CH-10 Measuring and Managing Economic Exposure – Foundations of Multinational Financial Management : Book Guide

CHAPTER 10 MEASURING AND MANAGING ECONOMIC EXPOSURE This chapter defines economic exposure as the extent to which a given currency change will change the value of a firm. Exchange risk is just the variability of a firm’s value that is due to uncertain currency changes. With regard to managing currency risk, the key issue is the proper role of corporate financial management. To the extent that the firm is operating in efficient financial markets, the primary exposure management objective of financial executives should be to arrange their firm’s finances in such a way as to minimize the real effects of exchange rate changes. The major burden of coping with exchange risk must be borne by the marketing and production people because they deal in imperfect product and factor markets where their specialized knowledge provides a real advantage. Their role is to design marketing and production strategies to deal with exchange risks. The appropriate marketing and production strategies are similar to those that would be suitable for any firm confronted with shifting relative output or input prices caused by any economic, political, or social factors. Key Points on Measuring Exchange Risk 1. Because the value of a firm is equal to the present value of future cash flows, accounting measures of exposure that are based on changes in the book values of foreign currency assets and liabilities need bear no relationship to reality. 2. Because currency changes are usually preceded by or accompanied by changes in relative price levels between two countries, it is impossible to determine exposure to a given currency change without considering simultaneously the offsetting effects of these price changes. This point is illustrated by the examples of Apex Spain, the Brazilian shoe manufacturer, and Chile. The latter two examples show what happens when the real exchange rate changes because inflation is not offset by exchange rate changes. Only foreign-currency denominated contractual cash flows are affected by nominal currency changes. Noncontractual operating cash flows are affected only by real currency changes. The domestic analogue is that only nominal cash flows are affected by inflation. Noncontractual domestic operating cash flows are affected only by relative price changes (i.e., by changes in the prices of the firm’s inputs relative to its outputs). The impact of real exchange rate changes depends on the location of that firm’s markets, its sources of inputs, and its degree of flexibility in shifting its marketing and production efforts. These points are brought out in Section 10.3 on identifying economic exposure. The cases of Aspen Skiing Company, Pemex, and Toyota Motor emphasize the fact that exchange risk is ubiquitous and that a thorough exchange risk analysis requires them to identify whether a company is selling and buying in a world market or a domestic market. The Spectrum case lets students see how sensitive the projected effects of currency changes are to assumptions about the effects of exchange rate changes on output and input prices, the price elasticity of demand, and the ability to substitute between domestic and foreign inputs. Here are two myths concerning exchange risk. Myth 1: Exchange rate changes always increase the riskiness of multinational corporations. It is accepted almost as an article of faith that exchange rate changes are bad for MNCs. And yet, devaluations (revaluations) are usually preceded by higher (lower) rates of inflation. This is PPP, the notion that an internal appreciation or depreciation in a currency’s purchasing power will ultimately be reflected in a change in its external value. Hence, it is clearly inappropriate to evaluate only the devaluation phase of an inflation devaluation cycle. In general, the effects of inflation on the dollar profits of a given firm or investment located in a foreign country are the reverse of a devaluation’s effects. For example, devaluation is probably the best corrective for an exporter or for a company selling locally that is facing stiff import competition. In either case, inflation will likely lead to an erosion of dollar profit margins which can only be reversed if a local currency devaluation occurs. Conversely, a firm selling locally without much import competition will usually benefit from inflation while being hurt by devaluation. Based on purchasing power parity, therefore, gains or losses from exchange rate changes should be offset over time by differences in relative rates of inflation. Therefore, for firms incurring costs and selling products in foreign countries, the net effect of currency movements may be less important in the long run. Thus, if nominal currency changes smooth out the profit peaks and valleys caused by differing rates of inflation, devaluations or revaluations should actually reduce earnings variability for MNCs. Only if currency changes involve real exchange rate changes does risk increase. Myth 2: MNCs are more subject to exchange risk than domestic companies. If exchange risk means the degree to which a firm’s value is affected by currency changes, this proposition is not self evident. For example, domestic facilities that supply foreign markets normally entail much greater exchange risk than foreign facilities supplying local markets (because material and labor used in a domestic plant are paid for in the home currency while the products are sold in a foreign currency). Take, for instance, a Japanese company which builds a plant to produce cars for export, primarily to the U.S. That company will incur exchange risk from the point at which it invests in facilities to supply a foreign market (the U.S.) since its yen expenses will be matched with dollar, instead of yen, revenues. All too frequently, however, firms neglect these effects when analyzing proposed foreign investments. Furthermore, a purely domestic company selling locally but facing import competition may be seriously hurt (helped) by the devaluation (revaluation) of a competitor’s HC. Thus, contrary to conventional wisdom, the MNC may be subject to less exchange risk than an exporter, given the MNC’s greater ability to adjust its marketing and production operations on a global basis. For example, MNCs with worldwide production systems can allocate production among their plants in line with the changing dollar costs of production. Unlike the purely domestic firm, an MNC has the option of increasing production in a nation whose currency has devalued and decreasing production in a country whose currency has revalued. The ability to shift production depends on many factors, including the power of the unions involved. However, the innovative nature of the typical MNC means a continued generation of new products. The sourcing of these new products among the firm’s various plants can be done based on the costs involved. KEY POINTS ON MANAGING EXCHANGE RISK 1. Since currency risk affects all facets of a firm’s operations, it should not be the concern of financial managers alone. Top executives should incorporate exchange rate expectations into nonfinancial decisions. 2. Operating managers should develop marketing and production initiatives that help to ensure profitability over the long run. They should also devise anticipatory or proactive, rather than reactive, strategic alternatives in order to gain competitive leverage internationally. 3. The key to effective exposure management is to integrate currency considerations into the general management process. 4. Managers trying to cope with actual or anticipated exchange rate changes must first determine whether the exchange rate change is real or nominal. Nominal changes can be ignored. Real changes must be responded to. 5. If real, the manager must first assess the permanence of the change. In general, real exchange rate movements that narrow the gap between the current rate and the equilibrium rate are likely to be longer lasting than are those that widen the gap. Neither, however, will be permanent. Rather, there will be a sequence of equilibrium rates, each of which has its own implications for the firm’s marketing and production strategies. 6. The role of the financial executive in an integrated exchange risk program is fourfold: to provide local operating management with forecasts of inflation and exchange rates; to identify and highlight the risks of competitive exposure; to structure evaluation criteria such that operating managers are not rewarded or penalized for the effects of unanticipated real currency changes; and to estimate and hedge whatever real operating exposure remains after the appropriate marketing and production strategies have been put in place. SUGGESTED ANSWERS TO “EURO APPRECIATION HURTS SOUTHERN EUROPEAN EXPORTS” 1. Why are southern European countries particularly vulnerable to a strong euro? Answer: Southern European countries are particularly vulnerable to a strong euro because they specialize in the export of low-tech, commodity-type products such as textiles, footwear, and toys. These products face competition from low-priced substitutes from China and other Asian countries. Thus, their price elasticity of demand is high. 2. How does the relatively high inflation rate in southern Europe add to the problems created by a strong euro? Answer: The high inflation rates in southern European countries mean the real value of the euro has appreciated even more than its nominal value, making their products even less cost-competitive with Asian imports. 3. In contrast to southern Europe, northern Europe, especially Germany, exports more complex and brand-name manufactured items, such as automobiles, machine tools, and specialty chemicals. Would you expect German exports to be more or less sensitive to pricing pressures from a strong euro than southern European exports? Explain. Answer: German exports should be less sensitive to pricing pressures from a strong euro because these products tend to be highly differentiated, reducing their price elasticity of demand. The price elasticity of demand is reduced further because Chinese and other Asian manufacturers do not manufacture many of these products, meaning Asian products are not close substitutes for most German products. In addition, much of the competition for German exports is other German exports (e.g.. BMW and Mercedes). With most competitors based in Germany, then all will face the same change in their cost structure from euro appreciation, and all can raise their foreign currency prices without putting any of them at a competitive disadvantage relative to their domestic competitors. 4. It turns out that Italian companies exporting food products such as Parma ham and Parmigiano cheese have not seen a drop in exports, nor have high-fashion exporters such as Armani and Valentino despite the strong euro. Explain Answer: The products pointed to in this question are branded, differentiated products, without close substitutes from Asian or other countries. As such, one would expect them to have a much lower price elasticity of demand than exists for undifferentiated products that face close substitutes from China and elsewhere. SUGGESTED ANSWERS TO “HOW RISING GOLD PRICES HURT HARMONY” 1. How much rand revenue per ounce was Harmony generating on September 11, 2001? Three years later? Answer: Harmony’s rand revenue per ounce on September 11, 2001, based on a price per ounce of $288 and an exchange rate of R8.62/$, stood at 288 * 8.62 = R2,482.56. Three years later, with a much higher gold price ($420/oz) and a higher exchange rate (R6.35/$), Harmony’s rand revenue per ounce was 420 * 6.35 = R2,667. 2. Compare Harmony’s earnings per ounce in rand terms during 2001:Q2 with the same figure in 2004:Q2. Answer: With a profit per ounce in 2001:Q2 of $20 and an average exchange rate during the quarter of R8.04/$ (see question 3), Harmony’s profit averaged R160.80 (20 * 8.04). In 2004:Q2, with an average exchange rate of R6.60/$ and a loss of $50 an ounce, Harmony’s rand loss averaged R330/oz (50 * 6.60). 3. The average exchange rate during 2001:Q2 was R8.04/$; in 2004:Q2, it was R6.60/$. By how much would Harmony have to reduce its rand costs per ounce in 2004:Q2 in order to make the same rand profit per ounce it was earning in 2001:Q2? Answer: To go from a loss of R330/oz to a profit of R160.80/oz, Harmony would have to cut its rand costs by the difference between these two figures, or R490.80 (given the reasonable assumption revenue per ounce stays the same). SUGGESTED ANSWERS TO “CHECK THE EURO AND SHIP THE BOXES!” 1. Why does a rise in the dollar hurt Markel? How does a falling dollar help Markel? Answer: With a 70% share of the world market for Teflon-coated cable-control liners, it is obvious that Markel exports a substantial amount of its output. With Markel’s export revenues denominated in foreign currency (and also determined in foreign currency, primarily euros it appears) and its costs set in dollars, a rise in the value of the dollar will either squeeze Markel’s margins (if it holds euro prices constant) or lower its sales volume (if it raises euro prices to compensate for a stronger dollar). A falling dollar has the opposite effect as specific euro prices translate into more dollars. Alternatively, Markel has the option of lowering its euro price, while still maintaining its dollar margins, in order to capture more market share. 2. What does Markel do to hedge its currency risk? Can Markel use hedging to completely eliminate its currency risk? Answer: As the mini-case points out, Markel uses forward contracts to lock in dollar revenues for the next several months and tries to improve efficiency to survive when the dollar appreciates (praying does not count in hedging). However, hedging cannot completely eliminate its currency risk through hedging as much of its risk involves operating exposure. That is, Markel’s competitive position is affected by changes in the value of the dollar and other currencies. 3. Comment on Markel’s policy of selective hedging. Are there any speculative elements involved in such a policy? Would you recommend Markel continue to follow a policy of selective hedging? Why or why not? Answer: As discussed in Chapter 10, a selective hedging policy often leads to taking higher risks by hedging only when a currency change is expected and going unhedged otherwise. If financial markets are efficient, however, firms cannot hedge against expected exchange rate changes. Interest rates, forward rates, and sales-contract prices should already reflect currency changes that are anticipated, thereby offsetting the loss reducing benefits of hedging with higher costs. The unavoidable conclusion is that a firm can protect itself only against unexpected currency changes. Moreover, there is always the possibility of bad timing, as illustrated by Mr. Hoban’s forward sale of euros when he guessed wrongly that the euro would continue to fall. In effect, a policy of selective hedging involves betting that you are smarter than the foreign exchange market. This bet is one that many companies have learned to regret. Companies that really can beat the market should probably do this full time as they then would not have to deal with tough competitors, demanding customers, and difficult employees. 4. What are the basic elements of Markel’s pricing policy? Does this pricing policy reduce its currency risk? Explain. Answer: Markel’s basic pricing policy is to charge customers relatively stable prices in their own currencies to build overseas market share, while absorbing currency gains or losses. It also signs contracts in foreign currency based on its expectations of where exchange rates are headed. It sometimes guesses wrong on these contracts as well. 5. Does locking in Markel’s dollar costs of raw materials through multiyear dollar contracts automatically reduce the company’s currency exposure? Answer: No. Note that Markel is locking in its dollar costs at the same time it is locking in foreign currency revenues. For Markel, this means it will be feast or famine. If the dollar falls in value, it will earn windfall profits as its foreign currency revenues translate into more dollars. If the dollar rises, however, it will lose with the decline in the value of its foreign currency revenue. Allowing its dollar costs to move with its dollar revenues on overseas sales will provide some hedge against exchange rate fluctuations. SUGGESTED ANSWERS TO “PORSCHE REVS UP ITS RESULTS” 1. Why does Porsche face more operating exposure than Mercedes or BMW? Answer: Both Mercedes and BMW have U.S. plants, giving them a natural operating hedge against a rising euro. That is, the very same event (a strong euro) that lowers euro revenues per dollar of U.S. auto sales also lowers the euro cost of manufacturing for Mercedes and BMW. In contrast, Porsche makes its cars entirely in Europe but generates 40% to 45% of its sales revenue in the U.S. For Porsche, therefore, its dollar operating cash inflows are not offset by dollar operating cash outflows. 2. Is Porsche really fully hedged through July 31, 2007? Suppose that gains on all its outstanding options were included in reported earnings for its fiscal year ended July 31, 2004. Answer: If Porsche reported the gains on all its outstanding options in earnings for the fiscal year ended July 31, 2004, then it will have no future currency gains to offset its ongoing uncompetitive cost structure associated with the problem of competing in the U.S. in dollars while manufacturing in Europe in euros. The only future gains it would realize on its options would stem from a further rise in the value of the euro, which would make Porsche even less competitive in the U.S. market. 3. Why would analysts be nervous if up to 75% of Porsche’s pretax profit for fiscal year 2004 came from gains on foreign currency options? Answer: Gains such as these are unpredictable because they stem from an unexpected rise in the value of the euro. As such, they cannot be counted on. Once these gains are stripped away, Porsche’s profit from operations is only 25% of its reported profit. Suppose, for example, that the euro stayed where it is. Then Porsche will have no more gains on its currency options but it will still be stuck with an uncompetitive cost structure and low operating profits. SUGGESTED ANSWERS TO “A STRONG REAL HURTS EMBRAER” 1. What factors affect Embraer’s operating exposure? Why did the real's appreciation reduce Embraer's operating profit? Answer: Most of its revenue comes from exports priced in dollars while most of its costs are denominated in reais. This currency mismatch between revenues and costs is the price source of its operating exposure. At the same time, it is competing against foreign companies that have a different cost structure than it does. 2. Did Embraer decrease or increase its currency risk by hedging its dollar liabilities? Explain. Answer: Embraer has significant dollar cash inflows while most of its cash outflows are in reais. The dollar liabilities actually establish a partial hedge of its dollar inflows. By hedging these liabilities, therefore, Embraer increased its currency risk. 3. How can Embraer use financial hedging to reduce its currency risk? Answer: It can better match its cash inflows and outflows by selling its contracted for dollar revenues forward. However, this strategy only goes so far. Most of the company’s value depends on its anticipated future sales, which will largely be in dollars. To hedge these revenues, Embraer should finance a substantial fraction of its assets with dollars (or swap its real loans for dollars). 4. Suppose Embraer's $608 million in dollar receivables mentioned above were outstanding at the beginning of the second quarter and that payment for $397 million was not received until the end of the quarter. The remaining $211 million was still outstanding at the end of the quarter. With an 18% real appreciation during the quarter, how much of a dollar loss would Embraer take on these receivables? In performing the calculation, consider that Embraer must first translate its dollar receivables into reais and then convert any loss measured in reais back into dollars. Answer: If e0 is the dollar value of the real at the beginning of the second quarter, then Embraer’s total receivables in terms of reais were R608,000,000/e0. At the end of the quarter, with an 18% appreciation in the dollar value of the real, these receivables were worth R608,000,000/1.18e0., where 1.18e0. is the dollar value of the real at the end of the second quarter given the 18% real appreciation. Taking the difference between the beginning and ending real values of these dollar receivables translates into a loss in terms of the real equal to R92,745,762.71/e0. In dollar terms (converting the real loss into dollars using the end-of-second-quarter exchange rate), this loss equals 1.18e0 * 92,745,762.71/e0, or $109,440,000. SUGGESTED ANSWERS TO “LAKER AIRWAYS CRASHES AND BURNS” 1. What were the key components of Laker Airways’ operating exposure? Answer: Laker’s operating exposure stemmed from the imbalance in the currency denomination of cash flows (dollar-denominated cash outflows far exceeding dollar-denominated cash inflows). If sterling depreciated, its dollar costs converted into sterling would rise more rapidly than the sterling value of its dollar-denominated revenue. Moreover, not only were these revenues and costs denominated in dollars, they were also determined in dollars. Specifically, fuel and marketing expenses in the U.S. are set in dollar terms, as are fares for U.S. customers (who are comparing Laker’s fares to other dollar fares). Compounding Laker’s problem was the fact that it was targeting the most price-elastic segment of the market, meaning that it could not raise sterling-equivalent prices to cover its higher sterling costs because its customer would desert it. 2. What options did it have to hedge its operating exposure? Answer: Laker might have indexed its sterling fare to the day-to-day exchange rate. It might also have directed more of its marketing efforts toward American travelers, thereby giving it a more diversified demand structure. 3. Could Laker have hedged its "natural" dollar liability exposure? Answer: The first option of indexing the sale of sterling airfare to the day-to-day exchange rate was not a viable alternative. Advertisements, based on a set sterling fare, would have had to be revised almost daily and would have discouraged the company’s “price-elastic, budget-conscious” clientele. The option of Laker directing more of its marketing efforts toward American travelers is a more viable one. When the pound devalued against the dollar, fewer British tourists would vacation in the U.S., but more Americans would travel to Britain. Laker could also have financed the acquisition of DC-10 aircraft in sterling rather than in dollars, thereby more closely matching its pound outflows with its pound inflows. This example points out that the currency denomination of debt financing can ill afford to be determined apart from the currency risk faced by the firm’s total business portfolio. 4. Should Laker have financed its purchase of DC-10 aircraft by borrowing sterling from a British bank rather than using the dollar-denominated financing supplied by McDonnell Douglas and the Exim bank? Consider the fact that Exim bank, a U.S. government agency, subsidized this financing in order to promote U.S. exports. Answer: Because of the interest subsidy provided by McDonnell Douglas and the Exim bank on the funds they supplied to Laker, the covered sterling cost of the dollar financing would have been less than the cost of borrowing sterling directly from a British bank at a market rate of interest. Thus it made sense for Laker to finance its purchase of DC-10 aircraft with dollar-denominated funds from McDonnell Douglas and the Exim Bank rather than by borrowing sterling from a British bank. However, Laker should have hedged this loan with forward contracts or by swapping the dollar loan for a pound loan, in effect converting the dollar loan into a pound liability. SUGGESTED ANSWERS TO CHAPTER 10 QUESTIONS 1. Please answer the following questions. 1.a. Define exposure, differentiating between accounting and economic exposure. What role does inflation play? Answer: Accounting exposure results when exchange rate changes alter the home currency value of foreign currency denominated assets and liabilities. The big debate in the accounting profession centers on which foreign currency assets and liabilities should be translated at the current rate (these assets and liabilities are exposed because their HC values change in line with the exchange rate) and which assets and liabilities should be translated at the historical rate (the rate in effect at the time the asset was acquired or the liability incurred). These latter assets and liabilities are regarded as not being exposed because they maintain their home currency values regardless of what happens to the exchange rate. By contrast, economic exposure measures the extent to which a given currency change affects the value of the firm. Nominal exchange rate changes affect the home currency value of the transaction exposure component of economic exposure because these cash flows are fixed. But only real exchange rate changes –inflation adjusted currency changes – affect the firm’s future sales revenues and costs, its operating cash flows. 1.b. Describe at least three circumstances under which economic exposure is likely to exist. Answer: Circumstances in which a firm faces economic exposure include when the firm: Has entered into sales or purchase contracts denominated¬ in a foreign currency; ii) Is selling or buying abroad or it faces domestic competition from imports and the real exchange rate changes; and iii) Is operating in a foreign country whose government taxes nominal rather than real income. 1.c. Of what relevance are the IFE and PPP to your answers to parts a and b? Answer: If PPP holds exactly, then the second situation involving exchange risk – a change in the real exchange rate – can never occur. Similarly, if the IFE holds continually, firms face no exposure on foreign currency denominated transactions. In both cases, gains or losses on exchange rate changes are always offset, either by losses or gains due to offsetting changes in price levels or by price adjustments that reflect expected change rate changes. 1.d. What is exchange risk, as distinct from exposure? Answer: Exchange risk involves the extent to which uncertain exchange rate changes lead to uncertain fluctuations in the value of the firm. If the firm has no exposure, it has no exchange risk. 1.e. Under what circumstances might MNCs be less subject to exchange risk than purely domestic firms in the same industry? Answer: Multinational corporations (MNCs) might be less subject to exchange risk than purely domestic firms in the same industry under the following circumstances: 1. Natural Hedging: MNCs often have operations, revenues, and expenses in multiple currencies. This natural diversification can act as a hedge against exchange rate fluctuations, as gains in one currency might offset losses in another. 2. Geographic Diversification: MNCs operate in various countries and regions. This geographic spread can mitigate the impact of adverse currency movements in any single market, reducing overall exchange risk. 3. Operational Flexibility: MNCs can shift production, sourcing, and sales between different countries in response to currency fluctuations. This flexibility allows them to optimize operations and minimize exposure to unfavorable exchange rates. 4. Access to Financial Instruments: MNCs often have better access to sophisticated financial instruments and hedging strategies, such as forward contracts, options, and swaps, which they can use to manage and mitigate exchange rate risk effectively. 5. Economies of Scale in Risk Management: MNCs typically have larger, more sophisticated treasury departments capable of managing exchange rate risk more efficiently than smaller, purely domestic firms. 6. Revenue Diversification: MNCs derive their revenues from multiple markets and currencies. A downturn in one currency or market can be offset by stable or growing revenues in another, reducing the overall impact of exchange rate fluctuations. 7. Cost Management: MNCs can manage costs more effectively by sourcing raw materials, labor, and services from countries with favorable exchange rates, reducing their exposure to any single currency. In contrast, purely domestic firms are more vulnerable to exchange rate risk because they typically have revenues and expenses in one currency. Even if they import raw materials or export products, they may not have the same level of diversification or access to hedging strategies, making them more susceptible to the impact of currency fluctuations. 2. The sharp decline of the U.S. dollar between 1985 and 1995 significantly improved the profitability of U.S. firms both at home and abroad. 2.a. In what sense is this profit improvement false prosperity? Answer: High profits are due to the state of the dollar, not to sustainable competitive advantage. A reversal of the dollar’s fortunes (as has recently occurred) will cause these profits to disappear. In the meantime, management may mistakenly believe it has performed well; this could lower incentives for efficient production and critical innovation of sustainable competitive advantages. 2.b. How would you incorporate the decline in the dollar in evaluating management performance? In making investment decisions? Answer: There are several ways to insulate the manager’s performance against currency shocks. First, one could tie compensation to comparable firms who will suffer the same relative currency shocks. Second, one could construct a hedge (real or synthetic) to determine the value added based on activity outside of exchange variations. In other words, try to determine what fraction of a firm’s profits are due to the value of the dollar, and what fraction can be attributed to controllable factors. In investment decisions, the manager should determine the market price of currency risk. Do otherwise equivalent firms that bear differing levels of currency risk earn different required rates of return? If so, then the market price of currency risk needs to be incorporated explicitly into the discount rate applied to capital projects. Also, an investment manager can develop future currency scenarios and assess profitability under these alternative scenarios. This exercise determines how robust profit projections are to changing international conditions. 2.c. Comment on the following statement: “The sharp appreciation of the U.S. dollar during the early 1980s might have been the best thing that ever happened to American industry.” Answer: The resulting severe competitive pressure from foreign firms forced American industry to get lean and mean. This corporate restructuring raised productivity, made companies more responsive to the marketplace, led to improved product quality, shorter product cycles, and redirected capital to more productive uses. This doesn’t mean that American companies appreciated the tune up; most people don’t like being put on a restrictive diet and being forced to exercise. 3. What marketing and production techniques can firms initiate to cope with exchange risk? Answer: Market selection and market segmentation provide the basic parameters within which a company may adjust its marketing mix over time. Short term tactical responses include adjustments of pricing, promotional, and credit policies. Product sourcing and plant location are the principal variables companies manipulate to manage competitive risks that can’t be dealt with through marketing changes alone. This could include building plants overseas, buying more components overseas, allocating production among plants in line with their changing relative costs, and designing new facilities to provide added flexibility in making substitutions among various sources of goods so as to be better able to respond to relative price differences among domestic and imported inputs. 4. What is the role of finance in protecting against exchange risk? Answer: The role of financial management is to structure the firm’s liabilities such that when strategic operational adjustments are underway, the reduction in asset earnings is matched by a corresponding decrease in the cost of servicing these liabilities. For example, a firm that has developed a sizable export market should hold a portion of its liabilities in that country’s currency. In this way, any shortfall in operating cash flows due to an exchange rate change will be offset by a reduction in the debt service expenses. 5. E&J Gallo is the largest vintner in the U.S. It gets its grapes in California (some of which it grows itself) and sells its wines throughout the U.S. Does Gallo face currency risk? Why and how? Answer: E&J Gallo faces exchange risk because its wines are competing against foreign wines and changes in the value of the dollar affect its competitiveness. In the early 1980s, for example, the soaring dollar enabled vintners from countries such as France and Italy to cut their wine prices in the U.S. and still earn a good franc or lira profit. Gallo was forced to match these price cuts since the wine categories it sells in tend to be very price sensitive. Gallo’s loss of revenue was offset somewhat by the drop in wine grape prices. California wine grape prices fell since the demand for these grapes is derived from the demand for California wines. As the demand for California wines fell so did the demand for California wine grapes and their prices. 6. DaimlerChrysler’s Chrysler division exports vans to Europe in competition with the Japanese. Similarly, Compaq exports computers to Europe. However, its biggest competitors are all American companies – IBM, Hewlett-Packard, and Tandem. Assuming all else is equal, which of these companies--Chrysler or Digital – is likely to benefit more from a weak dollar? Explain. Answer: Chrysler is likely to be the bigger beneficiary of a weak dollar since its primary competitors are the Japanese. The falling dollar gives Chrysler an opportunity to gain market share in Europe from the Japanese by holding its dollar prices constant, thereby lowering its prices in terms of the various European currencies. The Japanese carmakers cannot respond effectively since their costs have not changed in European currency terms. Conversely, by holding its prices constant in European currency terms, Chrysler can fatten its profit margins. Compaq, on the other hand, will not gain a competitive advantage relative to its primary competitors from a falling dollar since all of them, being U.S. companies, share a common cost structure. Competition will likely force them to pass along lower costs (in European terms) in the form of lower European currency prices. This will probably expand the market overall, but no one company will gain a competitive advantage. By the same token, the existence of a common cost structure means that Compaq will be less affected than Chrysler by a rise in the dollar’s value. 7. In 1994, the Singapore dollar rose by 9% in real terms against the U.S. dollar. What was the likely impact of the strong Singapore dollar on U.S. electronics manufacturers using Singapore as an export platform? Consider the following facts. On average, materials and components – 85% of which are purchased abroad – account for about 60% of product costs. Labor accounts for an additional 15%; other operating costs account for the remaining 25%. Answer: The impact was less than might be expected. With 85% of materials and components coming from abroad, the net effect of the 9% rise in the real value of the Singapore dollar on this component of cost is likely to be only about 1.35% (0.15 * 0.09). Since these costs account for about 60% of product costs, the net effect on the overall cost of manufacturing will be only about 0.8%. Assuming that the other 40% of costs are fully exposed to the rise in the real value of the Singapore dollar, the impact of a 9% rise on overall manufacturing costs is 3.6% (0.4 * 0.09). The combination of these two cost elements is a rise in total costs of 4.4%, or just about half the 9% rise in the Singapore dollar. To the extent that some of the other elements of cost (especially energy and capital equipment) come from abroad or are price in U.S. dollar terms, this amount will overstate the overall impact of the rise in the real value of the Singapore dollar on U.S. costs of producing in Singapore. At the extreme, if only labor costs (which account for only 15% of total costs) are exposed, the net impact of the rise in the Singapore dollar is just 1.35% (0.15 * 0.09). 8. Di Giorgio International (DGI), a subsidiary of California-based Di Giorgio Corp., processes fruit juices and packages condiments in Turnhout, Belgium. It buys Brazilian orange concentrate in dollars, German apples in marks, Italian peaches in lire, and cartons in Dutch guilders. At the same time, its exports 85% of its production. Assess DGI’s currency risk and determine how it can structure its financing to reduce this risk. Answer: A key question is whether the supplies bought DGI and the products it sells are priced domestically or internationally. The odds are that both inputs and outputs are priced at least somewhat in domestic terms because of the costs and time lags involved in arbitraging among markets. Thus, while DGI is exposed to exchange risk on both its exports and its domestic (Belgian) sales, it has a natural hedge in the form of inputs purchased abroad and Belgian inputs. Since the countries in which it does business are all members of the EMS (except for Brazil), their currencies tend to move together. In the absence of better information, a best guess is that DGI is exposed to foreign exchange risk on its profit margin. One way to hedge this profit margin is to finance in ECUs a fraction of its assets equal to its return on investment. In this way, changes in the dollar value of operating profits will be offset by changes in the dollar cost of servicing its liabilities. Since the depreciation tax shield is also an important component of operating cash flow, and DGI’s depreciation is in Belgian francs, it should finance in Belgian francs a fraction of its assets equal to annual asset depreciation divided by total assets. In this way, if the Belgian franc devalues, DGI’s dollar cash flow from the depreciation tax shield will drop, but so will the cost of servicing its Belgian franc liabilities. 9. A U.S. company needs to borrow $100 million for a period of seven years. It can issue dollar debt at 7% or yen debt at 3%. 9.a. Suppose the company is an MNC with sales in the U.S. and inputs purchased in Japan. How should this affect its financing choice? Answer: According to the IFE, the difference in interest rates reflects expected appreciation in the value of the yen. That is, yen are not automatically less expensive to borrow just because the interest rate on yen is lower than the rate on dollars. From a risk management standpoint, the key issue is the currency risk being borne by the MNC and the effect of its borrowing decision on that currency risk. From the facts given in the question, it appears that based on its sourcing of inputs in Japan, the company is short yen (regardless of whether the input prices are denominated in yen or dollars). Other things being equal, therefore, it appears that the MNC should borrow dollars; borrowing yen will just exacerbate its short position in yen. However, if the company is competing with Japanese firms, then it is more likely to be long yen, in the sense that if the yen appreciates, its competitive position improves and vice versa if the yen depreciates. If this is the case, then the firm’s yen exposure is the net of its short and long exposure, which we cannot ascertain from the facts presented in the question. 9.b. Suppose the company is a multinational firm with sales in Japan and inputs that are primarily determined in dollars. How should this affect its financing choice? Answer: In this case, the firm clearly has a long economic exposure to yen. By financing in yen, the MNC can offset its economic exposure. 10. Huaneng Power International is a large Chinese company that runs coal-fired power plants in five provinces and in Shanghai. It has close to $1.2 billion in U.S. dollar debt whose proceeds it has used to purchase equipment abroad. 10.a. What currency risks does Huaneng face? Answer: The biggest problem for HPI is that its debt is denominated in dollars whereas its revenues are both denominated and determined in yuan. If the yuan depreciates in real terms against the dollar, HPI will see its dollar-equivalent cash inflows fall while its dollar cash outflows will remain the same on its debt. Given this currency mismatch, HPI’s net yuan profit will rise when the yuan appreciates in real terms against the U.S. dollar and fall when the yuan depreciates in real terms. Another currency risk faced by HPI stems from the fact that coal is traded in a global market and tends to be priced in dollars. If the dollar appreciates in real terms against the yuan, the yuan cost of coal will rise. If HPI is unable to pass that higher cost along to its customers, then it will see its yuan margins shrink. 10.b. Do its lenders face any currency risks? Explain. Answer: Yes. If the U.S. dollar appreciates enough, HPI will have difficulty servicing its dollar debts. Thus, the lenders are exposed to risk on their loans stemming from currency fluctuations even though these loans are priced in dollars. In effect, currency risk will be turned into credit risk. ADDITIONAL CHAPTER 10 QUESTIONS AND ANSWERS 1. Suppliers of the equipment used to make semiconductors, such as Applied Materials and LAM Research, who produce in the U.S. but are heavily dependent on sales to Asia, saw their share prices plummet in the wake of the Asian financial crisis. Explain. Answer: These firms had their costs denominated in dollars and a large portion of their revenues originating in Asia, particularly in Japan and South Korea. The steep decline in the value of Asian currencies led to a dramatic rise in the local currency prices of their equipment. Asian demand fell due to the price increases and because Japanese equipment makers became more competitive. Lower dollar profits, in turn, lowered the present value of the future cash flows of these companies and led to a decline in their stock prices. 2. Malaysian palm oil producers export more than 90% of their product for sale in dollars. Virtually all their costs, however, are in Malaysian ringgit. 2.a. How would the 30% fall in the value of the ringgit during 1997 affect the ringgit profitability of these producers? Explain. Answer: Ringgit depreciation combined with a dollar price for palm oil translates into an increase in the ringgit revenue generated by exports of palm oil. At the same time, ringgit costs stay about the same. The result is an increase in the ringgit profit earned by Malaysia’s palm oil producers. 2.b. How would the ringgit's depreciation affect the dollar profits of these producers? Explain. Answer: With over 90% of their output exported, the dollar revenue earned by the producers will remain constant (even though domestic sales are priced in ringgit, the ringgit price will reflect the dollar price earned overseas). Their dollar costs, which are sourced in ringgit, will decline in line with the ringgit’s depreciation. Hence, Malaysian palm oil producers will see their dollar profits rise with the ringgit’s depreciation. 3. Many business people and the business press believe that a devalued dollar offers a significant advantage to foreign bidders for American companies and real estate. Comment on this position. Answer: It is true that the foreign currency (FC) cost of buying U.S. assets declines in line with depreciation of the U.S. dollar. However, the FC value of future dollar cash flows generated by these assets will simultaneously decline as well. The net result is that the foreign currency return on investment in U.S. assets will remain the same with dollar depreciation. 4. Saint-Gobain, a French firm, and Pilkington PLC, a British firm, are arch rivals in the European flat-glass business. After Britain's exit from the ERM in September 1992, the pound fell by 15% against the franc. 4.a. What was the likely impact on Saint-Gobain's profitability of the pound devaluation? Answer: Saint-Gobain will be placed at a competitive disadvantage vis-à-vis Pilkington since Pilkington can maintain its pound prices – thereby cutting its prices in French franc and other European currency terms – and gain market share. Were Saint-Gobain to respond by cutting its prices, its franc profits would fall. Of course, if Saint-Gobain has substantial production capacity in the U.K. it will be able to offset some of its problems by shifting more production to its U.K. operations. (It doesn’t, so it must bear the full brunt of the pound devaluation.) 4.b. What was the likely impact on Pilkington’s profitability of the pound devaluation? Answer: Assuming that Pilkington is producing in England, its profitability should have gone up. Either it can fatten its margins by holding its European currency prices constant, or it can hold its pound prices constant and thereby gain market share from its European competitors. Of course, if Pilkington has other competitors who are producing in the U.K., then its competitive advantage will not be as great as it otherwise would be. 5. Bakrie, an Indonesian conglomerate, is assessing the likely consequences of the rupiah’s precipitous decline on its different businesses. These businesses include a telecommunications company that is building a network (using mostly imported equipment) throughout Jakarta to offer wireless service to its residents, a company that sells pipe to the Western firms exploiting Indonesia's oil and gas fields, and a big agricultural business (54% of its revenues are in dollars, compared with 40% of its costs) that owns rubber and palm plantations feeding a large refining and distribution operation. 5.a. Assess the likely impact of the rupiah’s depreciation on Bakrie's three different businesses. Answer: The telecommunications unit has its equipment costs in foreign currency whereas its revenues will be in devalued rupiah. Although its operating costs will be in rupiah as well, most expenses on a wireless network come from equipment costs. Hence, the net effect of rupiah devaluation on the telecommunications unit will be very negative. The pipe business will likely benefit from rupiah devaluation since it is paid in dollars, whereas its costs are largely in rupiah. Although the agricultural business’s dollar revenues and costs are more evenly balanced, it is a net recipient of dollars. Thus, it too should benefit from rupiah devaluation. 5.b. Which of Bakrie’s businesses will be most hurt by the rupiah’s fall? Will any of these businesses actually benefit from rupiah depreciation? Answer: The telecommunications business will be greatly hurt by rupiah devaluation. The other two businesses will benefit, although it is difficult to say which will benefit the most. 5.c. Bakrie has about $1 billion in foreign debt. Will this debt increase or decrease its currency exposure? Explain. Answer: As it turns out, the magnitude of Bakrie’s debt is so large that it completely offsets any benefits that rupiah devaluation might have on its agricultural and pipe businesses. The net effect of this transaction exposure is to swamp Bakrie and leave it greatly exposed to adverse effects from the rupiah’s devaluation. 6. Midwestern Bank has lent $10 million to finance an equipment sale to Thailand by Lasertech, a major exporter located in Michigan. Both the loan and the sale are priced in U.S. dollars. 6.a. Is Midwestern’s loan to Lasertech exposed to exchange risk? Explain. Answer: Yes. If the U.S. dollar appreciates against the Thai baht (which it has), the Thai importer’s cost of paying Lasertech will go up and Lasertech will likely have more difficulty collecting on its sale. If the importer defaults on the sale, Lasertech may have trouble repaying its debt. Thus, Midwestern is exposed to risk on its loan stemming from currency fluctuations even though the loan is priced in dollars. 6.b. Suppose Midwestern has lent money to Lasertech secured by the general credit of the company. Are these loans exposed to exchange risk? Explain. Answer: Yes. If the dollar appreciates against other currencies, Lasertech will face more competition from foreign companies and will be under pressure from foreign customers to lower its dollar prices (who will see prices in their domestic currencies rise with dollar appreciation). By diminishing Lasertech’s profitability, a stronger dollar will also diminish the probability of timely repayment of Midwestern’s loans to Lasertech and, hence, Midwestern’s profitability. To the extent Midwestern’s loans are affected by the value of the dollar, those loans are subject to exchange risk. 7. Why should managers focus on marketing and production strategies to cope with foreign exchange risk? Answer: Unlike transaction exposure, which is amenable to financial hedging, competitive exposures – those arising from competition with firms based in other currencies – are longer term, harder to quantify, and cannot be dealt with solely through financial hedging techniques. Rather, they require more strategic maneuvers involving changes in operating strategies. For this reason, the major burden of exchange risk management must fall on the shoulders of marketing and production executives. These executives deal in imperfect product and factor markets where their superior knowledge and specialized skills provide them with a comparative advantage in adjusting to the relative price changes caused by currency changes. 8. In what sense is the boost in profits of American companies due to a falling dollar artificial? Answer: The higher profits experienced by American companies due to a falling dollar are not the result of management excellence, product innovation, or a new low cost production process. They are also not permanent since the real exchange rate follows a random walk. In this sense they are artificial. 9. How does a shorter product cycle time help companies reduce the exchange risk they face? Answer: Success in an environment characterized by volatile exchange rates depends on a firm’s ability to react to change within a shorter time horizon than ever before. A key is shorter product cycle times – the time it takes to bring new and improved products to market. With shorter product cycles, the company can incorporate more up to date technology in its goods and respond faster to emerging market niches and changes in taste. The result is less price elasticity of demand and less exchange risk. Such speed and flexibility enable companies to change their strategies substantially before the impact of any currency change can make itself felt. In this way, the adjustment period following a large exchange rate change can be compressed dramatically, lessening exchange risk. 10. Why do exchange rate changes bring feast or famine for Volvo, but neither feast nor famine for Ford? Consider the distribution and concentration of their production facilities worldwide. Answer: Volvo has almost all its production facilities located in Sweden while it exports a large fraction of its output. The resulting imbalance in its revenue/cost structure means that for Volvo it has been feast or famine: When the krona appreciates, Volvo’s exports suffer from a lack of cost competitiveness, while a real krona depreciation brings high profits. By contrast, Ford, with worldwide manufacturing facilities, has substantial leeway in reallocating various stages of production among its several plants in line with relative production and shipping costs. For Ford, therefore, it is neither feast nor famine. It neither benefits as much from dollar depreciation nor loses as much from dollar appreciation. 11. To cut costs when the dollar was at its peak, Caterpillar shifted production of small construction equipment overseas. By contrast, Caterpillar's main competitors in that area, Deere & Co. and J.I. Case, make most of their small construction equipment in the U.S. What are the most likely competitive consequences of this restructuring? Answer: Caterpillar now has a diversified cost structure. Thus, it won’t be hurt as much when the dollar rises again, but it also will not benefit as much when the dollar falls. Its main competitors, Deere & Co. and J.I. Case, now have a competitive advantage vis à vis Caterpillar by producing most of their small construction equipment in the U.S. Caterpillar has responded to the weak dollar by shifting parts sourcing back to the U.S. It has also made an intense commitment to improving its U.S. manufacturing. To do this, it launched its so-called Plant With a Future program. The program involved overhauling virtually all the firm’s U.S. factories, installing fancy new robotics and streamlining assembly systems. It replaced obsolete assembly lines and their large parts inventories with highly automated clusters or cells that produce components for final assembly. 12. When the dollar was strong and it could not earn a reasonable profit on European sales, Osmose International gave up its government permits to sell its chemical wood preservatives in much of Europe. “Why pay for a permit when you can't sell anything there anyway?” said its president. 12.a. What response do you have for the president of Osmose? Answer: Maintaining its permits gives Osmose the option to return to the European market if and when the dollar weakened. This option is valuable in a world where exchange rates can fluctuate dramatically and stay at depressed levels for many years (as has subsequently proved to be the case). When the dollar fell in value, Osmose decided to reenter the European market, but it found that reapplying for permits takes years. At the same time, Osmose no longer has a service organization in Europe. 12.b. How might you go about assessing the trade-offs involved for Osmose? Answer: The more a currency fluctuates, the more valuable an option to move back into a market quickly becomes. Such an option also rises in value with the cost of reentry (in the form of having to recreate a sales organization) and with the time it takes to reapply for permits. The value of maintaining the option of reentering the market quickly must be traded off against the cost of maintaining the permits and the sales organization. All else being equal, the higher the cost of maintaining the permits and sales organization, the less valuable it is to preserve the market reentry option. 13. To avoid speculation, Honda hedges only the sales it has clinched, not the ones it expects. Comment on Honda's currency risk strategy. Answer: Honda is hedging its transaction exposure, but this leaves it with operating exposure, which is typically a much larger fraction of total economic exposure. In other words, while hedging some of its exposure reduces risk, the risk reduction is much less than it could be if Honda took its operating exposure into account when deciding on how much to hedge. The policy of only hedging actual sales also leaves Honda vulnerable if the dollar strengthens temporarily, as it did at the end of 1993. A bigger problem facing the Japanese companies in hedging their exposure is that they tend to hedge selectively; that is, they hedge only if they think the dollar will decline and go unhedged otherwise. However, their guesses are often wrong. For example, at the start of 1994, many Japanese firms thought the dollar would continue to strengthen and thus failed to roll over their forward contracts. They subsequently lost a great deal of money when the dollar plummeted in January following another trade fight between Japan and the U.S. SUGGESTED SOLUTIONS TO CHAPTER 11 PROBLEMS 1. Hilton International is considering investing in a new Swiss hotel. The required initial investment is $1.5 million (or SFr1.875 million at the current exchange rate of $0.8 = SFr1). Profits for the first ten years will be reinvested, at which time Hilton will sell out to its partner. Based on projected earnings, Hilton's share of this hotel will be worth SFr 3.88 million in ten years. 1.a. What factors are relevant in evaluating this investment? Answer: Hilton should focus on the real dollar value of future cash flows, or 3,880,000e10/[(1+k)(1+ius)]10 where e10 is the nominal dollar value of the Swiss franc in ten years, ius is the average annual rate of U.S. inflation over the next ten years, and k is Hilton’s real required return for this project. That is, the SFr3.88 million expected to be received in ten years should first be converted to nominal dollars, then into real dollars, and finally discounted at the real required return. This present value figure should then be compared to $1.5 million, the current cost of the investment (3,380,000 * 0.80). 1.b. How will fluctuations in the value of the Swiss franc affect this investment? Answer: Only fluctuations in the real value of the Swiss franc matter; fluctuations in the nominal value of the Swiss franc that are fully offset by higher U.S. inflation should not affect the investment. If the real value of the Swiss franc rises, the real dollar price of the hotel services being sold by Hilton will also rise. If demand for these services is elastic, which it seems to be given the Swiss hotel industry’s heavy dependence on tourists, real dollar revenues will decline. Inelastic demand will cause an increase in real dollar revenues. The hotel’s real dollar cost of Swiss labor and services will rise. Thus, if PPP holds, nominal currency changes shouldn’t affect Hilton’s Swiss investment; if PPP does not hold, an increase in the real exchange rate is likely to reduce the real value of Hilton’s investment. 1.c. How would you forecast the $:SFr exchange rate ten years ahead? Answer: There are several ways to forecast the nominal Swiss exchange rate ten years out: (1) Rely on the IFE, using nominal interest differentials between U.S. and Swiss bonds with maturities of ten years; (2) project relative price levels changes in Switzerland and the U.S. over the next ten years and then use PPP to forecast the rate change; and (3) use the forward rate if a ten year swap can be found. But what really matters is what happens to the real exchange rate. The best forecast of the real rate ten years out is the current spot rate. Over the long run, PPP tends to hold, leading to a relatively constant real exchange rate. 2. A proposed foreign investment involves a plant whose entire output of 1 million units per annum is to be exported. With a selling price of $10 per unit, the yearly revenue from this investment equals $10 million. At the present rate of exchange, dollar costs of local production equal $6 per unit. A 10% devaluation is expected to lower unit costs by $0.30, while a 15% devaluation will reduce these costs by an additional $0.15. Suppose a devaluation of either 10% or 15% is likely, with respective probabilities of 0.4 and 0.2 (the probability of no currency change is 0.4). Depreciation at the current exchange rate equals $1 million annually, while the local tax rate is 40%. 2.a. What will annual dollar cash flows be if no devaluation occurs? Answer: The cash flows associated with each exchange rate scenario are: Devaluation 0% 10% 15% Revenue $10.00 $10.00 $10.00 Less Variable Cost -6.00 -5.70 -5.55 Less Depreciation -1.00 -0.90 -0.85 Taxable Income 3.00 3.40 3.60 Less Tax @ 40% -1.20 -1.36 -1.44 After-Tax Income 1.80 2.04 2.16 Add Depreciation 1.00 0.90 0.85 Cash Flow 2.80 2.94 3.01 With no devaluation, the annual cash flow will equal $2.8 million. 2.b. Given the currency scenario described above, what is the expected value of annual after tax dollar cash flows assuming no repatriation of profits to the U.S.? Answer: The expected dollar cash flow will equal the sum of the cash flows under each possible devaluation percentage multiplied by the probability of that devaluation occurring or 2.8(0.4) + 2.94(0.4) + 3.01(0.2) = $2.9 million. Thus expected dollar cash flows actually increase by $100,000. If the impact of the expected devaluation of 7% (0.1 * 0.4 + 0.15 * 0.2) were calculated by reducing expected cash flows by 7%, the expected (and incorrect) result would be a loss of $196,000 (2.8 * 0.07). 3. Mucho Macho is the leading beer in Patagonia, with a 65% share of the market. Because of trade barriers, it faces essentially no import competition. Exports account for less than 2% of sales. Although some of its raw material is bought overseas, the large majority of the value added is provided by locally supplied goods and services. Over the past five years, Patagonian prices have risen by 300%, and U.S. prices have risen by about 10%. During this time period, the value of the Patagonian peso has dropped from P 1 = $1.00 to P 1 = $0.50. 3.a. What has happened to the real value of the peso over the past five years? Has it gone up or down? A little or a lot? Answer: The real value of the Patagonian peso, relative to its value five years ago, is now $0.50 * 4/1.1 = $1.82. Thus, the real value of the peso has risen by 82%. As discussed in the chapter, an increase in the real value of the local currency should boost dollar profits for those firms selling locally and not subject to import competition. 3.b. What has the high inflation over the past five years likely done to Mucho Macho’s peso profits? Has it moved profits up or down? A lot or a little? Explain. Answer: A reasonable assumption is that both Mucho Macho’s sales and costs have risen at least at the rate of Patagonian inflation. Thus, its peso profits, which equal the difference between the two, have risen at least 300% over the past five years. In fact, sales have probably risen by more than the rate of inflation, while costs have risen at less than the rate of inflation because some of the inputs are bought overseas. 3.c. Based on your answer to part a, what has been the likely effect of the change in the peso’s real value on Mucho Macho’s peso profits converted into dollars? Have dollar equivalent profits gone up or down? A lot or a little? Explain. Answer: Given the answers to items a and b, each peso of profits five years ago should now have grown to at least four pesos. Converting these profits into dollars at the lower exchange rate ($0.50 vs. $1) yields at least two dollars of profit today for every dollar of profit five years ago. 3.d. Mucho Macho has applied for a dollar loan to finance its expansion. Were you to look solely at its past financial statements in judging its creditworthiness, what would be your likely response to Mucho Macho's dollar loan request? Answer: The real appreciation of the Patagonian peso should have boosted Mucho Macho’s dollar profits dramatically. Thus, any analysis of creditworthiness based solely on its financial statements would show a very profitable and successful company and one deserving of a loan. 3.e. What foreign exchange risk would such a dollar loan face? Explain. Answer: The profitability of Mucho Macho is an artifact of the real peso appreciation. Thus it is artificial and not sustainable. The odds are that the government will be unable to maintain such an overvalued exchange rate for long. Once the peso devalues, the dollar value of Mucho Macho’s peso cash flow will plummet and so will its ability to repay its dollar loan. This exercise points out that an analysis of credit risk based solely on financial statements is valid only if one assumes that the conditions that gave rise to the numbers reflected on these statements will persist into the future. Under a controlled exchange rate system in an inflationary environment, the real exchange rate is subject to dramatic changes. These changes in turn will give rise to dramatic changes in the business environment, making past financial statements irrelevant in forecasting future cash flows. Although the numbers have been changed, this problem is based on an actual situation. In the late 1970s, some major American banks lent a great deal of money to one of the largest Chilean brewers. This brewer faced essentially no competition and so was highly profitable in both peso and dollar terms prior to devaluation of the peso. Although its credit looked impeccable, the brewer’s loans are now in default. The bankers forgot to assess the conditions that led to the brewer’s high profits and the likelihood that these conditions would persist. When government intervention causes nominal exchange rate changes to lag inflation, the real value of the currency will rise. The more rapid the inflation and the greater the lag, the greater the real exchange rate change. The increasing real value of the local currency in turn will cause pressures to build up that must ultimately be released through an LC devaluation. Thus, in assessing credit risk for foreign borrowers operating in a controlled rate system, it is necessary to assess their creditworthiness both before and after the inevitable devaluation. 4. In 1990, General Electric acquired Tungsram Ltd., a Hungarian light bulb manufacturer. Hungary’s inflation rate was 28% in 1990 and 35% in 1991, while the forint (Hungary’s currency) was devalued 5% and 15%, respectively, during those years. Corresponding inflation for the U.S. was 6.1% in 1990 and 3.1% in 1991. 4.a. What has happened to the competitiveness of GE’s Hungarian operations during 1990 and 1991? Explain. Answer: Since forint devaluations haven’t kept pace with Hungary’s roaring inflation, we know that the forint’s real exchange rate has risen. Specifically, if the nominal exchange rate (dollar value of the forint) at the start of 1990 was e0, the forint’s real value at the end of 1991 was: 0.95 * 0.85e0 * (1.28)(1.35)/[(1.061)(1.031)] = 1.276e0 This equation reflects the fact that if the nominal exchange rate (dollar value of the forint) at the start of 1990 was e0, then the 5% devaluation during 1990 left it at 0.95e0 by the end of 1990. A further 15% devaluation during 1991 would have left the nominal rate equal to 0.95 * 0.85e0 by the end of 1991. Based on this equation, we can see that the real exchange rate increased by 27.6% during this two-year period. The sharp appreciation in the real value of the forint reduced the cost competitiveness of GE’s Hungarian operations. 4.b. In early 1992, GE announced that it would cut back its capital investment in Tungsram. What might have been the purpose of GE’s publicly announced cutback? Answer: GE was trying to put pressure on the Hungarian government to devalue further the forint and thereby improve the cost competitiveness of its Tungsram manufacturing facilities. In effect, GE was telling the Hungarian government that it was in business to make a profit and that if it couldn’t make a profit in Hungary because of the high forint and the resulting sharp jump in its costs, it was not going to invest there in the future. 5. In 1985, Japan Airlines (JAL) bought $3 billion of foreign exchange contracts at ¥180/$1 over 11 years to hedge its purchases of U.S. aircraft. By 1994, with the yen at about ¥100/$1, JAL had incurred over $1 billion in cumulative foreign exchange losses on that deal. 5.a. What was the economic rationale behind JAL’s hedges? Answer: Most likely, JAL had signed contracts to take delivery of planes in the future and was using forward contracts to protect itself against a rise in the value of the dollar that would increase the yen cost of buying the planes. Alternatively, the forward contracts could have been used to hedge purchases of U.S. planes financed by borrowing dollars. 5.b. Did JAL’s forward contracts constitute an economic hedge? That is, is it likely that JAL’s losses on its forward contracts were offset by currency gains on its operations? Answer: The answer to this question depends on whether JAL’s yen operating profits are negatively correlated with the yen’s value. If a stronger yen means lower yen operating profits, then these forward contracts would constitute an economic hedge. Some factors to consider in deciding whether this is likely to be the case are as follows. First, a good part of JAL’s costs are for Japanese flight crews, whose pay is denominated and determined in yen. To the extent that fares are determined in dollars (in part because JAL is competing with U.S. airlines, JAL’s yen profits will vary inversely with the yen’s value). At the same time, a stronger yen will induce more Japanese to travel to the U.S. but fewer Americans to visit Japan, increasing outbound volume but reducing inbound volume. Where the balance lies is an empirical question. It turns out that JAL has been hurt by yen appreciation and is now looking to cut costs, primarily by reducing its Japanese work force through job buyouts and hiring foreigners. It has also focused more on serving leisure travelers since the yen’s strength has led unprecedented numbers of Japanese tourists to travel abroad. 6. Nissan produces a car that sells in Japan for ¥1.8 million. On September 1, the beginning of the model year, the exchange rate is ¥150:$1. Consequently, Nissan sets the U.S. sticker price at $12,000. By October 1, the exchange rate has dropped to ¥125:$1. Nissan is upset because it now receives only $12,000 * 125 = ¥1.5 million per sale. 6.a. What scenarios are consistent with the U.S. dollar’s depreciation? Answer: Any model of exchange rate determination may be applied here. In a monetary model this would include a relative increase in the U.S. money supply (or velocity), a relative decrease in U.S. income, or the expectation of these events in future periods. In an open economy Keynesian model, yen appreciation could arise from an increase in U.S. imports from Japan (due to an increase in U.S. income). If PPP holds, then relative prices levels should also have changed by 10%. Alternatively, the exchange rate change could be due to government intervention to push down the dollar’s value, or it could be due to the cessation of government intervention that was previously maintaining an overvalued dollar. 6.b. What alternatives are open to Nissan to improve its situation? Answer: The alternatives open to Nissan are: Raise prices in the U.S. market. ii) Do nothing for the short run. Incur some losses and hope that the exchange rate will return to ¥200. In addition, hold U.S. sales receipts in dollars and do not repatriate funds until the exchange rate is more favorable. The second part of this strategy is probably useless since it requires that any exchange rates changes not be offset by the differing interest rates between Japan and the U.S. iii) Invest in the U.S. and build the cars there. (In 1993, 45% of the cars Toyota sold in the U.S. were U.S. made.) iv) Try to reduce production costs in Japan, including buying more parts overseas. (How have production costs in Japan changed because of the exchange rate change? For example, consider the cost of domestic labor and the costs of imported iron ore and oil.) Many Japanese firms have also found that they could cut costs by simplifying their product line as well as by reducing the variety of parts used in their products. For example, Nissan offers 437 different kinds of dashboard meters, 110 types of radiators, and over 300 varieties of ashtrays. In 1993, Nissan ordered its designers to slash the number of unique parts in its vehicles by 40%. Model variations, which had ballooned to more than 2,200, will be rolled back 35%. Another strategy being used by Japanese automakers is have designers work closely with suppliers, marketing, and manufacturing people--thus avoiding expensive mistakes later on and reducing product development times and costs. Japanese companies are also, for the first time, closing factories and cutting jobs. v) Recognize that your comparative advantage is permanently lost and exit the U.S. market. vi) Switch production to higher quality, less price elastic and more income elastic cars. 6.c. How should Nissan respond in this situation? Answer: The appropriate response by Nissan depends on its interpretation of the nature of the economic disturbance that caused the exchange rate change. If it believes that the shock is temporary, Nissan must calculate how long it will take for the exchange rate to return to its original level. If the shock is nominal (PPP holds), then the real terms of trade between Japan and the U.S. are unaffected. In this case, U.S. prices in general should have been rising and Nissan can pass along all of the exchange rate change to his U.S. customers. (This is an important point: Is PPP a “leading” or a “lagging” relationship? How quickly can exchange rate changes be incorporated into domestic prices?) In the present circumstance, it is virtually certain that the 10% drop in the value of the dollar is not just a manifestation of purchasing power parity; that is, the dollar depreciation is not due to a 10% jump in the U.S. price level relative to the Japanese price level in the space of one month (a 314% annual rate of U.S. inflation). If the exchange rate change is real, which it almost surely is, then the yen appreciation is not associated with offsetting changes in domestic prices. In this case, Nissan must make some real changes in response to stay competitive with U.S. automakers. These changes depend on whether the increase in the real exchange rate is expected to be temporary or permanent. If the increase is due to intervention by the U.S. or Japanese central banks, the change is likely to be temporary because it is a movement away from equilibrium. Alternatively, a real exchange rate change that is due to market forces or to the cessation of intervention by the Japanese or U.S. central banks can be assumed permanent. Permanent in this context means that the best predictor of tomorrow’s real exchange rate is today’s rate. It doesn’t mean that the real rate tomorrow will be the same as the real rate today; rather, the real rate follows a random walk. If the real exchange rate increase is expected to be temporary, it may not pay Nissan to raise dollar prices and lose market share in the U.S. The reason is that when the real exchange rate readjusts, enabling Nissan to be price competitive again, it will be expensive to buy back market share. But if the real exchange rate increase is expected to be permanent, then Nissan should consider raising its prices (the extent depends on the price elasticity of demand) and making more basic changes in production and marketing strategy. Most Japanese firms have followed a strategy of cutting costs at home and keeping dollar prices constant as long as possible so as to hang onto U.S. market share. 6.d. Suppose that on November 1, the U.S. Federal Reserve intervenes to rescue the dollar, and the exchange rate adjusts to ¥220:$1 by the following July. What problems and/or opportunities does this situation present for Nissan and for General Motors? Answer: Here, the tables are reversed from part c. Nissan is “enjoying” an increase of 10% in its yen receipts from U.S. auto sales. Whether its "enjoyment" is real depends again on the nature of the economic disturbance associated with the exchange rate change. If Japanese production costs are rising because of inflation (associated with the yen devaluation) Nissan need not be better off in real terms. Its opportunities still depend on the “real/nominal” and “permanent/ temporary” nature of the shock. It is interesting to think about the possibilities here for domestic wage and price controls, foreign exchange controls, or foreign exchange market intervention that might be associated with these sharp exchange rate changes. Even if Nissan can determine an optimal response to the exchange rate change, its response may be foreclosed by government regulations. In this case, Nissan must consider second best strategies. 7. Chemex, a U.S. maker of specialty chemicals, exports 40% of its $600 million in annual sales: 5% goes to Canada and 7% each to Japan, Britain, Germany, France, and Italy. It incurs all its costs in U.S. dollars, while most of its export sales are priced in the local currency. 7.a. How is Chemex affected by exchange rate changes? Answer: As an exporter, Chemex is helped by dollar depreciation and hurt by dollar appreciation. If the dollar appreciates, the firm’s costs will appreciate in terms of the foreign currencies in which it sells. If it raises its foreign currency prices, it risks losing sales, and with them profits and worse, permanent market standing. If it does not raise prices in the foreign currencies, its dollar profit margins shrink, and with them its profits. Yet, Chemex may not be affected as much by currency changes as a commodity chemical maker would be since its products are differentiated (it makes specialty chemicals). To the extent that its major competitors are other American companies, who share a common cost structure, its exchange risk will be lower still. 7.b. Distinguish between Chemex’s transaction exposure and its operating exposure. Answer: Chemex’s transaction exposure stems from the fact that most of its export sales are priced in the local currency of the countries to which it exports. Its operating exposure arises because the dollar equivalent prices that it can charge in foreign markets and its foreign sales volume at a given dollar price are affected by currency changes. In other words, currency changes will affect the profits that Chemex can earn abroad. To the extent that Chemex faces competition in the U.S. from foreign firms, its domestic profits will also depend on exchange rates. 7.c. How can Chemex protect itself against transaction exposure? Answer: Chemex can hedge its transaction exposure by selling its foreign currency receipts forward for dollars. 7.d. What financial, marketing, and production techniques can Chemex use to protect itself against operating exposure? Answer: Chemex can finance its assets with foreign-currency-denominated debt in proportion to its sales in each country. This would involve raising 40% of its financing in foreign currencies as follows: 5% in Canadian dollars and 7% each in Japanese yen, British pounds, DM, French francs, and Italian lira. Although only a rough guide, this approach would help align its cost structure with its market structure. On the marketing side, Chemex’s position in the specialty chemical business already provides a hedge against currency risk since it reduces the price elasticity of demand. Chemex should continue to fund R&D to ensure a continuing stream of products with lower price elasticity of demand and work on bringing these new products to market quickly. In addition, Chemex should try to add more value to its products by providing more service to customers. This technique also lowers the price elasticity of demand, which is the basic marketing strategy for coping with currency risk. Chemex must also decide whether to price for market share or profit margin. This decision, which depends on both the price elasticity of demand and the marginal cost of production, will determine by how much it adjusts its dollar price when exchange rates change. On the production side, Chemex could globally source to shift suppliers in line with changing relative production costs in different countries. This strategy, however, is unlikely to pay big dividends because the raw materials that Chemex uses are commodity chemicals whose prices are similar worldwide. Chemex could also set production facilities in its major markets. But this strategy may not permit Chemex to take full advantage of production economies of scale. Chemex can also embark on a program of institutionalized cost cutting. The latter is just good business practice and will be beneficial regardless of currency movements. 7.e. Can Chemex eliminate its operating exposure by hedging its position every time it makes a foreign sale or by pricing all foreign sales in dollars? Why or why not? Answer: Either approach will allow Chemex to eliminate its transaction exposure. But neither will protect Chemex’s margins on future sales. This can only be done by hedging the present value of future sales, which is what financing assets with foreign currency debt in proportion to foreign sales effectively does. 8. During 1993, the Japanese yen appreciated by 11% against the dollar. In response to the lower cost of the main imported ingredients – beef, cheese, potatoes, and wheat for burger buns –McDonald’s Japanese affiliate reduced the price on certain set menus. For example, a cheeseburger, soda, and small order of French fries were marked down to ¥410 from ¥530. Suppose the higher yen lowered the cost of ingredients for this meal by ¥30. 8.a. How much of a volume increase is necessary to justify the price cut from ¥530 to ¥410? Assume the previous profit margin (contribution to overhead) for this meal was ¥220. What is the implied price elasticity of demand associated with this necessary rise in demand? Answer: The net effect of the price cut and the lower yen cost of ingredients is a decline in profit per meal of ¥90 (¥120 - ¥30). The new profit margin per meal will now fall to ¥130 (¥220 - ¥90). This is a decline of 41% (90/220). To maintain overall yen profitability, given unit profits only 59% of what they were previously, the volume of meals must rise by 69% (0.59 * 1.69 = 1). From a dollar standpoint, however, the new profit margin has fallen only 34%. This can be seen as follows. The new profit margin of ¥130 is worth 11% more in dollar terms. As a fraction of the previous margin, this is equivalent to a dollar margin that is 66% of the previous dollar margin (130 * 1.11/220). The difference of 34% represents the decline in the dollar margin. To maintain total dollar profits, therefore, McDonald’s volume must rise by 52% (0.66 * 1.52 = 1). 8.b. Suppose sales volume of this meal rises by 60%. What will be the percentage change in McDonald’s dollar profit from this meal? Answer: Here, the new dollar profit relative to the previous one will be 0.66 * 1.60 = 1.06, or a 6% rise in dollar profit. 8.c. What other reasons might McDonald’s have had for cutting price besides raising its profits? Answer: McDonald’s may be trying to raise its market share in the expectation that this will enable it to later capitalize on this expansion and sell additional meals in the future. In addition, McDonald’s may be able to sell higher-priced meals to the additional people (family members and friends) that come along with the customers buying the discounted meals. In other words, the discounted meals may serve as loss leaders. 9. In 1990, a Japanese investor paid $100 million for an office building in downtown Los Angeles. At the time, the exchange rate was ¥145/$1. When the investor went to sell the building five years later, in early 1995, the exchange rate was ¥85/$1 and the building’s value had collapsed to $50 million. 9.a. What exchange risk did the Japanese investor face at the time of his purchase? Answer: The risk is that the value of the dollar would fall against the yen and that the dollar revenues would not keep up with the decline in the value of the dollar. 9.b. How could the investor have hedged his risk? Answer: The investor could have financed his purchase of the building by borrowing dollars, so that the very same event that led to a decline in the yen value of his asset – namely, a dollar decline – would simultaneously reduce the yen cost of the liability used to finance that asset. He could also have taken out a long-dated forward contract to hedge the yen value of his building. Nothing would have protected the investor from the decline in the building’s dollar price. 9.c. Suppose the investor financed the building with a 10% downpayment in yen and a 90% dollar loan accumulating interest at the rate of 8% per annum. Since this is a zero-coupon loan, the interest on it (along with the principal) is not due and payable until the building is sold. How much has the investor lost in yen terms? In dollar terms? Answer: Based on the 10% downpayment, the investor’s initial yen investment was ¥1.45 billion (0.10 * 100 million * 145). At an interest rate of 8%, the $90 million loan used to finance the balance of the building’s price will grow by the end of five years to $132,239,527 (1.085 * $90,000,000). On selling the building and paying off the loan, the investor will have a dollar loss of $82,239,527 ($132,239,527 - $50,000,000). At the current spot rate of ¥85/$1, this dollar loss translates into a yen loss of ¥6.99 billion. Adding this loss to the investor’s initial downpayment of ¥1.45 billion yields a total yen loss for the investor of ¥8.44 billion. 9.d. Suppose the investor financed the building with a 10% downpayment in yen and a 90% yen loan accumulating interest at the rate of 3% per annum. Since this is a zero-coupon loan, the interest on it (along with the principal) is not due and payable until the building is sold. How much has the investor lost in yen terms? In dollar terms? Answer: If the investor had financed the building with the 90% yen loan, the investor would have had to borrow 100,000,0000 * 0.90 * ¥145 = ¥13.05 billion. At an interest rate of 3%, the ¥13.05 billion loan will grow by the end of five years to ¥15.13 billion (1.035 * ¥13.05 billion). The $50 million sale price translates into ¥4.25 billion (50,000,000 * 85). After paying off the loan, the investor has a loss of ¥10.88 billion. Adding to this loss the initial downpayment of ¥1.45 billion produces a total loss for the investor of ¥12.33 billion. It can be seen from the answer to part c that the use of dollar financing reduced the investor’s loss. The investor, of course, lost anyway because the value of the building declined instead of rising by at least the rate of interest. 10. Over the past year, China has experienced an inflation rate of about 22%, in contrast to U.S. inflation of about 3%. At the same time, the exchange rate has gone from Y8.1/U.S.$1 to Y7.6/U.S.$1. 10.a. What has happened to the real value of the yuan over the past year? Has it gone up or down? A little or a lot? Answer: The real value of the yuan, relative to its value one year ago, has risen significantly. Specifically, in dollar terms, the nominal exchange rate has appreciated from $0.1235 (1/8.1) to $0.1316 (1/7.6), a 6.54% increase ([0.1316 - 0.1235]/0.1235). In real terms, the yuan has appreciated to $0.1316 * 1.22/1.03 = $0.1559. Thus, the real value of the yuan has risen by 21.1%: (0.1559 - 0.1235)/0.1235 = 26.2% If PPP held, the yuan should have devalued to a new exchange rate of e = 8.1 * 1.22/1.03= Y9.59/$ You can tell this is the PPP rate because at this exchange rate, the real rate remains at Y8.7/$: Real rate = 9.59 * 1.03/1.22 = Y8.1/$ 10.b. What are the likely effects of the change in the yuan’s real value on the dollar profits of a company like Procter & Gamble that sells almost exclusively in the local market? Answer: A reasonable assumption is that P&G’s sales, which are generated domestically, have risen at least at the rate of Chinese inflation. Meanwhile, costs are partially denominated in dollars (via imports of various inputs) and partially in yuan (via locally-sourced inputs, including labor). Hence, costs have risen by less than the rate of Chinese inflation (since the inflation-adjusted value of the dollar and, therefore, dollar-denominated costs have fallen). This means that yuan profits, which equal the difference between revenues and costs, have risen at least 22% over the past year. In turn, given the 6.54% rise in the dollar value of the yuan, dollar profits for P&G should have risen by at least 30% (1.22 * 1.0654 - 1). These results just point to the more general truth that an increase in the real value of the local currency should boost dollar profits for those firms selling locally and not subject to import competition. 10.c. What are the likely effects of the change in the yuan’s real value on the dollar profits of a textile manufacturer that exports most of its output to the U.S.? What can it do to manage these effects? Answer: The impact of the rise in the real value of the yuan on a textile manufacturer that exports most of its output to the U.S. will be the opposite of its impact on P&G. Specifically, the textile manufacturer will find that its costs in dollar terms have risen by about 30% (taking into account the combined effects of Chinese inflation and yuan appreciation) whereas its dollar revenues have risen by about the rate of U.S. inflation, or 3%. The combination of a 3% rise in revenues and a 30% rise in costs means shrinking margins in dollars. Since the dollar has fallen against the yuan, the result in an even bigger squeeze on the yuan profit margin. ADDITIONAL CHAPTER 11 PROBLEMS AND SOLUTIONS Problems 1 and 2 are based on the Spectrum Manufacturing AB case (scenarios 1, 2, and 3) presented in the chapter. Calculate Spectrum’s economic exposure under the following new scenarios: 1. Scenario 4: Sales and import prices rise; domestic materials substituted for imported materials; other variables remain the same. 1.a. Spectrum is able to raise the krona price of its sheet plastic to SEK 25 to exactly offset the effect of the devaluation. 1.b. Because of domestic materials substitutions, krona operating expenditures rise by only 4% relative to the base case. 1.c. Physical sales volume stays at its predevaluation level. SCENARIO 4 Answer: Under this scenario the post devaluation operating cash flow will be $1,268,000 annually. The calculations are shown in Exhibit 1. Spectrum’s first year gain from operations is: First year cash flow (SEK 4 = $1) = $900,000 First year cash flow (SEK 5 = $1) = $1,268,000 Net gain from devaluation = $368,000 The present value of the economic gain associated with a krona devaluation in this case, based on a three year adjustment period, is $939,212, as follows: Year Post-Devaluation Cash Flow Pre-Devaluation Cash Flow Change in Cash Flow 15% Present Value Factor Present Value 1 $1,268,000 $900,000 $368,000 0.870 $320,160 2 $1,268,000 $900,000 $368,000 0.756 $278,208 3 $1,418,000 $900,000 $518,000 0.658 $340,844 Net Gain $939,212 This gain occurs because the sales price increase keeps dollar revenues constant while dollar costs of production fall. If krona production costs rise, much, if not all, of this gain will be dissipated. The year 3 figure of $1,418,000 includes a $150,000 gain on repayment of the krona loan. Exhibit 1. Summary of Projected Operations for Spectrum Manufacturing AB: Scenario 4 Financial Component Units (000) Unit Price (SEK) Total (SEK) Domestic Sales 600 25 15,000,000 Export Sales 400 25 10,000,000 Total Revenue 25,000,000 Total Operating Expenses 11,232,000 Overhead Expenses 3,500,000 Interest on Krona Debt (10%) 300,000 Depreciation 900,000 Net Profit Before Tax 9,068,000 Income Tax @ 40% 3,627,000 Profit After Tax 5,441,000 Add Back Depreciation 900,000 Net Cash Flow in Krona 6,341,000 Net Cash Flow in Dollars (SEK 5 = $1) $1,268,000 This gain occurs because the sales price increase keeps dollar revenues constant while dollar costs of production fall. If krona production costs rise, much, if not all, of this gain will be dissipated. The year 3 figure of $1,418,000 includes a $150,000 gain on repayment of the krona loan. 2. Scenario 5: Volume and import prices rise; other variables remain the same. 2.a. The krona sales price remains at SEK 20. 2.b. Unit sales volume rises by 50%, both domestically and abroad, owing to the lower dollar price. 2.c. Because krona costs of local labor and materials stay the same, krona unit operating expenditures rise by only 5.6%. 2.d. The firm’s various overhead expenses do not change. SCENARIO 5 Answer: The net result of the assumptions in scenario 5 is a yearly post devaluation operating cash flow of $1,163,000 – an increase of $263,000 over the pre devaluation level of $900,000 (see Exhibit 2). Note that a 50% increase in sales volume leads to an 82% increase in profit after tax but to only a 62% increase in krona cash flow. The latter effect is due to the fixed depreciation charge which causes taxes to rise more rapidly than profits. This tax factor combined with the krona devaluation results in a rise in annual U.S. dollar operating cash flow of only 29%. The resulting post devaluation cash flows for the following three years and consequent change in economic value are: Year Post-Devaluation Cash Flow Pre-Devaluation Cash Flow Change in Cash Flow 15% Present Value Factor Present Value 1 $1,163,000 $900,000 $263,000 0.870 $228,810 2 $1,163,000 $900,000 $263,000 0.756 $198,828 3 $1,313,000* $900,000 $413,000 0.658 $271,754 Net Gain $669,392 * Includes a gain of $150,000 on repayment of the krona loan. Exhibit 2. Summary of Projected Operations for Spectrum Manufacturing AB: Scenario 5 Financial Component Units (000) Unit Price (SEK) Total (SEK) Domestic Sales 900 20 18,000,000 Export Sales 600 20 12,000,000 Total Revenue 30,000,000 Total Operating Expenses 17,017,000 Overhead Expenses 3,500,000 Interest on krona debt (10%) 300,000 Depreciation 900,000 Net Profit Before Tax 8,193,000 Income Tax @ 40% 3,277,000 Profit After Tax 4,916,000 Add Back Depreciation 900,000 Net Cash Flow in Kroner 5,816,000 Net Cash Flow in Dollars (SEK 5 = $1) $1,163,000 3. On January 1, the U.S. dollar: Japanese yen exchange rate is $1 = ¥250. During the year, U.S. inflation is 4% and Japanese inflation is 2%. On December 31, the exchange rate is $1 = ¥235. What are the likely competitive effects of this exchange rate change on Caterpillar Tractor, the American earth moving manufacturer, whose toughest competitor is Japan’s Komatsu? Answer: The real value of the yen changed from $0.004000 (1/250) at the start of the year to $0.004339 (1/235 * 1.04/1.02) at the end of the year, an increase of 8.47%. Caterpillar Tractor should benefit from this increase in the real value of the yen since Komatsu does most of its manufacturing in Japan. The inflation adjusted dollar cost of Japanese supplied components and labor will rise in line with the increase in the real value of the yen. Komatsu’s raw materials and energy prices should not rise in dollar terms because these resources are imported. 4. You are asked to lend money for a major commercial real estate development in Calexico, which is on the California side of the Mexican border. There is some talk about a further devaluation of the Mexican peso. What information do you need to assess the creditworthiness of this project? Answer: The economic viability of a shopping mall largely determined by the number of shoppers who frequent the development and the amount of money they spend there. In the case of a shopping center in Calexico, the odds are that many of the potential customers are Mexican. If the Mexican government has been artificially propping up the value of the peso, which it is has done consistently, then Mexicans will find that their pesos have more purchasing power in the U.S. The result will be more traffic for a shopping mall in a U.S. border town and higher profits. However, this situation is one of artificial prosperity that will not last long; when the peso is devalued, Mexican shoppers will stay home and profits will decline. This analysis is based on experience. Prior to 1982, the rising real value of the Mexican peso meant that border areas in Texas and California were popular markets for Mexican citizens and a large portion of the retail sales in these areas were to Mexican citizens. Laredo and other American border towns bustled with free spending Mexican shoppers. U.S. goods were cheaper and easier to find than at home. But after Mexico’s two peso devaluations in 1982 quadrupled the price of dollar from 25 pesos to over 100, the lucrative traffic was washed out. Business activity was off by as much as 80% in some Texas border towns and nearly a third of the small businesses in the Rio Grande Valley were threatened with bankruptcy. Returning to the shopping center project, the more dependent it is on Mexican customers and the higher the real value of the peso is currently, the more exchange risk the project faces. 5. About two thirds of all California almonds are exported. The ups and downs of the U.S. dollar, therefore, cause headaches for almond growers. To avoid these problems, a grower decides to concentrate on domestic sales. Does that grower bear exchange risk? Why and how? Answer: A grower who sells only in the U.S. still bears exchange risk because the price at which he can sell his almonds varies with the exchange rate. For example, when the dollar appreciates, foreigners will demand fewer almonds at the current dollar price. This will cause the dollar price at which almonds are sold overseas to fall. Hence, almond growers who previously sold overseas will now find it more profitable to sell in the U.S. This will drive down the price of almonds in the U.S. until it just equals the price of almonds in Japan and other foreign markets minus transportation costs. If the dollar depreciates, the foreign demand for almonds at the current dollar price will increase, raising almond prices at home and abroad. This is just another illustration of the law of one price. It holds because growers will arbitrage between domestic and foreign markets in the search for higher profits. 6. Aldridge Washmon Co. is one of the largest distributors of heavy farming equipment in Brownsville, Texas, located on the border with Mexico. The time is late 1981. Sales have increased dramatically over the past two years, and Aldridge is requesting an expansion of its credit line. What information would you as a banker need before you accede to its request? Answer: The key to this question is to recognize that the real value of the Mexican peso rose dramatically over this time period. Thus, the rise in Aldridge Washmon’s sales was due almost exclusively to the rising real value of the Mexican peso, which made it less and less expensive for Mexican farmers to buy its farming equipment. By 1982, Mexican farmers accounted for 80% of its business. But the company experienced artificial prosperity. Once the peso devalued, as it had to, Aldridge’s sales plummeted because Mexican farmers could no longer afford its machines. According to an Aldridge manager, “Business just stopped flat, like running a car into a brick wall.” Aldridge plans to use the expanded line of credit to finance additional working capital, primarily accounts receivable on Mexican sales and additional inventory. When the peso devalues, Mexican buyers will have trouble repaying their dollar debts and Aldridge will have difficulty repossessing its tractors in Mexico. Thus, its receivables will be worth much less than 100 cents on the dollar. In addition, Aldridge will be stuck with a large inventory of tractors and other equipment. The value of this inventory will drop since the major market for farm equipment will have disappeared. Hence, even if the bank secures its loan with Aldridge’s inventory and receivables, the value of this collateral will drop following peso devaluation. One other consideration is worth mentioning. If peso devaluation makes Mexican agriculture more competitive in world markets, then Mexican farmers will gain from devaluation and will demand more farm equipment. This is a plausible scenario but is unlikely to hold here because we already know that the Mexican farmers benefited from a real appreciation of the peso; hence, a real peso devaluation should have the opposite effects. Evidently, Mexican farmers are selling in a protected domestic market. If they were exporting or competing against imports, they would have been hurt by the rising real value of the peso. As we saw in the chapter, companies selling in the local market and facing minimal import competition will gain from real LC appreciation and lose from LC devaluation. The opposite effects would be experienced by companies dealing in traded goods. This discussion implies the information that Aldridge’s bankers should gather: Who is it selling to? How will these customers be affected by peso depreciation? What has happened to the real value of the peso and what is likely to happen to its value in the future? What will happen to the value of collateral if the peso devalues? 7. Assess the likely consequences of a declining dollar on Fluor Corporation, the international construction engineering contractor based in Irvine, California. Most of Fluor's value added involves project design and management; most of its costs are for U.S. labor in design, engineering, and construction management services. Answer: Fluor will benefit from a falling dollar since it will be more cost competitive vis a vis foreign contractors both at home and abroad. Its costs are primarily denominated and determined in dollars. Thus, when the dollar declines, these costs fall relative to those of its foreign competitors. Although many of the costs incurred on foreign projects are set in the local currency, these costs are the same for all potential competitors. Hence, in competing against foreign firms, Fluor will find that some of its costs are the same while other of its costs, particularly for the labor involved in design, engineering, and construction management services, are now lower. This is analogous to the situation confronting the U.S. chemical industry in problem #12. 8. The European chemical industry pays for an estimated 79% of its oil based feedstock in dollars. Thus, its costs are declining sharply because of the drop in the price of oil combined with the sharp decline in the value of the dollar. What is the likely impact on the European chemical industry's profits of the dollar decline? Will it now be more competitive relative to the American chemical industry? Answer: The implication that lower dollar oil prices combined with the lower value of the dollar, by sharply cutting the costs of European chemical companies, will make them more competitive vis à vis American chemical companies is fallacious. Whether measured in dollars, DM, French francs, or British pounds, the price of oil is the same to all chemical companies worldwide. Thus, although a drop in the price of oil is likely to increase chemical industry profits, it will not disproportionately favor firms in one country over those in another. But when it comes to labor and other goods and services sourced locally, U.S. chemical companies will now enjoy a competitive cost advantage. Whether measured in dollars, DM, or ECUs the price of labor and other non oil inputs will now be lower for American firms than for European firms. The net result is that the decline in oil prices is neutral in terms of national competitiveness but the depreciation of the dollar will give U.S. chemical firms a competitive advantage. This prediction has been borne out: Companies like Du Pont, Dow Chemical, and Hercules have benefited greatly from dollar depreciation. By contrast, dollar depreciation has hurt European chemical companies. 9. Cooper Industries is a maker of compressors, pneumatic tools, and electrical equipment. It does not face much foreign competition in the U.S., and exports account for only 7% of its sales. Does it face exchange risk? Answer: As a supplier to industrial customers who compete against imports and that sell overseas, Cooper Industries benefits from a weaker dollar and is hurt by a stronger dollar. Customer sales rise with a weak dollar and fall with a strong dollar and these changes translate into more or less sales for Cooper. This is analogous to the case of Nippon Steel discussed in problem #16 below. 10. The Edmonton Oilers (Canada) of the National Hockey League are two time defending Stanley Cup champions. (The Stanley Cup playoff is hockey’s equivalent of football’s Super Bowl or baseball’s World Series.) As is true of all NHL teams, most of the Oilers’ players are Canadian. How are the Oilers affected by changes in the Canadian dollar/U.S. dollar exchange rate? Answer: The fact that the Oilers are paid in Canadian dollars does not affect the answer to this question very much. While the C$ is the currency of denomination, the U.S.$ is the currency of determination. That is, the Canadian dollar salaries paid to the Oilers’ players are just equal to what the players’ salaries would be in U.S. dollars converted into Canadian dollars. Thus, the Edmonton Oilers are hurt by appreciation of the U.S.$ vis a vis the C$ and benefited by U.S. dollar depreciation. Consider what would happen, for example, if the U.S.$ appreciates against the C$. If the Oilers’ C$ salaries are not raised, they will find they are being paid less than players on U.S. hockey teams. The Oilers will be forced to raise the Canadian dollar equivalent of its players’ salaries to keep them on a par with their U.S. rivals. Otherwise, the Edmonton Oilers will either lose players to U.S. teams or have a hostile team. Player nationality is irrelevant. Canadian teams compete in a world market for talent and must pay the market price. 11. South Korean companies such as Goldstar, Samsung, and Daewoo have captured more than 10% of the U.S. color TV market with their small, low priced TV sets. They are also becoming more significant exporters of videocassette recorders and small microwave ovens. What currency risk do these firms face? Answer: These firms have benefited greatly from the appreciation of the Japanese yen against the U.S. dollar because the won has not risen by nearly the same extent against the dollar. They have used their cost advantage vis à vis Japanese competitors to boost sales of low end consumer electronics products by cutting prices below the level at which the Japanese could make money. Yen depreciation or won appreciation would reduce their cost advantage. Similarly, they face currency risk because competitors in other nations, such as Taiwan or Thailand, might devalue their currencies against the won. 12. A common complaint leveled against the Japanese government is that it deliberately holds down the value of the yen to boost exports of Japanese products. American steelmakers have been particularly vocal in their complaints. As a remedy, steelmakers in 1985 asked President Reagan to curtail Japanese steel imports further and to impose a 25% tariff to offset what they describe as the "artificial" undervaluation of the yen. Does Nippon Steel profit from a weak yen? What are the likely consequences of the recent appreciation of the yen? Here are some facts. Imports of U.S. raw materials priced in dollars account for about one-third of costs, and exports to the U.S. generate about 4% to 5% of its revenues. Nippon Steel currently is exporting as much steel as it can to the U.S. under existing quota restrictions. What additional information do you need to fully assess the impact of currency changes on Nippon Steel? Answer: The initial response is that Nippon Steel gains more on the cost side than it loses on the revenue side from yen appreciation since it is not selling much overseas anyway. However, this analysis is misleading. Specifically, the demand for Japanese steel is driven largely by the demand for Japanese exports, such as cars and machine tools, that embody that steel. Other things being equal, as the yen appreciates, Japanese companies become less competitive abroad and they export less. This cuts their demand for Japanese steel. Meanwhile, other Japanese steel companies have access to the same lower cost raw materials as does Nippon Steel. Competition among Japanese steel companies forces them to cut their yen prices in line with the decline in their yen costs. Thus, the benefit on the cost side is competed away and Nippon Steel is stuck with a loss of sales. The result: Nippon Steel is hurt by yen appreciation and is helped by yen depreciation. 13. Monsanto Co., the St. Louis chemical firm, is a major seller of herbicides. Its two brand name herbicides, Roundup and Lasso, have a large share of the U.S. and foreign markets. Its major competitors are other U.S. chemical companies. How are sales and profits of these products, as well as Monsanto’s other chemicals, likely to be affected by changes in the value of the dollar? Answer: Monsanto will be hurt by dollar appreciation and helped by dollar depreciation. However, because it sells brand name products, the demand for its products is less price elastic than if it sold commodities. Thus, Monsanto will not be affected as much by currency changes as it would be if it were in a pure commodity business. The impact of currency changes will be greater on those of its product lines that are commodities. 14. Black & Decker Manufacturing Co. of Towson, Maryland, has roughly 45% of its assets and 40% of its sales overseas. How does a soaring dollar affect its profitability, both at home and abroad? Answer: Black & Decker has a rough balance between foreign sales and costs. Thus, as the dollar appreciates, both its sales revenue and its costs decline approximately in line with each other. This means that its profits will decline roughly in line with the rise of the dollar. (If both revenues and costs fall, say, 10%, then profit must also fall by 10%.) Dollar depreciation leads to corresponding increases in dollar revenues and costs. The bottom line is that B&D’s profits fall as the dollar rises and rise as the dollar falls. If B&D didn’t produce overseas, but instead exported from its U.S. plants, then currency changes would lead to much greater swings in its profits. Note that B&D’s domestic profitability is also affected by currency changes since it faces competition in the U.S. from foreign companies such as Japan’s Makita. 15. The shipbuilding industry is facing a worldwide capacity surplus. Although Japan currently controls about 50% of the world market, it is facing severe competition from the South Koreans. Japanese shipyards are extraordinarily productive, but at current price levels were just about breaking even with an exchange rate of ¥240 = $1. What are the likely effects on Japanese shipbuilders of a yen appreciation to ¥180 = $1? The South Korean won has maintained its dollar value. Answer: The statement that “Japanese shipyards are extraordinarily productive” tells you that there is not much room for cost cutting by Japanese shipyards. Hence, Japanese shipyards will be devastated by a rise in the yen, as they were. As the yen appreciates against the won, South Korean shipyards gained a substantial cost advantage vis a via the Japanese. According to a story in the Wall Street Journal, “Japanese industry officials say ship buyers now automatically bypass Japanese makers, turning instead to Hyundai Corp. and other South Korean shipbuilders, which enjoy comparative reprieve on the currency front.” The only degree of freedom to adjust Japanese shipbuilder costs took place on the wage side. Japanese firms typically pay a substantial fraction of workers’ wages in the form of a semi annual bonus that is tied to corporate profits. Thus, during hard times, labor costs fall automatically. However, this decrease in labor costs was not nearly enough and many Japanese shipyards went bankrupt. A spokesman for the Japan Ship Exporters Association said that they couldn’t lower prices further. “They’re already at the bottom. We can do nothing but watch competitors take away orders.” Japanese shipyards have responded by designing innovative ships for which demand is price inelastic. They are no longer competitive in the commodity ship business. 16. Nissho Iwai American Corporation is the American arm of a large Japanese trading company that deals in everything from steel to tuna fish. Assess the credit risk implications for Nissho Iwai of a 30% rise in the dollar value of the yen. Answer: Yen appreciation makes Nissho Iwai’s products less competitive in the U.S. market. The greater the extent to which Nissho deals in commodity products (like steel and tuna fish), the more its sales and profits will be hurt by an appreciating yen. Conversely, if Nissho shifts its mix toward more technically sophisticated and more differentiated products, it will be less affected by the rising yen. The firm could in fact benefit from the strong yen by using its intelligence gathering system to find newly cost-competitive American products that it can now export to Japan. 17. Thomasville Plastics Corp. has contracted to buy $1.1 million worth of Japanese plastic-injection molding machines. The contract price is set in dollars. Does Thomasville bear any currency risk associated with this purchase? Explain. Answer: Thomasville bears exchange risk because a falling dollar might push up spare parts prices. This assumes that the parts are unique and cannot be gotten from domestic producers. It will also have to pay higher prices when it goes to replace machines that wear out, assuming that it doesn’t want to mix and match machines from different manufacturers. 18. Middle American Corp. (MAC) produces a line of corn silk cosmetics. All of the inputs are purchased domestically and processed at the factory in Iowa. Sales are only in the U.S. 18.a. Is there any sense in which MAC is exposed to the risk of foreign exchange rate changes that effect large MNCs? If yes, how could MAC protect itself from these risks? Answer: MAC is exposed to the risk that the French franc/U.S. dollar exchange rate may change and alter the price of French cosmetics relative to U.S. cosmetics. The problem is analogous to problem 1. If the exchange rate change is real or if tastes change toward French cosmetics (another real disturbance), the market value of MAC shares should fall. The firm could protect itself by having net French franc liabilities. Some questions to ask are: How could MAC protect itself against the possible change in consumer tastes? What is the cost to MAC of establishing and maintaining the French franc liability position? What are the benefits? 18.b. If MAC opens a sales office in Paris, will its exposure to exchange rate risks increase? Explain. Answer: Your immediate reaction may be that the risks increase because MAC has more foreign currency operations on the books. However, exposure depends on the relative magnitudes of asset and liability positions in the foreign currencies. MAC may find ways to hedge the exchange risks associated with the French franc and incur no additional risks. In fact, we could look at the Paris venture as a way to diversify and therefore reduce several of the business risks faced by MAC. 19. Gizmo, U.S.A. is investigating medium term financing of $10 million in order to build an addition to its factory in Toledo, Ohio. Gizmo’s bank has suggested the following alternatives: Type of Loan Rate 3-year U.S. dollar loan 3-year euro loan 3-year Swiss franc loan 14 8 4 19.a. What information does Gizmo require to decide among the three alternatives? Answer: It is useful to divide this problem into two issues: what is the expected cost and what is the risk of each alternative. Defining the terms “cost” and “risk” requires careful thought. If we assume that (1) the international money markets are efficient and (2) the IFE holds (these are separate issues) then the expected cost of each loan is the same. If the market is anticipating that for the next three years the euro and the Swiss franc will appreciate 6% and 10% annually, respectively, then the expected U.S. dollar cost of each loan is the same. If we are unwilling to make assumptions (1) and (2), then we need to use independent forecasts of the euro and Swiss franc exchange rates to calculate the loan whose expected U.S. dollar cost is the lowest. Even if the expected cost of each loan is the same, the risk associated with each loan may be different for Gizmo. This risk will depend on the currency denomination of assets that Gizmo holds as well as on the markets in which Gizmo buys its inputs and sells it outputs. For example, if Gizmo sells many products in Germany, then it probably has accounts receivable denominated in euros. It can use these receivables to pay off a euro-denominated loan and avoid the risks that are associated with an uncertain $/€ rate. If Gizmo desires a particular risk level, then it may rationally prefer a particular currency denomination for the loan. It may also be that forward markets are more developed in one currency or that unanticipated exchange rate changes are smaller in one currency, and therefore, the risks associated with that currency are smaller even if the expected costs are the same. 19.b. Suppose the factory will be built in Geneva, Switzerland, rather than Toledo. How does this affect your answer in part a? Answer: If the factory in Geneva sells in Switzerland, then Gizmo has an asset which is essentially denominated in Swiss francs. This may establish a natural hedge against a Swiss franc loan and reduce the risk of this particular alternative. If the expected cost of each loan alternative if the same, and if the firm seeks to reduce total risk, then this information would suggest a Swiss franc loan. But if the Swiss factory is exporting to the U.S., or is selling in the Swiss market and facing import competition, then some dollar financing or financing in the currency of the country in which its main competitors are located might be appropriate. If the objective is to minimize currency risk, the relative amount of financing to do in each currency will also depend on the sources of Gizmo’s inputs, particularly the extent to which it uses Swiss labor. The more labor intensive the production process, the less useful Swiss franc financing will be in reducing Gizmo’s exposure (since by using Swiss labor it already has Swiss franc outflows). 20. In September 1992, Dow Chemical reacted to the currency chaos in Europe by switching to DM pricing for all its products in Europe. The purpose, said a Dow executive, was to shift currency risk from Dow to its European customers. Moreover, said the Dow executive, the policy was fairer: By setting the same DM price throughout Europe, Dow’s new policy would nullify any advantage that a Dow customer in one company might have over competitors in another country based on currency swings. 20.a. What is Dow really trying to accomplish with its new pricing policy? Answer: Dow was really trying to raise its prices in those European counties whose currencies devalued so as to preserve its dollar margins, which were eroding from the devaluations. 20.b. What is the likelihood that this new policy will reduce Dow’s currency risk? Answer: Not very likely. Unless all its leading competitors go along with DM pricing (its U.S. and foreign competitors said that they wouldn’t follow Dow but would continue doing business in local currencies), Dow will have to cut its DM price every time the DM appreciates or else lose market share. In other words, Dow can’t use DM pricing to avoid margin erosion when European currencies devalue against the dollar unless it is willing to sacrifice market share. 20.c. How are Dow’s customers likely to respond to this new policy? Answer: They will simply demand lower DM prices if their currencies devalue. If Dow doesn’t cut its DM prices, many of them will buy from those of Dow’s competitors who are willing to cut their dollar or DM prices. 21. Boeing Commercial Airplane Co. manufactures all its planes in the U.S. and prices them in dollars, even the 50% of its sales destined for overseas markets. Assess Boeing’s currency risk. How can it cope with this risk? Answer: Boeing would have currency risk even in the absence of foreign competition since currency fluctuations will translate its dollar prices into varying amounts of foreign currency to its foreign customers. Given that foreign demand is somewhat responsive to price, and that Boeing prices in dollars, dollar appreciation will reduce foreign demand. Alternatively, to maintain sales volume, Boeing will be forced to cut its dollar price. Dollar depreciation benefits Boeing since it can either raise its dollar price, while keeping its foreign currency prices constant, or keep its dollar price constant and thereby cut its foreign currency prices and boost sales overseas. In reality, Boeing does face a major foreign competitor – Airbus Industries, a European consortium. The existence of Airbus increases Boeing’s price elasticity of demand and, hence, its exchange risk (i.e., Boeing is hurt more by dollar appreciation and helped more by dollar depreciation). Boeing can cope with this currency risk by sourcing some of its parts and components abroad, possibly from foreign firms with whom it forms strategic alliances. 22. Fire King International, an Indiana manufacturer of fire resistant filing cabinets and disk storage units, has sought to protect itself from currency risk by pricing its export sales in dollars and holding firm on price. What currency risk does Fire King face from a rising dollar? How can Fire King manage that risk? Answer: This question is similar to the one involving U.S. Farm Raised Fish Trading Co. (Chapter 9, #8). As before, the answer is no. What Fire King has done is to eliminate its transaction exposure, but it still faces operating exposure. The competitiveness of its products overseas is affected by the changing value of the dollar. The strong dollar caused export sales to plunge more than 60% in 1983. Unlike most small exporters, Fire King decided to do more than wait out the dollar. The company stopped promoting items that were available at a lower price from foreign competitors. Instead, Fire King began to promote quality, emphasizing such top of the line items as a fancy wood covered cabinet. It also shifted its emphasis away from such difficult markets as Europe to those where the strong dollar was having less of an impact, including the Far East, the Middle East, the Caribbean countries, and Canada. And within those markets, the company began selectively to target buyers, such as banks, that were favorably disposed to U.S. goods. At the same time, Fire King saw the strength of the dollar as an opportunity to boost its own imports. The company added a line of such complementary products as fire resistant safes from Japan and data storage units from Sweden to sell in the U.S. Finally, officials from Fire King attended more trade shows and increased their contact with foreign distributors and customers. 23. Cost Plus Imports is a West Coast chain specializing in low cost imported goods, principally from Japan. It has to put out its semiannual catalogue with prices that are good for six months. Advise Cost Plus Imports on how it can protect itself against currency risk. Answer: A company such as Cost Plus will typically negotiate purchase contracts with the suppliers of its catalogue merchandise in advance. Cost Plus could hedge these purchases using forward contracts. A problem, though, is that if the foreign currencies devalue during the life of the catalogue, prices of substitute products for the items in the catalogue will likely come down somewhat. In this case, some customers who might have bought from Cost Plus will decide to buy the cheaper substitutes, costing Cost Plus sales. This is very likely here given the nature of Cost-Plus products: low cost goods presumably bought by a price sensitive clientele. The existence of quantity risk in addition to price risk suggests that Cost Plus should hedge less than 100% of its projected sales. As an alternative, Cost Plus could buy call options to cover its foreign purchases. If the foreign currencies drop below the call option price, the firm won’t exercise its options; if they rise above the call price, Cost Plus will exercise them. 24. Matsushita exports about half of its TV set production to the U.S. under its Panasonic, Quasar, and Technics brand names. It prices its products in yen. Suppose the yen moves from ¥130 = $1 to ¥110 = $1. What currency risk is Matsushita facing? How can it cope with this currency risk? Answer: As the yen rises against the dollar, Japanese producers such as Matsushita become less competitive in the U.S. We have good evidence on what Matsushita is doing to cope with the strong yen. Matsushita has raised prices in the U.S., although not to the extent of yen appreciation. Like other Japanese firms, Matsushita is willing to accept lower profits rather than give up market share that it has acquired. Typically, price increases are made in conjunction with the introduction of new models. Matsushita is also facing more competition from Korean exporters like Goldstar and Samsung. These firms are using the opportunity presented by the yen’s rise to sell more inexpensive televisions, microwave ovens, VCRs, and stereos. This means that Matsushita’s ability to raise price varies among products. It will have a difficult time getting price increases to stick on inexpensive products facing competition from Korean firms. By contrast, it will have an easier time raising price on the more expensive end of the consumer spectrum: the better stereos, cameras, TVS, and VCRs. The greater pricing latitude in this segment reflects that fact that most competitors in upmarket products are also Japanese firms with a similar cost structure. To bolster this strategy, Matsushita is investing more money in R&D to come up with higher quality, more technologically sophisticated products. Matsushita has also launched a crash effort to cut its costs through overhauls of products and factories in Japan as well as by shifting some production to lower cost manufacturing facilities in countries like Taiwan or South Korea as well as the U.S. In many cases, parts produced abroad are shipped back to Japan to be incorporated in finished products. For example, Matsushita now produces car audio systems and VCRs in the U.S., printers, electronic typewriters and microwave ovens in the U.K., motors and copiers in Germany, and VCRs in France. It has also stepped up its purchases from foreign suppliers. The next stage has already begun: Matsushita is exporting finished products from offshore plants for sale to Japanese consumers. It is also trying to cut manufacturing costs at home by increased automation and better product design and material use. Another approach taken by Matsushita and other Japanese firms is to diversify out of consumer electronics and home appliances and into industrial markets, such as factory automation, where quality is more important and price less so. It hopes to sell fewer TVs and stereos and more robots, semiconductors, and office equipment. This involves hiring more technical people, more R&D spending, and retraining engineers as industrial salespeople. To be successful here, Matsushita must cut the time between laboratory development of new equipment and their commercial application. The chapter points out Matsushita and other Japanese companies are pruning their product lines after a decade of product proliferation. Perhaps 50% to 80% of the product lines of many Japanese companies account for no more than about 20% of sales, yet require major investments in design, capital equipment, and working capital. By eliminating low volume, low margin products, Matsushita and other Japanese companies can boost their profits. 25. Lyle Shipping, a British company, has chartered out ships at fixed U.S. dollar freight rates. How can Lyle use financing to hedge against its exposure? How will your recommendation affect Lyle’s translation exposure? Lyle uses the current rate method to translate foreign currency assets and liabilities. However, the charters are off balance sheet items. Answer: Since Lyle has chartered out its ships in dollars, it has fixed dollar revenues. By financing its ship purchases with dollars, Lyle can offset these contractual dollar inflows with contractual dollar outflows. Accountants will note that Lyle bears significant translation exposure. As the dollar rises against the pound, Lyle will show losses on its dollar debt and vice versa when the dollar falls. But gains or losses on the debts will be canceled out over time by changes in its operating cash flows. In 1984, when the dollar rose, its chairman pointed out that “Although foreign exchange losses have now been provided for in full on all loans and leases as if they had been repayable at 30 June 1984, it must be borne in mind that these are secured against ships chartered out at fixed freight rates, the U.S. dollar income from which will be sufficient to service both the interest and capital on the underlying loans. This future income will offset the exchange losses now provided for.” 26. Texas Instruments (TI) manufactures integrated circuits and memory chips that it sells around the world. It has major markets in Europe. TI’s primary competitors are Japanese companies. 26.a. What factors will influence TI’s exposure to movements in the dollar value of European currencies? Answer: Since TI’s main competitors worldwide are Japanese companies, one critical factor affecting its exposure is the $/¥ exchange rate. If the dollar appreciates relative to, say, the euro, but the $/¥ exchange rate remains constant, then TI should be able to raise its euro prices without suffering a loss of competitive advantage. However, changes in the dollar value of the euro that are not offset by changes in the dollar value of the yen, or changes in the $/¥ rate (even if the dollar value of the euro has not changed), expose TI to currency risk. Here we must ask how price-sensitive the European demand for TI chips is. The more price sensitive the demand, the more currency risk TI faces. Memory chips, being commodities, are likely to be more price-sensitive than microprocessors. TI’s currency risk also depends on the value-added work performed in Europe. The more value added done in Europe, or that can be done in Europe, the less currency risk TI faces since its local currency inflows will be offset by local currency outflows. 26.b. Does TI’s European business have yen exposure? Explain. Answer: As mentioned in the answer to part a, TI has significant yen exposure. Yes, Texas Instruments (TI) does have yen exposure in its European business. This is primarily because TI, like many multinational corporations, sources components and materials from various countries, including Japan. Transactions involving these components and materials are often conducted in Japanese yen. Additionally, TI's European operations may also sell products to Japanese companies or compete with Japanese companies in the European market, adding another layer of yen exposure due to competitive pricing and financial interactions with Japanese entities. Yen exposure for TI in Europe could arise from: 1. Purchases of Components and Raw Materials: TI might procure components or raw materials from Japan, which are paid for in yen. This exposes the company to fluctuations in the yen exchange rate. 2. Sales to Japanese Companies: If TI's European business involves selling products to Japanese companies, these transactions might be conducted in yen, leading to exchange rate risk. 3. Competitive Pricing: Competing with Japanese companies in the European market can result in indirect yen exposure, as pricing strategies may need to consider the yen-euro exchange rate. 4. Financial Transactions: Any loans, investments, or other financial transactions denominated in yen would also contribute to yen exposure. Overall, yen exposure can affect TI’s financial performance, especially if there are significant fluctuations in the yen exchange rate. Companies typically use hedging strategies to mitigate such risks. 26.c. How can TI use financing to reduce its yen exposure, to the extent this exposure exists? Answer: TI should finance itself to a significant extent with Japanese yen, so the same event (e.g., yen depreciation) that reduces TI’s dollar cash inflows will simultaneously reduce the dollar amount of its yen debt servicing costs. 27. South Korea’s Korean Air Lines (KAL) is the world’s 12th largest passenger airline and its second-largest cargo carrier. It has borrowed $5 billion (much of it denominated in dollars) to finance its fleet of planes. 27.a. In what ways is KAL affected by depreciation of the won against the dollar? Answer: The won’s depreciation against the dollar harms KAL in three ways. (1) Its dollar-denominated debt service payments rise in won terms because more won are needed to buy the dollars to pay interest and principal on its loans. (2) Its own cost of fuel rises since fuel prices are set in dollars. (3) Its own revenue growth slows down and may even fall as Asian fliers try to conserve their falling incomes. There are other considerations as well in assessing KAL’s currency risk. To the extent that KAL can replace Asian customers with U.S. and European customers attracted by the lower cost of visiting Asia, then KAL can boost its own operating income. However, KAL is unlikely to be able to fully recoup the lost income from its lost Asian customers. This prediction has been borne out by KAL’s actual experience following the won’s plunge in 1997. 27.b. How can KAL use financing to reduce its currency risk? Answer: KAL should finance its planes in won, so as to balance its revenues with its expenses. Such a policy is unlikely to eliminate KAL’s currency risk but at least it will not exacerbate it. Financing its fleet in dollars will add a transaction exposure to its operating exposure. 27.c. KAL argues that its jet fleet naturally hedges its currency exposure. Do you agree or disagree? Explain. Answer: There is some truth to KAL’s claim. The jet fleet is easy to sell and is likely to retain most of its dollar value. But this natural hedge only exists if KAL intends to sell off its fleet. To the extent that KAL continues to operate its fleet, then the fleet’s value is based on the cash flows generated by its operations. KAL’s won operating cash flow is unlikely to keep up with the won cost of servicing its dollar debts. 27.d. At the end of 1997, KAL decided to sell off its older planes, use the proceeds to pay down some of its debt, and replace the sold planes with aircraft it leases through a subsidiary in Ireland. Will this strategy lower KAL’s high debt ratio? Answer: All KAL is doing here is substituting lease payments for debt payments. The two are equivalent. KAL’s Irish subsidiary must borrow to finance the planes. On a consolidated basis, therefore, KAL is still responsible for these debts. To the extent that the Irish subsidiary borrows without recourse to its parent, then KAL must inject enough equity into the subsidiary to maintain its credit rating. At the same time, even though KAL can keep the subsidiary’s debts off its book through nonrecourse financing, it will also lose its assets (the planes, since they are leased and not owned). Hence, KAL does not lower its debt: equity ratio by leasing planes through an Irish subsidiary. 28. Over the past year, Thailand has experienced an inflation rate of about 7%, in contrast to U.S. inflation of about 2.5%. At the same time, the exchange rate for the Thai baht (B) has gone from B26.1/$1 to B38.9/$1. 28.a. What has happened to the real value of the baht over the past year? Has it gone up or down? A little or a lot? How does this compare to the change in its nominal value? Answer: The real value of the baht, relative to its value one year ago, has fallen significantly. Specifically, in dollar terms, the nominal exchange rate has depreciated from $0.03831 (1/26.1) to $0.02571 (1/38.9), a 32.9% decrease ([0.02571 - 0.03831]/0.03831). In real terms, the baht has declined to $0.02571 * 1.07/1.025 = $0.02684. Thus, the real value of the baht has fallen by 30.0%: (0.02684 - 0.03831)/0.03831 = -30.0% If PPP held, the baht should have devalued to a new exchange rate of e = 26.1 * 1.07/1.025 = B27.25/$ You can tell this is the PPP rate because at this exchange rate, the real rate remains at B26/1/$: Real rate = 27.25 * 1.025/1.07 = B26.1/$ 28.b. What are the likely effects of the change in the baht’s real value on the dollar profits of the Thai subsidiary of a company like Coca-Cola that sells almost exclusively in the Thai market? Answer: A reasonable assumption is that Coca-Cola’s sales, which are generated domestically, have risen at about the rate of Thai inflation. Meanwhile, costs are partially denominated in dollars (via imports of various inputs) and partially in baht (via locally-sourced inputs, including labor). Hence, costs have risen by more than the rate of Thai inflation (since the inflation-adjusted value of the dollar and, therefore, dollar-denominated costs have risen). How much more depends on the mix of domestic inputs and imported inputs. Since we don’t know the profit margin on Coke, and the mix of domestic and imported inputs, we can’t determine the actual consequences of the combined rise in baht revenues and rise in baht costs, although it is likely that baht profits have fallen given the large devaluation of the baht. However, even if baht profits have risen, they have done so by less than the 7% baht inflation rate. At best, therefore, dollar profits for Coca-Cola have fallen by at least 28.2%, the combined effect of a 7% increase in baht profits and a 32.9% decrease in the dollar value of the baht. This change in dollar profits can be computed by indexing old dollar profits at 1 and assuming that new baht profit rises by 7%: New dollar profit - old dollar profit = 1.07 * (1 - 0.329) -1 = -0.282 These results just point to the more general truth that an decrease in the real value of the local currency should reduce dollar profits for those firms selling locally and not subject to import competition (which would allow them to raise prices by the extent of the local currency devaluation). 28.c. What are the likely effects of the change in the baht’s real value on the dollar profits of a textile manufacturer that exports most of its output to the U.S.? Answer: The impact of the fall in the real value of the baht on a textile manufacturer that exports most of its output to the U.S. will be the opposite of its impact on Coca-Cola. Specifically, the textile manufacturer will find that its costs in dollar terms have fallen by about 28.2% (taking into account the combined effects of Thai inflation and baht depreciation) whereas its dollar revenues have risen by about the rate of U.S. inflation, or 2.5%. The combination of a 2.5% rise in revenues and a 28.2% drop in costs means increasing margins in dollars. Since the dollar has risen against the baht, the result in an even bigger increase in the baht profit margin. 28.d. Suppose that Coca-Cola took out a B130 million loan at the beginning of the year. If the interest rate on the loan was 18%, what was Coca-Cola’s real (inflation-adjusted) baht cost of borrowing baht over the past year in percentage terms? Answer: According to the Fisher effect, the relationship between the nominal interest rate, r, the inflation rate, i, and the real interest rate, a, is as follows: 1 + r = (1 + a)(1 + i) Solving this equation for the real rate, a, we get a = (1 + r)/(1 + i) - 1 Substituting the values given above in this equation yields a real baht cost of Coca-Cola’s loan of 10.28%: a = 1.18/1.07 - 1 = 10.28% 28.e. Given the parameters in part d, what was Coca-Cola’s dollar cost of borrowing baht over the past year? Answer: At an exchange rate of B26.1/$, Coca-Cola’s loan of B130 million translated into a dollar figure of $4,980,843 (130,000,000/26.1). At the end of the year, Coca-Cola owes the bank principal plus interest of B130,000,000 * 1.18, or B153,400,000. At the end-of-year exchange rate of B38.9/$, this figure translates into a dollar figure of $3,943,445. Hence, Coca-Cola’s dollar cost of borrowing baht for the year is -$1,037,398 ($3,943,445 - $4,980,843), or -20.8% (-$1,037,398/$4,980,843) in percentage terms. In other words, the baht’s depreciation more than offset the interest owed, yielding a negative nominal dollar cost for the baht loan. Solution Manual for Foundations of Multinational Financial Management Atulya Sarin, Alan C. Shapiro 9780470128954