Chapter 9
Operating Exposure
T Questions
By any other name Operating exposure has other names
1.
What are they, and what do the words in these names suggest about the nature of operating exposure?
Economic exposure emphasizes that the exposure is created by the economic consequences of an
unexpected exchange rate change. Economic consequences, in turn, suggests that the impact is due to
the response of external forces in the economy, rather than, say, something directly under the control
of management. Competitive exposure suggests that the consequences of an unexpected exchange
rate change are due to a shift in the competitive position of a firm, vis-á-vis its competitors. Strategic
exposure suggests that matters of long-range cost changes and price setting, needed to anticipate or
adjust to an unexpected change in exchange rates, are matters of corporate strategy; i.e., how the
company positions itself in anticipation of risks caused by exchange rate changes.
Exposure type comparison
2.
From a cash flow measurement perspective, what is the major difference between losses from
transaction exposure and from operating exposure?
Both exposures deal with changes in expected cash flows. Transaction exposure deals with changes
in near-term cash flows that have already been contracted for (such as foreign currency accounts
receivable, accounts payable, and other debts). Operating exposure deals with changes in long-term
cash flows that have not been contracted for but would be expected in the normal course of future
business. One might view operating exposure as “anticipated future transactions exposure,” although
the concept is broader because the impact of the exposure might be through sales volume or operating cost
changes.
Given a known exchange rate change, the cash flow impact of transaction exposure can be measured
precisely whereas the cash flow impact of operating exposure remains a conjecture about the future.
Intra-company cash flows
3.
What are the differences between operating cash flows and financial cash flows from parent to
subsidiary or vice versa? List several cash flows in both categories and indicate why that flow takes place.
Operating cash flows. These flows arise from normal business (production, marketing, selling)
between parent and subsidiary.
(a) Payment for goods and services: Parents and subsidiaries frequently buy and sell components
and/or services from each other as a matter of seeking the most cost efficient way of doing business.
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173
(b) Rent and lease payments Parents and subsidiaries often use each other’s physical facilities.
Examples of rented or leased physical assets range from factory buildings to corporate aircraft.
Decisions on ownership vs. renting from a related company may be based on the search for
efficiency, on tax laws, or on the historical evolution of the multinational firm.
(c) Royalties and license fees. Subsidiaries often use or produce goods that are patented by the
parent, and they also sell under brand names controlled by the parent. For these “benefits” to the
subsidiary the subsidiary usually pays a royalty (often a percent of sales) or a license fee (often a
flat fee).
(d) Management fees and distributed overhead. Certain expense of the parent are incurred on behalf
of the subsidiary. Examples include the salaries of parent staff temporarily working for the
subsidiary and subsidiary share of overhead (headquarters costs) that are incurred for the benefit
of the world-wide enterprise. Subsidiaries pay their share by remitting management fees and
overhead contribution to the parent.
Financial cash flows. These flows arise because of managerial decisions to transfer funds from
subsidiary to parent or vice versa. They are optional in the sense that they are not made for a
compelling operating purpose but rather from a decision over which management exercises greater
discretion.
(a) Dividends paid to parent. Whether or not the subsidiary pays dividends to its parent is at the
discretion of the board of directions.
(b) Parent invested equity capital. The parent may or may not choose to advance additional
ownership capital into its subsidiary. Additional equity investment is only one of several ways by
which the parent can add cash to its investment in the subsidiary. (See next item.)
(c) Parent lending to subsidiary. Instead of investing additional equity capital, a parent may decide
to make a long-term loan to its subsidiary. The same amount of cash can be invested, but under a
legal form that allows repayment of the principal (as well as interest), whereas “repayment” of an
equity investment amounts to a liquidating dividend.
(d) Interest on intrafirm lending. If the parent loans funds to its subsidiary, interest on that loan
represents a financial cash flow back to the parent.
(e) Intrafirm principal repayment. If the parent loans funds to its subsidiary, repayment of the
principal represents a cash flow back to the parent.
Expected exchange rate changes
4.
Why do unexpected exchange rate changes contribute to operating exposure, but expected exchange
rate changes do not?
Expected changes in foreign exchange rates should be incorporated in all financial plans of a MNE,
including both operating and financial budgets. Hence the arrival of an expected exchange rate
change should not be a surprise requiring alteration of existing plans and procedures.
Unexpected exchange rate changes are those that could not have been anticipated or built into
existing plans. Hence a reevaluation of existing plans and procedures must be considered.
One must note that because budgets are built around expected exchange rate changes, the unexpected
exchange rate is the deviation from the expected exchange rate, rather than the deviation from the
actual exchange rate at the time a budget was prepared.
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Moffett • Fundamentals of Multinational Finance, Second Edition
Macroeconomic uncertainty
5.
What is “macroeconomic uncertainty” and how does it relate to measuring operating exposure?
Macroeconomic uncertainty is the sensitivity of the firm’s future cash flows to macroeconomic
variables in addition to foreign exchange, such as changes in interest rates and inflation rates.
Who owns whom?
6.
The Economist (December 1–7, 2001, p. 4 of “Survey” insert) reported on a French company that had
a subsidiary in India, which Indian subsidiary in turn had its own subsidiary back in France. How
would you conjecture the operating exposure to the world-wide French firm of an unexpected
devaluation of the Indian rupee relative to the French franc?
As suggested, any answer is pure conjecture. The purpose of the question is to point out how in fact
operating exposure can be quite complicated to anticipate.
One possible response is that a devaluation of the Indian rupee would make products manufactured
by the French firm in India cheaper and thus allow for greater sales volume and possibly greater cash
flows in India. If the French parent imported components from India, costs in France might fall, sales
increase, and French cash flow might increase. If the Indian sub-subsidiary in France were only a
marketing and distribution subsidiary, its franc cash flow should increase. However if the Indian subsubsidiary in France provided components to India, Indian costs would rise, and sales and cash flow
might fall in India.
All in all, it would be a complicated task for French management to figure out exactly what its
operating exposure is—which is the point of this somewhat convoluted example.
Strategic responses
7.
What strategic responses can a multinational firm make to avoid loss from its operating exposure?
The key to effective preparations for an unexpected devaluation is anticipation. Major changes to
protect a firm after an unexpected devaluation are minimally effective. Possibilities include:
Diversifying operations. World-wide diversification in effect pre-positions a firm to make a quick
response to any loss from operating exposure.
•
•
The firm’s own internal cost control system and the alertness of its foreign staff should give the
firm an edge in anticipating countries where the currency is weak. Recognizing a weak currency
is different from being able to predict the time or amount of a devaluation, but it does allow some
defensive planning.
If the firm is already diversified, it should be able to shift sourcing, production or sales effort
from one country/currency to another in order to benefit from the change in the post-devaluation
economic situation. Such shifts could be marginal or major.
Diversifying financing. Unexpected devaluations change the cost of the several components of
capital—in particular, the cost of debt in one market relative to another.
•
If a firm has already diversified its sources of financing, that is, established itself as a known and
reputable factor in several capital markets, it can quickly move to take advantage of any
temporary deviations from the international Fisher effect by changing the country or currency
where borrowings are made.
Chapter 9
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175
Proactive policies to offset foreign exchange exposure
8.
A fine line exists between fully anticipated exchange rate changes and possible-but-not-assured
exchange rate changes. If management believes an exchange rate change might take place but can not
estimate the timing or amount of such change, what might management do to alleviate the possible
consequences of such an uncertain devaluation?
The four most common proactive policies and a brief explanation are:
(a) Matching currency cash flows. The essence of this approach is to create operating or financial
foreign currency cash outflows to match equivalent foreign currency inflows. Often debt is
incurred in the same foreign currency in which operating cash flows are received.
(b) Risk-sharing agreements. Contracts, including sales and purchasing contracts, between parties
operating in different currency areas can be written such that any gain or loss caused by a change
in the exchange rate will be shared by the two parties.
(c) Back-to-back loans. Two firms in different countries lend their home currency to each other and
agree to repay each other the same amount at a latter date. This can be viewed as a loan between
two companies (independent entities or subsidiaries in the same corporate family) with each
participant both making a loan and receiving 100% collateral in the other’s currency. A back-toback loan appears as both a debt (liability side of the balance sheet) and an amount to be received
(asset side of the balance sheet) on the financial statements of each firm.
(d) Currency swap. In terms of financial flows, the currency swap is almost identical to the back-toback loan. However in a currency swap, each participant gives some of its currency to the other
participant and receives in return an equivalent amount of the other participant’s currency. No
debt or receivable shows on the financial statements as this is in essence a foreign exchange
transaction. The swap allows the participants to use foreign currency operating inflows to unwind
the swap at a later date.
Paradox? Operating Gains with Transaction Losses
9.
The possibility of a gain or loss on operating exposure offset by an opposite loss or gain on
transaction exposure may appear incongruous. Explain why, when the currency in which a foreign
subsidiary operates falls in value, the parent firm may experience both an operating gain and a
transaction loss.
An exchange rate change causes a shift in both the cash flow needed to settle existing financial
obligations (transaction exposure) and the future cash flows from operating the foreign affiliate
(operating exposure.) It is possible that these will work in opposite directions, as in the chapter
example for Trident Corporation. Each change individually is the consequence of both the price and
the volume (i.e., the elasticity) for that account.
Overview: In its essence, a devaluation might cause a transaction loss because more local currency is
needed to settle outstanding foreign-currency debts, and less is received from outstanding foreigncurrency receivables. However if the devaluation results in a surge in volume because the local
subsidiary is more competitive in its home market or in export markets, overall future cash flows (and
future profits) may rise. Assuming for discussion a devaluation of the currency of the subsidiary,
individual accounts may be influenced as follows:
Sales: Local sales prices may increase or remain the same in local currency terms, depending on local
competition. This depends in part on whether competing goods in the local market are sourced
domestically or from foreign countries. Export sales prices could increase in local currency terms if
the firm chooses to maintain the foreign currency price fixed. If the foreign currency price is reduced
(fixed local currency price) export volume might increase depending on the price elasticity of
demand.
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Moffett • Fundamentals of Multinational Finance, Second Edition
Direct costs: Whether or not direct costs in local currency terms rise depends, in the first instance, on
whether they represent imported or local content. The replacement cost of imported content rises as
soon as new imports are purchased; production may be costed at “old” imported prices for a while
(increasing reported profit margins), but eventually the “new” and higher import prices must be
charged to cost of goods sold. Local material and goods do not inherently increase with a
depreciation of the local currency; however, depreciation may lead to inflationary conditions that
cause local suppliers and local labor to demand more. Often a lag exists between increased cost of
local goods and labor, but generalizations are difficult.
Fixed costs: In theory fixed costs should remain “fixed,” but in practice they may creep up, possibly
with a time lag, for the same reasons mentioned above for local direct costs.
Volume: Sales volume, and consequent changes in the profit contribution of marginal sales, may
change in any direction. In theory a rise in local prices should cause demand to fall, but if the rise
leads to an expectation of more future price increases, buyers may “rush” to buy more before
additional price increases. Short-run and long-run consequences are likely to be different in this
regard.
Subsidiary borrowing from parent
10. Newly established foreign subsidiaries are often financed with debt supplied by the parent, perhaps
because a new subsidiary has no financial credit record or worthiness of its own, or maybe because
the parent firm can acquire capital more cheaply. As soon as the affiliate is operational, however,
parent firms usually encourage or require their subsidiaries to arrange their own local debt financing.
How would this approach serve as a natural hedge for most subsidiaries?
The greater the amount of local currency debt a subsidiary can acquire, the greater the proportion of
its free cash flows (cash remaining after cash operating expenses) that is naturally hedged. This is
because a portion of the subsidiary’s free cash flow (roughly net income plus depreciation) can be
used to service the local currency debt, rather than be exchanged for the parent’s currency, remitted to
the parent, and used by the parent to service parent-currency debt.
T Mini-Case: Toyota’s European Operating Exposure
1.
Why do you think Toyota had waited so long to move much of its manufacturing for European sales
to Europe?
Automobile manufacturing is a very complex and capital intensive industry. Toyota, like most
manufacturers, wished to continue to enjoy the benefits of scale and scope economies in
manufacturing as long as possible, and had resisted the movement of more and more of its
manufacturing into the local and regional markets. Time, however, was now running out.
2.
If the British pound were to join the European Monetary Union would the problem be resolved? How
likely do you think this is?
The British joining the EMU would eliminate the currency risk between the UK and Europe, but not
between Japan and Europe. The UK joining the EMU would eliminate the deviations in currency
value between the British pound and the euro only.
Although there has been continuing and heated debate over the possibility of Britain joining the
EMU, there is at present no specific plan to do so. In many ways the UK believes itself to be
somewhat the beneficiary of being the single large “European” country which is not euro-based.
Chapter 9
3.
Operating Exposure
177
If you were Mr. Shuhei, how would you categorize your problems and solutions? What was a shortterm and what was a long-term problem?
The problems, at least on the basis of the data presented, appear to be primarily exchange rateinduced pricing problems. The fall in the value of the euro against the yen throughout 1999 and early
2000 was significant (for example calculate the percentage change in the value of the euro between
January 1999 and July 2000). For some unknown reason most of Toyota’s North American
operations had moved to manufacturing bases in North America, while Toyota had continued to try
and service European sales via exports from Japan. The recent decision to manufacture a new
European-targeted product, the Yaris, from production in Japan was in the continuing strategy. It did
not appear to be a good strategy given the recent direction of exchange rate movements.
The primary short-term solution was to continue to absorb yen-based cost increases in lower margins
on European sales—assuming that the market would not bear passing-through the exchange rate
changes. In the medium-to-long-term, Toyota must inevitably move more of the automobile’s content
into manufacturing operations within the EMU (and not the United Kingdom).
4.
What measures would you recommend Toyota Europe take to resolve the continuing operating
losses?
If Toyota was willing to continue incurring the operating losses in Europe, and put market share goals
above profit goals, then continuing the current operating and pricing policy would be in order. The
euro had regained some of its weakness against the yen in the recent year.
The fact that significant Toyota operations existed in the United Kingdom would be a continuing
dilemma as long as the UK stayed out of the EMU. The strength of the pound against the euro—and
the new-found stability in that rate seen in 2000 and 2001—did not bode well for UK-based
operations for European sales. In the longer-term, Toyota, like many other multinationals, would
have to consider moving more of its manufacturing and cost structure to within the EMU, not in
Japan and not in the UK.
T Mini-Case: Porsche Exposed
1.
Do you believe that Porsche’s management is appropriately concerned with stockholder wealth? Does
Porsche’s ownership structure work to the benefit or detriment of public shareholders?
Although Porsche is publicly traded, the company is controlled by only two stockholders, the Porsche
and Piéch families. As the quotation by Holger Härter makes clear, the two families hold exclusive
shareholder influence over management. An interesting point for class discussion is whether the
families actually ever exercise these rights. It is not clear from the information or evidence presented
that they influence or direct current management headed by Dr. Wendelin Wiedeking. They may
simply agree with current leadership and therefore remain quietly complicit.
What this means for minority shareholders is that they do participate in the distributed profits and any
and all capital gains (losses) which the traded preference shares provide, but they have no voting
rights and therefore no ability to act as owners in whole. It also explains in part the company’s
relatively uncooperative response to the requests of analysts and stock exchanges for more frequent
reporting (as well as more detailed disclosure in their financial reporting). A final related component
of this governance discussion is the structure of management compensation. The compensation
packages of senior management were nearly exclusively focused on the recorded profitability of the
firm from year to year, and not on the market’s assessment of that performance, the share price.
178
2.
Moffett • Fundamentals of Multinational Finance, Second Edition
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.
Exposure. Porsche’s currency exposure is fundamentally a long-term operating exposure arising
from where and how it operates its business. Because the company is relatively simple in structure
compared to most multinationals, and transparent in the type of currency exposure it incurs, most of
its currency exposure can be viewed as a series of transaction exposures, both existing (already an
existing account receivable or inventory line item on the company’s balance sheet) and anticipated
(not yet contractually existing, but with a high likelihood that they will occur).
Alternatives. There are a number of alternatives, which we cover here in brief.
(1) Pass-through. The discussion of exchange rate pass-through is relevant, but not really a hedging
solution. Pass-through does exactly what it says, it passes on to the buyer a portion of the
exchange rate movement. This is in effect what Porsche has already done to some degree as
described previously. As always, at some point the price elasticity of demand for the product
changes so that further price increases through pass-through result in declining sales revenue.
(2) Diversifying operations. If the company believed that it would be continuing to generate
significant proportions of its sales in US dollar markets, it could match these sales values with
production values by manufacturing in a US dollar environment. Other auto companies like
BMW (produces today in South Carolina) and Mercedes (produces today in Alabama) have
pursued this strategy successfully.
The obvious advantage of this strategy is that production and sales are effectively matched, the
company’s operations and operating results are insulated from major currency movements (not
counting translation and consolidation impacts of reporting US dollar sales in consolidated
earnings in euros.) The obvious argument against this approach is that building cars anywhere
other than where they are currently manufactured and assembled would result in either real or
perceived decreases in quality or related performance.
(3) Diversifying financing. This strategy is actually easier and cheaper to implement, and would
require Porsche to either acquire new debt which was US dollar denominated or alter existing
non-dollar debt into dollar-servicing (through cross currency swaps). The objective would be to
match dollar cash inflows from US sales with dollar cash outflows in US dollar debt service
(principal and interest).
Porsche has chosen not to use this approach most likely because it does not “do debt.” The firm
has not needed debt to finance its operating activities and investing activities under the current
management team (since 1993), and it also does not philosophically believe in using debt (see
page 5 of the case). A good point of discussion with students, however, is that a company does
not necessarily need debt to use debt. The benefits of leverage are well known, and although
many successful companies today do not choose to use debt (Intel, Dell, Exxon-Mobil, Microsoft
to name a few), this does not necessarily prevent Porsche from revisiting this judgement. The
benefit of using a financing hedge like dollar-denominated debt is that it would take less active
management and would not require a major outlay of capital out front like currency options
require (option premiums).
Current Strategy. The company has been hedging the US dollar long position by estimating its
annual US dollar sales and hedging that exposure by purchasing put options on the US dollar (the
right to sell US dollars for euros at a specific exchange rate). The company has been purchasing these
options in what it refers to as a “three-year rolling hedge” in which it hedges expected US dollar sales
three years out into the future. As each year matures, and the associated options expire, the company
has replaced them with a new three-year option position. (The three-year time horizon may actually
be longer, but Porsche has not been willing to describe in any adequate detail the nature of how their
hedging program is structured or operated.)
Chapter 9
3.
Operating Exposure
179
Do you think 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?
Students generally seem to come to a conclusion that, although the current hedging program is
expensive to purchase and operate, it has done well to date. Also, although other premium-priced
automobile manufacturers have chosen to diversify operations, and seemingly successfully
maintained the consumer’s faith in their quality and brand, this is a choice of management, and
difficult to second-guess. That said, in the end, the enormity of Porsche’s exchange rate exposure is
not going to go away. Hedging it with financial derivatives is inherently a stop-gap measure, and does
nothing to restructure or prepare the company for the long-term. Therefore, the possibility of a
financing hedge, dollar-denominated debt, should clearly be reconsidered.
Post Script. In January 2004 the following article appeared in the Financial Times (Porsche itself did
not make any press release related to this issuance). It seems that Porsche was beginning to increase
the use of US$debt.
T Car Sector Groups Busy in Wake of Daimler Deal New Issues
More car sector names appeared on the bond market yesterday in the wake of DaimlerChrysler’s deal
earlier in the week, with small transactions from Toyota and BMW and an announcement by the luxury
car maker Porsche. BMW US Capital, guaranteed by the German car maker BMW, added Pounds 100m to
its outstanding 4.625 percent 2006 bond. The issue, which carried an A1 rating from Moody’s, was led by
ABN Amro and JP Morgan. Toyota Motor Credit Corporation, rated triple-A by both Moody’s and S&P,
offered a Euros 100m bond maturing in January 2008. UBS was sole lead.
In the pipeline, Porsche announced it had mandated Merrill Lynch and ABN Amro for a bond issue worth
several hundred million dollars, to be placed with US private investors. The German company, which has
the highest profit margins in the auto sector, said the bond would be used for its long-term financing needs
and would replace a Euros 256m issue—nicknamed the “SUV bond”—launched in 1998 to fund the
development of its Cayenne sports-utility vehicle. But Porsche said the new issue would not be used to
fund the development of an updated version of its 911 sports car, widely expected later this year, or a
possible fourth model range.
Source: By Adrienne Roberts, The Financial Times, January 16, 2004, p. 43.
180
T Problems
Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 9.1 Trident Europe: Case 4
Balance Sheet Information, End of Fiscal 2002
Assets
Liabilities and net worth
Cash
Accounts receivable
Inventory
Net plant and equipment
Sum
€1,600,000
3,200,000
2,400,000
4,800,000
€800,000
Accounts payable
Short-term bank loan
1,600,000
Long-term debt
1,600,000
Common stock
1,800,000
Retained earnings
6,200,000
€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
Assumptions
Exchange rate, $/€
Sales volume (units)
Export sales volume (case 4)
Sales price per unit
Export sales price per unit (case 4)
Direct cost per unit
Case 3
1.2000
1,000,000
1.0000
1,000,000
1.0000
2,000,000
1.0000
1,000,000
€12.80
€12.80
€12.80
€15.36
€9.60
€9.60
€9.60
€9.60
Case 4
1.0000
500,000
500,000
€12.80
€15.36
€9.60
Annual Cash Flows before Adjustments
€12,800,000 €12,800,000 €25,600,000 €15,360,000
Sales revenue
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
€1,710,000
€1,710,000
€4,910,000
€4,270,000
Pretax profit
Income tax expense
581,400
81,400
1,669,400
1,451,800
€1,128,600
€1,128,600
€3,240,600
€2,818,200
Profit after tax
Add back depreciation
600,000
600,000
600,000
600,000
€1,728,600
€1,728,600
€3,840,600
€3,418,200
Cash flow from operations, in euros
Cash flow from operations, in dollars
$2,074,320
$1,728,600
$3,840,600
$3,418,200
Adjustments to Working Capital for 2003 and 2007 Caused by Changes in Conditions
€3,200,000
€3,200,000
€6,400,000
€3,840,000
Accounts receivable
Inventory
2,400,000
2,400,000
4,800,000
2,400,000
€3,520,000
2,400,000
€5,600,000
—
Operating Exposure
€5,600,000 €11,200,000
€6,240,000
€5,920,000
€5,600,000
€640,000
€320,000
—
Year-End Cash Flows
$2,074,320
$1,728,600 $(1,759,400)
$2,778,200
$2,253,400
$2,074,320
$1,728,600
$3,840,600
$3,418,200
$2,573,400
$2,074,320
$1,728,600
$3,840,600
$3,418,200
$2,573,400
$2,074,320
$1,728,600
$3,840,600
$3,418,200
$2,573,400
$2,074,320
$1,728,600
$9,440,600
$4,058,200
$2,893,400
Change in Year-End Cash Flows from Base Conditions
na
$(345,720) $(3,833,720)
$703,880
$179,080
na
$(345,720)
$1,766,280
$1,343,880
$499,080
na
$(345,720)
$1,766,280
$1,343,880
$499,080
na
$(345,720)
$1,766,280
$1,343,880
$499,080
na
$(345,720)
$7,366,280
$1,983,880
$819,080
Present Value of Incremental Year-End Cash Flows
na
$(1,033,914)
$2,866,106
$3,742,892
$1,354,489
Chapter 9
Sum
Change from base conditions in 2003
Year
1 (2003)
2 (2004)
3 (2005)
4 (2006)
5 (2007)
Year
1 (2003)
2 (2004)
3 (2005)
4 (2006)
5 (2007)
€14,080,000
9,600,000
890,000
600,000
€2,990,000
1,016,600
€1,973,400
600,000
€2,573,400
$2,573,400
181
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Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 9.2 Trident Europe: Case 5
Balance Sheet Information, End of Fiscal 2002
Assets
Liabilities and net worth
Cash
Accounts receivable
Inventory
Net plant and equipment
Sum
€1,600,000
3,200,000
2,400,000
4,800,000
€12,000,000
€800,000
1,600,000
1,600,000
1,800,000
6,200,000
€12,000,000
Accounts payable
Short-term bank loan
Long-term debt
Common stock
Retained earnings
Sum
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
Assumptions
Exchange rate, $/€
Sales volume (units)
Export sales volume (case 4)
Sales price per unit
Export sales price per unit (case 4)
Direct cost per unit
Case 2
Case 3
1.2000
1,000,000
1.0000
1,000,000
1.0000
2,000,000
1.0000
1,000,000
€12.80
€12.80
€12.80
€15.36
€9.60
€9.60
€9.60
€9.60
Case 5
1.0000
500,000
500,000
€15.36
€15.36
€11.52
Annual Cash Flows before Adjustments
€12,800,000 €12,800,000 €25,600,000
€15,360,000
Sales revenue
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
€1,710,000
€1,710,000
€4,910,000
€4,270,000
Pretax profit
Income tax expense
581,400
581,400
1,669,400
1,451,800
€1,128,600
€1,128,600
€3,240,600
€2,818,200
Profit after tax
Add back depreciation
600,000
600,000
600,000
600,000
€1,728,600
€1,728,600
€3,840,600
€3,418,200
Cash flow from operations, in euros
Cash flow from operations, in dollars
$2,074,320
$1,728,600
$3,840,600
$3,418,200
Adjustments to Working Capital for 2003 and 2007 Caused by Changes in Conditions
€3,200,000
€3,200,000
€6,400,000
€3,840,000
Accounts receivable
Inventory
2,400,000
2,400,000
4,800,000
2,400,000
€3,840,000
2,880,000
€5,600,000
—
Operating Exposure
€5,600,000 €11,200,000
€6,240,000
€6,720,000
€5,600,000
€640,000
€1,120,000
—
Year-End Cash Flows
$2,074,320
$1,728,600
$(1,759,400)
$2,778,200
$913,520
$2,074,320
$1,728,600
$3,840,600
$3,418,200
$2,033,520
$2,074,320
$1,728,600
$3,840,600
$3,418,200
$2,033,520
$2,074,320
$1,728,600
$3,840,600
$3,418,200
$2,033,520
$2,074,320
$1,728,600
$9,440,600
$4,058,200
$3,153,520
Change in Year-End Cash Flows from Base Conditions
na
$(345,720) $(3,833,720)
$703,880 $(1,160,800)
na
$(345,720)
$1,766,280
$1,343,880
$(40,800)
na
$(345,720)
$1,766,280
$1,343,880
$(40,800)
na
$(345,720)
$1,766,280
$1,343,880
$(40,800)
na
$(345,720)
$7,366,280
$1,983,880
$1,079,200
Present Value of Incremental Year-End Cash Flows
na
$(1,033,914)
$2,866,106
$3,742,892
$(605,247)
Chapter 9
Sum
Change from base conditions in 2003
Year
1 (2003)
2 (2004)
3 (2005)
4 (2006)
5 (2007)
Year
1 (2003)
2 (2004)
3 (2005)
4 (2006)
5 (2007)
€15,360,000
11,520,000
1,068,000
600,000
€2,172,000
738,480
€1,433,520
600,000
€2,033,520
$2,033,520
183
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Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 9.3 Denver Plumbing Company (A)
Assumptions
Sales volume per year
US dollar price per unit
Direct costs as % of US$sales price
Direct costs per unit
Spot exchange rate, Rmb/$
Expected spot rate, Rmb/$
Unit volume decrease if price increased
Sales to China
US dollar price per unit
Unit volume
Sales revenue, Rmb
Less direct costs
Gross profits, Rmb
Values
1,000,000
$24.00
75%
$18.00
8.2700
10.0000
−10%
Case 1
Same Rmb Price
Case 2
Same US$Price
$19.85
1,000,000
$24.00
900,000
$19,848,000
(18,000,000)
$1,848,000
$21,600,000
(16,200,000)
$5,400,000
Better.
Problem 9.4 Denver Plumbing Company (B)
Assumptions
Sales volume per year
US dollar price per unit
Direct costs as % of US$price
Direct costs per unit
Spot exchange rate, Rmb/$
Expected spot rate, Rmb/$
Values
1,000,000
$24.00
75%
$18.00
8.2700
10.0000
Assumptions
Volume change
(if price increased)
Volume growth
(same Rmb price)
WACC
Values
1%
12%
10%
Alternative 1: Keep Same Chinese Sales Price
Revenue
$19,848,000
$22,229,760
$24,897,331
$27,885,011
$31,231,212
$34,978,958
$39,176,433
$43,877,605
Direct Costs
$18,000,000
$20,160,000
$22,579,200
$25,288,704
$28,323,348
$31,722,150
$35,528,808
$39,792,265
Present Value
of Margin
$1,680,000
$1,710,545
$1,741,646
$1,773,313
$1,805,555
$1,838,383
$1,871,808
$1,905,841
$14,327,091
(Continued)
Operating Exposure
Volume
1,000,000
1,120,000
1,254,400
1,404,928
1,573,519
1,762,342
1,973,823
2,210,681
Present Value
Factor
0.9091
0.8264
0.7513
0.6830
0.6209
0.5645
0.5132
0.4665
Chapter 9
Year
1
2
3
4
5
6
7
8
Cum PV of Gross Margin
Gross
Margin
$1,848,000
$2,069,760
$2,318,131
$2,596,307
$2,907,864
$3,256,807
$3,647,624
$4,085,339
185
186
Alternative 2: Raise Chinese Sales Price
Year
1
2
3
4
5
6
7
8
Cum PV of Gross Margin
Volume
900,000
909,000
918,090
927,271
936,544
945,909
955,368
964,922
Revenue
$21,600,000
$21,816,000
$22,034,160
$22,254,502
$22,477,047
$22,701,817
$22,928,835
$23,158,124
Direct Costs
$16,200,000
$16,362,000
$16,525,620
$16,690,876
$16,857,785
$17,026,363
$17,196,626
$17,368,593
Gross
Margin
$5,400,000
$5,454,000
$5,508,540
$5,563,625
$5,619,262
$5,675,454
$5,732,209
$5,789,531
Present Value
Factor
0.9091
0.8264
0.7513
0.6830
0.6209
0.5645
0.5132
0.4665
Denver Plumbing is much better off raising the Chinese sales price to maintain the US dollar price, and suffering the lower volumes. The volume
decrease does not offset the stronger US dollar price per unit receieved.
Present Value
of Margin
$4,909,091
$4,507,438
$4,138,648
$3,800,031
$3,489,119
$3,203,646
$2,941,529
$2,700,859
$29,690,361
Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 9.4 Denver Plumbing Company (B) (Continued)
Problem 9.5 Hawaiian Macadamia Nuts
a. How much should Hawaiian Macadamia Nuts (HMN) borrow in yen?
Hawaiian receives one hundred million yen per month; this is its on-going long yen exposure. To hedge this exposure, it wishes to create a short yen position by
borrowing Japanese yen (a money market or financial hedge). The loan could be of any maturity—one, two, three years—whatever Hawaiian wished to lock-in.
Regardless of the final maturity, it is the monthly payment, thecombined principal and interest payment on the loan, which is to be matched against the monthly yen
cash inflow.
Month
Monthly cash inflow (million ¥)
Monthly yen principal & interest
Net yen exposure
Jan
Feb
Mar
Apr
100.00 100.00 100.00
100.00
(100.01) (100.01) (100.01) (100.01)
(0.01) (0.01)
(0.01)
(0.01)
May
Jun
July
Aug
Sep
Oct
Nov
Dec
100.00 100.00 100.00 100.00
100.00
100.00
100.00 100.00
(100.01) (100.01) (100.01) (100.01) (100.01) (100.01) (100.01) (100.01)
(0.01)
(0.01)
(0.01)
(0.01)
(0.01)
(0.01)
(0.01) (0.01)
Using the Excel commands to calculate a leveled payment below, and assuming a one year loan and an annual interest rate of 4.000%, the principal can be found
through a trial and error process which matches the yen cash inflow (nearly, the net yen exposure of 0.01 remains).
1,174.50
4.000%
0.333%
1.00
12.00
(100.01)
(this cell is found through trial and error, focusing on the monthly payment above for January)
(% per annum/12)
(maturity in years/12)
Note that there is no explicit interest rate given in the problem. The amortizing loan payments, and therefore the desired loan principal, will change slightly with
different interest rate assumptions. For example, if the interest rate were assumed to be 5.000%, the desired loan principal would be ¥1,168.10.
Operating Exposure
a. Therefore a loan of ¥1,174.5 million is needed to offset the yen exposure. The yen loan could be of any maturity, as long as the payments are monthly to
match the exposure.
Chapter 9
Principal of loan (million ¥)
Interest rate (percent per annum)
Interest rate (monthly)
Loan maturity (years)
Loan maturity (months)
Monthly payment
b. The terms of payment on the yen loan should be amortizing, so that the actual yen cash inflows cover all principal and interest payments on a monthly basis.
187
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Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 9.6 Cellini Fashionwear’s risk-sharing
The use of risk-sharing agreements.
a. If the exchange rate changes immediately to Ps6.00/$, what will be the dollar cost of 6 months
of imports to Cellini Fashionwear?
Bottom
Top
The allowable range of exchange rates is (Ps/$)
3.50
4.50
Outside of this range the trading partners will share
the extra risk equally.
New exchange rate (Ps/$)
Allowable exchange rate (Ps/$)
Difference to be shared (Ps/$)
Cellini’s share
Boselli’s share
6.00
4.50
1.50
0.75
0.75
Therefore, Cellini will use the following effective exchange rate after risk-sharing:
Top of range
4.50
Cellini’s share
0.75
Effective total of risk-sharing
5.25
Assuming that 6 months of imports will still be (Ps)
Effective exchange rate for Cellini (Ps/$)
Cellini’s cost in US dollars
8,000,000
5.25
$1,523,809.52
However, the lower cost of importing might lead to higher Cellini sales and therefore a higher
import total than Ps 8 million.
b. At Ps6.00/$, what will be the peso export sales in Boselli Leather goods to Cellini Fashionwear?
The export sales of Boselli would remain at Ps 8 million, unless the lower dollar cost encourages
Cellini to import more from Boselli.
Chapter 8
Transaction Exposure
189
Problem 9.7 Autocars, Ltd.
Assumptions
Invoice price of car
Spot exchange rate, NZ$/£
Risk-sharing band, percentage
Sales to New Zealand Distributors
a. What are the outside ranges?
(initial spot rate + or − 5%)
Values
£12,000
1.6400
5.00%
Lower Band
Upper Band
1.7220
1.5580
b. Cost to the Kiwi distributor for 10 cars
New current spot rate (N$/£)
Is this within the band?
Cost of 10 cars at this exchange rate (NZ$)
Receipts to Autocar in British pounds
(Within the band Autocar receives £12,000/car, as expected)
1.7000
Yes
204,000
£120,000
c. Cost to the Kiwi distributor for 10 cars
New current spot rate (N$/£)
Is this within the band?
Cost of 10 cars at this exchange rate (NZ$)
Receipts to Autocar in British pounds
(Within the band Autocar receives £12,000/car)
1.6500
Yes
198,000
£120,000
d. How does this shift the currency risk?
Autocars bears no risk within the 5% range. The distributor carries all of the risk within 5%.
If the exchange rate falls outside the 5% range, Autocar shares the risk with distributor.
e. Who benefits from this risk-sharing agreement?
Both parties in practice. The manufacturer has predictable revenues within the range, while the
distributor bears a moderate level of currency risk within the 5% range.
The distributor will hopefully be able to provide a more stable pricing to pass on to the customer,
which will also benefit the manufacturer through a more stable and sustainable distributor sales outlet.
190
Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 9.8 High-Profile Printers, Inc. (A)
Pricing decisions in foreign markets experiencing devaluations.
Assumptions
Existing sales price per unit
Exchange rate
Prices in
US dollar prices
(R$/$)
Brazilian reais
$200.00 →
3.4000 →
680
If the real falls in value, the new implied US$price:
New dollar price if no real price change
$170.00 ←
4.0000 ←
680
If the US$price is changed to keep US$price:
New real price is current US$price at new exchange rate:
$200.00 →
4.0000 →
800
Direct cost per unit in the US, percent of price
Direct cost per unit in the US
60%
$120.00
3.4000
408
Unit volume
Decrease in unit volume from price increase
New lower unit volume
50,000
−20.0%
40,000
Alternative #1: Maintain same price in reais:
Sales revenue (R$680 × 50,000 )/(R$4.000/$)
Less direct costs (US$120 × 50,000)
Contribution margin in US dollars
$8,500,000
6,000,000
$2,500,000
Alternative #2: Raise price in reais (and accept lower volume):
Sales revenue (R$800 × 40,000 )/(R$4.000/$)
Less direct costs (US$120 × 40,000)
Contribution margin in US dollars
$8,000,000
4,800,000
$3,200,000
Discussion
Alternative #2 is preferable. In the short run (one year), HPP would be better off to increase its sales price in reais
in Brazil and accept the lower sales volume. The contribution margin if real prices are raised is $3,200,000, whereas
if the price in reais is left unchanged HPP’s contribution margin is only $2,500,000. This is a short-run solution,
and does not consider possible longer-run effects that might come from raising the local price and/or accepting
a smaller market share.
Problem 9.9 High-Profile Printers, Inc. (B)
Pricing decisions on export sales when foreign curency denominated sales may decline from real price changes.
Assumptions
Initial sales volume
Sales volume growth
Sales price, US$
Direct cost per unit
End
of year
1
2
3
4
5
6
Value
50,000
10%
$170.00
$120.00
Present Value
2,232,143
2,192,283
2,153,135
2,114,686
2,076,924
2,039,836
Present value of contribution margins
$12,809,008
Operating Exposure
Assumptions
Initial sales volume
Sales volume growth
Sales price, US$
Direct cost per unit
Chapter 9
Alternative #1: Maintain current Brazilian sales price and volume grows 10% per annum
Contribution
12%
Sales volume
US$Revenue
Direct Costs
Margin
PV Factor
50,000
8,500,000
6,000,000
2,500,000
0.8929
55,000
9,350,000
6,600,000
2,750,000
0.7972
60,500
10,285,000
7,260,000
3,025,000
0.7118
66,550
11,313,500
7,986,000
3,327,500
0.6355
73,205
12,444,850
8,784,600
3,660,250
0.5674
80,526
13,689,335
9,663,060
4,026,275
0.5066
Value
40,000
4%
$200.00
$120.00
191
(Continued)
192
End
of year
1
2
3
4
5
6
Alternative #2: Raise Brazilian sales price to R$400 and volume grows only 4% per annum from a lower volume base
Contribution
12%
Sales volume
US$Revenue
Direct Costs
Margin
PV Factor
Present Value
40,000
8,000,000
4,800,000
3,200,000
0.8929
2,857,143
41,600
8,320,000
4,992,000
3,328,000
0.7972
2,653,061
43,264
8,652,800
5,191,680
3,461,120
0.7118
2,463,557
44,995
8,998,912
5,399,347
3,599,565
0.6355
2,287,589
46,794
9,358,868
5,615,321
3,743,547
0.5674
2,124,189
48,666
9,733,223
5,839,934
3,893,289
0.5066
1,972,462
Present value of contribution margins
$14,358,000
Alternative #2 is preferable, yielding a higher present value of total contribution margin over the expected remaining life of the export sales.
Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 9.9 High-Profile Printers, Inc. (B) (Continued)
Chapter 8
Transaction Exposure
Problem 9.10 Hedging Hogs: Risk-Sharing at Harley Davidson
Calculating boundaries for risk-sharing agreements.
Assumption Set
Spot rate, central rate, A$/US$
Fixed rate zone, percent from central rate
Sharing zone boundaries, percent from central rate
Value
1.2800
2.500%
5.000%
a. Fixed Rate & Risk Sharing Zones
Sharing Zone: upper boundary
1.2190
5.00%
Fixed rate: upper boundary
1.2488
2.50%
CENTRAL RATE
1.2800
Fixed rate: lower boundary
1.3128
−2.50%
Sharing Zone: lower boundary
1.3474
−5.00%
If the spot rate falls between the fixed rate boundaries, between A$1.2488/$and A$1.3128/US$, the
company guarantees its distributors prices in their local currency calculated using the central rate.
If the spot rate falls between the fixed rate upper boundary and the sharing zone upper boundary,
the company will “share” the exchange rate risk with the distributor. It calculates the effective rate
as the fixed rate upper boundary + (0.5 × (spot − 1.2190))
If the spot rate falls between the fixed rate lower boundary and the sharing zone lower boundary,
the company will “share” the exchange rate risk with the distributor. It calculates the effective rate
as the fixed rate lower boundary + (0.5 × (spot − 1.2190))
(Continued)
193
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Moffett • Fundamentals of Multinational Finance, Second Edition
Problem 9.10 Hedging Hogs: Risk-Sharing at Harley Davidson (Continued)
b. If Harley ships a hog costing US$8,500, and the spot exchange rate on the order date is A$1.3442/US$,
what is the price to the Australian dealership?
The spot rate falls between the fixed rate lower boundary and the sharing zone lower boundary.
This means that the effective rate is a “shared rate”:
Spot rate, A$/US$
Fixed rate: lower boundary A$/US$
Difference, A$/US$
1.3442
1.3128
0.0314
Effective rate = lower boundary + (0.5 × (difference))
1.3285
Hog price in US$
Effective exchange rate, A$/US$
Hog price to distributor, A$
$8,500.00
1.3285
11,292.34
c. If Harley ships a hog costing US$8,500, and the spot exchange rate on the order date is A$1.2442 /US$,
what is the price to the Australian dealership?
The spot rate falls between the central rate and fixed rate upper boundary, in the zone of fixed rate pricing.
This means that the effective rate is the central rate.
Hog price in US$
Effective exchange rate, A$/US$
Hog price to distributor, A$
$8,500.00
1.2800
10,880.00