Chapter Ten Answers 1. Transaction versus Economic Exposure. Compare and contrast transaction exposure and economic exposure. Why would an MNC consider examining only its “net” cash flows in each currency when assessing its transaction exposure? ANSWER: Transaction exposure is due only to international transactions by a firm. Economic exposure includes any form by which the firm’s cash flow will be affected. Foreign competition may increase due to currency fluctuations. This could affect the firm’s cash flow, but did not affect the value of any ongoing transactions. Thus, it represents a form of economic exposure but not transaction exposure. Transaction exposure is a subset of economic exposure. Consideration of all cash flows in a particular currency is not necessary when some inflows and outflows offset each other. Only net cash flows are necessary. 2. Assessing Transaction Exposure. Your employer, a large MNC, has asked you to assess its transaction exposure. Its projected cash flows are as follows for the next year: Currency Danish krone (DK) British pound (£) Total Inflow DK50,000,000 £2,000,000 Total Outflow DK40,000,000 £1,000,000 Current Exchange Rate in U.S. Dollars $.15 $1.50 Assume that the movements in the Danish krone and the pound are highly correlated. Provide your assessment as to your firm’s degree of transaction exposure (as to whether the exposure is high or low). Substantiate your answer. ANSWER: The net exposure to each currency in U.S. dollars is derived below: Foreign Currency Danish krone (DK) British pound (£) Net Inflows in Foreign Currency +DK10,000,000 +£1,000,000 Current Exchange Rate $.15 $1.50 Value of Exposure $1,500,000 $1,500,000 The krone and pound values move in tandem against the dollar. Both the krone and the pound exposure show positive net inflows. Thus, their exposure should be magnified if their exchange rates against the U.S. dollar continue to be highly correlated. 3. Factors That Affect a Firm’s Transaction Exposure. What factors affect a firm’s degree of transaction exposure in a particular currency? For each factor, explain the desirable characteristics that would reduce transaction exposure. ANSWER: Currency variability—low level is desirable. Currency correlations—low level is desirable for currencies that are net inflows, while a high level is desirable for pairs of currencies in which one currency shows future net inflows while the other currency shows future net outflows. 4. Currency Correlations. Kopetsky Co. has net receivables in several currencies that are highly correlated with each other. What does this imply about the firm’s overall degree of transaction exposure? Are currency correlations perfectly stable over time? What does your answer imply about Kopetsky Co. or any other firm using past data on correlations as an indicator for the future? ANSWER: Its exposure is high since all currencies move in tandem—no offsetting effect is likely. If one of these currencies depreciates substantially against the firm’s local currency, all others will as well, and this reduces the value of these net receivables. No! Thus, past correlations will not serve as perfect forecasts of future correlations. Firms can not presume that past correlations will be perfectly accurate forecasts of future correlations. Yet, historical data may still be useful if the general ranking of correlations is somewhat stable. 5. Currency Effects on Cash Flows. How should appreciation of a firm’s home currency generally affect its cash inflows? How should depreciation of a firm’s home currency generally affect its cash outflows? ANSWER: Appreciation of the firm’s home currency reduces inflows since the foreign demand for the firm’s goods is reduced and foreign competition is increased. Depreciation of the firm’s home currency should increase inflows since it will likely increase foreign demand for the firm’s goods and reduce foreign competition. 6. Transaction Exposure. Fischer Inc., exports products from Florida to Europe. It obtains supplies and borrows funds locally. How would appreciation of the euro likely affect its net cash flows? Why? ANSWER: Fischer Inc. should benefit from the appreciation of the euro, because it should experience a strong demand for its products when the euro has more purchasing power (can obtain dollars at a low price). 7. Exposure of Domestic Firms. Why are the cash flows of a purely domestic firm exposed to exchange rate fluctuations? ANSWER: If the firm competes with foreign firms that also sell in a given market, the consumers may switch to foreign products if the local currency strengthens. 8. Measuring Economic Exposure. Memphis Co. hires you as a consultant to assess its degree of economic exposure to exchange rate fluctuations. How would you handle this task? Be specific. ANSWER: Regression analysis can be used to determine the relationship between the firm’s value and exchange rate fluctuations. Stock returns can be used as a proxy for the change in the firm’s value. The time period can be segmented into two subperiods so that regression analysis can be run for each subperiod. The sign and magnitude of the regression coefficient will imply how the firm’s value is influenced by each currency. Also, the coefficients can be compared among subperiods for each currency to determine how the impact of a currency is changing over time. 9. Factors That Affect a Firm’s Translation Exposure. What factors affect a firm’s degree of translation exposure? Explain how each factor influences translation exposure. ANSWER: The greater the percentage of business conducted by subsidiaries, the greater is the translation exposure. The greater the variability of each relevant foreign currency relative to the headquarters’ home (reporting) currency, the greater is the translation exposure. The type of accounting method employed can also affect translation exposure. 10. Translation Exposure. Consider a period in which the U.S. dollar weakens against the euro. How will this affect the reported earnings of a U.S.-based MNC with European subsidiaries? Consider a period in which the U.S. dollar strengthens against most foreign currencies. How will this affect the reported earnings of a U.S.-based MNC with subsidiaries all over the world? ANSWER: The consolidated earnings will be increased due to the strength of the subsidiaries’ local currency (the euro). The consolidated earnings will be reduced due to the weakness of the subsidiaries’ local currencies. 11. Transaction Exposure. Aggie Co. produces chemicals. It is a major exporter to Europe, where its main competition is from other U.S. exporters. All of these companies invoice the products in U.S. dollars. Is Aggie’s transaction exposure likely to be significantly affected if the euro strengthens or weakens? Explain. If the euro weakens for several years, can you think of any change that might occur in the global chemicals market? ANSWER: If the euro strengthens, European customers can purchase Aggie’s goods with fewer euros. Since Aggie’s competitors also invoice their exports in dollars, Aggie Company will not gain a competitive advantage. Nevertheless, the overall demand for the product could increase because the chemicals are now less expensive to European customers. If the euro weakens, European customers will need to pay more euros to purchase Aggie’s goods. Since Aggie’s competitors also invoice their exports in dollars, Aggie Company may not necessarily lose some of its market share. However, the overall European demand for chemicals could decline because the prices paid for them have increased. If the euro remained weak for several years, some companies in Europe may begin to produce the chemicals, so that customers could avoid purchasing dollars with weak euros. That is, the U.S. exporters could be priced out of the European market over time if the euro continually weakened. 12. Economic Exposure. Longhorn Co. produces hospital equipment. Most of its revenues are in the United States. About half of its expenses require outflows in Philippine pesos (to pay for Philippine materials). Most of Longhorn’s competition is from U.S. firms that have no international business at all. How will Longhorn Co. be affected if the peso strengthens? ANSWER: If the peso strengthens, Longhorn will incur higher expenses when paying for the Philippine materials. Because its competition is not affected in a similar manner, Longhorn Company is at a competitive disadvantage when the peso strengthens. 13. Economic Exposure. Lubbock, Inc., produces furniture and has no international business. Its major competitors import most of their furniture from Brazil and then sell it out of retail stores in the United States. How will Lubbock, Inc., be affected if Brazil’s currency (the real) strengthens over time? ANSWER: If the Brazilian real strengthens, U.S. retail stores will likely have to pay higher prices for the furniture from Brazil, and may pass some or all of the higher cost on to customers. Consequently, some customers may shift to furniture produced by Lubbock Inc. Thus, Lubbock Inc. is expected to be favorably affected by a strong Brazilian real. 14. Economic Exposure. Sooner Co. is a U.S. wholesale company that imports expensive high-quality luggage and sells it to retail stores around the United States. Its main competitors also import high-quality luggage and sell it to retail stores. None of these competitors hedge their exposure to exchange rate movements. Why might Sooner’s market share be more volatile over time if it hedges its exposure? ANSWER: If Sooner Company hedged its imports, then it would have an advantage over the competition when the dollar weakened (since its competitors would pay higher prices for the luggage), and could possibly gain market share or would have a higher profit margin. It would be at a disadvantage relative to the competition when the dollar strengthened and may lose market share or be forced to accept a lower profit margin. When Sooner Company does not hedge, the amount paid for imports would depend on exchange rate movements, but this is also true for all of its competitors. Thus, Sooner is more likely to retain its existing market share. 15. PPP and Economic Exposure. Boulder, Inc., exports chairs to Europe (invoiced in U.S. dollars) and competes against local European companies. If purchasing power parity exists, why would Boulder not benefit from a stronger euro? ANSWER: If purchasing power parity exists, a stronger euro would occur only because the U.S. inflation is higher than European inflation. Thus, the European demand for Boulder’s chairs may not be affected much since the inflated prices of U.S.-made chairs would have offset the European consumer’s ability to obtain cheaper dollars. The European consumer’s purchasing power of European chairs versus U.S. chairs is not affected by the change in the euro’s value. 16. Measuring Changes in Economic Exposure. Toyota Motor Corp. measures the sensitivity of its exports to the yen exchange rate (relative to the U.S. dollar). Explain how regression analysis could be used for such a task. Identify the expected sign of the regression coefficient if Toyota primarily exports to the United States. If Toyota established plants in the United States, how might the regression coefficient on the exchange rate variable change? ANSWER: The dependent variable is a percentage change (from one period to the next) in Toyota’s export volume to the U.S. The independent variables are (1) the percentage change in the yen’s value with respect to the dollar, (2) a measure of the strength of the U.S. economy, and (3) any other factors that could affect the volume of Toyota’s exports. The regression coefficient related to the exchange rate variable (as defined here) would be negative, since a decrease in the yen’s value is likely to cause an increase in the U.S. demand for Toyotas built in Japan. If Toyota established plants in the U.S., dealers do not need to purchase Toyotas in Japan. Thus, the demand for Toyotas is less sensitive to the exchange rate, which should cause the regression coefficient for the exchange rate variable to decrease. 17. Impact of Exchange Rates on Earnings. Cieplak, Inc., is a U.S.-based MNC that has expanded into Asia. Its U.S. parent exports to some Asian countries, with its exports denominated in the Asian currencies. It also has a large subsidiary in Malaysia that serves that market. Offer at least two reasons related to exposure to exchange rates why Cieplak's earnings were reduced during the Asian crisis. ANSWER: First, its receivables from its exports were converted to fewer dollars due to the depreciation of the Asian currencies. Second, any funds remitted by the Malaysian subsidiary converted to fewer dollars for the parent. Third, the earnings generated by the Malaysian subsidiary were translated to fewer dollars on the consolidated income statement (translation exposure) even if it did not remit any earnings to the parent. Advanced Questions 18. Speculating Based on Exposure. During the Asian crisis in 1998, there were rumors that China would weaken its currency (the yuan) against the U.S. dollar and many European currencies. This caused investors to sell stocks in Asian countries such as Japan, Taiwan, and Singapore. Offer an intuitive explanation for such an effect. What types of Asian firms would have been affected the most? ANSWER: If China weakened its currency, importers of Asian products may purchase more Chinese products, which could have enhanced the performance of the Chinese exporters, but could have adversely affected the performance of the exporters in other Asian countries. Thus, there was concern that depreciation of the yuan would adversely affect the economies of the other countries. 19. Comparing Transaction and Economic Exposure. Erie Co. has most of its business in the U.S., except that it exports to Belgium. Its exports were invoiced in euros (Belgium’s currency) last year. It has no other economic exposure to exchange rate risk. Its main competition when selling to Belgium’s customers is a company in Belgium that sells similar products, denominated in euros. Starting today, Erie Co. plans to adjust its pricing strategy to invoice its exports in U.S. dollars instead of euros. Based on the new strategy, will Erie Co. be subject to economic exposure to exchange rate risk in the future? Briefly explain. ANSWER: Economic exposure still exists because a weak euro would encourage Belgian customers to switch to local competitors. 20. Using Regression Analysis to Measure Exposure. a. How can a U.S. company use regression analysis to assess its economic exposure to fluctuations in the British pound? ANSWER: A U.S. company could quantify its performance by measuring the percentage change in earnings, stock price, or some other variable to be used as the dependent variable. The independent variable is the percentage change in the British pound. Lagged exchange rate variables could also be included as additional independent variables to capture any lagged impact of the pound’s movements on the firm. b. In using regression analysis to assess the sensitivity of cash flows to exchange rate movements, what is the purpose of breaking the database into sub periods? ANSWER: Breaking the database into sub periods enables one to understand how the impact of the currency is changing over time. c. Assume the regression coefficient based on assessing economic exposure was much higher in the second sub period than in the first sub period. What does this tell you about the firm’s degree of economic exposure over time? Why might such results occur? ANSWER: The firm is more exposed to change in currency values. This could occur if the firm hedges currency positions less, or is simply increasing its degree of foreign business. 21. Transaction Exposure. Vegas Corp. is a U.S. firm that exports most of its products to Canada. It historically invoiced its products in Canadian dollars to accommodate the importers. However, it was adversely affected when the Canadian dollar weakened against the U.S. dollar. Since Vegas did not hedge, its Canadian dollar receivables were converted into a relatively small amount of U.S. dollars. After a few more years of continual concern about possible exchange rate movements, Vegas called its customers and requested that they pay for future orders with U.S. dollars instead of Canadian dollars. At this time, the Canadian dollar was valued at $.81. The customers decided to oblige, since the number of Canadian dollars to be converted into U.S. dollars when importing the goods from Vegas was still slightly smaller than the number of Canadian dollars that would be needed to buy the product from a Canadian manufacturer. Based on this situation, has transaction exposure changed for Vegas Corp.? Has economic exposure changed? Explain. ANSWER: Transaction exposure is reduced since Vegas will have less receivables in Canadian dollars. However, the economic exposure will not necessarily be reduced because a weak Canadian dollar could cause a lower demand for its exports and will still affect cash flows. 22. Measuring Economic Exposure. Using the following cost and revenue information shown for DeKalb, Inc., determine how the costs, revenue, and cash flow would be affected by three possible exchange rate scenarios for the New Zealand dollar (NZ$): (1) NZ$ = $.50, (2) NZ$ = $.55, and (3) NZ$ = $.60. (Assume U.S. sales will be unaffected by the exchange rate.) Assume that NZ$ earnings will be remitted to the U.S. parent at the end of the period. Ignore possible tax effects. Forecasted Net Cash Flows: DeKalb Inc. (in millions of U.S. dollars and New Zealand dollars) U.S. Business $800 500 300 100 –$100 Sales Cost of Materials Operating Expenses Interest Expense Cash Flow New Zealand Business NZ$800 100 0 0 NZ$700 ANSWER: (Figures are in millions) NZ$=$.50 NZ$=$.55 Sales U.S. $ 800 $ 800 New Zealand NZ$800 = 400 NZ$800 = 440 Total $ 1,200 $ 1,240 Cost of Materials U.S. $ 500 $ 500 NZ$=$.60 $ 800 NZ$800 = 480 $ 1,280 $ 500 New Zealand Total NZ$100 = $50 $ 550 NZ$100 = $55 $ 555 NZ$100 = $60 $ 560 Operating expenses $300 $300 $300 Interest expenses $100 $100 $100 Cash flow $250 $285 $320 The preceding table shows that DeKalb Inc. is adversely affected by a weaker New Zealand dollar value. This should not be surprising since the New Zealand business has relatively high NZ$ revenue compared to NZ$ expenses. This analysis assumes that the NZ$ received are converted to U.S. dollars at the end of the period.