Topic 7: Foreign Exchange Exposure II

1. How would you define economic exposure to exchange risk?
2. Explain the competitive and conversion effects of exchange rate changes on the firm’s operating cash flow.
3. Discuss the determinants of operating exposure.
4. General Motors exports cars to Spain, but the strong dollar against the euro hurts sales of GM cars in Spain. In the Spanish market, GM faces competition from Italian and French car makers, such as Fiat and Renault, whose operating currencies are the euro. What kind of measures would you recommend so that GM can maintain its market share in Spain?
5. Evaluate the following statement: “A firm can reduce its currency exposure by diversifying across different business lines.”
6. Exchange rate uncertainty may not necessarily mean that firms face exchange risk exposure. Explain why this may be the case.
7. If PPP holds, does the firm face any exchange rate risk? Explain.
8. Matsushita exports about half of its TV set production to the United States 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?
9. About two-thirds of Californian almonds are exported. The ups and downs of the US dollar cause headaches for growers. To avoid this, growers decide to concentrate on domestic sales. Does the grower bear exchange rate risk? Why and how?
10. In the annual results of Nestle, a large diversified Swiss-based food company with operations in more than 100 countries, management states that it does not hedge foreign exchange exposure. What might be the rationale behind this policy?
11. In order to avoid speculation, Honda hedges only the sales it has clinched, not the ones it expects. Comment on Honda’s currency risk strategy.
12. Black & Decker Manufacturing Co. of Towson, Md., has roughly 45% of its costs and 40% of its sales overseas. How does the soaring dollar affect its profitability, both at home and abroad?

13. A U.S. company needs to borrow $100 million for a period of seven years. It can issue dollar debt at 7 percent or yen debt at 3 percent.

(a) Suppose the company is a multinational firm with sales in the United States and inputs purchased in Japan. How should this affect its financing choice?

(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?

14. 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.

15. Hilton International is considering investing in a new Swiss hotel. The required initial investment is $1.5 million (or SFr 2.38 million at the current exchange rate of $0.63 = SFr 1). 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.

(a) What factors are relevant in evaluating this investment?

(b) How will fluctuations in the value of the Swiss franc affect this investment?

(c) How would you forecast the $:SFr exchange rate ten years ahead?

16. 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 percent devaluation is expected to lower unit costs by $0.30, while a 15 percent devaluation will reduce these costs by an additional $0.15. Suppose a devaluation of either 10 percent or 15 percent is likely, with respective probabilities of .4 and .2 (the probability of no currency change is .4). Depreciation at the current exchange rate equals $1 million annually, while the local tax rate is 40 percent.

(a) What will annual dollar cash flows be if no devaluation occurs?

(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 United States?

17. Why should managers focus on marketing and production strategies to cope with foreign exchange risk?

18. 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.

(a) In what sense is this profit improvement false prosperity?

(b) How would you incorporate the decline in the dollar in evaluating management performance? In making investment decisions?

(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.”

19. 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.

(a) Assess the likely impact of the rupiah’s depreciation on Bakrie’s three different businesses.

(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?

(c) Bakrie has about $1 billion in foreign debt. Will this debt increase or decrease its currency exposure? Explain.

20. Mucho Macho is the leading beer in Patagonia, with a 65 percent share of the market. Because of trade barriers, it faces essentially no import competition. Exports account for less than 2 percent 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 percent, and U.S. prices have risen by about 10 percent. During this time period, the value of the Patagonian peso has dropped from P 1 = $1.00 to P 1 = $0.50.

(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?

(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.

(c) Based on your above answers, 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.

(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?

(e) What foreign exchange risk would such a dollar loan face? Explain.

21. Goodwear-Gorkiy is the Russian subsidiary of an American tyre company. Goodwear-Gorkiy manufactures tyres in Russia to sell to members of the Commonwealth of Independent States. Its projected income statement is as follows:

Sales (1,000,000 tyres @ Ruble 120,000/tyre) 120,000,000,000 rubles

Direct costs (1,000,000 tyres @ Ruble 80,000/tyre) 80,000,000,000

Cash fixed overhead 4,000,000,000

Depreciation 16,000,000,000

Profit before Russian income taxes 20,000,000,000

Income taxes — none due to tax holiday _____________

Profit after Russian income taxes 20,000,000,000

Add back depreciation 16,000,000,000

Cash flow from operations — in rubles 36,000,000,000 rubles

Current exchange rate: Rubles 3,000 = $1.00

Cash flow from operations — in dollars $12,000,000

Suppose that the ruble drops in value from 3,000/$ to 4,000/$.

What is the resulting operating exposure if

(i) Goodwear-Gorkiy does not raise its ruble sales price, but

1. Goodwear-Gorkiy’s Czech competitor, which had been importing into Russia, drops out, and Goodwear-Gorkiy’s unit sales increase 10% as a result.
2. Also, Goodwear-Gorkiy’s direct costs and cash fixed overheads increase by an unknown percent and this is given by %.

Hint: Assume that the costs increase by an unknown percent given by %.

Past exam question

22. A recent article in the New York Times mentioned that PSA Peugeot Citroën of France “said it might lose 600 million euros ($744 million) this year because of the strong euro.” Discuss at least two ways that European carmakers can use to respond as the US dollar weakens? Past exam question