finance data bank

Essay Questions

11.1 Trident Corporation: A Multinational's Operating Exposure

1) An expected change in foreign exchange rates is not included in the definition of operating exposure, because both management and investors should have factored this information into their evaluation of anticipated operating results and market value. Describe how the expected change in foreign exchange rates would be reflected in the decision-making process from the perspective of a) management, b) debt service, c) the investor, and d) the broader macroeconomic perspective.

Answer: From a management perspective, budgeted financial statements already reflect information about the effect of an expected change in exchange rates.

From a debt service perspective, expected cash flow to amortize debt should already reflect the international Fisher effect. The level of expected interest and principal repayment should be a function of expected exchange rates rather than existing spot rates.

From an investor's perspective, if the foreign exchange market is efficient, information about expected changes in exchange rates should be widely known and thus reflected in a firm's market value. Only unexpected changes in exchange rates, or an inefficient foreign exchange market, should cause market value to change.

From a broader macroeconomic perspective, operating exposure is not just the sensitivity of a firm's future cash flows to unexpected changes in foreign exchange rates, but also its sensitivity to other key macroeconomic variables. This factor has been labeled as macroeconomic uncertainty.

11.2 Measuring Operating Exposure

1) An unexpected change in exchange rates impacts a firm’s expected cash flows at four levels; a) the short run, b) medium run: equilibrium, c) medium run: disequilibrium, and d) the long run. Describe the impact on cash flows over each of these categories identifying the time frame for each as well as the price changes, volume changes, and structural changes associated with each stage.

Answer:

Phase	Time	Price Changes	Volume Changes	Structural Change
Short Run	Less than one year	Prices are fixed/contracted	Volumes are contracted	No competitive market changes
Medium Run: Equilibrium	Two to five years	Complete pass-through of exchange rate changes	Volumes begin a partial response to prices	Existing competitors begin partial responses
Medium Run: Disequilibrium	Two to five years	Partial pass-through of exchange rate changes	Volumes begin a partial response to prices	Existing competitors begin partial responses
Long Run	More than five years	Completely flexible	Completely flexible	Threat of new entrants and changing competitor responses

11.3 Strategic Management of Operating Exposure

1) Diversification is possibly the best technique for reducing the problems associated with international transactions. Provide one example each of international financial diversification and international operational diversification and explain how the action reduces risk.

Answer: An MNE well known in the financial markets could borrow money in a country in which the firm receives foreign currency. The MNE could then use the receivables to repay the loan in the foreign currency and avoid uncertainties in exchange rates.

An MNE could establish production facilities in several countries. This could be beneficial in at least two ways. First, such diversification reduces the probability of unfavorable changes in exchange rates for one country from significantly reducing the firm's profitability. Second, an MNE with facilities in several countries is well positioned by using internal sources to recognize when a disequilibria in the market arises.

11.4 Proactive Management of Operating Exposure

1) A British firm has a subsidiary in the U.S., and a U.S. firm, known to the British firm, has a subsidiary in Britain. Define and then provide an example for each of the following management techniques for reducing the firm's operating cash flows. The following are techniques to consider:

(a) matching currency cash flows

(b) risk-sharing agreements

(c) back-to-back or parallel loans

rates.

Back-to-back loans provide for parent-subsidiary cross border financing without incurring direct currency exposure. For example, using our British and U.S. firms, the British firm could lend pounds to the U.S. subsidiary in Britain at the same time that the U.S. firm lends an equivalent amount of dollars to the British subsidiary in the U.S. Later, the loans would be simultaneously repaid.