1,Chapter 6,Managing Economic Exposure And Translation Exposure,2,Objectives,This chapter shows how an MNC can restructure its operations to reduce economic exposure. Such a strategy is related to the firms long-run operations. It also briefly describes how an MNCs translation exposure can be reduced. Yet, It is advised that the limitations of hedging translation exposure receives as much attention as the hedging strategy itself.,3,Economic Exposure,Economic exposure refers to the impact exchange rate fluctuations can have on a firms future cash flows. Recall that corporate cash flows can be affected by exchange rate movements in ways not directly associated with foreign transactions.,4,Economic Exposure,Exchange rate changes are often linked to variability in real growth, inflation, interest rates, governmental actions, the changes may cause firms to adjust their financing and operating strategies. The importance of managing economic exposure can be seen from the case of the bankruptcy of Laker Airways, and from the the 1997-98 Asian crisis.,5,How Financial Markets Affected Laker Airlines,Laker Airways is a British airline that generated much of its revenue in British pounds, a large proportion of its expenses (such as fuel, oil, and debt payments), however, were denominated in dollars. As the dollar strengthened in the foreign exchange market in 1981, Laker needed larger amounts in pounds to cover its dollar-denominated expenses. In January 1981, Laker borrowed $131 millions in the financial markets from a group of U.S. and European banks . The debt was denominated in U.S dollars and therefore had to be repaid in U.S. dollars. Lakers decision,6,How Financial Markets Affected Laker Airlines,to obtain dollar-denominated debt in the financial markets further increased its economic exposure. As the dollar continued to strengthen, the firms revenues could not adequately cover its dollar-denominated expenses. Consequently, Laker Airways went bankrupt. It might have avoided bankruptcy if it had reduced its economic exposure, either by reducing its dollar-denominated expenses or by increasing its dollar-denominated revenue. Overall, Lakers performance was affected by conditions in the foreign exchange market along with its decision to borrow dollars in the debt market.,7,Economic Exposure,A firm can assess its economic exposure by determining the sensitivity of its expenses and revenues to various possible exchange rate scenarios. The firm can then reduce its exposure by restructuring its operations to balance its exchange-rate-sensitive cash flows. Note that computer spreadsheets are often used to expedite the analysis.,8,Economic Exposure,Restructuring may involve: increasing/reducing sales in new or existing foreign markets, increasing/reducing dependency on foreign suppliers, establishing or eliminating production facilities in foreign markets, and/or increasing or reducing the level of debt denominated in foreign currencies.,9,Economic Exposure,MNCs must be very confident about the long-term potential benefits before they proceed to restructure their operations, because of the high costs of reversal.,10,Managing Madison Inc.s Economic Exposure (example),The amount of Madisons earnings before taxes is inversely related to the strength of the Canadian dollar, since the higher expenses more than offset the higher revenue. ( Exhibit 6.1) Madison may reduce its exposure by increasing Canadian sales, reducing orders of Canadian materials, and/or borrowing less from Canadian banks. ( Exhibit 6.2),11,Managing Madison Inc.s Economic Exposure (example),Exhibit 6.1 Original Impact of Possible Exchange Rate Movements on Earnings of Madison, Inc. (in Millions) Exchange Rate Scenario C$ = $.75 C$ = $.80 C$ = $.85 Sales: (1) U.S. $300.00 $304.00 $307.00 (2) Canadian C$4 = 3.00 C$4 = 3.20 C$4 = 3.40 (3) Total $303.00 $307.20 $310.40 Cost of goods sold: (4) U.S. $ 50.00 $ 50.00 $50.00 (5) Canadian C$200 = 150.00 C$200= 160.00 C$200 = 170.00 (6) Total $200.00 $210.00 $220.00 (7) Gross Profit $103.00 $ 97.20 $ 90.40 Operating expenses: (8) U.S.: Fixed $ 30.00 $ 30.00 $ 30.00 (9) U.S. Variable(10% of total sales) 30.30 30.72 31.04 (10) Total 60.30 60.72 61.04 (11) EBIT $ 42.70 $ 36.48 $ 29.36 Interest expense: (12) U.S. $ 3.00 $ 3.00