Chapter 12
Managing Economic
Exposure and Translation
exposure
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
Chapter Objectives
•
•
To explain how an MNC’s economic
exposure can be hedged.
To explain how an MNC’s translation
exposure can be hedged.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA
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.
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
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.
PepsiCo
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Scandinavian Business Seating
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Scandinavian Business Seating
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
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.
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
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.
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Example from ch 10 –
Mannerton plc
• Mannerton plc sells to the UK and Europe
– A strong € increases UK sales somewhat due
to increased competitiveness
– European sales are assumed to be constant
at €40 and European costs are much higher
(about € 200)
• Mannerton therefore lose money if the €
appreciates
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Impact of exchange rate movements
Euro exc. rate
UK sales (£)
European sales (€ 40)
Total sales
Scenario 1 Scenario 2 Scenario 3
0,6
0,7
0,8
300,00
304,00
307,00
24,00
28,00
32,00
324,00
332,00
339,00
Cost of goods sold:
UK costs
European Costs
Total costs
50,00
120,00
170,00
50,62
141,73
192,35
51,08
163,46
214,54
Gross profit
154,00
139,65
124,46
Operating expenses:
UK fixed costs
UK variable costs
Total
30,00
30,72
60,72
30,00
31,10
61,10
30,00
31,38
61,38
EBIT
93,28
78,56
63,08
Interest expense:
UK interest
European interest (10 m €)
Total
3,00
6,00
9,00
3,00
7,00
10,00
3,00
8,00
11,00
Earnings before taxes (EBT)
84,28
68,56
52,08
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Mannerton plc
• Mannerton should change its operational
structure by increasing European sales and
decreasing the share of European costs
– Increase € sales by 20 by spending £2 on
advertising
– £10 on materials from UK and £1 mill on other
exp.
– Reduce € costs by €100 and increasing £ costs
by 50
– Increase £ borrowing by £3.5 and reduce £
borrowing by €5
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Different operational structure
Euro exc. rate
UK sales (£)
European sales (€ 40)
Total sales
Scenario 1
Original
Proposed
0,6
0,6
300,00
300,00
24,00
36,00
324,00
336,00
Scenario 2
Original
Proposed
0,7
0,7
304,00
304,00
28,00
42,00
332,00
346,00
Scenario 3
Original
Proposed
0,8
0,8
307,00
307,00
32,00
48,00
339,00
355,00
Cost of goods sold:
UK costs
European Costs
Total costs
50,00
120,00
170,00
130,00
60,00
190,00
50,62
141,73
192,35
131,55
70,83
202,38
51,08
163,46
214,54
132,71
81,67
214,38
Gross profit
154,00
146,00
139,65
143,62
124,46
140,62
Operating expenses:
UK fixed costs
UK variable costs
Total
30,00
30,72
60,72
32,00
31,72
63,72
30,00
31,10
61,10
32,00
32,10
64,10
30,00
31,38
61,38
32,00
32,38
64,38
EBIT
93,28
82,28
78,56
79,52
63,08
76,24
Interest expense:
UK interest
European interest (10 m €)
Total
3,00
6,00
9,00
6,50
3,00
9,50
3,00
7,00
10,00
6,50
3,50
10,00
3,00
8,00
11,00
6,50
4,00
10,50
Earnings before taxes (EBT)
84,28
72,78
68,56
69,52
52,08
65,74
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Earnings before tax £
million
Revenue is more stable
90
80
70
60
50
1
2
3
Scenarios
From the Mannerton example in the text, the original steep slope is replaced through
reducing exposure by the dotted lesser slope. It is less risky, fewer losses but fewer gains
from exchange rate variation
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
A Case Study in
Hedging Economic Exposure
• Silverton Co., a U.K. firm, has three independent
units that conduct some business in Europe. It is
concerned about its exposure to the euro.
• To determine whether it is exposed and the
source of the exposure, Silverton applies a
series of regression analysis to its cash flows
and the euro’s movements.
• PCFt = a0 + a1(%∆€)t + µ
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Assessment of
Silverton’s Cash Flows and the Euro’s Movements
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Regression output Unit A
SUMMARY OUTPUT
Regression Statistics
Multiple R
0,304404315
R Square
0,092661987
Adjusted R Square
-0,036957729
Standard Error
3,394370714
Observations
9
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
7
8
SS
MS
F
Significance F
8,23662107 8,236621 0,714875713 0,425783
80,65226782 11,52175
88,88888889
Coefficients
Standard Error
-0,142548596
1,132067678
-0,282937365
0,334637828
t Stat
P-value
Lower 95% Upper 95%Lower 95,0%
Upper 95,0%
-0,12592 0,903336505 -2,81946 2,534366 -2,81946 2,534366
-0,8455 0,425783335 -1,07423 0,508355 -1,07423 0,508355
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Regression output Unit B
SUMMARY OUTPUT
Regression Statistics
Multiple R
0,425963344
R Square
0,18144477
Adjusted R Square
0,064508309
Standard Error
2,558992348
Observations
9
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
SS
MS
F
Significance F
1 10,16091 10,16091 1,551652649
0,252966588
7 45,83909 6,548442
8
56
CoefficientsStandard Error t Stat
P-value
-0,63174946 0,853458 -0,74022 0,483247208
0,31425486 0,252281 1,245654 0,252966588
Lower 95% Upper 95%Lower 95,0%
Upper 95,0%
-2,649856724 1,386358 -2,64986 1,386358
-0,282295192 0,910805
-0,2823 0,910805
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
Regression output Unit C
SUMMARY OUTPUT
Regression Statistics
0,932567514
Multiple R
0,869682169
R Square
0,851065335
Adjusted R Square
0,671521457
Standard Error
9
Observations
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
1
7
8
Significance F
F
MS
SS
0,000245334
21,06563475 21,06563 46,71483
3,156587473 0,450941
24,22222222
P-value
t Stat
Coefficients Standard Error
0,223961317 2,705072 0,030415
0,605831533
0,066202693 6,834825 0,000245
0,452483801
Upper 95,0%
Lower 95% Upper 95%Lower 95,0%
0,076247171 1,135416 0,076247 1,135416
0,295939308 0,609028 0,295939 0,609028
Cost and Management Accounting: An Introduction, 7th edition
Colin Drury
ISBN 978-1-40803-213-9 © 2011 Cengage Learning EMEA
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.
Cost and Management
International
Accounting:
FinancialAn
Management,
Introduction,
2nd7th
edition
edition
Jeff
Colin
Madura
Drury
and Roland Fox
ISBN 978-1-40803-213-9
ISBN 978-1-4080-3229-9
© 2011©Cengage
2011 Cengage
Learning
Learning
EMEAEMEA