sincethehigherexpensesmorethanoffsetthehigherrevenue.•MadisonmayreduceitsexposurebyincreasingCanadiansales,reducingordersofCanadianmaterials,and/orborrowinglessfromCanadianbanks.C12-10•TranslationexposureresultswhenanMNCtranslateseachsubsidiary’sfinancialdatatoitshomecurrencyforconsolidatedfinancialreporting.•Translationexposuredoesnotdirectlyaffectcashflows,butsomefirmsareconcernedaboutitbecauseofitspotentialimpactonreportedconsolidatedearnings.TranslationExposureC12-11•AnMNCmayattempttoavoidtranslationexposurebymatchingitsforeignliabilitieswithitsforeignassets.•Tohedgetranslationexposure,forwardorfuturescontractscanbeused.Specifically,anMNCmaysellthecurrencythatitsforeignsubsidiaryreceiveasearningsforward,thuscreatinganoffsettingcashoutflowinthatcurrency.TranslationExposureC12-12•Forexample,aU.S.-basedMNCthatisconcernedaboutthetranslatedvalueofitsBritishearningsmayenteraone-yearforwardcontracttosellpounds.•Ifthepounddepreciatesduringthefiscalyear,thegaingeneratedfromtheforwardcontractpositionwillhelptooffsetthetranslationloss.TranslationExposureC12-13•Hedgingtranslationexposureislimitedby:¤inaccurateearningsforecasts,¤inadequateforwardcontractsforsomecurrencies,¤accountingdistortions(thechoiceofthetranslationexchangerate,taxes,etc.),and¤increasedtransactionexposure(duetohedgingactivities).TranslationExposureC12-14•Inparticular,iftheforeigncurrencydepreciatesduringthefiscalyear,thetransactionlossgeneratedbyaforwardcontractpositionwillsomewhatoffsetthetranslationgain.•Notethatthetranslationgainissimplyapapergain,whilethelossresultingfromthehedgeisarealloss.TranslationExposureC12-15•Perhaps,thebestwayforMNCstodealwithtranslationexposureistoclarifyhowtheirconsolidatedearningshavebeenaffectedbyexchangeratemovements.TranslationExposureC12-16•TheannualreportsformanyMNCsmaybefoundat’hedgingofeconomicand/ortranslationexposures.OnlineApplicationC12-17ImpactofHedgingEconomicExposureonanMNC’sValuenttmjtjtjk1=1,,1ERECFE=ValueE(CFj,t)=expectedcashflowsincurrencyjtobereceivedbytheU.S.parentattheendofperiodtE(ERj,t)=expectedexchangerateatwhichcurrencyjcanbeconvertedtodollarsattheendofperiodtk=weightedaveragecostofcapitaloftheparentHedgingDecisionsonEconomicExposureC12-18•ManagingEconomicExposure¤AssessingEconomicExposure¤ReducingEconomicExposurethroughRestructuring¤IssuesInvolvedintheRestructuringDecisionChapterReviewC12-19ChapterReview•ManagingTranslationExposure¤UseofForwardContractstoHedgeTranslationExposure¤LimitationsofHedgingTranslationExposure¤AlternativeSolutiontoHedgingTranslationExposure•HowEconomicExposureManagementAffectsanMNC’sValue