slide 1 of 20 slides developed by jeff madura, with additions and enhancements by tim richardson...

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Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson

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Managing Economic Exposure and Translation Exposure

Chapter 12Chapter 12

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Exchange Rate Exposure

Reminder: There are 3 forms by which a Reminder: There are 3 forms by which a MNC is exposed to exchange rate MNC is exposed to exchange rate fluctuationsfluctuations

1. Transaction exposure1. Transaction exposure 2. Economic Exposure - Chapter 122. Economic Exposure - Chapter 12 3. Translation Exposure3. Translation Exposure

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Economic ExposureEconomic Exposure is essentially the fact that the cash flows is essentially the fact that the cash flows

of the MNCs are sensitive to exchange of the MNCs are sensitive to exchange rate movementsrate movements

if the exchange rate goes up, or down, if the exchange rate goes up, or down, usually this is caused by economic usually this is caused by economic circumstances in the particular country - circumstances in the particular country - this is why we call it Economic this is why we call it Economic ExposureExposure

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Managing Economic Exposure

Economic exposureEconomic exposure– any impact of exchange rate fluctuations any impact of exchange rate fluctuations

on future cash flowson future cash flows affect cash flows in manner not associated with affect cash flows in manner not associated with

currency transactionscurrency transactions

– an MNC would examine how all cash flow an MNC would examine how all cash flow is affected by exchange rate movement is affected by exchange rate movement

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Transaction ExposureTransaction Exposure is the fact that you have to make is the fact that you have to make

conversions of the currency into foreign conversions of the currency into foreign currency for some parts of the intl currency for some parts of the intl businessbusiness

Economic ExposureEconomic Exposure is the fact that once you make that is the fact that once you make that

conversion - the currency could go up conversion - the currency could go up or down - and give you advantages or or down - and give you advantages or disadvantagesdisadvantages

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Sometimes Hedging

is not relevant

““Corporate cash flows can sometimes Corporate cash flows can sometimes be effected by exchange rate be effected by exchange rate movements in ways not directly movements in ways not directly associated with foreign exchange associated with foreign exchange transactions”transactions”

““Thus firms cannot JUST focus on Thus firms cannot JUST focus on hedging - they have to determine how hedging - they have to determine how cash flows will be affectedcash flows will be affected

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Example: British Laker AirlinesExample: British Laker Airlines What happened?What happened? Revenues generated in poundsRevenues generated in pounds large amount of expenses in dollarslarge amount of expenses in dollars when dollar strengthens, expenses when dollar strengthens, expenses

creep upcreep up bank loan also denominated in dollarsbank loan also denominated in dollars

Laker w

ent bankrupt

Laker w

ent bankrupt

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Assessing economic exposureAssessing economic exposure– examine sensitivity of revenues and costs examine sensitivity of revenues and costs

to exchange rate fluctuationto exchange rate fluctuation an imbalance between costs and revenues an imbalance between costs and revenues

creates higher exposure levelcreates higher exposure level

– determine sensitivity of earnings to determine sensitivity of earnings to exposureexposure

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Restructuring

You can increase advertising costs and You can increase advertising costs and hope to increase saleshope to increase sales

you can borrow money from one you can borrow money from one country, to pay back loans in anothercountry, to pay back loans in another

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Economic Exposure

US firm with subsidiary in Japan US firm with subsidiary in Japan – most revenue raised in the US dollarsmost revenue raised in the US dollars– most costs occur in Japanese yenmost costs occur in Japanese yen– most borrowing occurs in Japanmost borrowing occurs in Japan

a currency imbalance exists between costs and a currency imbalance exists between costs and revenues revenues

– Income statement becomes sensitive to Income statement becomes sensitive to currency fluctuationscurrency fluctuations

Measuring exposure for US MNC YMeasuring exposure for US MNC Y

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Economic Exposure

Income statement becomes sensitive to Income statement becomes sensitive to currency fluctuationscurrency fluctuations– effect of currency imbalance among costs effect of currency imbalance among costs

and revenuesand revenues


CostsCosts RevenuesRevenues

Net earningsNet earnings

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Economic Exposure

Impact if yen were to strengthenImpact if yen were to strengthen– increases MNC Y’s production costsincreases MNC Y’s production costs– increases MNC Y’s interest expensesincreases MNC Y’s interest expenses– decreases net earningsdecreases net earnings


CostsCosts Net earningsNet earnings

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Economic Exposure

Response to a strong yen over timeResponse to a strong yen over time– MNC Y may change emphasis of the two MNC Y may change emphasis of the two

sitessites increase Japanese revenueincrease Japanese revenue shift costs to USshift costs to US

– attempt to reduce effect of currency attempt to reduce effect of currency imbalance imbalance


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Analysis with Computer Spreadsheets

Allows you to understand the results of Allows you to understand the results of different scenarios because you can different scenarios because you can plug in the different exchange rate plug in the different exchange rate changes - and see the subsequent changes - and see the subsequent resultsresults

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When Deciding to Restructure

One must address the following questionsOne must address the following questions

Each of these 4 questions is important Each of these 4 questions is important because they reflect a different part of because they reflect a different part of the firm’s income statementthe firm’s income statement

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One must address the following questionsOne must address the following questions

Should the firm attempt to increase or Should the firm attempt to increase or decrease salesdecrease sales

Should the firm increase or decrease its Should the firm increase or decrease its dependency on foreign suppliersdependency on foreign suppliers

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the following questions, , , ,the following questions, , , ,

Should the firm establish or eliminate Should the firm establish or eliminate production facilitiesproduction facilities

Should the firm increase or reduce its Should the firm increase or reduce its level of debt denominated in foreign level of debt denominated in foreign currenciescurrencies

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By making cars in the U.S.A., they pay By making cars in the U.S.A., they pay for parts in dollars, and sell the cars for for parts in dollars, and sell the cars for dollars, and pay employees in dollars, dollars, and pay employees in dollars,

so if dollars change in respect to Yen, it so if dollars change in respect to Yen, it doesn’t mean much cause very little has doesn’t mean much cause very little has to be paid for in Yen, and very little goes to be paid for in Yen, and very little goes back to Japan in Yenback to Japan in Yen

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Summary

Economic exposureEconomic exposure– balances sensitivity of revenues and balances sensitivity of revenues and

expenses to exchange rate fluctuationsexpenses to exchange rate fluctuations

slide 1 of 20 slides developed by jeff madura, with additions and enhancements by tim richardson...

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