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International Financial Management Jeff Madura 8th -IM-ch12

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Answer for International Financial Management Jeff Madura 8th

    Chapter 12

    Managing Economic Exposure and Translation Exposure

Lecture Outline

Economic Exposure

     Use of the Income Statement to Assess Economic Exposure

     How Restructuring Can Reduce Economic Exposure

     Issues Involved in the Restructuring Decision

    A Case Study in Hedging Economic Exposure

     Savor Co.’s Dilemma

     Assessment of Economic Exposure

     Identifying the Source of the Unit’s Exposure

     Possible Strategies to Hedge Economic Exposure

     Savor’s Hedging Solution

     Limitations of Savor’s Optimal Hedging Strategy

Hedging Exposure to Fixed Assets

Managing Translation Exposure

     Using Forward Contracts to Hedge Translation Exposure

     Limitations of Hedging Translation Exposure

    187

188 International Financial Management

    Chapter Theme

    This chapter shows how an MNC can restructure its operations to reduce economic exposure. Such a strategy is related to the firm's long-run operations, unlike transaction exposure.

    This chapter also briefly describes how translation exposure can be reduced. Yet, it is advised that the limitations of hedging translation exposure receive as much attention as the hedging strategy itself.

Topics to Stimulate Class Discussion

1. Identify the economic exposure of a small business that you are aware of.

    2. Even if you believe translation exposure is relevant, is it worthwhile to hedge it? Explain.

    3. Compare the degree of translation exposure between a small firm whose foreign subsidiary

    generates 50% of its business versus a huge exporting company with no subsidiaries.

POINT/COUNTER-POINT:

    Can an MNC Reduce the Impact of Translation Exposure by

    Communicating?

    POINT: Yes. Investors commonly use earnings to derive an MNC’s expected future cash flows. Investors do not necessarily recognize how an MNC’s translation exposure could distort their estimates of the MNC’s future cash flows. Therefore, the MNC could clearly communicate in its annual report and elsewhere how the earnings were affected by translation gains and losses in any period. If investors have this information, they will not overreact to earnings changes that are primarily attributed to translation exposure.

    COUNTER-POINT: No. Investors focus on the bottom line and should ignore to any communication regarding the translation exposure. Moreover, they may believe that translation exposure should be accounted for anyway. If foreign earnings are reduced because of a weak currency, the earnings may continue to be weak if the currency remains weak.

    WHO IS CORRECT? Use InfoTrac or some other search engine to learn more about this issue. Which argument do you support? Offer your own opinion on this issue.

    ANSWER: Both points have some merit. Some investors may believe that the bottom line earnings are the key, which implies that there should not be an adjustment for translation exposure. This supports the counter-point. However, an MNC should provide investors with much detail about translation exposure, and let investors use the information as they wish. Some investors may adjust the cash flow estimates once they are aware of the translation exposure. Their valuation could be affected by information pertaining to the translation exposure, because they may want to remove any earnings effects due to translation exposure. MNCs can not dictate the valuation processes used by investors, but they can facilitate the processes by providing all the information about translation exposure that may be desired

Chapter 12: Managing Economic Exposure and Translation Exposure 189

    by some investors. Many MNCs do not provide much information, which forces investors to try to guess at the degree of translation exposure.

Answers to End of Chapter Questions

1. Reducing Economic Exposure. Baltimore, Inc., is a U.S.-based MNC that obtains 10 percent of

    its supplies from European manufacturers. Sixty percent of its revenues are due to exports to

    Europe, where its product is invoiced in euros. Explain how Baltimore can attempt to reduce its

    economic exposure to exchange rate fluctuations in the euro.

     ANSWER: Baltimore Inc. could reduce its economic exposure by shifting some of its U.S.

    expenses to Europe. This may involve shifting its sources of materials or even part of its

    production process to Europe. It could also reduce its European revenue but this is probably not

    desirable.

2. Reducing Economic Exposure. UVA Co. is a U.S.-based MNC that obtains 40 percent of its

    foreign supplies from Thailand. It also borrows Thailand’s currency (the baht) from Thai banks

    and converts the baht to dollars to support U.S. operations. It currently receives about 10 percent

    of its revenue from Thai customers. Its sales to Thai customers are denominated in baht. Explain

    how UVA Co. can reduce its economic exposure to exchange rate fluctuations.

     ANSWER: UVA Company has periodic outflow payments in Thai baht that are substantially more

    than its Thai baht inflow payments. UVA could reduce its economic exposure by attempting to

    increase sales in Thailand, which would generate additional Thai baht inflows.

3. Reducing Economic Exposure. Albany Corp. is a U.S.-based MNC that has a large government

    contract with Australia. The contract will continue for several years and generate more than half of

    Albany's total sales volume. The Australian government pays Albany in Australian dollars. About

    10 percent of Albany's operating expenses are in Australian dollars; all other expenses are in U.S.

    dollars. Explain how Albany Corp. can reduce its economic exposure to exchange rate fluctuations.

     ANSWER: Albany may ask the Australian government to provide payment in U.S.

    dollars. Alternatively, Albany could attempt to shift some of its expenses to Australia, by either

    purchasing Australian supplies or shifting part of the production process to Australia. These

    strategies will increase Australian dollar outflows, so that the Australian dollar inflows and

    outflows are more balanced.

4. Tradeoffs When Reducing Economic Exposure. When an MNC restructures its operations to

    reduce its economic exposure, it may sometimes forgo economies of scale. Explain.

     ANSWER: An MNC may attempt to use several production plants. The production could be

    increased in countries whose home currency is weak (since demand for products in those countries

    would be higher). However, to have such flexibility requires that production plants are

    scattered. Consequently, the firm forgoes the economies of scale that may be achieved by

    establishing one large production plant.

190 International Financial Management

    5. Exchange Rate Effects on Earnings. Explain how a U.S.-based MNC's consolidated earnings are

    affected when foreign currencies depreciate.

     ANSWER: A U.S.-based MNC's consolidated earnings are reduced by the translation effect when

    foreign currencies depreciate. Foreign earnings are translated at the average exchange rate over the

    fiscal year, so low values of foreign currencies result in a low level of consolidated earnings.

6. Hedging Translation Exposure. Explain how a firm can hedge its translation exposure.

     ANSWER: A firm can hedge translation exposure by selling forward the currency of the firm's

    foreign subsidiary. Thus, if the foreign currency depreciates, the translation loss will be somewhat

    offset by the gain on the short position created by the forward contract.

7. Limitations of Hedging Translation Exposure. Bartunek Co. is a U.S.-based MNC that has

    European subsidiaries and wants to hedge its translation exposure to fluctuations in the euro’s value.

    Explain some limitations when it hedges translation exposure.

     ANSWER: The limitations are as follows. First, Bartunek Inc. needs to forecast its foreign

    subsidiary earnings and may forecast inaccurately. Thus, it will hedge against a level of foreign

    earnings that differs from actual foreign earnings.

    Second, forward contracts are not available for all currencies, although Bartunek will not be

    affected by this limitation since forward contracts in euros are available.

     Third, translation losses are not tax-deductible, while gains on forward contracts used to hedge

    translation exposure are taxed.

     Fourth, transaction exposure may be increased as a result of hedging translation exposure.

8. Effective Hedging of Translation Exposure. Would a more established MNC or a less established

    MNC be better able to effectively hedge its given level of translation exposure? Why?

     ANSWER: This question is intended to stimulate class discussion. There is no perfect

    answer. One opinion is that a more established MNC can better predict its level of foreign earnings,

    because its foreign business is stabilized. Therefore, it is more able to hedge the appropriate

    amount of foreign earnings.

9. Comparing Degrees of Economic Exposure. Carlton Co. and Palmer, Inc., are U.S.-based MNCs

    with subsidiaries in Mexico that distribute medical supplies (produced in the United States) to

    customers throughout Latin America. Both subsidiaries purchase the products at cost and sell the

    products at 90 percent markup. The other operating costs of the subsidiaries are very low. Carlton

    Co. has a research and development center in the United States that focuses on improving its

    medical technology. Palmer, Inc., has a similar center based in Mexico. The parent of each firm

    subsidizes its respective research and development center on an annual basis. Which firm is subject

    to a higher degree of economic exposure? Explain.

     ANSWER: Carlton Company is subject to a higher degree of economic exposure because it does

    not have much offsetting cost in Mexico. Palmer Inc. incurs costs in Mexico for its research and

    development center.

Chapter 12: Managing Economic Exposure and Translation Exposure 191

10. Comparing Degrees of Translation Exposure. Nelson Co. is a U.S. firm with annual export sales

    to Singapore of about S$800 million. Its main competitor is Mez Co., also based in the United

    States, with a subsidiary in Singapore that generates about S$800 million in annual sales. Any

    earnings generated by the subsidiary are reinvested to support its operations. Based on the

    information provided, which firm is subject to a higher degree of translation exposure? Explain.

     ANSWER: Since Nelson Company does not have any subsidiaries, its exposure to exchange rate

    fluctuations would not be classified as translation exposure. Conversely, Mez Company is subject

    to translation exposure.

Advanced Questions

11. Managing Economic Exposure. St. Paul Co. does business in the United States and New

    Zealand. In attempting to assess its economic exposure, it compiled the following information.

     a. St. Paul’s U.S. sales are somewhat affected by the value of the New Zealand dollar (NZ$),

    because it faces competition from New Zealand exporters. It forecasts the U.S. sales based on

    the following three exchange rate scenarios:

     Revenue from U.S. Business

     Exchange Rate of NZ$ (in millions)

     NZ$ = $.48 $100

     NZ$ = .50 105

     NZ$ = .54 110

     b. Its New Zealand dollar revenues on sales to New Zealand invoiced in New Zealand dollars are

    expected to be NZ$600 million.

     c. Its anticipated cost of goods sold is estimated at $200 million from the purchase of U.S.

    materials and NZ$100 million from the purchase of New Zealand materials.

     d. Fixed operating expenses are estimated at $30 million.

    e. Variable operating expenses are estimated at 20 percent of total sales (after including New

    Zealand sales, translated to a dollar amount).

     f. Interest expense is estimated at $20 million on existing U.S. loans, and the company has no

    existing New Zealand loans.

     Create a forecasted income statement for St. Paul Co. under each of the three exchange rate

    scenarios. Explain how St. Paul's projected earnings before taxes are affected by possible exchange

    rate movements. Explain how it can restructure its operations to reduce the sensitivity of its

    earnings to exchange rate movements without reducing its volume of business in New Zealand.

     ANSWER:

    Forecasted Income Statements for St. Paul Company

192 International Financial Management

    (Figures are in millions)

     NZ$ = $.48 NZ$ = $.50 NZ$ = $.54

    Sales

     U.S. $100 $105 $110

     New Zealand NZ$600 = 288 NZ$600 = 300 NZ$600 = 324

     Total $388 $405 $434

Cost of goods sold

     U.S. $200 $200 $200

     New Zealand NZ$100 = 48 NZ$100 = 50 NZ$100 = 54

     Total $248 $250 $254

Gross profit $140 $155 $180

     NZ$ = $.48 NZ$ = $.50 NZ$ = $.54

    Operating expenses

     U.S.: Fixed $ 30 $ 30 $ 30

     U.S.: Variable (20%

     of total sales) 78 81 87

     Total $108 $111 $117

Earnings before interest

     and taxes $ 32 $ 44 $ 63

Interest expense

     U.S. $ 20 $ 20 $ 20

     New Zealand NZ$0 = 0 NZ$0 = 0 NZ$0 = 0

     Total $ 20 $ 20 $ 20

Earnings before taxes $ 12 $ 24 $ 43

     ANSWER: The forecasted income statements show that St. Paul Company is favorably affected by

    a strong New Zealand dollar (since its NZ$ inflow payments exceed its NZ$ outflow payments). St.

    Paul Company could reduce its economic exposure without reducing its New Zealand revenues by

    shifting expenses from the U.S. to New Zealand. In this way, its NZ$ outflow payments would be

    more similar to its NZ$ inflow payments.

    12. Assessing Economic Exposure. Alaska Inc. plans to create and finance a subsidiary in Mexico that

    produces computer components at a low cost and exports them to other countries. It has no other

    international business. The subsidiary will produce computers and export them to Caribbean islands

    and will invoice the products in U.S. dollars. The values of the currencies in the islands are

    expected to remain very stable against the dollar. The subsidiary will pay wages, rent, and other

    operating costs in Mexican pesos. The subsidiary will remit earnings monthly to the parent.

    a. Would Alaska’s cash flows be favorably or unfavorably affected if the Mexican peso

    depreciates over time?

    Chapter 12: Managing Economic Exposure and Translation Exposure 193

    ANSWER: Alaska’s cash flows would be favorably affected, because it has only cash outflows in

    pesos, and can periodically convert dollars to cover its expenses in pesos.

    b. Assume that Alaska considers partial financing of this subsidiary with peso loans from Mexican

    banks instead of providing all the financing with its own funds. Would this alternative form of

    financing increase, decrease, or have no effect on the degree to which Alaska is exposed to

    exchange rate movements of the peso?

ANSWER: Alaska’s subsidiary already has cash outflows in pesos with no cash inflows in pesos.

    The partial financing with pesos would increase the cash outflows in pesos, which results in a greater exposure to the possible appreciation of the peso.

    13. Hedging Continual Exposure. Consider this common real-world dilemma by many firms that rely

    on exporting. Clearlake Inc. produces its products in its factory in Texas, and exports most of the products to Mexico each month. The exports are denominated in pesos. Clearlake Inc. recognizes that hedging on a monthly basis does not really protect against long-term movements in exchange rates. It also recognizes that it could eliminate its transaction exposure by denominating the exports in pesos, but that it still would have economic exposure (because Mexican consumers would reduce demand if the peso weakened). Clearlake Inc. does not know how many pesos it will receive in the future, so it would have difficulty even if a long-term hedging method was available. How can Clearlake realistically deal with this dilemma and reduce its exposure over the long-term? [There is no perfect solution, but in the real world, there rarely are perfect solutions.]

    ANSWER: Clearlake Inc. could consider producing its products within Mexico and selling them locally. It may be able to reduce its costs, and now would have some expenses denominated in pesos that offset a portion of the revenue in pesos. Thus, its exposure would be reduced. A limitation of this strategy is that it may have to close its factory in Texas, and lay off its employees, if it creates a plant in Mexico.

    An alternative strategy is that it obtain loans denominated in pesos that it can use to finance its existing operations. Its interest expenses in pesos would offset a portion of the peso revenue it receives, and would therefore reduce exchange rate risk. However, it may have to pay a higher interest rate in Mexico than what it pays in the U.S. because interest rates are typically higher in Mexico.

    Solution to Continuing Case Problem: Blades, Inc.

    1. How will Blades be negatively affected by the high level of inflation in Thailand if the Thai customer renews its commitment for another three years?

    ANSWER: If the Thai customer renews its commitment for another three years, the price Blades receives in baht would continue to be fixed. Conversely, Blades’ cost of goods sold incurred in

    Thailand would be subject to the high level of inflation in Thailand. In addition, the high inflation may cause the baht to depreciate, which would reduce the dollars received from baht-denominated sales to Thailand.

194 International Financial Management

    2. Holt believes that the Thai importer will renew its commitment in two years. Do you think his

    assessment is correct? Why or why not? Also, assume that the Thai economy returns to the high

    growth level that existed prior to the recent unfavorable economic events. Under this assumption,

    how likely is it that the Thai importer will renew its commitment in two years?

    ANSWER: Before renewing its commitment to purchase a fixed number of products at a fixed price

    from Blades, the Thai importer would have to assess the advantages and disadvantages of such an

    arrangement. If the Thai level of inflation continues to be high, the retailer has the advantage of

    incurring costs denominated in baht that are not subject to the high level of inflation. However, if

    consumers in Thailand continue to reduce their spending on leisure products, the Thai firm may not

    be able to sell all of the products it has purchased from Blades.

    If the Thai economy returns to a high growth level, the Thai customer will probably renew its

    commitment. This is because it can be reasonably certain that it will sell all of the products it has

    committed itself to purchase from Blades. Furthermore, the costs it incurs are still not subject to the

    high level of inflation prevailing in Thailand.

    3. For each of the three possible values of the Thai baht and the British pound, use a spreadsheet to

    construct a pro forma income statement for the next year. Briefly comment on the level of Blades’

    economic exposure.

    ANSWER: (See spreadsheet attached.) Blades, Inc. does not appear to be subject to a high level of

    economic exposure based on the analysis. Nevertheless, a depreciation of the Thai baht by 10

    percent to an average level of $.0198 over the year would decrease its earnings before taxes by

    approximately 5 percent. Thus, Blades, Inc. is subject to some economic exposure.

     THB=$0.0220 THB=$0.0209 THB=$0.0198

     BP=$1.530 BP=$1.485 BP=$1.500

    Sales

     (1) U.S. (520,000 units × $120/pair) $ 62,400,000 $ 62,400,000 $ 62,400,000

     (2) Thai (180,000 units × THB4,594 × $ 18,192,240 $ 17,282,628 $ 16,373,016

     Exchange Rate)

     (3) British (200,000 units × 80 pounds × $ 24,480,000 $ 23,760,000 $ 24,000,000

     Exchange Rate)

     (4) Total $ 105,072,240 $ 103,442,628 $ 102,773,016

Cost of goods sold:

     (5) U.S. ([900,000 80,000] units × $70) $ 57,400,000 $ 57,400,000 $ 57,400,000

     (6) Thai (80,000 units × THB3,000 × $ 5,280,000 $ 5,016,000 $ 4,752,000

     Exchange Rate)

     (7) Total $ 62,680,000 $ 62,416,000 $ 62,152,000

     (8) Gross profit $ 42,392,240 $ 41,026,628 $ 40,621,016

Operating Expenses:

     (9) U.S.: Fixed $ 2,000,000 $ 2,000,000 $ 2,000,000

     (10) U.S.: Variable (11% of U.S. sales) $ 6,864,000 $ 6,864,000 $ 6,864,000

     (11) Total $ 8,864,000 $ 8,864,000 $ 8,864,000

     (12) Earnings before taxes $ 33,528,240 $ 32,162,628 $ 31,757,016

Chapter 12: Managing Economic Exposure and Translation Exposure 195

    4. Now repeat your analysis in question 3 but assume that the British pound and the Thai baht are

    perfectly correlated. For example, if the baht depreciates by 5 percent, the pound will also

    depreciate by 5 percent. Under this assumption, is Blades subject to a greater degree of economic

    exposure? Why or why not?

    ANSWER: (See spreadsheet attached.) If the British pound and the Thai baht are perfectly

    correlated, Blades’ level of economic exposure increases. This is because Blades generates inflows

    in both pounds and baht. Under this scenario, a depreciation of the pound and the baht by 10

    percent would reduce Blades’ earnings before taxes by approximately 11 percent.

     THB=$0.0220 THB=$0.0209 THB=$0.0198

     BP=$1.50 BP=$1.425 BP=$1.350

    Sales

     (1) U.S. (520,000 units × $120/pair) $ 62,400,000 $ 62,400,000 $ 62,400,000

     (2) Thai (180,000 units × THB4,594 × $ 18,192,240 $ 17,282,628 $ 16,373,016

     Exchange Rate)

     (3) British (200,000 units × 80 pounds × $ 24,000,000 $ 22,800,000 $ 21,600,000

     Exchange Rate)

     (4) Total $ 104,592,240 $ 102,482,628 $ 100,373,016

Cost of goods sold:

     (5) U.S. ([900,000 80,000] units × $70) $ 57,400,000 $ 57,400,000 $ 57,400,000

     (6) Thai (80,000 units × THB3,000 × $ 5,280,000 $ 5,016,000 $ 4,752,000

     Exchange Rate)

     (7) Total $ 62,680,000 $ 62,416,000 $ 62,152,000

     (8) Gross profit $ 41,912,240 $ 40,066,628 $ 38,221,016

Operating Expenses:

     (9) U.S.: Fixed $ 2,000,000 $ 2,000,000 $ 2,000,000

     (10) U.S.: Variable (11% of U.S. sales) $ 6,864,000 $ 6,864,000 $ 6,864,000

     (11) Total $ 8,864,000 $ 8,864,000 $ 8,864,000

     (12) Earnings before taxes $ 33,048,240 $ 31,202,628

    $ 29,357,016

    5. Based on your answers to the previous three questions, what actions could Blades take to reduce its

    level of economic exposure to Thailand?

    ANSWER: There are several actions Blades could take. The analysis above illustrates that

    economic exposure can be reduced by conducting its international business in countries whose

    currencies are not highly correlated. Thus, Blades could be exporting to or importing from other

    countries besides Thailand and the United Kingdom. Another action Blades could take is to borrow

    in baht, which would reduce the number of baht that would have to be converted to dollars, as the

    baht receivables could be used to repay to baht-denominated loans. The borrowed funds could then

    be converted to dollars to pay for U.S. supplies. However, the high level of interest rates may not

    make this a feasible alternative. To further reduce its economic exposure, Blades could also buy

    more supplies from Thailand instead of the U.S. in order to create more cash outflows in baht. This

196 International Financial Management

    would further reduce the level of economic exposure, as more baht revenues could be used to buy Thai supplies. However, the success of this approach depends on the impact of the high level of inflation in Thailand on market prices for the imported components.

Solution to Supplemental Case: Madison, Inc.

    a. While economic exposure adversely affected the firm's performance in a recent period, it should favorably affect the firm's performance in the future. A weak Canadian dollar (which has been forecasted) would favorably affect Madison, Inc. under the prevailing operational structure. If the structure is revised, Madison will be less exposed to the Canadian dollar's exchange rate movements. Therefore, it will not benefit as much from the weaker Canadian dollar. Economic exposure can be beneficial when currencies move in a particular direction. The shareholders would be better off if the firm remains exposed while the Canadian dollar is expected to weaken.

     One may argue that the Vice-president should also be better off if Madison remains exposed, based on the forecast of the Canadian dollar. However, a counter argument is that the Vice-president may be better off if economic exposure is reduced. If by chance the Canadian dollar unexpectedly continued to appreciate, Madison's earnings would be adversely affected, and the Vice-president could lose his job. This issue usually generates much classroom discussion. Students should attempt to put themselves in the place of the Vice-president. If the Vice-president does not receive a bonus tied to earnings, he may prefer a strategy that is least risky in order to preserve his job (even if this strategy conflicts with satisfying shareholders).

    b. The prevailing operational structure allows the firm to benefit from a weaker Canadian dollar. Yet, if the Canadian dollar appreciates, the Vice-president could be fired. Thus, the Vice-president may choose a structure that reduces economic exposure, even though the expected earnings are reduced. Shareholders would have preferred that Madison remained exposed, since the expected return is higher, and do not suffer the same severe consequences as the Vice-president if the Canadian dollar appreciates.

     If the Vice-president's compensation was somewhat tied to earnings, there would be less chance of a conflict of interests. The Vice-president would be more encouraged to preserve the exposure because he would directly realize some of the benefits resulting from higher performance. In addition, the firm should have an implicit policy that does not place all the blame on the Vice-president if the policy of maintaining the prevailing structure backfires. If the Canadian dollar appreciates and earnings are adversely affected, is the poor performance the fault of the Vice-president? Is it the fault of the employees that developed the forecasts of the Canadian dollar? These issues generate interesting discussions. It should be emphasized that employees should not be fired any time they incorrectly forecast a currency to move in a particular direction. And the Vice-president should not be fired when his decision was based on input from others that he thought was reliable.

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