Transaction, Operating Accounting Exposures

Transaction, Operating, & Accounting (Translation) vulnerabilitys Foreign Ex heighten Exposure measures the potential for a mansions profitability, sugar cash flow, and market abide by to alter because of a change in stand in rates. Q What are the 3 main foreign alter exposures? A 1) Transaction Exposure 2) Operating Exposure 3) Accounting Exposure Transaction Exposure measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates.Operating Exposure (Economic Exposure, Competitive Exposure, Strategic Exposure) measures a change in the present value of a firm resulting from any change in future expected operational cash flows caused by unexpected changes in exchange rates. Accounting Exposure (Translation Exposure) measures accounting-derived changes in owners loveliness as a result of translating foreign funds financial statements into a single reportage currency. Exhibit 8. 1 pic Note In the fourth cast of 2001 Amazon. om reported a net income of $5 million, due in part to a one-time foreign currency gain of $16 million. Hedging To take a position that will rise (or fall) in value to offset a change in value of an existing position. Benefits of Hedging Costs of Hedging improve the planning capability of the firm. Risk-averse strategy that benefits management more than Reduced the likelihood of financial distress. i. e. the risk that cashshareholders. (i. e. shareholders can diversify currency risk on an flows will fall below what is required for debt payments and continuedas needed basis) operations) Consumes the firms resources and expected cash flows to the firm Management has a relative advantage over shareholders. (i. e. are not increased. (i. e. gency theory, NPV of hedging is zero, understanding the currency risk of the firm and take advantage of a and FX losses appear on the I/S while hedging are buried in disequilibrium through selective hedging) operating(a) and touch on expen ses) Transaction Exposure Transaction Exposure measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates. Transaction exposure can arise from the following activities ? get or selling foreign goods and services on credit. Borrowing or lending in another currency. ? Foreign exchange contracts. Exhibit 8. 3 The life history Span of Transaction Exposure pic Example Expect to squirrel away ? 1,000,000 in three months on a sale, minimum acceptable value $1,700,000. Q What type of movement exposure has occurred? A Billing Exposure S0 = $1. 7640/? ES90= $1. 76/? F90= $1. 7540/? iU. K. = 10% per year (2. 5% per quarter) kU. K. = 8% per year (2% per quarter) iU. S. = 8% per year (2% per quarter) kU. S. = 6% per year (1. 5% per quarter) P90ATM = $1. 75 (1. 5% premium) P90OTM = $1. 71 (1% premium)Note ES90 is the deemd plaza rate in three months, i is the borrowing interest rate, and k is the investment interest rate, P90ATM is an a t-the- bullion three-month put option, and P90OTM is an out-of-the-money three month put option. Q Is the pound expected to appreciate or depreciate? A Depreciate Q What is the forward premium/discount on the pound? A pic Q What are the four alternatives to hedge a transaction exposure? A1) Remain unhedged 2) Hedge in the forward market 3) Hedge in the money market 4) Hedge in the options market 1) Remain unhedged, collect ? 1,000,000 in three months at the new agency rate. pic 2) Hedge in the forward market, collect ? 1,000,000 in three months at $1. 7540/?. pic 3) Hedge in the money market, borrow ? 975,610 today, and exchange for dollars at the topical spot rate ($1. 7640/? ). Invest the $1,720,976 for 90 days, and in 90 days pay back the loan + interest with the ? 1,000,000. Q To construct a money market hedge, how much should the investor borrow today if the annual interest rate is 10% and the company expects to receive ? 1,000,000 in 90 days? A pic Q At what investment rate is the money market hedge victor to the forward contract? A pic pic Note Either the forward contract or the money market hedge is better than an uncovered position if the spot rate at time 2 is less than the forward rate. But, if the funds can be invested at anything above 7. 68% (or 1. 92% for 90 days) thus the money market hedge is a better option than the forward contract. If the spot rate at time 2 is greater than what can be earned by investing the funds in the company (in this case the funds are invested in the company yielding the companys WACC of 12% or $1,772,605) then the uncovered hedge would be superior. 4) Hedge in the options market.An at-the-money1 (ATM) put option is selling for a 1. 5% premium. The cost of the option is (size of the option) x (premium) x (spot rate) = cost, in this case ? 1,000,000 x 0. 015 x $1. 7640 = $26,460. This is the maximum loss, while the maximum gain is the spot price the cost of the option. pic To compare the alternatives, first estima te what you expect spot rates to be, then estimate a range of possible prices, and consider your ability to accept the downside. Then select the best strategy. some(a) Examples pic Q Transaction exposure arises from what? A Sales and expenses that are already contracted for.Operating Exposure Operating Exposure (Economic Exposure, Competitive Exposure, Strategic Exposure) measures a change in the present value of a firm resulting from any change in future expected operating cash flows caused by unexpected changes in exchange rates. Q Operating Exposure depends on whether an unexpected change in exchange rates causes unanticipated changes in what? A Sales volume, gross r as yetue prices, or operating costs Figure 9. 1 Financial and Operating Cash Flows Between Parent and Subsidiary pic Q What are four proactive ways to manage operating exposure?A 1) Matching currency cash flows 2) Risk-sharing agreements 3) Back-to-back or parallel loans 4) Currency swaps Note Planning for operating exposure depends on the fundamental interaction of strategies in finance, marketing, purchasing, and production. Accounting (Translation) Exposure Accounting Exposure (Translation Exposure) measures accounting-derived changes in owners equity as a result of translating foreign currency financial statements into a single reporting currency. Q What are the financial goals of the multinational enterprise? A1) To maximize unify after-tax income ) To minimize the firms effective worldwide tax burden 3) To correct the positioning of the firms income, cash flows, and available funds. Note These goals are frequently seen as inconsistent. Functional currency the overleap currency used by the foreign subsidiary in its day-to-day operations. Q What are the two basic methods for the description of foreign subsidiary financial statements? A 1) The current rate method 2) The temporal method Current rate method a method of translating the financial statements of foreign affiliates into the parents reporting currency.All assets and liabilities are translated at the current exchange rate. Temporal method assumes that a number of individual line item assets such as inventory and net plant and equipment are restated regularly to reflect market value. Q Which method is the most common worldwide? A The current rate method Q What are the advantages of the current rate method? A 1) The variability of reported earnings due to translation gains or losses is eliminated, because the gain or loss on translation goes directly to a reserve account (rather than passing through the income statement). ) Does not distort balance planing machine ratios such as the current ratio or debt-to-equity ratio (because the relative proportions of the individual balance sheet accounts remain the alike. Q What is the disadvantage of the current rate method? A 1) It violates the accounting principle of carrying balance sheet accounts at historical costs. Q What is the advantage of the temporal m ethod? A 1) Foreign nonmonetary assets are carried at their original cost in the parents consolidated statement. Homework Problems Chapter 8 1.Imagine one of the companies from your final examination project is expecting an $80million payment in one year. The company also expects $20million in expenses in one year. Use truly figures or the following Current spot rate 3. 4x/$ (trend shows 3. 8x/$ two months ago) Interest rates are 14% in your sylvan and 4% in the U. S. forrad contracts are too expensive Based on the current spot rate and relative interest rates, please advise your company on its currency exposure. Chapter 9 2. Imagine one of your companies will soon be exporting to China.Use the following (replace the $ equivalent with your currency at the current spot price) Current sales of 1,000,000 units per year at a price equivalent to $24 each. Current spot price Rmb8. 2/$, but the H. K. advisory will drop the value next week to Rmb10/$. Direct costs are 75% of the U. S. d ollar sales price. Accepting this forecast, advise the company on two options 1) Maintain the same renminbi price (i. e. no change in price) 2) Raise the price to offset the devaluation and experience a 10% drop in unit volume. A) What would be the short (one year) impact of each strategy?B) Which do you recommend? Optional Assignment (0. 5 participation points) Prepare a write-up on the country you are doing for your final project. (Include GDP, inflation, major exports/imports, major stock exchange, currency, exchange rate, and anything else you find interesting and relevant) use sources like countryreports. org, cia. gov, etc. And remember to compare your country to something (i. e. the U. S. or another country in the region) Try to make everything you turn in look professional, imagine youre getting paid for your work.Please cite your sources throughout the report, and if you could e-mail it to me before next Monday, thats even better. Final Project These are two great sites to look at for your final project globaledge. msu. edu www. world-exchanges. org 1 An at-the-money put, means that the strike price is equal to the current spot price Meaning an investor is indifferent between exercising the option or going to the market. In this case the forward rate is $1. 7540/? , and the option is $1. 75/? nonnegative 1. 5% premium.