Chapter 9 Operating Exposure
Operating Exposure: Learning Objectives <ul><li>Examine how operating exposure arises through the unexpected changes in bo...
Operating Exposure <ul><li>Measuring the operating exposure of a firm requires forecasting and analyzing all the firm’s fu...
Operating & Financing Cash Flows <ul><li>Operating cash flows  arise from intercompany and intracompany receivables and pa...
Operating & Financing Cash Flows Subsidiary Parent Operational Cash Flows Payment for goods & services Rent and lease paym...
Expected Versus Unexpected Changes in Cash Flows <ul><li>Operating exposure  is far more important for the long-run health...
Trident’s Operating Exposure <ul><li>Trident derives much of its reported profits from its German subsidiary and there has...
Trident’s Operating Exposure Trident Europe (Hamburg, Germany) Euro Competitive Environment Trident Corporation (Los Angel...
Trident’s Operating Exposure <ul><li>Trident Europe manufactures in Germany from European material and labor </li></ul><ul...
Trident’s Operating Exposure
Trident’s Operating Exposure <ul><li>Assume that on January 1, 2003 the euro unexpectedly drops 16.67% in value from $1.20...
Strategic Management of Operating Exposure <ul><li>The objective of both operating and transaction exposure management is ...
Diversifying Operations <ul><li>Diversifying operations means diversifying the firm’s sales, location of production facili...
Diversifying Financing <ul><li>Diversifying the financing base means raising funds in more than one capital market and in ...
Proactive Management of Operating Exposure <ul><li>Operating and transaction exposures can be  partially managed  by adopt...
Matching Currency Cash Flows <ul><li>One way to offset an anticipated continuous long exposure to a particular currency is...
Matching Currency Cash Flows U.S. Corporation Canadian Corporation (buyer of goods) Exports goods to Canada Payment for go...
Currency Clauses: Risk-sharing <ul><li>Risk-sharing is a contractual arrangement in which the buyer and seller agree to “s...
Currency Clauses: Risk-sharing <ul><li>Ford’s payment to Mazda would therefore be </li></ul><ul><li>Note that this movemen...
Back-to-Back Loans <ul><li>A  back-to-back loan , also referred to as a  parallel loan  or  credit swap , occurs when two ...
Back-to-Back Loans The back-to-back loan provides a method for parent-subsidiary cross border financing without incurring ...
Currency Swaps <ul><li>Currency swaps  resemble back-to-back loans except that it does not appear on a firm’s balance shee...
Currency Swaps <ul><li>For example, a Japanese firm exporting to the US wanted to construct a matching cash flow swap, it ...
Currency Swaps Wishes to enter into a swap to “ pay dollars” and “receive yen” Japanese Corporation Assets  Liabilities & ...
Leads and Lags:  Re-timing the Transfer of Funds <ul><li>Firms can reduce both operating and transaction exposure by accel...
Leads and Lags:  Intracompany <ul><li>Leading and lagging between related firms is more feasible because they presumably e...
Leads and Lags:  Intercompany <ul><li>Leading or lagging between independent firms requires the time preference of one fir...
Leads and Lags:  Reinvoicing Centers <ul><li>A reinvoicing center is a separate corporate subsidiary that serves as a type...
Use of a Reinvoicing Center 3. The reinvoicing center takes legal title to the goods.  1. Trident USA  ships goods directl...
Leads and Lags:  Reinvoicing Centers <ul><li>There are three basic benefits arising from the creation of a reinvoicing cen...
Contractual Approaches <ul><li>Some MNEs now attempt to hedge their operating exposure with contractual strategies </li></...
Summary of Learning Objectives <ul><li>Foreign exchange exposure  is a measure of the potential for a firm’s profitability...
Summary of Learning Objectives <ul><li>The objective of operating exposure management is to anticipate and influence the e...
Mini-Case:  Porsche Exposed <ul><li>In January 2004, Porsche’s management became concerned with re-evaluating its currency...
Mini-Case:  Impact of Treasury Profits on EBIT Margins Source: CreditSuisse/First Boston, December 13, 2003, p. 47, p. 70....
Mini-Case:  Porsche Exposed <ul><li>Do you believe, based on the facts of the case, that Porsche’s management is appropria...
Exhibit 9.1  Financial and Operating Cash Flows Between Parent and Subsidiary
Exhibit 9.2  Trident Corporation and Its European Subsidiary: Operating Exposure of the Parent and Its Subsidiary
Exhibit 9.3  Trident Europe
Exhibit 9.4  Matching: Debt Financing as a Financial Hedge
Exhibit 9.5  Using a Back-to-Back Loan for Currency Hedging
Exhibit 9.6  Using a Cross- Currency Swap to Hedge Currency Exposure
Exhibit 9.7  Use of a Reinvoicing Center
Exhibit 1  Toyota Motor’s European Currency Operating Structure
Exhibit 2  Daily Exchange Rates: Japanese Yen per Euro
Exhibit 3  Daily Exchange Rates: British Pounds per Euro
Exhibit 1  United Kingdom and NAFTA Sales and Production of Selected European Automakers as a Percent of Global Results, 2...
Exhibit 2  Impact of Porsche’s Treasury Profits on EBIT Margins
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Mazda 0321286375 2009 Presentation

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Mazda 0321286375 2009 Presentation

  1. 1. Chapter 9 Operating Exposure
  2. 2. Operating Exposure: Learning Objectives <ul><li>Examine how operating exposure arises through the unexpected changes in both operating and financing cash flows </li></ul><ul><li>Evaluate strategic alternatives to managing operating exposure </li></ul><ul><li>Detail the proactive policies firms use in managing operating exposure </li></ul>
  3. 3. Operating Exposure <ul><li>Measuring the operating exposure of a firm requires forecasting and analyzing all the firm’s future individual transaction exposures together with the future exposure of all the firm’s competitors and potential competitors </li></ul><ul><ul><li>Example: Eastman Kodak has a transaction exposures from present and future sales abroad </li></ul></ul><ul><ul><li>The sum of these future exposures will have an effect on Kodak’s cash flows as exchange rates change </li></ul></ul><ul><ul><li>Kodak’s value and competitiveness depends on these cash flows and whether or not it can manage them better than their competition </li></ul></ul><ul><li>This long term view is the objective of operating exposure analysis </li></ul>
  4. 4. Operating & Financing Cash Flows <ul><li>Operating cash flows arise from intercompany and intracompany receivables and payables, rent and lease payments, royalty and licensing fees, and other associated fees </li></ul><ul><li>Financing cash flows are payments for the use of inter and intracompany loans and stockholder equity </li></ul>
  5. 5. Operating & Financing Cash Flows Subsidiary Parent Operational Cash Flows Payment for goods & services Rent and lease payments Royalties and license fees Management fees & distributed overhead Financial Cash Flows Dividend paid to parent Parent invested equity capital Interest on intrafirm lending Intrafirm principal payments
  6. 6. Expected Versus Unexpected Changes in Cash Flows <ul><li>Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure </li></ul><ul><ul><li>Planning for operating exposure is total management responsibility since it depends on the interaction of strategies in finance, marketing, purchasing, and production </li></ul></ul><ul><ul><li>An expected change in exchange rates is not included in the definition of operating exposure because management and investors should have factored this into their analysis of anticipated operating results and market value </li></ul></ul>
  7. 7. Trident’s Operating Exposure <ul><li>Trident derives much of its reported profits from its German subsidiary and there has been an unexpected change in the value of the euro thus affecting Trident significantly </li></ul><ul><li>Trident’s German subsidiary is operating in a euro-denominated competitive environment </li></ul><ul><ul><li>The subsidiary’s profitability and performance will be impacted by any changes in performance and pricing from its suppliers and customers as a result of changes in the US$/euro exchange rate </li></ul></ul>
  8. 8. Trident’s Operating Exposure Trident Europe (Hamburg, Germany) Euro Competitive Environment Trident Corporation (Los Angeles, USA) US$ Reporting Environment US$/ € Trident’s Suppliers Trident’s Customers 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. Will costs change? How will the sales, costs, and profits of the German subsidiary change? Will the altered profits of the German subsidiary, in euro, translate into more or less in US dollars? Will prices & sales volume change?
  9. 9. Trident’s Operating Exposure <ul><li>Trident Europe manufactures in Germany from European material and labor </li></ul><ul><li>Half of production is sold within Europe the other half is exported to non-European countries </li></ul><ul><li>All sales are invoiced in euros and average collection period is 90 days </li></ul><ul><li>Inventory is equal to 25% of annual direct costs </li></ul><ul><li>Depreciation is €600,000 per annum </li></ul><ul><li>Corporate tax is 34% in Germany </li></ul>
  10. 10. Trident’s Operating Exposure
  11. 11. Trident’s Operating Exposure <ul><li>Assume that on January 1, 2003 the euro unexpectedly drops 16.67% in value from $1.200/€ to $1.000/€ </li></ul><ul><ul><li>If no devaluation had occurred, Trident Europe was expected to perform as shown in the base case </li></ul></ul><ul><ul><li>To illustrate let us assume three various post-devaluation scenarios on Trident Europe’s operating exposures </li></ul></ul><ul><ul><ul><li>Case 1: Devaluation, no change in any variable </li></ul></ul></ul><ul><ul><ul><li>Case 2: Increase in sales volume only </li></ul></ul></ul><ul><ul><ul><li>Case 3: Increase in sales price only </li></ul></ul></ul>
  12. 12. Strategic Management of Operating Exposure <ul><li>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 </li></ul><ul><li>To meet this objective, management can diversify the firm’s operating and financing base </li></ul><ul><li>Management can also change the firm’s operating and financing policies </li></ul>
  13. 13. Diversifying Operations <ul><li>Diversifying operations means diversifying the firm’s sales, location of production facilities, and raw material sources </li></ul><ul><li>If a firm is diversified, management is prepositioned to both recognize disequilibrium when it occurs and react competitively </li></ul><ul><li>Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies </li></ul>
  14. 14. Diversifying Financing <ul><li>Diversifying the financing base means raising funds in more than one capital market and in more than one currency </li></ul><ul><li>If a firm is diversified, management is prepositioned to take advantage of temporary deviations from the International Fisher effect </li></ul>
  15. 15. Proactive Management of Operating Exposure <ul><li>Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated currency exposures </li></ul><ul><li>Six of the most commonly employed proactive policies are </li></ul><ul><ul><li>Matching currency cash flows </li></ul></ul><ul><ul><li>Risk-sharing agreements </li></ul></ul><ul><ul><li>Back-to-back or parallel loans </li></ul></ul><ul><ul><li>Currency swaps </li></ul></ul><ul><ul><li>Leads and lags </li></ul></ul><ul><ul><li>Reinvoicing centers </li></ul></ul>
  16. 16. Matching Currency Cash Flows <ul><li>One way to offset an anticipated continuous long exposure to a particular currency is to acquire debt denominated in that currency </li></ul><ul><li>This policy results in a continuous receipt of payment and a continuous outflow in the same currency </li></ul><ul><li>This can sometimes occur through the conduct of regular operations and is referred to as a natural hedge </li></ul>
  17. 17. Matching Currency Cash Flows U.S. Corporation Canadian Corporation (buyer of goods) Exports goods to Canada Payment for goods in Canadian dollars Exposure : The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollars Principal and interest payments on debt in Canadian dollars Canadian Bank (loans funds) US Corp borrows Canadian dollar debt from Canadian Bank Hedge : The Canadian dollar debt payments act as a financial hedge by requiring debt service, an outflow of Canadian dollars
  18. 18. Currency Clauses: Risk-sharing <ul><li>Risk-sharing is a contractual arrangement in which the buyer and seller agree to “share” or split currency movement impacts on payments </li></ul><ul><ul><li>Example: Ford purchases from Mazda in Japanese yen at the current spot rate as long as the spot rate is between ¥115/$ and ¥125/$. </li></ul></ul><ul><ul><li>If the spot rate falls outside of this range, Ford and Mazda will share the difference equally </li></ul></ul><ul><ul><li>If on the date of invoice, the spot rate is ¥110/$, then Mazda would agree to accept a total payment which would result from the difference of ¥115/$- ¥110/$ (i.e. ¥5) </li></ul></ul>
  19. 19. Currency Clauses: Risk-sharing <ul><li>Ford’s payment to Mazda would therefore be </li></ul><ul><li>Note that this movement is in Ford’s favor, however if the yen depreciated to ¥130/$ Mazda would be the beneficiary of the risk-sharing agreement </li></ul>
  20. 20. Back-to-Back Loans <ul><li>A back-to-back loan , also referred to as a parallel loan or credit swap , occurs when two firms in different countries arrange to borrow each other’s currency for a specific period of time </li></ul><ul><ul><li>The operation is conducted outside the FOREX markets, although spot quotes may be used </li></ul></ul><ul><ul><li>This swap creates a covered hedge against exchange loss, since each company, on its own books, borrows the same currency it repays </li></ul></ul>
  21. 21. Back-to-Back Loans The back-to-back loan provides a method for parent-subsidiary cross border financing without incurring direct currency exposure. Indirect Financing British parent firm 1. British firm wishes to invest funds in its Dutch subsidiary Dutch firm’s British subsidiary 3. British firm loans British pounds directly to the Dutch firm’s British subsidiary Direct loan in pounds Dutch parent firm 2. British firm identifies a Dutch firm wishing to invest funds in its British subsidiary British firm’s Dutch subsidiary 4. British firm’s Dutch subsidiary loans euros to the Dutch parent Direct loan in euros
  22. 22. Currency Swaps <ul><li>Currency swaps resemble back-to-back loans except that it does not appear on a firm’s balance sheet </li></ul><ul><li>In a currency swap, a dealer and a firm agree to exchange an equivalent amount of two different currencies for a specified period of time </li></ul><ul><ul><li>Currency swaps can be negotiated for a wide range of maturities </li></ul></ul><ul><li>A typical currency swap requires two firms to borrow funds in the markets and currencies in which they are best known or get the best rates </li></ul>
  23. 23. Currency Swaps <ul><li>For example, a Japanese firm exporting to the US wanted to construct a matching cash flow swap, it would need US dollar denominated debt </li></ul><ul><li>But if the costs were too great, then it could seek out a US firm who exports to Japan and wanted to construct the same swap </li></ul><ul><li>The US firm would borrow in dollars and the Japanese firm would borrow in yen </li></ul><ul><li>The swap-dealer would then construct the swap so that the US firm would end up “paying yen” and “receiving dollars” </li></ul><ul><li>The Japanese firm would then be “paying dollars” and “receiving yen” </li></ul><ul><li>This is also called a cross-currency swap </li></ul>
  24. 24. Currency Swaps Wishes to enter into a swap to “ pay dollars” and “receive yen” Japanese Corporation Assets Liabilities & Equity Debt in yen Sales to US Swap Dealer Receive dollars Pay dollars Pay yen Receive yen Wishes to enter into a swap to “ pay yen” and “receive dollars” United States Corporation Debt in US$ Assets Liabilities & Equity Sales to Japan Inflow of yen Inflow of US$
  25. 25. Leads and Lags: Re-timing the Transfer of Funds <ul><li>Firms can reduce both operating and transaction exposure by accelerating or decelerating the timing of payments that must be made or received in foreign currencies </li></ul><ul><ul><li>To lead is to pay early </li></ul></ul><ul><ul><li>To lag is to pay late </li></ul></ul><ul><li>Leading and lagging can be done between related firms (intracompany) or with independent firms (intercompany) </li></ul>
  26. 26. Leads and Lags: Intracompany <ul><li>Leading and lagging between related firms is more feasible because they presumably embrace a common set of goals for the consolidated group </li></ul><ul><li>In the case of financing cash flows with foreign subsidiaries, there is an additional motivation for early or late payments to position funds for liquidity reasons </li></ul><ul><li>For example, a subsidiary which is allowed to lag payments to the parent company is in reality “borrowing” from the parent </li></ul><ul><li>Because the use of leads and lags is an obvious technique for minimizing foreign exchange exposure, and for shifting the burden of financing, many governments impose limits on the allowed range </li></ul>
  27. 27. Leads and Lags: Intercompany <ul><li>Leading or lagging between independent firms requires the time preference of one firm to be imposed to the detriment of the other firm </li></ul><ul><li>For example, Trident Europe may wish to lead in collecting its Brazilian accounts receivable that are denominated in real because it expects the real to drop in value compared with the euro </li></ul><ul><li>However, the only way the Brazilians would be willing to pay their accounts payable early would be for the German creditor to offer a discount about equal to the forward discount on the real (or the difference between Brazilian and German interest rates for the period of prepayment) </li></ul>
  28. 28. Leads and Lags: Reinvoicing Centers <ul><li>A reinvoicing center is a separate corporate subsidiary that serves as a type of “middle-man” between the parent or related unit in one location and all foreign subsidiaries in a geographic region </li></ul><ul><li>The following exhibit depicts the U.S. manufacturing unit of Trident Corporation invoicing the firm’s reinvoicing center – located within the corporate HQ in Los Angeles – in U.S. dollars </li></ul><ul><li>However, the physical goods are shipped directly to Trident Brazil </li></ul><ul><li>The reinvoicing center in turn re-sells to Trident Brazil in Brazilian real </li></ul><ul><li>Consequently, all operating units deal only in their own currency, and all transaction exposure lies with the reinvoicing center </li></ul>
  29. 29. Use of a Reinvoicing Center 3. The reinvoicing center takes legal title to the goods. 1. Trident USA ships goods directly to the Brazilian subsidiary. 2. The invoice by Trident USA, which is denominated in U.S. dollars, is passed to the reinvoicing center. 4. The reinvoicing center invoices Trident Brazil in Brazilian real, repositioning the currency exposure from both operating units to the reinvoicing center. Trident USA (Manufactures unfinished switches) Trident Brazil (Finishes for local sales) Physical goods Goods are resold by reinvoicing center to Brazilian sales subsidiary in Brazilian real (R$) Reinvoicing Center Goods are sold by Trident USA to reinvoicing center in U.S. dollars
  30. 30. Leads and Lags: Reinvoicing Centers <ul><li>There are three basic benefits arising from the creation of a reinvoicing center: </li></ul><ul><ul><li>Management of foreign exchange exposures </li></ul></ul><ul><ul><li>Guaranteeing the exchange rate for future orders </li></ul></ul><ul><ul><li>Managing intra-subsidiary cash flows </li></ul></ul><ul><li>The main disadvantage is one of cost relative to benefits received as an additional corporate unit must be created and a separate set of books must be kept </li></ul>
  31. 31. Contractual Approaches <ul><li>Some MNEs now attempt to hedge their operating exposure with contractual strategies </li></ul><ul><li>These firms have undertaken long-term currency option positions hedges designed to offset lost earnings from adverse changes in exchange rates </li></ul><ul><li>The ability to hedge the “unhedgeable” is dependent upon predictability </li></ul><ul><ul><li>Predictability of the firm’s future cash flows </li></ul></ul><ul><ul><li>Predictability of the firm’s competitor responses to exchange rate changes </li></ul></ul><ul><li>Few in practice feel capable of accurately predicting competitor response, yet some firms employ this strategy </li></ul>
  32. 32. Summary of Learning Objectives <ul><li>Foreign exchange exposure is a measure of the potential for a firm’s profitability, cash flow, and market value to change because of a change in exchange rates </li></ul><ul><li>MNEs encounter three types of currency exposure: (1) transaction; (2) operating; and (3) translation exposure </li></ul><ul><li>Operating exposure measures the change in value of the firm that results from changes in future operating cash flows caused by an unexpected change in exchange rates </li></ul><ul><li>Operating strategies for the management of operating exposures emphasize the structuring of firm operations in order to create matching streams of cash flows by currency: this is termed matching </li></ul>
  33. 33. Summary of Learning Objectives <ul><li>The objective of operating exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firm’s future cash flows, rather than being forced into passive reaction </li></ul><ul><li>Proactive policies include matching currency of cash flow, currency risk sharing clauses, back-to-back loans, and cross currency swaps </li></ul><ul><li>Contractual approaches have occasionally been used to hedge operating exposure but are costly and possibly ineffectual </li></ul>
  34. 34. Mini-Case: Porsche Exposed <ul><li>In January 2004, Porsche’s management became concerned with re-evaluating its currency hedging strategy as it was becoming something of a lightning rod for criticism </li></ul><ul><li>Although the currency hedging results had been positive, many experts believed that Porsche had simply been ‘more lucky than good’ </li></ul><ul><li>There was growing nervousness that the company was actually speculating on currency movements, which was not in the best interests of shareholders </li></ul>
  35. 35. Mini-Case: Impact of Treasury Profits on EBIT Margins Source: CreditSuisse/First Boston, December 13, 2003, p. 47, p. 70. Values for 2003/04 are estimates.
  36. 36. Mini-Case: Porsche Exposed <ul><li>Do you believe, based on the facts of the case, that Porsche’s management is appropriately concerned with stockholder wealth? </li></ul><ul><li>Does Porsche’s ownership structure work to the benefit or detriment of public shareholders? </li></ul><ul><li>Is Porsche’s current currency hedging strategy protecting it from adverse exchange rate changes? </li></ul><ul><li>Will this work as well in the long run? </li></ul><ul><li>What are alternative hedging strategies? </li></ul><ul><li>Does the company’s currency hedging strategy reflect a particular bias? </li></ul>
  37. 37. Exhibit 9.1 Financial and Operating Cash Flows Between Parent and Subsidiary
  38. 38. Exhibit 9.2 Trident Corporation and Its European Subsidiary: Operating Exposure of the Parent and Its Subsidiary
  39. 39. Exhibit 9.3 Trident Europe
  40. 40. Exhibit 9.4 Matching: Debt Financing as a Financial Hedge
  41. 41. Exhibit 9.5 Using a Back-to-Back Loan for Currency Hedging
  42. 42. Exhibit 9.6 Using a Cross- Currency Swap to Hedge Currency Exposure
  43. 43. Exhibit 9.7 Use of a Reinvoicing Center
  44. 44. Exhibit 1 Toyota Motor’s European Currency Operating Structure
  45. 45. Exhibit 2 Daily Exchange Rates: Japanese Yen per Euro
  46. 46. Exhibit 3 Daily Exchange Rates: British Pounds per Euro
  47. 47. Exhibit 1 United Kingdom and NAFTA Sales and Production of Selected European Automakers as a Percent of Global Results, 2002
  48. 48. Exhibit 2 Impact of Porsche’s Treasury Profits on EBIT Margins
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