Chapter 12 Operating Exposure Learning Objectives Examine how

Chapter 12 Operating Exposure

Learning Objectives • Examine how operating exposure arises in a multinational firm through unexpected changes in corporate cash flows • Analyze how to measure operating exposure’s impact on a business unit through the sequence of volume, price, cost, and other key variable changes • Evaluate strategic alternatives to managing operating exposure • Detail the proactive policies firms use in managing operating exposure 12 -2 © 2016 Pearson Education, Inc. All rights reserved.

Operating Exposure • Operating exposure, also called economic exposure, competitive exposure, and even strategic exposure, on occasion, measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates. • Ganado Corp. is a U. S. -based multinational firm. Exhibit 12. 1 shows Ganado’s basic structure and currencies of operation. 12 -3 © 2016 Pearson Education, Inc. All rights reserved.

Exhibit 12. 1 Ganado Corporation: Structure and Operations 12 -4 © 2016 Pearson Education,

Ganado Corporation Cash Flows • Operationally the functional currencies of the individual subsidiaries in combination determine the overall operating exposure of the firm in total. • Net operating cash flow is the source of value created by the firm over time • Ganado in Germany buys and sells in euros, Ganado U. S. buys and sells in dollars, but Ganado China has sales based in dollars, euros, and renminbi—the latter being the dominant cash flow for Ganado China 12 -5 © 2016 Pearson Education, Inc. All rights reserved.

Static versus Dynamic Operating Exposure • Measuring exchange rate exposure required analysis of short and intermediate term fixed or static) contracts, and longer term (more dynamic) forecasting • Using Ganado as an example, we have 3 divisions of roughly equal size and we assume the dollar is depreciating against the euro while the renminbi is slowly revaluing. – Ganado China: In the short-term, fewer profits, may need to raise prices in the long-term – Ganado Germany: No change in the short–term, may also be affected by eventual higher prices from China – Ganado U. S. : No change in the short–term, may also be affected by eventual higher prices from China 12 -6 © 2016 Pearson Education, Inc. All rights reserved.

Operating and Financing Cash Flows • 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 units of the same company) receivables and payables, rent and lease payments, royalty and license fees and assorted management fees. • Financing cash flows are payments for loans (principal and interest), equity injections and dividends of an inter and intracompany nature. • Exhibit 12. 2 summarizes cash flow possibilities for Ganado U. S. and China. 12 -7 © 2016 Pearson Education, Inc. All rights reserved.

Exhibit 12. 2 Financial and Operating Cash Flows Between Parent and Subsidiary 12 -8

Expected versus Unexpected Changes in Cash Flow • Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure. • However, operating exposure is inevitably subjective because it depends on estimates of 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 © 2016 Pearson Education, Inc. All rights reserved.

Expected versus Unexpected Changes in Cash Flow • An expected change in foreign exchange rates is not included in the definition of operating exposure, because both management and investors should have factored this information into their evaluation of anticipated operating results and market value. • From a manager’s 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 reflected in a firm’s market value. • Only unexpected changes in exchange rates, or an inefficient foreign exchange market, should cause market value to change. 12 -10 © 2016 Pearson Education, Inc. All rights reserved.

Measuring Operating Exposure • Exhibit 12. 3 shows how a change in exchange rates can impact expected cash flows at four levels: – Short Run – Medium Run (equilibrium) – Medium Run (disequilibrium) – Long Run 12 -11 © 2016 Pearson Education, Inc. All rights reserved.

Exhibit 12. 3 Operating Exposure’s Phases of Adjustment and Response 12 -12 © 2016

Measuring Operating Exposure: Ganado Germany • Exhibit 12. 4 presents the impact on the firm given an unexpected change in exchange rates. • Exhibit 12. 5 summarizes the current baseline forecast for Ganado Germany’s income and operating cash flows – Case 1: Depreciation, no change in any variable – Case 2: Increase in sales volume; other variables remain constant – Case 3: Increase in sales price; other variables remain constant – Case 4: Sales price, cost, and volume increase 12 -13 © 2016 Pearson Education, Inc. All rights reserved.

Exhibit 12. 4 Ganado and Ganado Germany 12 -14 © 2016 Pearson Education, Inc.

Exhibit 12. 5 Ganado Germany’s Valuation: Baseline Analysis 12 -15 © 2016 Pearson Education,

Ganado Germany, Case 4: Price, Cost, and Volume Increases • Exhibit 12. 6 is a combination of possible outcomes – 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 clearly 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 (after NWC increase), and € 2, 713, 590 for each of the following four years. • Ganado Germany’s present value is now $9, 018, 195. 12 -16 © 2016 Pearson Education, Inc. All rights reserved.

Exhibit 12. 6 Ganado Germany: Case 4— Sales Price, Volume, and Costs Increase 12

Measurement of Loss • Exhibit 12. 7 summarizes the change in Ganado’s German subsidiary value across our small set of simple cases from an instantaneous and permanent change in the value of the euro from $1. 20/€ to $1. 00/€. – Case 1: Ganado’s German subsidiary’s value falls by the percent change in the exchange rate, -16. 7%. – Case 2: Volume increased by 40% as a result of increasing price competitiveness, the German subsidiary’s value increased 22. 5%. – Case 3: The change in the exchange rate was completely passedthrough to a higher sales price, which resulted in a massive 66% increase in subsidiary value. – Case 4: The resulting change in subsidiary valuation of +24. 2% may be creeping toward a “realistic outcome. ” 12 -18 © 2016 Pearson Education, Inc. All rights reserved.

Exhibit 12. 7 Summary of Ganado Germany Value Changes to Depreciation of the Euro

Strategic Management of Operating Exposure • 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. 12 -20 © 2016 Pearson Education, Inc. All rights reserved.

Strategic Management of Operating Exposure • 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. 12 -21 © 2016 Pearson Education, Inc. All rights reserved.

Strategic Management of Operating Exposure • 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. • Again, this would not be an option for a domestic firm (if it has limited its financing to one capital market). 12 -22 © 2016 Pearson Education, Inc. All rights reserved.

Proactive Management of Operating Exposure • Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures. • The most commonly employed proactive policies include: – Matching currency cash flows – Risk-sharing agreements – Back-to-back or parallel loans – Cross-currency swaps – Contractual approaches 12 -23 © 2016 Pearson Education, Inc. All rights reserved.

Proactive Management of Operating Exposure • Matching Currency Cash Flows (Exhibit 12. 8) – 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. 12 -24 © 2016 Pearson Education, Inc. All rights reserved.

Exhibit 12. 8 Debt Financing as a Financial Hedge 12 -25 © 2016 Pearson

Proactive Management of Operating Exposure • 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. 12 -26 © 2016 Pearson Education, Inc. All rights reserved.

Proactive Management of Operating Exposure • Back-to-Back or Parallel Loans (Exhibit 12. 9) – 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. 12 -27 © 2016 Pearson Education, Inc. All rights reserved.

Exhibit 12. 9 Back-to-Back Loans for Currency Hedging 12 -28 © 2016 Pearson Education,

Proactive Management of Operating Exposure • 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). 12 -29 © 2016 Pearson Education, Inc. All rights reserved.

Proactive Management of Operating Exposure • Cross-Currency Swaps (Exhibit 12. 10) – 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. 12 -30 © 2016 Pearson Education, Inc. All rights reserved.

Exhibit 12. 10 Using Cross. Currency Swaps 12 -31 © 2016 Pearson Education, Inc.

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 12 -32 © 2016 Pearson Education, Inc. All rights reserved.