Operating Exposure

Operating Exposure
Operating exposure, also called economic exposure, competitive exposure, and even strategic exposure on occasion, 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.

Attributes of Operating Exposure
Measuring the operating exposure of a firm requires forecasting and analyzing all the firm’s future individual transaction exposures together with the future exposures of all the firm’s competitors and potential competitors worldwide. From a broader perspective, operating exposure is not just the sensitivity of a firm’s future cash flows to unexpected changes in foreign exchange rates, but also to its sensitivity to other key macroeconomic variables. This factor has been labeled macroeconomic uncertainty.

Attributes of Operating Exposure
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 of an inter and intracompany nature

Financial & Operating Cash Flows Between Parent & Subsidiary
Financial Cash Flows
Dividend paid to parent Parent invested equity capital Interest on intrafirm lending Intrafirm principal payments

Payment for goods & services Rent and lease payments Royalties and license fees Management fees & distributed overhead


Operational Cash Flows

Attributes of Operating Exposure
Operating exposure is far more important for the long-run health of a business than changes caused by transaction or accounting exposure. Operating exposure is inevitably subjective, because it depends on estimates of future cash flow changes over an arbitrary time horizon. Planning for operating exposure is a total management responsibility because it depends on the interaction of strategies in finance, marketing, purchasing, and production.

Attributes of Operating Exposure
An expected change in foreign exchange rates is not included in the definition of operating exposure, because both management and investors should have factored this information into their evaluation of anticipated operating results and market value. From an investor’s perspective, if the foreign exchange market is efficient, information about expected changes in exchange rates should be reflected in a firm’s market value. Only unexpected changes in exchange rates, or an inefficient foreign exchange market, should cause market value to change.

Measuring the Impact of Operating Exposure
An unexpected change in exchange rates impacts a firm’s expected cash flows at four levels, depending on the time horizon used: Short run Medium run: Equilibrium case Medium run: Disequilibrium case Long run

Measuring the Impact of Operating Exposure
Carlton Inc. is a U.S. based company engaged in the production of telecommunications industry. The company is facing dilemma as a result of an unexpected change in the value of the euro, the currency of economic consequence for the German subsidiary. There is concern over how the subsidiaries revenues (price and volumes in euro terms), costs (input costs in euro terms), and competitive landscape will change with a fall in the value of the euro.

The Case
Carlton Germany manufactures in Germany and sells half of its proceeds to non-European countries.All sales are in euros and A/R =1/4 of total sales. Inventory=90days. Depreciation = €600,000 per year, Corporate tax rate in Germany = 34% . Balance Sheet on 31/12/02 and alternative scenarios are given as follows. Assume that on /01/0103, before the start of commercial activity begins, the euro unexpectedly drops 16.67% in value, from $1.2000/€ to $1.0000/€. If no devaluation had occurred , Carlton Germany was expected to perform in 2003 as per base case. Generating a $ cash flow from operations for Carlton of $2,074,320.

Carlton Germany
Balance Sheet Information, End of Fiscal 2002 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 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 1.2000 1,000,000 € 12.80 € 9.60 Case 1 Assumptions 1.0000 1,000,000 € 12.80 € 9.60 Case 2 1.0000 2,000,000 € 12.80 € 9.60 Case 3 1.0000 1,000,000 € 15.36 € 9.60 Case 4 1.0000 500,000 500,000 € 12.80 € 15.36 € 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 2003 and 2007 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 2003 € € € 5,600,000 € 640,000 € Year-End Cash Flows Year 1 (2003) $ 2,074,320 $ 1,728,600 $ (1,759,400) $ 2,778,200 $ 2 (2004) $ 2,074,320 $ 1,728,600 $ 3,840,600 $ 3,418,200 $ 3 (2005) $ 2,074,320 $ 1,728,600 $ 3,840,600 $ 3,418,200 $ 4 (2006) $ 2,074,320 $ 1,728,600 $ 3,840,600 $ 3,418,200 $ 5 (2007) $ 2,074,320 $ 1,728,600 $ 9,440,600 $ 4,058,200 $ Change in Year-End Cash Flows from Base Conditions Year 1 (2003) na $ (345,720) $ (3,833,720) $ 703,880 $ 2 (2004) na $ (345,720) $ 1,766,280 $ 1,343,880 $ 3 (2005) na $ (345,720) $ 1,766,280 $ 1,343,880 $ 4 (2006) na $ (345,720) $ 1,766,280 $ 1,343,880 $ 5 (2007) 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 $

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 3,520,000 2,400,000 5,920,000 320,000 2,253,400 2,573,400 2,573,400 2,573,400 2,893,400 179,080 499,080 499,080 499,080 819,080 1,354,489

Carlton, Inc. and Carlton Germany
Carlton, Inc.
(Palo Alto, CA, USA) Will the altered profits of the German subsidiary, in euro, translate into more or less in US dollars?

US$ Reporting Environment US$/€ Euro Competitive Environment

Carlton Germany
(Munich, Germany)

How will the sales, costs, and profits of the German subsidiary change?

Carlton’s Suppliers
Will costs change?

Carlton’s Customers
Will prices and sales volume change? How much?

An unexpected depreciation in the value of the euro alters both the competitiveness of the subsidiary and the financial results which are consolidated with the parent company.

Strategic Management of Operating Exposure
The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firm’s future cash flows, rather than merely hoping for the best. To meet this objective, management can diversify the firm’s operating and financing base. Management can also change the firm’s operating and financing policies. A diversification strategy does not require management to predict disequilibrium, only to recognize it when it occurs.

Strategic Management of Operating Exposure
If a firm’s operations are diversified internationally, management is prepositioned both to recognize disequilibrium when it occurs and to react competitively. Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies. Domestic firms may be subject to the full impact of foreign exchange operating exposure and do not have the option to react in the same manner as an MNE.

Strategic Management of Operating Exposure
If a firm’s financing sources are diversified, it will be prepositioned to take advantage of temporary deviations from the international Fisher effect. However, to switch financing sources a firm must already be well-known in the international investment community. Again, this would not be an option for a domestic firm (if it has limited its financing to one capital market).

Proactive Management of Operating Exposure
Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures. The four most commonly employed proactive policies are:
Matching currency cash flows Risk-sharing agreements Back-to-back or parallel loans Currency swaps

Proactive Management of Operating Exposure
In this example, a US firm has continuing export sales to Canada. In order to compete effectively in Canadian markets, the firm invoices all export sales in Canadian dollars. This policy results in a continuing receipt of Canadian dollars month after month. This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements.

Matching: Debt Financing as a Financial Hedge
Canadian Corporation
(buyer of goods) Exports goods to Canada

Canadian Bank
(loans funds) US Corp borrows Canadian dollar debt from Canadian Bank

Payment for goods in Canadian dollars

U.S. Corporation

Principal and interest 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

Proactive Management of Operating Exposure
Matching currency cash flows
One way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching). Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms. In addition, the company could engage in currency switching, in which the company would pay foreign suppliers with Canadian dollars.

Proactive Management of Operating Exposure
Currency Clauses: Risk-Sharing:
An alternate method for managing a long-term cash flow exposure between firms is risk sharing. This is a contractual arrangement in which the buyer and seller agree to “share” or split currency movement impacts on payments between them. This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements.

Proactive Management of Operating Exposure
Back-to-Back Loans:
A back-to-back loan, also referred to as a parallel loan or credit swap, occurs when two business firms in separate countries arrange to borrow each other’s currency for a specific period of time. At an agreed terminal date they return the borrowed currencies. Such a swap creates a covered hedge against exchange loss, since each company, on its own books, borrows the same currency it repays.

Using a Back-to-Back Loan for Currency Hedging
1. British firm wishes to invest funds in its Dutch subsidiary 2. British firm identifies a Dutch firm wishing to invest funds in its British subsidiary

British parent firm
Direct loan in pounds

Indirect Financing

Dutch parent firm
Direct loan in euros

Dutch firm’s British subsidiary
3. British firm loans British pounds directly to the Dutch firm’s British subsidiary

British firm’s Dutch subsidiary
4. British firm’s Dutch subsidiary loans euros to the Dutch parent

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure.

Proactive Management of Operating Exposure

There are two fundamental impediments to widespread use of the back-to-back loan:
It is difficult for a firm to find a partner, termed a counterparty for the currency amount and timing desired. A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity – although each party has 100% collateral (denominated in a different currency).

Proactive Management of Operating Exposure
Currency Swaps:
A currency swap resembles a back-to-back loan except that it does not appear on a firm’s balance sheet. 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.

Using a Cross Currency Swap to Hedge Currency Exposure
Both the Japanese corporation and the U.S. corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt.

Japanese Corporation
Assets Inflow Sales to US of US$ Debt in yen Liabilities & Equity Inflow Assets

United States Corporation
Liabilities & Equity Debt in US$

Sales to Japan of yen Pay yen

Receive yen Pay dollars

Swap Dealer

Receive dollars

Wishes to enter into a swap to “pay dollars” and “receive yen”

Wishes to enter into a swap to “pay yen” and “receive dollars”

Proactive Management of Operating Exposure
Some MNEs now attempt to hedge their operating exposure with contractual hedges. The ability to hedge the “unhedgeable” is dependent upon:
Predictability of the firm’s future cash flows Predictability of the firm’s competitor’s responses to exchange rate changes

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