International Financial Management PDF

International Financial Management INTERNATIONAL FINANCIAL MANAGEMENT Managing Operating 3 & Translation Exposures Tzvetomir Tzanov, Ph.D. Department of IER & Business © T.Tzanov, Ph.D, UNWE  Internation...

International Financial Management INTERNATIONAL FINANCIAL MANAGEMENT Managing Operating 3 & Translation Exposures Tzvetomir Tzanov, Ph.D. Department of IER & Business © T.Tzanov, Ph.D, UNWE  International Financial Management Lecture outline To explain operating exposure To explain how an MNC’s operating exposure can be hedged To explain translation exposure To explain how an MNC’s translation exposure can be hedged References: Madura, J. International Financial Management, 12e; Shapiro, A. Multinational Financial Management, 9e. © T.Tzanov, Ph.D, UNWE  International Financial Management Operating exposure Operating exposure refers to the impact exchange rate fluctuations might have on a firm’s future cash flows (expected). Operating exposure, also called competitive/strategic exposure, and even economic 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. Corporate cash flows can be affected by exchange rate movements in ways not directly associated with foreign transactions – a firm should attempt to determine how future CF will be affected by ER movements. © T.Tzanov, Ph.D, UNWE  International Financial Management Operating exposure A MNC should determine OE to each currency – cash inflows and outflows. Pro forma Income statements for each subsidiary to derive estimates. Exchange rate changes are often linked to variability in real growth, inflation, interest rates, governmental actions. If material, the changes may cause firms to adjust their financing and operating strategies. The importance of managing operating exposure can be seen from the 1997-98 Asian crisis. Recent: CHF, RUB. A firm can assess its operating exposure by determining the sensitivity of its expenses and revenues to various possible exchange rate scenarios. © T.Tzanov, Ph.D, UNWE  International Financial Management Operating exposure The firm can then reduce its exposure by restructuring its operations – sales and future expenses to balance its exchange-rate-sensitive cash flows. To determine whether future expenses are more sensitive than future revenues to ER movements – computerized modelling. Regression analysis. 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. © T.Tzanov, Ph.D, UNWE  International Financial Management Operating exposure – restructuring of operations Restructuring may involve:  increasing/reducing sales in new or existing foreign markets,  increasing/reducing dependency on foreign suppliers,  establishing or eliminating (incl. as future options) production facilities in foreign markets, and/or  increasing or reducing the level of liabilities denominated in foreign currencies. MNCs must be aware about the long-term potential benefits before they proceed to restructure their operations, because of the high costs of reversal. © T.Tzanov, Ph.D, UNWE  International Financial Management Operating exposure – Hedging strategies Pricing policy – reducing/raising prices in case foreign currency depreciates/appreciates. Purchasing foreign supplies – reducing costs in periods of strong foreign currency. Financing with foreign funds – a portion of the business financed with loans in foreign currency. Revising operations of other units – a unit borrows foreign currency but may not need as much as would be necessary. Traditional, e.g. Forward contracts – only hedging for the period of the contract, OE however – continuous LT. © T.Tzanov, Ph.D, UNWE  International Financial Management Operating exposure – example © T.Tzanov, Ph.D, UNWE  International Financial Management Translation exposure Translation exposure results when an MNC translates each subsidiary’s financial data into its home currency for consolidated financial reporting. Translation exposure, also called accounting exposure, arises because financial statements of foreign subsidiaries – which are stated in foreign currency – must be restated in the parent’s reporting currency for the firm to prepare consolidated financial statements. Translation exposure does not directly affect cash flows (does not imply real CF!), but some firms are concerned about it because of its potential impact on reported consolidated earnings. © T.Tzanov, Ph.D, UNWE  International Financial Management Translation exposure Translation exposure – the potential for an increase or decrease in the parent’s net worth and reported net income caused by a change in exchange rates since the last translation. In addition, remeasurement of items. Translation in principle is simple: – Foreign currency financial statements must be restated in the parent company’s reporting currency. – If the same exchange rate were used to remeasure each and every line item on the individual statement, there would be no imbalances resulting from the remeasurement. – What if a different exchange rate were used for different line items on an individual statement? – An imbalance would result. © T.Tzanov, Ph.D, UNWE  International Financial Management Translation exposure Why would we use a different exchange rate in remeasuring different line items? – Translation principles in many countries are often a complex compromise between historical and current market valuation. – Historical exchange rates can be used for certain equity accounts and fixed assets, while current exchange rates can be used for current assets, current liabilities, income, and expense items. What does historical cost mean? – A measure of value used in accounting in which the price of an asset on the balance sheet is based on its nominal or original cost when acquired by the company. © T.Tzanov, Ph.D, UNWE  International Financial Management Translation exposure Most countries today specify the translation method used by a foreign subsidiary based on the subsidiary’s business operations (subsidiary characterization). For example, a foreign subsidiary’s business can be categorized as either an integrated foreign entity or a self- sustaining foreign entity. An integrated foreign entity is one that operates as an extension of the parent, with cash flows and business lines that are highly interrelated. A self-sustaining foreign entity is one that operates in the local economic environment independent of the parent company. © T.Tzanov, Ph.D, UNWE  International Financial Management Functional currency & Translation A foreign subsidiary’s functional currency is the currency of the primary economic environment where the company operates and in which it generates cash flows. In other words, it is the dominant currency used by the company in its day-to-day operations. The US for instance, requires that the functional currency of the foreign subsidiary be determined based on the nature and purpose of the subsidiary. If the statements are maintained in the local currency, and the local currency is the functional currency, they are translated into home currency (HC) of the parent. © T.Tzanov, Ph.D, UNWE  International Financial Management Translation exposure Two basic methods for the translation of foreign subsidiary financial statements are employed worldwide: – Current (non-current) rate method. – Temporal method. Current/non-current method – widely adopted in case of self-sustained foreign entity. Temporal – regular restatement to reflect market value (e.g.: inventory, but might be PP&E items as well). Regardless of which method is employed, a translation method must not only designate at what ER individual balance sheet and income statement items are remeasured, but also designate where any imbalance is to be recorded (current income or an equity reserve account). © T.Tzanov, Ph.D, UNWE  International Financial Management Translation exposure Translation in Bulgaria: – Common stock (equity) and paid-in capital accounts are translated at historical rates (non-current); – Current assets and liabilities (except equity) are translated at the current rate of exchange; – Income statement items are translated at the exchange rate on the dates they were recorded or an appropriately weighted average rate for the period; – Dividends (distributions) are translated at the rate in effect on the date of payment. © T.Tzanov, Ph.D, UNWE  International Financial Management Hedging of translation exposure An MNC may attempt to avoid translation exposure by matching its foreign liabilities with its foreign assets: Natural hedging; 100% matching practically impossible. To hedge translation exposure, traditional forward or futures contracts can be used. Specifically, an MNC may sell the currency that its foreign subsidiary receive as earnings forward, thus creating an offsetting cash outflow in that currency. © T.Tzanov, Ph.D, UNWE  International Financial Management Translation exposure For example, a BG-based MNC that is concerned about the translated value of its British subsidiary earnings may enter a one-year forward contract to sell pounds. If the pound depreciates during the fiscal year, the gain generated from the forward contract position will help to offset the translation loss. The best way for MNCs to deal with translation exposure is to clarify how their consolidated earnings have been affected by exchange rate movements. © T.Tzanov, Ph.D, UNWE  International Financial Management Translation exposure Hedging translation exposure is limited by: – inaccurate earnings forecasts, – inadequate forward contracts for some currencies, – accounting distortions (the choice of the translation exchange rate, taxes, etc.), and – increased transaction exposure (due to hedging activities). In particular, if the foreign currency depreciates during the fiscal year, the transaction loss generated by a forward contract position will somewhat offset the translation gain. Note that the translation gain is simply a paper gain, while the loss resulting from the hedge is a real loss. © T.Tzanov, Ph.D, UNWE  International Financial Management Appendix: ER forecasting Forecasting techniques: (1) Technical forecasting – the use of historical exchange rate data to predict future values. (Charting, trend analysis, tendencies). Corporations tend to use limited use of technical forecasting – focus on near future (not very helpful for developing corporate policies). Abundance of technical models – in case the pattern of currency values over time appears to be random – TF not appropriate. © T.Tzanov, Ph.D, UNWE  International Financial Management ER forecasting (2) (2) Fundamental forecasting –fundamental relationships between economic variables and ER. E(ER) = f(ΔI, ΔIR, ΔINC,...) Regression analysis, equations, sensitivity analysis (more than one possible outcomes for the factors in consideration). PPP (Purchasing power parity) considerations. Limitations – different impact of various factors, some factors cannot be easily quantified (economic and social developments, e.g. strikes). © T.Tzanov, Ph.D, UNWE  International Financial Management Exhibit 1. Technical forecasting © T.Tzanov, Ph.D, UNWE  International Financial Management Impact of hedging Operating exposure on an MNC’s value Hedging decisions on Operating exposure  m  n  E (CFj, t ) E (ER j, t )  j =1  Value =    t =1  (1 + k ) t    E (CFj,t ) = expected cash flows in currency j to be received by the parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent © T.Tzanov, Ph.D, UNWE  International Financial Management Thanks for your ATTENTION! © T.Tzanov, Ph.D, UNWE