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Globalization and the Multinational Firm


									Managing Economic Exposure

    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.

  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.

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

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.

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.

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

Economic Exposure Based on the Original
and Proposed Operating Structures

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.                     11
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             12
How to Restructure Operations to Balance
the Impact of Currency Movements on Cash
Inflows and Outflows
                    Recommended Action When a Foreign
  Type of             Currency Has a Greater Impact on
  Operation           Cash Inflows       Cash Outflows
 Sales in foreign   Reduce foreign     Increase foreign
 currency units     sales              sales
 Reliance on        Increase foreign   Reduce foreign
 foreign supplies   supply orders      supply orders
 Proportion of      Restructure debt   Restructure debt
 foreign debt       to increase debt   to reduce debt
                    payments in        payments in
                    foreign currency   foreign currency
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.
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.      15
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
Use of Forward Contracts to
Hedge Translation Exposure
  – 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.                17
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.                           18
Limitations of Hedging
Translation Exposure
   Increased   transaction exposure
    – If the foreign currency appreciates
      during the fiscal year, the
      transaction loss generated by a
      forward contract position will
      somewhat offset the translation
    – The translation gain is simply a
      paper gain, while the loss resulting
      from the hedge is a real loss.         19

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