M12_EITE1342_12E_IM_C12

Operating Exposure

 Questions

12-1. By Any Other Name. Operating exposure has other names. 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.

12-2. Exposure Type Comparison. 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.

12-3. Intracompany Cash Flows. 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.

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.

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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 expenses 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 worldwide 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 directors.

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.

12-4. Expected Exchange Rate Changes. 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 an 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.

12-5. Macroeconomic Uncertainty. 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.

52 Eiteman/Stonehill/Moffett • Multinational Business Finance, Twelfth Edition

12-6. Who Owns Whom? The Economist (December 1–7, 2001, p. 4 of “Survey” insert) reported on a

French company that had a subsidiary in India. The Indian subsidiary in turn had its own subsidiary 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 euro?

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 euro cash flow should increase. However if the Indian subsidiary 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.

12-7. Strategic Responses. 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. Worldwide diversification in effect prepositions 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.

12-8. Proactive Policies to Offset Foreign Exchange Exposure. 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 cannot 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.

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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 later 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-to-back 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-to-back loan. However in a currency swap, each participant gives some of its currency to the other participant and in return receives 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.

12-9. Paradox? The possibility of a gain or loss on operating exposure offset by an opposite loss or gain

on transaction exposure may appear contradictory. 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

foreign-currency 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 in the following ways.

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.

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.

54 Eiteman/Stonehill/Moffett • Multinational Business Finance, Twelfth Edition

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.

12-10. Subsidiary Borrowing from Parent. 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 subsidiary 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.