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Chapter 12 Compatibility Mode123
Chapter 12 Compatibility Mode123
12
Managing Economic Exposure
And Translation Exposure
12. 2
Economic Exposure
12. 3
Economic Exposure
12. 4
Income Statement Analysis to
Assess Economic Exposure
• MNCs can determine the impact of FX exposure
by assessing the sensitivity of their cash inflows
and outflows to various possible exchange rate
scenarios.
• The MNC can then minimize its FX exposure by
restructuring its operations to reduce its “net”
exchange-rate-sensitive cash flows.
• Use spreadsheets to facilitate analysis.
12. 5
Base Case: Impact of Exchange Rate Movements on
Earnings of Madison, Inc. (In Millions)
12. 6
Managing
Madison Inc.’s Economic Exposure
• Madison Inc.’s Net FX Exposure: C$206 m outflow
• Madison’s earnings before taxes is inversely
related to the Canadian dollar’s strength, since the
higher expenses more than offset the higher
revenue when the Canadian dollar strengthens.
• Madison may reduce its exposure by increasing
Canadian sales, reducing orders of Canadian
materials, and borrowing less in Canadian dollars.
12. 7
How to Minimize Economic
Exposure
• Restructuring can reduce economic exposure by
shifting the sources of costs or revenue to other
locations in order to match cash inflows and
outflows in foreign currencies.
• The new structure is then evaluated by assessing
how the revised cash flows are sensitive to
various possible exchange rate scenarios.
12. 8
Impact of Possible Exchange Rate Movements on
Earnings: Before and After Corporate Restructuring
(in Millions)
12. 9
Economic Exposure Based on the Original
and Proposed Operating Structures
12. 10
Crucial Issues Involved in the
Restructuring Decisions
• Restructuring operations is a long-term solution to
reducing economic exposure. It is a much more
complex task than hedging any foreign currency
transaction.
• MNCs must be very confident about the long-term
potential benefits before they proceed to
restructure their operations, because of the high
reversal costs.
12. 11
Strategies for Restructuring
12. 12
12. 13
A Case Study in
Hedging Economic Exposure
• Savor Co., a U.S. firm, has three independent
units that conduct business in the Eurozone. It is
concerned about its exposure to the euro.
• To determine whether it is exposed and the source
of the exposure, Savor applies a series of
regression analysis to its cash flows and the
euro’s movements.
12. 14
An Analysis of
Savor Co.’s Cash Flows and the Euro’s Movements
12. 15
A Case Study in
Hedging Economic Exposure
Assessment of Savor’s Exposure:
%TotalCashFlowt = a0 + a1%eurot + t
12. 16
A Case Study in
Hedging Economic Exposure
Assessment of Each Unit’s Exposure:
%UnitCashFlowt = a0 + a1%eurot + t
12. 18
A Case Study in
Hedging Economic Exposure
Possible Hedging Strategies:
• Pricing policy – Reduce domestic prices when the
euro depreciates.
• Hedging with forward contracts – Sell euros
forward to hedge against the adverse effects of a
weak euro.
• Purchasing foreign supplies – Costs will be
reduced during a weak-euro period.
12. 19
A Case Study in
Hedging Economic Exposure
Possible Hedging Strategies:
12. 20
Hedging Exposure to Fixed Assets
12. 21
Translation Exposure
12. 22
Translation Exposure Management
A simple example of earnings and balance sheet translation
Earnings Translation Management
Columbus, Inc., a US-based MNC has a subsidiary in France that is forecast to have an after tax earnings of €20 million during 2015.
2015 after tax earnings: €20 million Case#1: Repatriate earnings → Case of transactions exposure
Case#2: Reinvest earnings in France → Case of translation exposure
Exchange rate Jan 1, 2015 Dec 31, 2015 rate Ave. 2015 Forward Rate (sell €) quote provided on Jan 1, 2015
$1.30/€ spot $1.40/€ spot $1.35/€ $1.50/€ (Dec 31, 2015 delivery)
Case#2: Reinvest €20 million earnings in France
Strategy #1: No hedging of translation exposure
Per FASB-52, Translation of €20 French earning to $ (reporting currency) on Dec 31, 2015 = €20 × 1.35 = $27 million
Earnings after translation = $27 million
Strategy #2: Hedging translation exposure by selling euros forward at a stronger € rate than the actual future spot rate of $1.40/€
recorded on December 31, 2015.
Profit from executing forward contract = Sell euros forward – buy euros spot on Dec 31, 2015
= €20 million (1.50 – 1.40) = €20 × 0.10 = $2 million
Earnings after translation = $27 million + $2*(1-French corporate tax rate) million
Strategy #3: Hedging translation exposure by selling euros forward at a weaker € rate than the actual future spot rate (say, $1.36/€
instead of the recorded $1.40/€ spot rate).
A loss will be incurred while executing the forward contract, since euros will need to be purchased at say, $1.40/€ (future spot rate on
December 31, 2015) and the euro sold at a lower forward rate of $1.36/€. Loss= €20 million (1.36 – 1.40) = €20 x -0.04 = -$0.8 mn
Earnings after translation = $27 million (1.35x20) – $0.8 million = $26.2 million
12. 23
Limitations of
Hedging Translation Exposure
Inaccurate earnings forecasts
Inadequate forward contracts for some currencies
Accounting distortions
• Translation gains/losses are based on the average
exchange rate (which is unlikely to be the same as the
forward rate).
• Translation losses are not tax deductible.
12. 24