#p*a eefl*€-?g Hxp#sLss *

The essence of risk management lies in maximizing the areas

where we have some control over the outcome while

minimizing the areas where we have absolutely no control over

the outcome and the linkage between effect and csuse is hidden

from us. – Peier Bernstein, Against lhe Gods, 1 996.

Ll;A gt li : I”i {- $ 1}”} g CTf VE 5 I Examine how operating exposule arises through unexpected changes in both operating

and financing cash flows.

i Analyze the sequence of how unexpected exchange rate changes alter the economic performance of a business unit through the sequence of volume, price, cost, and other

key variable changes. 1 I Evaluate the strategic alternatives to managing operating exposure’

* Detail the proactive policies available to firms for managing operating exposure’

This chapter examines the economic exposure of a firm over time, what we term operating

exposure. Operating exposure,also referred lo as economic exposure, competitive exposure, ot strategic exposure,measures any change in the present value of a firm resulting from changes in future operating cash flows caused by any unexpected change in exchange rates. Operating exposure analysis assesses the impact of changing exchange rates on a firm’s own operations over coming months and years and on its competitive position vis-d-vis other firms. The goal

is to identify strategic moves or operating techniques the firm might wish to adopt to enhance its value in the face of unexpected exchange rate changes.

Operating exposure and transaction exposure are related in that they both deai with future cash flows. They differ in terms of which cash flows management considers and why those cash flows change when exchange rates change. We begin by revisiting the structure of our firm, Tiident Corporation, and how its structure dictates its iikely operating exposure. The chapter continues with a series of strategies and structures used in the man- agement of operating exposure, and concludes with a Mini-Case, Toyota’s European Oper- ating Exposure.

Ts ? s* * e-s6 {.”* a.g:*a c”a€-i q} ffi : A fuE *s Etix* mti cl st a I –

s

* g:*: n”ra { i xeg &:xpq;sLs s”r The structure and operations of a multinational company determine the nature of its oper- ating exposure. Tiident Corporation’s basic structure and currencies of operation are described in Exhibit 11.1. As a U.S.-based publicly traded company, ultimately all financial metrics and values have to be consolidated and expressed in U.S. dollars. That accounting exposure of the firm was described in Chapter 10. Operationally, however, the functional

i I li l.

k *+’ b’ g,i

F.:ut.6:

 

 

300 PART 3 Foreign Exchange ExPosure

Trident Corporation:

Sells domestrcally in Rmb

Structure and OPerations

Seils in the EU in €

Trident Chinese components to Germany in € -Trident China r——— —-> GermanY

lnenminoi, nmul (euros’ €) f .a4a::li.r:::1i : i::ti:r:

China and Germany are subsidiaries of Trident U S’

c r-r t””” “”*

p”n-“-nirlo u -s

Trident -> u.s.

in $ (U.S. donars, g)

S”q I S S’qfi trJp&l ty sno -e4l-e tL”, i I $

Material and labor costs are in renminbi (Rmb) .^

3ft”J ffio% i”**ti” (nmn) ana 50% export ($ and €)’ Material and laoor costs are in euros

(€)’

sll. “i.

sov. coq-esirc (€) and bO% export (€)

Materiat anO ‘abor costs a/e in dollars ($)

‘Suflr utu 50% dorr’esiic ($) ar-d 50% exporl

(ib)

Rmb functional

€ functional

$ functional

Trident China

Trident GermanY

Trident U.S.

currencies of the individual subsidiaries in combination determine the overall

operatin

exposure of the firm in total’ flects where and to whot The net operatrng cash flows of any

individual business unlt re

it ,”fft^uguin.if.orn tttotn and from where it buys:

Net operating : Receivables over time – Payables over time

cash flow from sales for inputs and labor

Forexample,TiidentGermanysellslocallyandexpolts,butailsalesareinvoiced- euros. A11 operating .”rir- inno*, are therefore

in its home currency, the euro’ on the co

side,laborcostsarelocalandineuros,asrveliaSmanyofitsmateriutinp.’tpurchasesbeit iocal and in euros. lt also purchases **fon”n,,

from Tiident china’ but those too a

invoiced in euros. Tii;;; Germany i, .r”uri,i “”to-functional, with all cash inflows and ou

t “T;[ : ;l’Jorporation U S is s i m’ a’ i^ :l’:’l”i: : Tlf1.3 ::T::1,*”;#;t::”‘J'” sales, domestic and i;;;;;;;ir””l, are in u.s-aoirutr.

All costs,labor and matetials’ sourct

domestically “rd i”t”;;;;i;;r[y,’are invoiclJi” us. dollars.

This includes purchases frc

Tiident China.TiidetiUS’ it therefore obviously dollar functional’

TiidentChinaismorecomplex.Cash*’no*’,laborandmaterials,arealldomestica: paid in Chinese r”n*Jbi-Cushinflows, fro*”u”.,

are generated across three different curre

cies as the company il; ;;;iiy in renminbi, as wellis exporting to both Germany rn ettr

and the united States in dollais. on net, uttttougt having some cash inflows

in both dolli

and euros, th” aomina”ftu””tt”y cash flow is the renminbi’

st*ti* iJ*rsus *ynar::ie *peratinE €x9:*su1e. . ,:- ^ c^-^^^c+i-c qnrl anal MeasuringtheoperatingexposureofafirmlikeTiidentrequiresforecastingandanalyzl all the firm,s future indi;du;l transaction

*-p..”t”t t”gethei wjth the future exposures of

the firm,s comperirors and potential **;ii,;; wo.i-a*ia.’ Exchange rate changes in

I

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til-i A.PTFR ll OperatingExposure

short term affect current and immediate contracts, generally termed transactions. But over the longer term, as prices change and competitors react, the more fundamental economic and

competitive drivers of the business may alter all cash flows of all units. A simple exampie wiil clarify the point.

Assume Tiident’s three business units are roughly equal in size. In 2012,the dollar starts depreciating in the market against the euro at the same time the Chinese government contin- ues the gradual revaluation of the renminbi. The operating exposure of each individual busi- ness unit then needs to be examined statically (transaction exposures) and dynamically (future business transactions not yet contracted for).

* Trident China. Sales in U.S. dollars will result in fewer renminbi proceeds in the immedi- ate period. Sales in euros may stay roughly the same in renminbi proceeds depending on the relative movement of the Rmb against the euro. General profitability will fall in the short run. In the longer term, depending on the markets for its products and the nature of competition, it may need to raise the price it sells its export products for, even to its U.S. parent company.

& Tiident Germany. Since this business unit’s cash inflows and outflows are ail in eutos, there is no immediate transaction exposure or change. It may suffer some rising input costs in the future if Tiident China does indeed eventually push through price increases of com- ponent saies. Profitability is unaffected in the short term.

* Trident U.S. Like Tiident Germany, Tiident U.S. has all local currency cash inflows and outflows. A fall in the value of the doltar will have no immediate (transaction exposure) impact, but may change over the medium to long term as input costs from China may rise

over time as the Chinese subsidiary tries to regain prior profit margins. But, iike Germany, short-term profitability is unaffected,

The net result for Tiident is possibly a fali in the total profitability of the firm in the short Jerm, primarily from the fall in profits of the Chinese subsidiary; that is, the short-term transaction/operating exposure impact, The fall in the dollar in the short term, however, is likely to have a positive impact on translation exposure, as profits and earnings in renminbi and euros translate into more and more dollars. Wali Street would likely like the results in the immediate quarter or two.

Operating and Finan*ing eash FFews The cash flows of the MNE can be divided into operating cash fTows and financing cash flows. Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables, rent and Iease payments for the use of facilities and equipment, royalty and license fees for the use of technoiogy and intellectual property, and assorted management fees for services provided.

Finuncing cash flows are payments for the use of intercompany and intracompany loans (principal and interest) and stockholder equity (new equity investments and dividends). Each of these cash flows can occur at different time intervals, in different amounts, and in dif- ferent currencies of denomination, and each has a different predictability of occurrence. We summarize cash flow possibilities in Exhibit 71.2 for Tiident China and Tiident U.S.

ffixp*eted v€rsu€ {Jncxpected ehanges in fash irlstir Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure. However, operatine exposure is inevitably subjective because it depends on estimates of future cash flow changes ovel’ an

 

 

342 f it,ll i :i Foreign Exchange Exposure

Financial and operating cash Flows between Parent and subsidiary

cash flows related to the financing of the subsidiary are Financial cash Flows Ci.f, tfo*r related to the businesi activities of the subsidiary are Operating Cash Flows

Trident China (toreign subsldiary)

Liabilities Assets and Equity

-+ A/R Debt Equity

Trident U.S. ,: (parent companY)

rs.\.ffi F.1 Wffi Ptffiffi

Liabilities Assets and Equity

Loan to Sub lnvest in Sub

A/P –*+r I

r+ I Debt Service I t.+ ancl Dividends —J

+– ———-‘ Payments for Components -<—- –

arbitrary time horizon. Thus, it does not spring from the’accounting process but rathe from the operating analysis. Planning for operating exposule is a total managemer responsibiliiy O”perraittg ,rpon the inteiaction of strategies in finance, marketing,

pulchaf

ing, and production.’ An ixpected change in foreign exchange rates is not included in the definition

of operal

ing exposure, because Loth manigement and investors should have factored this informatio

inio tlieir evaluation of anticipated operating results and market value.

l) From a management perspective, budgeted financial statements already reflect informe tion about the effect of an expected change in exchange rates’

* From a debt service perspective, expected cash flow to amortize debt shouid alread reflect the international Fisher effect. The level of expected interest and principi

repayment should be a function of expected exchange rates rather than existing spc

rates.

* From an investor’s perspective, if the foreign exchange market is efficient, informatio about expected changes in exchange rates should be widely known and thus

reflected in

firm’s market value. bnly unexpeclted changes in exchange fates, or an inefficient foreig

exchange market, should cause market value to change’

* From a broader macroeconomic perspective, operating exposure is not just the sensitivit of a firm’s future cash flows to unexpected changes in foreign exchange

rates, but also il

sensitivity to other key macroeconomic valiables. This factor has been labeled z n’t acr o ec ono mic Ltncert aintY.

Chapter ? described the parity relationships among exchange rates’ interest rates’ and infli

tion rates. However, these variables are often in disequilibrium with one another’ Therefor’

rn”rp”ct”a changes in interest rates and inflation raies could also have a simultaneous bt

differential impact on future cash flows. As discussed in Globat Finance in Practice ll’1’fixe

exchange rates obviously add an additional complexity to managing future cash flows an

generai corporate currency risk’

 

 

308 PART 3 Foreign Exchange Exposure

Expected dollar cash flow in every year exceeds the cash flow of 52,074,320 that had been originally expected. The increase in working capital causes net cash flow to be onlr $2,718.200 in20L2, but thereafter, the cash flow is $3,418,200 per year, with an additionai 5640,000 rvorking capital recovered in the fifth year. The key to this improvement is opera!– ing ieverage. If costs are incurred in euros and do not increase after a depreciation, ai increase in the sales price by the amount of depreciation will lead to sharply higher profits.

Other Possibilities. If any portion of sales revenues were incurred in other currencies, the sit- uation would be different.Tiident Germany might leave the foreign sales price unchanged. ir effect raising the euro-equivalent price. Alternatively, it might leave the euro-equivalec; price unchanged, thus lowering the foreign sales price in an attempt to gain volume. C: course, it could also position itself between these two extremes. Depending on elasticities an* the proportion of foreign to domestic sales, total sales revenue might rise or fall.

If some or all raw material or components were imported and paid for in hard currenciei. euro operating costs would increase after the depreciation of the euro. Another possibilitf is that local (not imported) euro costs would rise after a depreciation.

Measurement of Loss. Exhibit 11.5 summarizes the change in expected y’ear-end cash florvs for the three cases and compares them with the cash flow expected should no depreciatior occur (base case). These changes are then discounted by Tiident’s assumed weighted averasr cost of capital of 20″/” to obtain the present value of the gain (loss) on operating exposure.

In Case 1, in which nothing changes after the euro is devalued, Tiident incurs an operai- ing ioss with a present value of ($1,033,914). In Case 2, in which volume doubled with nc price change after depreciation,Tiident experienced an operating gain with a present value of $2,866,106. In Case 3, in which the euro sales price was increased and volume did na: change, the present value of the operating gain from depreciation was $3,742,892. An almos: infinite number of combinations of volume, price, and cost could follow any depreciation, ani any or all of them might take effect over time.

Strategie Managernent of Operating Expostlre The objective of both operating and transaction exposure management is to anticipate anci influence the effect of unexpected changes in exchange rates on a firm’s future cash flows. rather than merely hoping for the best, To meet this objective, management can diversfu the

firm’s operating and financing base. Management can also change the firm’s operating and

financing policies. The key to managing operating exposure at the strategic level is for management to rec-

ognize a disequilibrium in parity conditions when it occurs and to be pre-positioned to react most appropriately. This task can best be accomplished if a firm diversifies internationallr’ both its operating and its financing bases. Diversifying operations means diversifying sales. location of production facilities, and raw material sources. Diversifying the financing base means raising funds in more than one capital market and in more than one currency.

A diversification strategy permits the firm to react either actively or passively, depending on management’s risk preference, to opportunities presented by disequilibrium conditions in the foreign exchange, capital, and product markets. Such a strategy does not require manage- ment to predict disequilibrium but only to recognize it when it occurs. It does require man- agement to consider how competitors are pre-positioned with respect to their olvn operating exposures. This knowledge should reveal which firms would be helped or hurt competitively by alternative disequilibrium scenarios.

 

 

CHAFTf F II OperatingExposure 309

#5ver*9f.iring *p*rati*** If a firm’s operations are diversified internationally, management is pre-positioned both torecognize disequiiibrium when it occurs and to .”u.i

“o*pJtitively. consider the case wherepurchasing power parity is temporarily in disequilibrium. Although the disequilibrium mayhave been unpredictable’ manigem”nt

“un.ofGn recognize its symptoms as soon as theyoccur’ For example,.management might notice a chang! in comparative costs in the firm,sown plants iocated in different countries. It might alsJ observe changed profit margins orsales volume in one area compared to another, dlpending on price and income elasticities ofdemand and competitors’ reaitions.

Recognizing a temporary change in worldwide competitive conditions permits manage-ment to make changes in operating strategies. Management might mut” *urginur ,r,irr, insourcing raw materials, cornponents, or tinistred prodricts. If spare capacity exists, productionruns can be lengthened in one country and reduced in anothfr. Tne ma.teting “tio.t “un

t”strengthened in export markets where the firm’s products have become more price competi-tive because of the disequilibrium condition. Even if management does not actively distort normal operations when exchange rateschange, the firm should experience some beneficial portfolio ettects. The variability of itscash flows is probably reduced by international diveisification of its production, sourcing,and sales because exchange rate changes under disequilibrium conditions are likely toincrease the firm’s competitiveness in sote markets whiie reducing it in others. In that case,operating exposure would be neutralized. In contrast to the internationally diversified MNE, a purely domestic firm might be sub-

iect to the fuli impact of foreign “*.hu.rg.

operating exposure even though it does not haveforeign currency cash flows. Foi example]it “outa

exieri”nce intense import competition in itsdomestic market frol c^gmpeting firms producing in countries with undervalued currencies.A purely domestic firm does not have the opiion to react to an international disequilib-rium condition in the same manner as an MNE. In fact, a furety domestic firm will not bepositioned to recognize that a disequilibrium exists because it lacks comparative data from itsown internal sources’ By the time external data are available, it is often too late to react. Evenif a domestic firm recognizes the disequilibrium, it cannot qri”try shift production and salesinto foreign markets in which it has had no previous pr”r”n.”. constraints exist that may limit the feasibility oi diversifying production locations. Thetechnology of a particuiar industry may require iurg”

“rono-i”. of scale. High tech firms,such as Intel, prefer to iocate in places *tt”r” they ha:ve easy access to olher high tech suppli-ers’ a highly educated workforce, and one or more leading universities. Their R&D efforts areclosely tied to initial production and sales activities.

-tJi’rergri i ii-iU ht fi anFinrr

If a firm diversifies its financing sources, it will be pre-positioned to take advantage of tempo- rary deviations from the international Fisher effect. If interest rate differentials do not equal expected changes in exchange rates, opportunities to lower a firm’s cosf of capitalwill exist. However, to be able to switch financing sources, a firm must already be weli known in the international investment community, with banking contacts firmly established.. Again, this is not typically an option for a domestic firm.

As we will demonstrate in Chapter 12, diversifying sources of financing, regardless of the currency of denomination, can lower a firm’s cost of capital and increasJ its”availability ot capital’ It could also diversify such risks as resfn’cfive

“upitulmarket policies,

“ro “tt * *”-

straints if the firm is located in a segmented capital -uik”t. This is especially important forfirms resident in emerging markets.

 

 

312 PA fi T -r Foreign Exchange Exposure

world markets. They became something of a rarity during the 1960s when exchange rates were reiatively stable under the Bretton Woods Agreement. But with the return to floating exchange rates in the 1970s, firms with long-term customer-supplier relationships across bor- ders have returned to some old ways of maintaining mutually beneficial iong-term trade.

#**k-tc-*a*k l-*a*s A back+o-back loan, also referred to as a parallel loan or credit swap,occurs when two busi- ness firms in separate countries arrange to borrow each other’s currency for a specific period of time, At an agreed terminal date they return the borrowed currencies. The operaiion is conducted outside the foreign exchange markets, although spot quotations may be used as the reference point for determining the amount of funds to be swapped. Such a swap creates a covered hedge against exchange losg since each company, ofi jrs own books, borrows lhe same currency it repays. Back-to-back loans are also used at a time of actual or anticipated legal limitations on the transfer of investment funds to or from either country.

The structure of a typical back-to-back loan is illustrated in Exhibit 17.7 . A British parent firm wanting to invest funds in its Dutch subsidiary locates a Dutch parent firm that wants to invest funds in the United Kingdom.Avoiding the exchange markets entirely, the British par- ent lends pounds to the Dutch subsidiary in the United Kingdom, while the Dutch parent lends euros to the British subsidiary in the Netherlands. The two loans would be for equal val- ues at the current spot rate and for a specified maturity. At maturity, the two separate loans would each be repaid to the original lender, again without any need to use the foreign exchange markets. Neither loan carries any foreign exchange risk, and neither loan normally needs the approval of any governmentai body regulating the availabiiity of foreign exchange for investment purposes.

Parent company guarantees are not needed on the back-to-back loans because each loan carries the right of offset in the event of default of the other loan. A further agreement can

Back-to-Back Loans for Currency Hedging

1. British firm wishes to invest funds in its Dutch subsidiary

British Parent Firm

iri+*Fgi-l,t1tffi ii*;;t

t’ Direct loan I in oounds I,I

I t….’

Dutch Firm’s British Subsidiary

: !4?@q:+e4s!i:Ea*+€4€l;

3. British firm loans British pounds directly to the Dutch firm’s British subsidiary

2. British firm identifies a Dutch firm wishing to invest funds in its British subsidiary

Dutch Parent Firm

Direct loan in euros

British Firm’s Dutch Subsidiary

4. British firm’s Duich subsidiary loans euros from the Dutch parent

The backJo-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure.

 

 

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CHAPTER 1 1 Operating Exposure 313

provide for maintenance of principal parity in case of changes in the spot rate between the two countries. For example, if the pound dropped by more than, say, 6″/o for as long as 30 days, the British parent might have to advance additional pounds to the Dutch subsidiary to bring the principal value of the two loans back to parity. A simiiar provision would protect the British if the euro should weaken.Although this parity provision might lead to changes in the amount of home currency each party must lend during the period of the agreemenqlt does not increase foreign exchange risk, because at maturity all loans are repaid in the same currency loaned.

There are two fundarlental impediments to widespread use of the back-to-back loan. First, it is difficult for a firm to find a partner, termed a cowterparty, for the currency, amount, and timing desired. Secondly, a risk exists that one of the parties will fail to return the borrowed funds at the designated maturity-although this risk is minimized because each party to the loan has, in effect, 100% collateral, albeit in a different currency. These disadvan- tages have led to the rapid development and wide use of the currencv su,ap.

eross Curreney Swaps A cross currency swap resembles a back-to-back loan except that it does not appear on a firm’s balance sheet. As we noted briefly in Chapter 6, thi term swap is wldely used to describe a foreign exchange agreement between trvo parties to exchange a given amount of one currency for anothet and, after a period of time, to give back the original amounts swapped. Care should be taken to clarify which of the many different swaps is being referred to in a specific case.

In a currency swap, a firm and a swap dealer or swap bank agree to exchange an equiva- lent amount of two different currencies for a specified period of time. Currency swaps can be negotiated for a wide range of maturities up to at leasi 1O years. If funds are more expensive in one country than another,afee may be required to compensate for the interest differen- tial’ The swap dealer or swap bank acts as a middleman in setting up the swap agreement.

A typical currency swap first requires trvo firms to borrow funds in the markets and cur- rencies in which they are best known. For example, a Japanese firm would typically borrow yen on a regular basis in its home market. If. however, the Japanese firm were exporting to the United States and earning U.S. dollars. it might rvish to construct a match,ing cash flow hedge which would allow it to use the U.S. doilars earned to make regular debt-service pay- ments on U’S. dollar debt. If, however, the Japanese firm is not well known in the U.S. finan- cial markets, it may have no ready access to U.S. dollar debt.’ One way in which it could, in effect, borrow dollars, is to participate in a cross-currency swap (see Exhibit 11.8). The Japanese firm couid swap its yen-denominated debt service pay- ments with another firm that has U.S. dollar-debt service payments. This swap would have the Japanese firm “paying dollars” and “receiving yen.” The Japanese firm would then have dollar-debt service wifhout actually borrowing U.S. dollars. Simultaneously, a U.S. corpora- tion could actually be entering into a cross-“u.i”n.y swap in the opposite diiection-.,paying yen” and “receiving dollars.”The swap dealer is taking the role of a middleman.

Swap dealers arrange most swaps on a “blind basis,” meaning that the initiating firm does not know who is on the other side of the swap arrangement-the counterpartf. The firm views the dealer or bank as its counterparty. Beciuse the swap markets are dominated by the major money center banks worldwide, the counterparty risk is acceptable. Because the irvap dealer’s business is arranging swaps, the dealer cun g”rerully arrange for the currency, amount, and timing of the desired swap.

Accountants in the United States treat the currency swap as a foreign exchange transac- tion rather than as debt and treat the obligation to reverse the swap at some later.date as a forward exchange contract. Forward exchange contracts can be matched against assets, but they are entered in a firm’s footnotes rather than as balance sheet items. The result is that

 

 

314 PART 3 Foreign Exchange Exposure

ffim Using Cross-Cunency Swaps

Japanese Corporation

Liabilities and Equity

United States Corporation

Liabilities and Equity

Debt in US$

Receive dollars

Wishes to enter into a swap to “pay yen” and “receive dollars.”

:1

..i

l ”:

:

: a:

lnflow + of US$

Sales to U.S. Debt in yen

t I R.ceiue I v”nt.Pay

dollars

Wishes to enter into a swap to “pay dollars” and “receive yen.”

lnflow

—}>of yen

Swap llealer ‘ !=ib,****6s;sF!.

both translation and operating exposures are avoided, and neither a long-term receivable nor a long-term debt is created on the balance sheet.

Contractual Approaches: Hedging the Unhedgeatrle Some MNEs now attempt to hedge their operating exposure with contractual strategies. A number of firms like Merck (U.S.) have undertaken long-term currency option positions, hedges designed to offset lost earnings from adverse exchange rate changes. This hedging of what many of these firms refer to as strategic exposure or competitive exposure seems to fly in the face of traditional theory.

The ability of firms to hedge the “unhedgeable” is dependent upon predictability: 1,) the predictability of the firm’s future cash flows, and 2) the predictability of the firm’s competi- tor’s responses to exchange rate changes. Although the management of many firms may believe they are capable of prediciing their own cash flows, few in practice feel capable of accurately predicting competitor response. As illustratedby Global Finance in Practice 11.2, many firms still find even timely measurement of exposure a challenge.

Merck is an example of a firm whose management feels capable of both. The company possesses relatively predictable long-run revenue streams due to the product-niche nature of the pharmaceuticals industry. As a U.S.-based exporter to foreign markets, markets in which sales levels by product are relatively predictable and prices are often regulated by govern- ment, Merck can accurately predict net long-term cash flows in foreign currencies five and ten years into the future. Merck has a relatively undiversified operating structure. It is highly centralized in terms of where research, development, and production costs are located. Merck’s managers feel Merck has no real alternatives but contractual hedging if it is to weather long-term unexpected exchange rate changes. Merck has purchased over-the- counter (OfC) long-term put options on foreign currencies versus the U.S. dollar as

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Both the Japanese corporation and the U.s. corporation would like to enter into a cross-currency swap which would allow them to use foreign currency cash inflows lo service debt.

Sales to Japan

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CHAI’:j” f.n 1 2 The Global Cost andAvailability of Capital -1-1 I

worse we have achieved a global market for securities. The good news is that many firms have

been assisted to become MNEs because they now have access to a global cost and availabil- ity of capital. The bad news is that the correlation among securities markets has increased, thereby reducing, but not eliminating, the benefits of international portfolio diversification. Globaiization of securities markets has also led to more volatility and speculative behavior as shown by the emerging market crises of the 1995-2A01 period, and the 2008-2009 globai credit crisis.

Corporate Governance and the Gost of Capital. Would global investors be willing to pay a premium for a share in a good corporate governance company? A recent study of Norwegian and Swedish firms measured the impact of foreign board membership (Anglo-American) on

firm value. They summarized their findings as follows:

Using a sample of firnts with headquerters in Norway or Sweden the studv indicates a sig- nificantty higher value for firms that have outsicler Anglo-Anterican board member(s), after a variety of flrm-specific and corporate goverftance related factors have been con- trolled for. We argLte that this superior perforntance reflects the fact that these contpanies have successfully broken away front a partly segmented domestic capital matket by “importing” an Anglo-American corporate governance system. Such an “itnport” signals a

willingness on the part of the .firm to expose itsetf to intproved corporate governance ond

enhances its reputation in the financial market.s

Strategi* &!!la**es Strategic alliances are normally formed by firms that expect to gain synergies from one or more of the following joint efforts.They might share the cost of developing technology, or pursue complementary marketing activities. They might gain economies of scale or scope or a variety of other commercial advantages. However, one synergy that may sometimes by

overlooked is the possibility for a financially strong firm to help a financially weak firm to lower its cost of capital by providing attractively priced equity or debt financing’ This is illustrated inthe Gtobal Finance in Practice 12.1 on the strategic alliance between Bang and Olufsen and Philips.

ket where Philips did not have the quality image enjoyed by

Bang & Glufsen and phitip$ N.\f. B & o. phitips was concerned that financial pressure might

one exceilenr exampre or rinanciar synersy that rowered ” iT:: ?:r”.tiyT:; “-i?ff::n*ilTt’t3Tf T*T: firm’s cost of capital was provided by the cross-border strate- supported Philips’ political efforts to gain EU support to gic alliance of Philips N.V. of the Netherlands and Bang & make the few remaining European-owned consumer elec- Olufsen (B & O) of Denmark in 1990. Philips N.V. is one of the tronics firms more competitive than their strong Japanese largest multinational firms in the world and the ieading con- competitors. sumer electronics firm in Europe. B & O is a small European competitor hrut with a nice market niche at the high end of the

B & O,s Motivation audiovisual market.

philips was a major supplier of components to B & O, B & O was interested in an alliance with Philips to gain more a situation it wished to continue. lt also wished to join rapid access to its new technology and assisiance in

5lars Oxelheim and Tiond Rand6y, “The impact of foreign board membership on firm value,” -/o urnal of Banking

and Finance,Yol. 27, No. 12, 2003, p. 2369.

!f

lt

 

 

PA RT 4 Financing the Global Firm

converting that technology into B & O product applications. B & O wanted assurance of timely delivery of components at large volume discounts irom Philips itself, as well as access io Philip’s large network of suppliers under terms enjoyed by Philips. Equally important, B & O wanted to get an equity infu- sion from Philips to strengthen its own shaky financial posi- tion. Despite its commercial artisiry in recent years B & O had been only marginally profitabJe, and its publiciy traded shares were considered too risky to justiflz a new public equity issue either in Denmark or abroad. lt had no excess borrowing capacity.

The Strategic Alliance A strategic alliance was agreed upon that would give each pariner what ii desired commercially. Philips agreed to invest DKK342 million (about $50 million) to increase the equiiy of B & O’s mdn operating subsidiary ln return it received a 25% ownership of the expanded company.

When B & O’s strategic alliance was announced to the public on May 3, 1990, the share price of B & O Holding, the iisted company on the Copenhagen Stock Exchange. jumped by 35ok during the next two days. lt remained at thai level until the Gulf War crisis temporarily depressed B & O’s share price. The share price has since recovered and the expected synergies eventually materialized. B & O eventually bought back its shares from Philips at a price thai hacl been predetermined at the start.

ln evaluating what happened, we recognize lhal an industrial purchaser might be willing to pay a higher price for a firm that will provide it some synergies than would a porlfo- lio investor who does not receive these synergies. Portfolio investors are only pricing firm’s shares based on the normal risk versus return tradeoff. They cannot normally anticipate the value of synergies that might accrue to the firm from an unexpected strategic alliance pariner. The same conclusion should hold for a purely domestic strategic alliance but this example happens to be a cross-border alliance.

i::., ,

h=dil

The Cost of Capital for MNEs Compared to Dcmestic Firms Is the weighted average cost of capital for MNEs higher or lower than for their domestic counterparts? The answer is a function of the marginal ceist of capital, the relative after-tax cost of debt, the optimal debt ratio, and the relative cost of equity.

Availabitity of Capital We saw earlier in this chapter that international availability of capital to MNEs, or to other large firms that can attract international portfoiio investors, may allow them to lower their cost of equity and debt compared with most domestic firms. In addition, international avail- ability permits an MNE to maintain its desired debt ratio, even when significant amounts of new funds must be raised. In other words, an MNE’s marginal cost of capital is constant for considerable ranges of its capital budget. This statement is not true for most domestic firms. They must either rely on internally generated funds or borrow in the short and medium term from commercial banks.

Financial $tructure, $ystematic Risk. and the esst cf eapitalfcr MNEs Theoretically, MNEs should be in a better position than their domestic counterparts to support higher debt ratios because their cash flows are diversified internationally. The probability of a firm’s covering fixed charges under varying conditions in product, finan- cial, and foreign exchange markets should improve if the variability of its cash flows is minimized.

By diversifying cash flows internationally, the MNE, might be able to achieve the same kind of reduction in cash flow variability as portfolio investors receive from diversifying their security holdings internationally. The same argument applies – namely, that returns are not perfectly correlated between countries. For example, in 2000 Japan was in recession but

 

 

C H A P T I F 1 2 The Global Cost and Availability of Capitat 339

the United States was experiencing rapid growth. Therefore, we might have expected returns, on either a cash flow or an earnings basis, to be depressed in Japin and favorable in the United States. An MNE with operations located in both these countries could rely on its strong U’S. cash inflow to cover debt obligations, even if its Japanese subsidiary produced weak net cash inflows.

Despite the theo_retical elegance of this hypothesis, empirical studies have come to the opposite conclusion.b Despite the favorable effect of international diversification of cash flows, bankruptcy risk was only about the same for MNEs as for domestic firms. However, MNEs faced higher agency costs, political risk, foreign exchange risk, and asymmetric infor- mation’ These have been identified as the factors liading to low”r debt raiios and even a higher cost of long-term debt for MNEs. Domestic firms rely much more heavily on short and intermediate debt, which lie at the low cost end of the yield curve. . Even more surprising, one study found that MNEs have a higher level of systematic

risk than their domestic counterparts.T The same factor, “rured

this phenomenon as caused the lower debt ratios for MNEs. The study concluded that the increased standard deviation of cash flows from internationalization more than offset the lower correlation from diversification.

As we stated earlier in this chapter, the systematic risk term, F;, is defined as

B = pJ&i

om

Yhr.r”.pi- is the correlation coefficient between securityT and the market; o; is the standard

deviation of the return on firm j; and o,, is the standard deviation of the’market return. The MNE’s systematic risk could increase if the decrease in the correlation coefficient, pp, due to international diversification, is more than offset by an increase in s,, the standard deviation due to the aforementioned risk factors. This conclusion is consistent with the observation that many MNEs use a higher hurdle rate to discount expected foreign project cash flows’ In essence, they are accepting projects they consider to be riskier tharidomestic projects, thus potentially skewing upward their perteived systematic risk. At the least, MNEs need to earn a higher rate of return than their domistic equivalents in order to maintain their market value.

A more recent study found that internationalization actually allowed emerging market MNEs to carry a higher level of debt and lowered their systematic risk.8 Tliis iccurr”d because the emerging market MNEs are investing in morl stable economies abroad, a strategy that lowers their operating, financial, for-ign exchange, and political risks. The reduction in risk more than offsets their increased agency costl and aliows the emerging ryt”t MNEs to enjoy higher leverage and lower systematic risk than their U.S.-based MNE counterparts.

6lee, Kwang Chul and Chuck C.Y. Kwok, “Multinational Corporations vs. Domestic Corporations: International Environmental Factors and Determinants of Capital Structure,” -Iourn a! of International Business Studles, Summer 1988, pp. 195-217.

?Reeb, David M., Chuck C’Y. Kwok, and H. Young Baek, “systematic Risk of the Multinational Corporation, Joumal of International Business Srudies, Second euarter 199g, pp. 263_279. 8Kwok, Chuck C.Y’, and David M. Reeb,”Internationalization and Firm Risk:An Upstream-Downstream Hypoth- esis,” Journal of International Business Studies,Vol.31, Issue 4,2O0O, pp.611-630.

 

 

340 PA R-f 4 Financing the Global Firm

Solving a Rid€lle: [s the Weighteel Average

Cost cf C*pital for tu{NEs Realtry FXigher tBaasa f*r Their Domestie CcunterPafts? The riddle is that the MNE is supposed to have a lower marginal cost of capital (MCC) than

a domestic firm because of the MNE’s access to a global cost and availability of capital. On

the other hand, the empirical studies we mentioned show that the MNE’s weighted average

cost of capital (WACq is actually higher than for a comparable domestic firm because of

agency costs, foreign exchange risk, political risk, asymmetric information’ and other com-

plexities of foreign oPerations. The answer io tfris riddle lies in the link between the cost of capital, its availability, and

the opportunity set of projects. As the opportunity set of projects increases, eventually the

firrn needs to increase its capital budgef io the point where its marginal cost of capital is

increasing. The optimal capital budgeiwould stili be at the point where the rising marginal

cost of caiital equals the declining rite of return on the opportunity set of projects’ However’

this wouli be ai a higher weighted average cost of capital than would have occurred for a

lower level of the optimal capital budget’ To illustrate this linkage, p,xhibif1z3 shows the marginal cost of capital given

different

optimal capital budgets. AJsume that there are two different demand schedules based on the

opportunity set of piojects for both the multinational enterprise (MNE) and domestic coun-

terpart (DC). The line MRRDC depicts a modest set of potential projects’ It intersects the line

MCCrn{E at15Y” unO u $rtio million budget level. Ii intersects the MCCp6 at10″/o and a $140

milli#’|udget level. At these low budget levels the MCCMNE has a higher MCC and

F”T?Sg*TlFll-ftre Cost of Capitalfor MNE and Domestic Counterpart Compared

Marginal Cost of CaPital andhate ol Return (Percentage)

300 350 Budget (millions ot $)

 

 

CHAPTER 12 The GlobalCost andAvailability of Capital

Counterparts?

ls MNEu/asg > or < Domesticitlog6 ?

kwecc = ku I Eouitv I t Debt I I vrr”t I + ka(1-t) L vatue j

lii’v Empirical studies indicate MNEs have a lower

debt/capital ratio than domestic counterparls, indicating MNEs have a higher cost oi capitat.

I

I And rndicatrons are ihat MNEs have a lower average cost of debt than domestic counterparts, indicating MNEs have a |ower cost of capital.

341

probably weighted average cost of capital than its domestic counterpart (DC), as discovered

in the recent emPirical studies. The line MRR**, depicts a more ambitious set of projects for both the MNE and its

domestic counterpart.It ini”rr””ts the line MCCMNE still at L5o/” and a $350 million budget’

However, it intersects the MCCpg at20% and a budget level of $300 million’ At these higher

budget levels, the MCCNIb{E has a lower MCC and probably weighted avefage cost of capital

than its domestic counterpart, as predicted earlier in this chapter. In order to generalize this

conclusion, we would need to know under what conditions a domestic firm would be willing

to undertake the optimal capital budget despite its increasing the firm’s marginal cost of cap-

ital. At some point the MNE might also have an optimal capital budget at the point where its

MCC is rising. Empirical studies show that neither mature domestic firms nor MNrEs are typically willing

to assume the higher agency costs or bankruptcy risk associated with higher MCCs and capital

budgets. In fact, most mature firms demonstrate some degree of corporate rvealth maximizing

behivior.They are somewhat risk averse and tend to avoid returnilg to the market to raise fresh

equity. They prefer to limit their capital budgets to what can be financed with free cash flows’

Indeed, they have a so-called p..Ling order that determines the priority of which sources of

funds they tap and in what order.This behavior motivates shareholders to monitor management

more closely. They tie management’s compensation to stock performance (options)’ They may

also require othei types of contractual arrangements that are collectively part of agency costs’

In conclusion, if both MNEs and domestic firms do actually limit their capital budgets

to what can be financed without increasing their MCC, then the empirical findings that

tUNgt have higher WACC stands. If the domestic firm has such good growth opportunities that it chooses to undertake growth despite an increasing marginal cost of capital, then the

MNE wouid have a lower WACC. Exhibit 12.8 summarizes these conclusions’

HigherorLowerCostofGapitalThanTheirDomestic

The cost of equity required by investors is higher for multinational firms than for domestlc

firms. Possible explanations are higher levelJ of politicat risk, foreign exchange rsk, and higher

agency costsof doing business in a multinational managerial environment. However, at

i”iitiu”fy high tevels df the optimal capital budget, the MNE would have a lower cost of capital