1. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. Chapter 9 Operating Exposure

2. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-2 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.

3. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-3 Attributes of Operating Exposure Measuring the operating exposure of a firm requires forecasting and analyzing all the firm’s future individual transaction exposures together with the future exposures of all the firm’s competitors and potential competitors worldwide. 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 its sensitivity to other key macroeconomic variables. This factor has been labeled macroeconomic uncertainty.

4. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-4 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 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

5. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-5 Financial Cash Flows Operational Cash Flows Subsidiary Payment for goods & services Rent and lease payments Royalties and license fees Management fees & distributed overhead Dividend paid to parent Parent invested equity capital Interest on intrafirm lending Intrafirm principal payments Parent Exhibit 9.1 Financial & Operating Cash Flows Between Parent & Subsidiary

6. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-6 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 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.

7. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-7 Attributes of Operating Exposure 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 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.

8. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-8 Measuring the Impact of Operating Exposure An unexpected change in exchange rates impacts a firm’s expected cash flows at four levels, depending on the time horizon used: –Short run –Medium run: Equilibrium case –Medium run: Disequilibrium case –Long run

9. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-9 Measuring the Impact of Operating Exposure The following slide presents the dilemma facing Carlton, Inc. as a result of an unexpected change in the value of the euro, the currency of economic consequence for the German subsidiary. There is concern over how the subsidiaries revenues (price 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.

10. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-10 Carlton, Inc. (Palo Alto, CA, USA) Carlton Germany (Munich, Germany) An unexpected depreciation in the value of the euro alters both the competitiveness of the subsidiary and the financial results which are consolidated with the parent company. Carlton’s SuppliersCarlton’s Customers US$ Reporting Environment Euro Competitive Environment US$/€ Will prices and sales volume change? How much? Will costs change? How will the sales, costs, and profits of the German subsidiary change? Will the altered profits of the German subsidiary, in euro, translate into more or less in US dollars? Exhibit 9.2 Carlton, Inc. and Carlton Germany

11. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-11 Measuring the Impact of Operating Exposure Carlton Germany: –Case 1: Devaluation, 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.

12. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-12 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.

13. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-13 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. 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.

14. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-14 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. 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).

15. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-15 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 six most commonly employed proactive policies are: –Matching currency cash flows –Risk-sharing agreements –Back-to-back or parallel loans –Currency swaps –Leads and lags –Reinvoicing center

16. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-16 Proactive Management of Operating Exposure In this example, a US 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.

17. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-17 U.S. Corporation Canadian Corporation (buyer of goods) Exports goods to Canada Payment for goods in Canadian dollars Principal and interest payments on debt in Canadian dollars Canadian Bank (loans funds) US Corp borrows Canadian dollar debt from Canadian Bank Exposure: The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollars Hedge: The Canadian dollar debt payments act as a financial hedge by requiring debt service, an outflow of Canadian dollars Exhibit 9.4 Matching: Debt Financing as a Financial Hedge

18. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-18 Proactive Management of Operating Exposure Matching currency cash flows. –One way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching). –Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms. –In addition, the company could engage in currency switching, in which the company would pay foreign suppliers with Canadian dollars.

19. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-19 Proactive Management of Operating Exposure Currency Clauses: Risk-Sharing: –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.

20. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-20 Proactive Management of Operating Exposure 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. –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.

21. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-21 British parent firm British firm’s Dutch subsidiary 1. British firm wishes to invest funds in its Dutch subsidiary Dutch parent firm Dutch firm’s British subsidiary 2. British firm identifies a Dutch firm wishing to invest funds in its British subsidiary The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure. Indirect Financing 3. British firm loans British pounds directly to the Dutch firm’s British subsidiary Direct loan in pounds 4. British firm’s Dutch subsidiary loans euros to the Dutch parent Direct loan in euros Exhibit 9.5 Using a Back-to-Back Loan for Currency Hedging

22. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-22 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).

23. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-23 Proactive Management of Operating Exposure Currency Swaps: –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.

24. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-24 Japanese Corporation United States Corporation Debt in US$ Assets Liabilities & Equity Debt in yen Assets Liabilities & Equity Both the Japanese corporation and the U.S. corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt. Swap Dealer Wishes to enter into a swap to “pay yen” and “receive dollars” Wishes to enter into a swap to “pay dollars” and “receive yen” Pay yen Receive dollars Receive yen Pay dollars Sales to US Inflow of US$ Sales to Japan Inflow of yen Exhibit 9.6 Using a Cross Currency Swap to Hedge Currency Exposure

25. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-25 Proactive Management of Operating Exposure 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. –Intracompany leads and lags is more feasible as related companies presumably embrace a common set of goals for the consolidated group. –Intercompany leads and lags requires the time preference of one independent firm to be imposed on another.

26. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-26 Proactive Management of Operating Exposure Reinvoicing Centers: There are three basic benefits arising from the creation of a reinvoicing center: –Managing foreign exchange exposure –Guaranteeing the exchange rate for future orders –Managing intrasubsidiary cash flows

27. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-27 Exhibit 9.7 Use of a Reinvoicing Center

28. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-28 Proactive Management of Operating Exposure 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

29. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-29 Mini-Case Questions: Porsche Exposed Do you believe the Porsche’s management is appropriately concerned with shareholder wealth? Does Porsche’s ownership structure work to the benefit or detriment of public shareholders? In your opinion, is Porsche’s current currency hedging strategy protecting it from adverse exchange rate changes? Will it work as well in the long run as in the short run? Evaluate the other hedging strategies available to the firm and compare and contrast alternatives.

30. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 1-30 Mini-Case Questions: Porsche Exposed (cont’d) Do you think that Porsche’s currency hedging strategy reflects a particular bias of management and ownership regarding shareholder value creation? Do you believe that Porsche can continue to predict the future movement of the euro?