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
Parent Subsidiary
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 Case 1 Case 2 Case 3 Case 4
Assumptions
Exchange rate, $/€ 1.2000 1.0000 1.0000 1.0000 1.0000
Sales volume (units) 1,000,000 1,000,000 2,000,000 1,000,000 500,000
Export sales volume (case 4) 500,000
Sales price per unit € 12.80 € 12.80 € 12.80 € 15.36 € 12.80
Export sales price per unit (case 4) € 15.36
Direct cost per unit € 9.60 € 9.60 € 9.60 € 9.60 € 9.60
Annual Cash Flows before Adjustments
Sales revenue € 12,800,000 € 12,800,000 € 25,600,000 € 15,360,000 € 14,080,000
Direct cost of goods sold 9,600,000 9,600,000 19,200,000 9,600,000 9,600,000
Cash operating expenses (fixed) 890,000 890,000 890,000 890,000 890,000
Depreciation 600,000 600,000 600,000 600,000 600,000
Pretax profit € 1,710,000 € 1,710,000 € 4,910,000 € 4,270,000 € 2,990,000
Income tax expense 581,400 581,400 1,669,400 1,451,800 1,016,600
Profit after tax € 1,128,600 € 1,128,600 € 3,240,600 € 2,818,200 € 1,973,400
Add back depreciation 600,000 600,000 600,000 600,000 600,000
Cash flow from operations, in euros € 1,728,600 € 1,728,600 € 3,840,600 € 3,418,200 € 2,573,400
Cash flow from operations, in dollars $ 2,074,320 $ 1,728,600 $ 3,840,600 $ 3,418,200 $ 2,573,400
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 € 3,520,000
Inventory 2,400,000 2,400,000 4,800,000 2,400,000 2,400,000
Sum € 5,600,000 € 5,600,000 € 11,200,000 € 6,240,000 € 5,920,000
Change from base conditions in 2003 € - € - € 5,600,000 € 640,000 € 320,000
Year Year-End Cash Flows
1 (2003) $ 2,074,320 $ 1,728,600 $ (1,759,400) $ 2,778,200 $ 2,253,400
2 (2004) $ 2,074,320 $ 1,728,600 $ 3,840,600 $ 3,418,200 $ 2,573,400
3 (2005) $ 2,074,320 $ 1,728,600 $ 3,840,600 $ 3,418,200 $ 2,573,400
4 (2006) $ 2,074,320 $ 1,728,600 $ 3,840,600 $ 3,418,200 $ 2,573,400
5 (2007) $ 2,074,320 $ 1,728,600 $ 9,440,600 $ 4,058,200 $ 2,893,400
Year Change in Year-End Cash Flows from Base Conditions
1 (2003) na $ (345,720) $ (3,833,720) $ 703,880 $ 179,080
2 (2004) na $ (345,720) $ 1,766,280 $ 1,343,880 $ 499,080
3 (2005) na $ (345,720) $ 1,766,280 $ 1,343,880 $ 499,080
4 (2006) na $ (345,720) $ 1,766,280 $ 1,343,880 $ 499,080
5 (2007) 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
Carlton, Inc. and Carlton Germany
Will the altered profits of the
US$ Reporting Carlton, Inc. German subsidiary, in euro,
(Palo Alto, CA, USA) translate into more or less in
Environment US dollars?
US$/€
Euro Competitive Carlton Germany
How will the sales, costs,
and profits of the German
Environment (Munich, Germany) subsidiary change?
Carlton’s Suppliers Carlton’s Customers
Will costs change? 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 Canadian
Corporation Bank
(buyer of goods) Exports (loans funds)
goods to US Corp borrows
Canada Canadian dollar debt
from Canadian Bank
U.S.
Corporation Principal and interest
Payment for goods
in Canadian dollars 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 2. British firm identifies a Dutch firm wishing
in its Dutch subsidiary to invest funds in its British subsidiary
British parent Dutch parent
firm Indirect firm
Financing
Direct loan Direct loan
in pounds in euros
Dutch firm’s British firm’s
British subsidiary Dutch subsidiary
3. British firm loans British pounds 4. British firm’s Dutch subsidiary loans
directly to the Dutch firm’s British euros to the Dutch parent
subsidiary
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 United States
Corporation Corporation
Assets Liabilities & Equity Assets Liabilities & Equity
Inflow Inflow
Sales to US Debt in yen Sales to Japan Debt in US$
of US$ of yen
Receive Pay
yen yen
Pay Receive
dollars Swap Dealer dollars
Wishes to enter into a swap to Wishes to enter into a swap to
“pay dollars” and “receive yen” “pay yen” and “receive dollars”
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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
