1. FX Value Exposure Dr. Himanshu Joshi

2. FX Value Exposure.. The Intrinsic value of a firm’s operations (intrinsic V 0 ) is defined as the present value of the firm’s expected future after tax operating cash flow stream, using the firm’s cost of capital as the discount rate. We will simplify the analysis at this stage by assuming that the future cash flow stream is a perpetuity. For a perpetuity Value = C/r

3. FX Value Exposure.. FX changes cause changes in the intrinsic value of the firm’s operations through their impact on the expected stream of the firm’s future after tax operating cash flows. A firm’s operating cost does not change as the FX rate changes. However, cost of capital is not independent of FX operating exposure, we will discuss this in detail later..

4. FX Value Exposure.. For simplicity, we will assume that when FX rate change, our expectation of the level of the future operating cash flow stream changes be the same percentage as the change in the current operating cash flows. Because of this assumption and because the cost of capital does not change as the FX rate changes, the intrinsic value of the firm’s operations changes by the same percentage as the operating cash flow, given the FX change.

5. FX Value Exposure.. Thus a firm’s FX value exposure to the pound, denoted by Ę V£ $, is the elasticity of a firm’s intrinsic value V 0 $ to changes in the FX value of the pound, is equal to its FX operating exposure: Ę V£ $ = Ę O£ $ note that: the equality between FX value exposure and FX operating exposure does not depend upon our simplifying assumption of a level perpetual expected cash flows stream. For example, the above equation will hold even if the cash flow stream is expected to grow.

6. FX Value Exposure Example.. Suppose a US firm currently has an operating cash flow stream of $1000 per year into perpetuity and has a cost of capital of 10%. Thus the intrinsic value of the firm’s operations is $10,000. assume further that the firm’s FX operating exposure to the British pound, Ę O£ $ = 1.20. next assume that pounds depreciates by 15%.

7. Question.. Suppose a US firm currently has an expected perpetual operating cash flow stream of $100 per year, a cost of capital of 10%. Assume further that the firm’s FX operating exposure to the British pound is, Ę O£ $ =.90. next assume that the pound appreciates by 10%. Find the FX value exposure and the new intrinsic value of the firm’s operations.

8. FX Value Exposure.. EPF Example…

9. FX Value Exposure.. The intrinsic value of a firm equals the value of debt plus the intrinsic value of equity. V $ = D $ + S $ Where V $ = Value of the Firm S $ = I.Value of Firm’s equity D $ = Value of its debt..

10. Should Intrinsic Value of Equity be same as Intrinsic Value of Firm? S $ = V $ - D $ Until stated otherwise, we assume that the intrinsic value of the firm is same as intrinsic value of its operations. Or V $ o = V $. Some times V $ o < V $. If the firm has financial assets in addition to the operating assets..

11. How Do FX changes affect the Value of a Firm’s Debt? The Answer depends upon the currency denomination of the debt. If debt is denominated in the firm’s base currency, and FX change will not affect the value of its debt. If debt is denominated in a foreign currency, there will be an impact of the FX change on the value of debt in US dollars. The impact of FX changes on the US dollar value of foreign currency debt is one-for-one, that is, a pure FX conversion effect.

12. How Do FX changes affect the Value of a Firm’s Debt? An Example: Assume that a firm currently has £ 6,25,000 in pound denominated debt, and the spot FX rate is 1.60 $/£. Assume that pound appreciates by 20% to 1.92 $/£. D $ = £ 6,25,000 * 1.60$/£ = $ 1 million. The value of firm’s debt will also increase by 20%, to $1.2 million.. By itself, the $2,00,000 increase in the value of pound denominated debt is a loss to shareholders. We have learned that foreign currency debt functions as a hedge against FX fluctuation??

13. How Do FX changes affect the Value of a Firm’s Debt? An Example: Of course, if the debt is used is serving as a hedge, the stockholders will also gain from an increase in the value of the firm…

14. FX Equity Exposure.. A firm’s FX equity exposure is defined to be the elasticity of the firm’s intrinsic stock value to FX changes, viewed from the perspective of the firm’s base currency. Ę S£ $ = %∆ S $ / %∆ X $/£

15. FX Equity Exposure.. Three elements determine a firm’s FX equity exposure to a currency: (1)The firm’s FX Value or FX operating Exposure. (2)The financial leverage. (3)The relative amount of debt denominated in the FX operating exposure currency.

16. FX Equity Exposure.. Example.. Assume that a US firm XYZ Company has an operating exposure (and thus FX value exposure) of 1.20 to the euro, the intrinsic value of the firm in US dollars is V $ = $2000, and its overall debt value in US dollar is D $ = $600. Thus I.V of its equity S $ = $2000-$600 = $1400. Assume a 5% drop in the FX value of the euro. We compare two cases: 1.XYZ has no debt denominated in euros; 2.Half of XYZ’s debt is denominated in euros..

17. XYZ Company Intrinsic Value Balance Sheet: All debt is in US dollar Debt Case 1. A 5% drop in the FX value of the euro has resulted in a 6% drop in the firm’s Intrinsic value and 8.57% drop in the firm’s Stock’s Intrinsic value. The 8.57% decline in the equity value is a result of: 1.Drop in the value of firm 2.The firm’s financial leverage. 3.The fact that debt value does not change with FX change. Here firm’s FX equity exposure Ę S£ $ (1.71) > Firm’s FX value exposure Ę V£ $ (1.20)

18. XYZ Company Intrinsic Value Balance Sheet: Euro Debt and US dollar debt Case 2: A 5% drop in FX value of the euro has resulted into 6% drop in the value of the firm, and 7.5% drop in the value of firm’s equity. If 50% of its debt is denominated in exposure currency euro. Ę S£ $ = 1.50. which is less than 1.71 where all debt was $ denominated..

19. Case 3. if entire debt is Euro Denominated…

20. Equation… Ę S£ $ = Ę O£ $ - (D € $ /V $ ) 1 – (D $ /V $ ) Where D € $ = the value, measured in $, of firm’s euro denominated debt. And D $ = value of all the firm’s debt measured in US dollar, regardless of currency denomination..

21. Equation.. Ę S£ $ = Ę O£ $ - (D € $ /V $ ) 1 – (D $ /V $ ) The equation shows how both the FX hedging and financial leverage effects come into play. (D € $ /V $ ) more euro debt will tend to reduce the firm’s FX equity exposure to the euro than if non-euro debt is used. (D $ /V $ ), higher financial leverage, higher the FX equity exposure..

22. XYZ Example using Equation.. V $ =$2000, D $ = $600, S $ =$1400, D € $ = $300.

23. Question.. ABC company currently has V $ = $5000, D $ = $3000, and thus S $ =$2000. assume that ABC has an FX operating exposure of 1.60 to the euro. Assume that $2000 of the firm’s $3000 in debt is euro denominated debt and rest is US dollar debt. Assume that euro drops in FX value by 10%. Find the new Intrinsic value of ABC’s equity? Calculate FX equity exposure.

24. Hedging FX Value Exposure with Foreign Currency Debt Ę S£ $ = Ę O£ $ - (D € $ /V $ ) 1 – (D $ /V $ ) If a firm’s FX operating exposure to the euro is positive, you can see from the equation that if we put (D € $ /V $ ) = Ę O£ $ Ę S£ $ will be zero, (0). Thus, in this case it is possible to completely hedge FX operating Exposure solely with euro debt. If company has FX operating exposure to euro of.20, and it has euro-denominated debt in the amount of 20% of the Intrinsic value of the firm, the company has zero FX equity exposure to the euro.

25. Question.. ABC Company has currently V $ = $5000, D $ = $3000. assume an FX operating exposure of 0.30 to the euro. How much of ABC’s debt should be euro debt to eliminate the firm’s FX equity exposure to the euro?

26. Hedging FX Value Exposure with Foreign Currency Debt FX Operating Exposure to a currency may be relatively low, say.20 for a company with a relatively small proportion of its business in an overseas market. But other companies have higher FX operating exposures. A company with an FX operating exposure of 0.80 could in principle eliminate its FX equity exposure by having foreign currency debt in the amount of 80% of the firm’s intrinsic value. However, it may be unreasonable for a company to set its ratio of debt to intrinsic value ratio of 80%.. It is very high Financial leverage… When FX operating exposure is greater than 1 say 1.2, it makes no sense to consider a debt level higher than intrinsic value of the firm. Thus, there is a limitation to hedging FX exposure with foreign currency debt.

27. Hedging FX Value Exposure with Foreign Currency Debt The ultimate influence of foreign currency debt on a firm’s FX equity exposure depends upon the way the leverage and hedging effects interact, which depends in turn on the extent of the firm’s FX operating exposure or FX value exposure. One might think FX equity exposure would generally be lower if a company uses more exposure currency debt in its capital structure in place of its equity, and if FX operating exposure is positive. But this idea is correct only if FX operating exposure is less than 1. When FX operating exposure is greater than 1, FX equity exposure is always higher than FX value exposure. When FX operating exposure is greater than 1, the financial leverage effect dominates the FX hedging effect. The relationship between FX equity exposure and FX value Exposure is similar to what we found between FX NCF exposure and FX operating Exposure.

28. Hedging FX Value Exposure with Foreign Currency Debt Let’s extend the euro debt case of the XYZ Company where the FX equity exposure is 1.50, when firm starts with $300 euro debt. Assume that at time 0 (before any FX change), XYZ issues an additional euro debt for value $400 and uses the proceeds to repurchase equity, thinking that this additional euro debt will reduce the firm’s FX equity exposure to euro. Equity from $1400 to $1000 Debt from $ 600 (D $ $300 D € $ = $300) to now $1000.

29. Hedging FX Value Exposure with Foreign Currency Debt The operations of the firm, its operating cash flows and its Fx operating exposure to the euro all are unchanged by this purely financial transaction, and IV of XYZ remain $2000. As before, when FX value of euro drops by 5%, the IV of the firm drops by 5(1.20) = 6%. IV was $2000 (1-.06) = $1880. Now value of euro debt will drop by 5%. $700 (1-.05)=$665. New IV of equity = $1880-$665-$300 = $915 % change in stock Value change = $915/$1000 – 1 = -0.085 or 8.5% reduction… FX equity exposure is thus = -0.085/-.05 = 1.7…

30. Hedging FX Value Exposure with Foreign Currency Debt Thus by increasing its level of euro denominated debt in place of equity, the firm actually increases its FX equity exposure from 1.5 to 1.7.. The reason is impact of financial leverage dominates the impact of the euro debt’s FX hedging effect when the firm’s FX operating exposure is greater than 1.

31. Debt Maturity.. Assume that a US firm issues € 1000 of perpetual euro-denominated debt with a 5% coupon interest payment. Assume spot FX rate at the time of issue was $1/€, so the debt’s US dollar value is $1000. Now assume that at time 1 that the Spot FX rate is 1.20$/€. The firm must pay $60 to pay €50 interest. The firm’s euro debt now has a value of $1200.

32. Debt Maturity.. What if instead firm issues € 1000 of one year euro denominated debt with a 5% coupon int. payment? Again we assume spot FX rate of $1/€, so debt value in $ in $1000. Assume at time at FX rate is $1.2/€, Int = $60 and Value of debt = $1200. Assume that the firm can roll over the obligation, by again borrowing €1000 in one year at 5% interest. The proceeds of time 1 borrowing will be $1200. We can extend the reasoning through time.

33. FX Net Cash Flow Exposure vs. FX Equity Exposure While foreign currency debt will dampen both FX net cash flow exposure and FX equity exposure at the same time when FX operating exposure exceeds 0. However, the two exposures will generally be different given the same level of foreign debt. ITX case: Assume ITX has an FX operating exposure of 0.75. the expected operating cash flow is a level perpetuity of $1000 per year and the cost of capital is 10%.

34. FX Net Cash Flow Exposure vs. FX Equity Exposure Assume ITX has $7500 in British pound debt with a interest rate of 5%. The debt interest expense in US dollar is $375 per year. N $ = $1000-$375 = $625. If the pound depreciates by 20%. Its debt will also drop by 20% to $300.

35. FX Net Cash Flow Exposure vs. FX Equity Exposure Thus use of the pound debt make both FX NCF exposure and FX equity exposure lower than if US dollar debt is used. But there is no precise amount of pound debt that will make both NCF exposure and FX equity exposure = 0 simultaneously.. Firms may have to choose which is more important, reducing FX NCF exposure or FX Equity Exposure.

36. Unlevering Estimated FX Equity Exposure to FX Operating Exposure Ę O£ $ = Ę S£ $ * (1- D € $ /V $ ) + (D $ /V $ )