International Corporate Finance

March 22, 2011

Managing Operating Exposure
Chapter 12
Suggested Exercises: 1, 4, 6
 Operating Exposure

• Operating exposure 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.
• Also called:
– economic exposure,
– competitive exposure,
– strategic exposure.
 Operating & 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.
 Expected Versus Unexpected Changes in Cash
Flows
• An expected change in exchange rates is not included
in the definition of operating exposure
– Management and investors should have factored this into
their analysis of anticipated market value
• Management should use forward exchange rates
when preparing the operating budgets, rather than
assuming that the spot exchange rates will not change.
• Remember: Forward rate is an unbiased estimator of
future spot rates
• Therefore, only unexpected changes in exchange rates
should cause market value to change.
CASE STUDY: Trident Corporation and Its European Subsidiary:
Operating Exposure of the Parent and Its Subsidiary
 Trident Corporation and Its European Subsidiary:
Operating Exposure of the Parent and Its Subsidiary

Base Case:
• Trident Europe manufactures in Germany using European
material and labor.
• Half of its production is sold within Europe for euros and half is
exported to non-European countries.
• All sales are invoiced in euros.
• Accounts receivable are one-fourth of annual sales
– i.e. average collection period is 90 days.
• Inventory is equal to 25% of annual direct costs
• Depreciation on plant and equipment is Euro600,000 per year
• Corporate income tax is 34%
 Trident Corporation and Its European Subsidiary:
Operating Exposure of the Parent and Its Subsidiary
• On January 1, 2011, the Euro unexpectedly drops by
16.67% in value, from $1.2/ € to $1.0/ € .
• We need to predict: What will happen to the sales
volume, sales price, and operating costs?
– The answer will depend on Trident Europe’s, its customers’
and suppliers’ reaction to the devaluation.
• Case 1: No change in any variable
• Case 2: Sales volume in Europe and export volume double because
German-made telecom components are now more competitive
with imports (lower prices). Other variables remain constant
• Case 3: The Euro sales price increase from € 12.80 to € 15.36 to
maintain the same U.S. dollar-equivalent price (exchange rate pass
through). Other variables remain constant.
 BALANCE SHEET
End of Fiscal 2010

Assets Liabilities and net worth

Cash € 1,600,000 Accounts payable € 800,000

Accounts receivable 3,200,000 Short-term bank loan 1,600,000

Inventory 2,400,000 Long-term debt 1,600,000

Net plant and equipment 4,800,000 Common stock 1,800,000

Retained earnings 6,200,000

Sum € 12,000,000 Sum € 12,000,000

Important Ratios to be Maintained and Other Data

Accounts receivable, as percent of sales 25.00%

Inventory, as percent of annual direct costs 25.00%

Cost of capital (annual discount rate) 20.00%

Income tax rate 34.00%

 Base Case Case 1 Case 2 Case 3

Assumptions

Exchange rate, $/€ 1.2000 1.0000 1.0000 1.0000

Sales volume (units) 1,000,000 1,000,000 2,000,000 1,000,000

Sales price per unit € 12.80 € 12.80 € 12.80 € 15.36

Direct cost per unit € 9.60 € 9.60 € 9.60 € 9.60

Annual Cash Flows before Adjustments

Sales revenue € 12,800,000 € 12,800,000 € 25,600,000 € 15,360,000

Direct cost of goods sold 9,600,000 9,600,000 19,200,000 9,600,000

Cash operating expenses (fixed) 890,000 890,000 890,000 890,000

Depreciation 600,000 600,000 600,000 600,000

Pretax profit € 1,710,000 € 1,710,000 € 4,910,000 € 4,270,000

Income tax expense 581,400 581,400 1,669,400 1,451,800

Profit after tax € 1,128,600 € 1,128,600 € 3,240,600 € 2,818,200

Add back depreciation 600,000 600,000 600,000 600,000

Cash flow from operations, in euros € 1,728,600 € 1,728,600 € 3,840,600 € 3,418,200

Cash flow from operations, in dollars $ 2,074,320 $ 1,728,600 $ 3,840,600 $ 3,418,200

Adjustments to Working Capital for 2011 and 2015 Caused by Changes in Conditions

Accounts receivable € 3,200,000 € 3,200,000 € 6,400,000 € 3,840,000

Inventory 2,400,000 2,400,000 4,800,000 2,400,000

Sum € 5,600,000 € 5,600,000 € 11,200,000 € 6,240,000

Change from base conditions in 2011 € - € - € 5,600,000 € 640,000

 Year Year-End Cash Flows

1 (2011) $ 2,074,320 $ 1,728,600 $ (1,759,400) $ 2,778,200

2 (2012) $ 2,074,320 $ 1,728,600 $ 3,840,600 $ 3,418,200
3 (2013) $ 2,074,320 $ 1,728,600 $ 3,840,600 $ 3,418,200
4 (2014) $ 2,074,320 $ 1,728,600 $ 3,840,600 $ 3,418,200
5 (2015) $ 2,074,320 $ 1,728,600 $ 9,440,600 $ 4,058,200
Year Change in Year-End Cash Flows from Base Conditions
1 (2011) na $ (345,720) $ (3,833,720) $ 703,880
2 (2012) na $ (345,720) $ 1,766,280 $ 1,343,880
3 (2013) na $ (345,720) $ 1,766,280 $ 1,343,880
4 (2014) na $ (345,720) $ 1,766,280 $ 1,343,880
5 (2015) na $ (345,720) $ 7,366,280 $ 1,983,880
Present Value of Incremental Year-End Cash Flows
na $ (1,033,914) $ 2,866,106 $ 3,742,892

Base Case Case 1 Case 2 Case 3

 Measuring the Impact of Operating Exposure

• Short-run: One year operating budget.

– The prices and costs are rigid for the existing obligations,
they cannot be changed according to the market
conditions.
• Medium-run: 2-5 year budgets.
– If the parity conditions among foreign exchange rates,
nominal interest rates and inflation rates hold, there
would be no operating exposure (estimated cash flows =
actual cash flows)
– If the markets are in disequilibrium, the firm is exposed to
the operating risk.
 Strategic Management of Operating
Exposure
• Objective
– To anticipate and influence the effect of
unexpected changes in exchange rates on a firm’s
future cash flows
• How to meet this objective?
– Recognize a disequilibrium in foreign exchange
markets (e.g. Divergence from international
parity conditions)
– Diversify internationally firm’s operating base
– Diversify internationally firm’s financing base
 Diversifying Operations

• Diversify
– Location of sales
– Location of production facilities
– Location of raw material sources
• Benefits
– If a firm is diversified, management can recognize
disequilibrium when it occurs and react competitively.
– Recognizing a temporary change in worldwide
competitive conditions permits management to make
changes in operating and financial strategies
 Diversifying Financing
• Diversify by
– Raising funds in more than one capital market
– Raising funds in more than one currency
– Establishing banking relationships in more than
one country
• Benefits
– Reduce the variability of future cash flows due to
domestic business cycles
– Increase the availability of capital, and reduce
cost of capital
Proactive Management of Operating Exposure

• The six most commonly employed proactive policies are

1. Matching currency cash flows

2. Risk-sharing agreements
3. Back-to-back or parallel loans
4. Currency swaps
5. Leads and lags
6. Reinvoicing center
 1. Matching Currency Cash Flows
• Use when cash flows in foreign currency are relatively
constant and predictable over time.
• One way to offset an anticipated continuous long
exposure to a particular currency is to acquire debt
denominated in that currency.
• This policy results in a continuous receipt of payment
and a continuous outflow in the same currency.
• This can sometimes occur through the conduct of
regular operations (eg. buy raw materials in a country
from where the company expects revenues) and is
referred to as a natural hedge.
 Matching Currency Cash Flows
Exports US Corp borrows
goods to Canadian dollar debt
Canadian Canada from Canadian Bank Canadian
Corporation Bank
(buyer of goods) (loans funds)

U.S.
Corporation Principal and interest
Payment for goods
in Canadian dollars payments on debt
in Canadian dollars

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
 2. Risk-sharing
• Risk-sharing is a contractual arrangement in which the
buyer and seller agree to “share” or split currency
movement impacts on payments
• This agreement is intended to smooth the impact on
both parties of volatile and unpredictable exchange rate
movements
• Example
– Ford purchases from Mazda in Japanese yen at the current spot
rate as long as the spot rate is between ¥115/$ and ¥125/$.
– If the spot rate falls outside of this range, Ford and Mazda will
share the difference equally
• If on the date of invoice, the spot rate is ¥110/$,
(i.e. yen appreciated), Ford’s costs of purchasing
rises.
• Ford’s payment to Mazda would be:

 
 ¥25,000,000  ¥25,000,000
    $222,222.22
¥5.00/$ ¥112.50/$
 ¥115.00/$ - 
 2 

• Note that this movement is in Ford’s favor, however

if the yen depreciated to ¥130/$, Mazda would be
the beneficiary of the risk-sharing agreement
• What is Japanese yen is continuously appreciating?
 3. Back-to-Back Loan
(Parallel Loan; Credit Swap)
• Two firms in different countries arrange to borrow each
other’s currency for a specific period of time
– The operation is conducted outside the FOREX markets, although
spot quotes may be used
– The two loans would be for equal values at the current spot rate
for a specified maturity. But there may be additional clauses for
extreme unexpected changes in the future spot rates.
– This swap creates a covered hedge against exchange loss, since
each company, on its own books, borrows the same currency it
repays
 Back-to-Back Loans

1. British firm wishes to invest funds 2. British firm identifies a Dutch firm wishing
in its Dutch subsidiary to invest funds in its British subsidiary

British parent Dutch parent

Indirect
firm firm
Financing

Direct loan Direct loan

in pounds in euros

Dutch firm’s British firm’s

British subsidiary Dutch subsidiary
3. British firm loans British pounds 4. British firm’s Dutch subsidiary loans
directly to the Dutch firm’s British euros to the Dutch parent
subsidiary
The back-to-back loan provides a method for parent-subsidiary cross border
financing without incurring direct currency exposure.
•Impediments: (i) Finding a counterparty. (ii) counterparty risk
 4. Currency Swaps
• 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.
– Currency swaps can be negotiated for a wide range of
maturities
– A typical currency swap requires two firms to borrow funds
in the markets and currencies in which they are best known
or get the best rates
– The swap dealer, or the swap bank acts as the middleman
in setting up the swap agreement
– Do not appear on a firm’s balance sheet
 Currency Swaps

Japanese United States

Corporation Corporation

Assets Liabilities & Equity Assets Liabilities & Equity

Inflow Inflow
Sales to US Debt in yen Sales to Japan Debt in US$
of US$ of yen

Receive Pay
yen yen
Pay Receive
dollars Swap Dealer dollars

Wishes to enter into a swap to Wishes to enter into a swap to

“pay dollars” and “receive yen” “pay yen” and “receive dollars”
 5. 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.
– To lead is to pay early.
• A firm holding soft currency and having debts denominated in hard
currency will pay the hard currency debt as soon as possible. The
objective is to pay currency debts before the currency drops in value.
– To lag is to pay late.
• A firm holding a hard currency and having debts denominated in soft
currency will lag by paying the debt late. (less currency will be
needed if soft currency depreciates)
 6. Reinvoicing Centers

• A subsidiary or department of a multinational

corporation where all intrafirm transactions are
centralized and foreign currency related receivables
and liabilities are netted.
• 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
Use of a Reinvoicing Center
Managing Translation Exposure

Chapter 13
Suggested Exercises:1, 2, 3, 4
 Translation (Accounting) Exposure

 Translation exposure is the risk of adverse effects on a firm`s

financial statements that may arise from changes in exchange
rates.
 Translation exposure results from translating foreign currency denominated
financial statements into the parent’s consolidated reporting currency.
 Translation exposure is the potential for an increase or decrease in the
parent’s net worth or reported net income caused by a change in exchange
rates since the last translation.
 Overview of Translation
• Main cause: Different exchange rates are
used in translating different line items in
accounting statements.
– Historical exchange rates are used for certain
equity accounts, fixed assets, and inventory items,
– Current exchange rates are used for current
assets, current liabilities, income, and expense
items.
 Translation Methods

 Translation methods differ by country along two

dimensions:
– Degree of independence from the parent
company
• Integrated foreign entity
• Self-sustaining foreign entity

– Functional Currency
 Categorizing the Foreign Subsidiaries
• Most countries today specify the translation
method used by a foreign subsidiary based on the
subsidiary’s business operations (subsidiary
characterization).
– A foreign subsidiary’s business can be categorized as
either an integrated foreign entity or a self-sustaining
foreign entity.
– An integrated foreign entity is one that operates as an
extension of the parent, with cash flows and business
lines that are highly interrelated.
– A self-sustaining foreign entity is one that operates in
the local economic environment independent of the
parent company.
 Functional Currency

• A foreign affiliate’s functional currency is the

currency of the primary economic environment in
which the subsidiary operates
• The geographic location of a subsidiary and its
functional currency can be different
– Example: US subsidiary located in Singapore may find that
its functional currency could be
• U.S. dollars (integrated subsidiary)
• Singapore dollars (self-sustaining subsidiary)
• British pounds (self-sustaining subsidiary)
Economic Indicators
for Determining the
Functional Currency
 Translation Methods
 There are two basic methods for the translation of
foreign subsidiary financial statements:
– The current rate method
– The temporal method
• Either method designates:
(1) The exchange rate at which individual balance sheet and
income statement items are remeasured
(2) Where any imbalances are to be recorded
• balance sheet ?
• income statement ?
 Current Rate Method
• The current rate method is the most prevalent in the world
today.
– Assets and liabilities are translated at the current rate of exchange on
the day of the statement.
– Income statement items are translated at the exchange rate on the
dates they were recorded, or at an appropriately weighted average
rate for the period.
– Dividends (distributions) are translated at the rate in effect on the
date of payment.
– Common stock and paid-in capital accounts are translated at historical
rates.
 Current Rate Method

• Gains or losses caused by translation adjustments are not included in the

calculation of consolidated net income.
• Rather, translation gains or losses are reported separately and
accumulated in a separate equity reserve account (on the B/S) with a title
such as cumulative translation adjustment (CTA).
• The biggest advantage of the current rate method is that the gain or loss
on translation does not pass through the income statement but goes
directly to a reserve account (reducing variability of reported earnings).
 Current Rate Method: Summary

Item Translation Rate

Assets and Liabilities Balance Sheet Date
Income Statement Either the actual exchange rate on the dates
Items the various revenues, expenses, gains and
losses were incurred or at a weighted
average exchange rate for the period
Dividends Date of payment
Common Stock Historical Rate
Paid-in Capital Historical Rate
 Temporal Method

• Under this method, specific assets and liabilities are translated

at exchange rates consistent with the timing of the item’s
creation.
• The temporal method assumes that items such as inventories
and net plant and equipment are restated to reflect market
value.
• Gains or losses resulting from remeasurement are carried
directly to current consolidated income, and not to equity
reserves (increased variability of consolidated earnings).
 Temporal Method: Summary
Item Translation Rate
Monetary Assets Current Exchange Rates
Monetary Liabilities Current Exchange Rates
Nonmonetary Assets Historical Exchange Rates
Income Statement Items Average Exchange Rate
Depreciation Historical Exchange Rates
Cost of Goods Sold Historical Exchange Rates
Dividends Exchange Rate on Payment Date
Common Stock, Paid-in Historical Exchange Rates
Capital
 Temporal Method

 Any gains or losses from remeasurement are

carried directly to current consolidated
income and not to equity reserves.
 Foreign exchange gains and losses arising
from the translation process creates earnings
volatility.
 U.S. Translation Procedures
 Governed by Financial Accounting Standards Number 52 (FAS
52)
 The US differentiates foreign subsidiaries on the basis of
functional currency, not subsidiary characterization
– If the statements are maintained in the local currency, and the local
currency is the functional currency, they are translated by the current
rate method
– If the statements are maintained in local currency, and the US dollar is
the functional currency, they are remeasured by the temporal method
– If the statements are in local currency and neither the local currency
or the US dollar is the functional currency, the statements must first
be remeasured into the functional currency by the temporal method,
and then translated into US dollars by the current rate method
If the financial statements of the foreign subsidiary are expressed
in a foreign currency, the following determinations need to be
made:
Is the local currency the
functional currency?
No Yes

Is the dollar the Translated to dollars

functional currency? (current rate method)

Remeasure from foreign

No Yes Remeasure to dollars
currency to functional
(temporal method) (temporal method)
and translate to dollars
(current rate method)
 Hyperinflation Countries
 Hyperinflation:
• Cumulative inflation has been 100% or more for over a
three-year period
• Financial statements of the subsidiaries must be translated
using the temporal method
– The rationale is to correct the problem of the “disappearing
asset”
– If the current rate method were used, depreciation would
be overstated in real terms and the book value of the
physical assets would disappear from the balance sheet
 Translation Example
• The functional currency of the subsidiary is the euro
• The currency of the parent is US dollars
• Euro
– December 2002: $1.200/€
– January 2003: $1.000/€
16.67% depreciation
• PP&E, common stock, and long-term debt were acquired at a past rate of
$1.2760/€
• Inventory on hand was purchased or manufactured when the average
exchange rate was $1.2180/€
• The example will also look at the consequences had the euro appreciated
to $1.3200/€
 Managerial Implications
• The translation loss or gain is larger under the
current rate method because inventory and
PP&E as well as monetary assets are deemed
exposed
• The managerial implications are
– If management expects a currency to depreciate, it
could minimize translation exposure by reducing net
exposed assets
– If management expects appreciation, it should
increase net exposed assets to benefit from the gain
 Should Firms Hedge Translation Exposure?

No Yes
• The value of the firm is the • Investors don’t have
PV of cash flows enough information to
• Translation exposure estimate cash flows and
doesn’t effect cash flows, so instead must rely on
ignore it reported earnings.
• If reported earnings are
distorted by translation
issues, investors will
misvalue the firm.
 Managing Translation Exposure
• Balance Sheet Hedge
– Requires an equal amount of exposed foreign
currency assets and liabilities on a firm’s
consolidated balance sheet
– A change in exchange rates will change the value
of exposed assets but offset that with an opposite
change in liabilities
– This is termed monetary balance
– The cost of this method depends on relative
borrowing costs in the varying currencies
Trident Europe, Balance Sheet Exposure
 Balance Sheet Hedge
• To achieve a balance sheet hedge:
– Reduce exposed euro assets
– Increase exposed euro liabilities
• Exchange existing euro cash for dollars
• Borrow euros, and exchange the borrowed
euros for dollars
• When is a balance sheet hedge justified?
– The foreign subsidiary is about to be liquidated so
that the value of its cumulative translation
adjustment would be realized
– The firm has debt covenants or bank agreements that
state the firm’s debt/equity ratios will be maintained
within specific limits
– Management is evaluated on the basis of certain
income statement and balance sheet measures that
are affected by translation losses or gains
– The foreign subsidiary is operating in a
hyperinflationary environment
 Which Exposure to Minimize?

• Firms seeking to reduce transaction and

translation exposures typically reduce
transaction exposure first.
• They then recalculate translation exposure
and then decide if any residual translation
exposure can be reduced without creating
more transaction exposure.