Unlock document.
This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
POINT/COUNTER-POINT:
Can an MNC Reduce the Impact of Translation Exposure by Communicating?
POINT: Yes. Investors commonly use earnings to derive an MNC’s expected future cash flows. Investors
do not necessarily recognize how an MNC’s translation exposure could distort their estimates of the
MNC’s future cash flows. Therefore, the MNC could clearly communicate in its annual report and
elsewhere how the earnings were affected by translation gains and losses in any period. If investors have
this information, they will not overreact to earnings changes that are primarily attributed to translation
exposure.
COUNTER-POINT: No. Investors focus on the bottom line and should ignore to any communication
regarding the translation exposure. Moreover, they may believe that translation exposure should be
accounted for anyway. If foreign earnings are reduced because of a weak currency, the earnings may
continue to be weak if the currency remains weak.
WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support?
Offer your own opinion on this issue.
ANSWER: Both points have some merit. Some investors may believe that the bottom line earnings are the
Answers to End of Chapter Questions
1. Reducing Economic Exposure. Baltimore, Inc., is a U.S.-based MNC that obtains 10 percent of its
supplies from European manufacturers. Sixty percent of its revenues are due to exports to Europe,
where its product is invoiced in euros. Explain how Baltimore can attempt to reduce its economic
exposure to exchange rate fluctuations in the euro.
2. Reducing Economic Exposure. UVA Co. is a U.S.-based MNC that obtains 40 percent of its foreign
supplies from Thailand. It also borrows Thailand’s currency (the baht) from Thai banks and converts
the baht to dollars to support U.S. operations. It currently receives about 10 percent of its revenue
from Thai customers. Its sales to Thai customers are denominated in baht. Explain how UVA Co. can
reduce its economic exposure to exchange rate fluctuations.
3. Reducing Economic Exposure. Albany Corp. is a U.S.-based MNC that has a large government
contract with Australia. The contract will continue for several years and generate more than half of
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Managing Economic Exposure and Translation Exposure 2
Albany's total sales volume. The Australian government pays Albany in Australian dollars. About 10
percent of Albany's operating expenses are in Australian dollars; all other expenses are in U.S. dollars.
Explain how Albany Corp. can reduce its economic exposure to exchange rate fluctuations.
ANSWER: Albany may ask the Australian government to provide payment in U.S. dollars.
4. Tradeoffs When Reducing Economic Exposure. When an MNC restructures its operations to reduce
its economic exposure, it may sometimes forgo economies of scale. Explain.
ANSWER: An MNC may attempt to use several production plants. The production could be
5. Exchange Rate Effects on Earnings. Explain how a U.S.-based MNC's consolidated earnings are
affected when foreign currencies depreciate.
ANSWER: A U.S.-based MNC's consolidated earnings are reduced by the translation effect when
6. Hedging Translation Exposure. Explain how a firm can hedge its translation exposure.
7. Limitations of Hedging Translation Exposure. Bartunek Co. is a U.S.-based MNC that has
European subsidiaries and wants to hedge its translation exposure to fluctuations in the euro’s value.
Explain some limitations when it hedges translation exposure.
8. Effective Hedging of Translation Exposure. Would a more established MNC or a less established
MNC be better able to effectively hedge its given level of translation exposure? Why?
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Managing Economic Exposure and Translation Exposure 3
9. Comparing Degrees of Economic Exposure. Carlton Co. and Palmer, Inc., are U.S.-based MNCs
with subsidiaries in Mexico that distribute medical supplies (produced in the United States) to
customers throughout Latin America. Both subsidiaries purchase the products at cost and sell the
products at 90 percent markup. The other operating costs of the subsidiaries are very low. Carlton Co.
has a research and development center in the United States that focuses on improving its medical
technology. Palmer, Inc., has a similar center based in Mexico. Each firm subsidizes its respective
research and development center on an annual basis. Which firm is subject to a higher degree of
economic exposure? Explain.
10. Comparing Degrees of Translation Exposure. Nelson Co. is a U.S. firm with annual export sales to
Singapore of about S$800 million. Its main competitor is Mez Co., also based in the United States,
with a subsidiary in Singapore that generates about S$800 million in annual sales. Any earnings
generated by the subsidiary are reinvested to support its operations. Based on the information
provided, which firm is subject to a higher degree of translation exposure? Explain.
Advanced Questions
11. Managing Economic Exposure. St. Paul Co. does business in the United States and New Zealand. In
attempting to assess its economic exposure, it compiled the following information.
a. St. Paul’s U.S. sales are somewhat affected by the value of the New Zealand dollar (NZ$), because
it faces competition from New Zealand exporters. It forecasts the U.S. sales based on the
following three exchange rate scenarios:
Revenue from U.S. Business
Exchange Rate of NZ$ (in millions)
NZ$ = $.48 $100
NZ$ = .50 105
NZ$ = .54 110
b. Its New Zealand dollar revenues on sales to New Zealand invoiced in New Zealand dollars are
expected to be NZ$600 million.
c. Its anticipated cost of materials is estimated at $200 million from the purchase of U.S. materials
and NZ$100 million from the purchase of New Zealand materials.
d. Fixed operating expenses are estimated at $30 million.
e. Variable operating expenses are estimated at 20 percent of total sales (after including New Zealand
sales, translated to a dollar amount).
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Managing Economic Exposure and Translation Exposure 4
f. Interest expense is estimated at $20 million on existing U.S. loans, and the company has no
existing New Zealand loans.
Forecast net cash flows for St. Paul Co. under each of the three exchange rate scenarios. Explain how
St. Paul's projected net cash flows are affected by possible exchange rate movements. Explain how it
can restructure its operations to reduce the sensitivity of its net cash flows to exchange rate movements
without reducing its volume of business in New Zealand.
ANSWER:
12. Assessing Economic Exposure. Alaska Inc. plans to create and finance a subsidiary in Mexico that
produces computer components at a low cost and exports them to other countries. It has no other
international business. The subsidiary will produce computers and export them to Caribbean islands
and will invoice the products in U.S. dollars. The values of the currencies in the islands are expected to
remain very stable against the dollar. The subsidiary will pay wages, rent, and other operating costs in
Mexican pesos. The subsidiary will remit earnings monthly to the parent.
a. Would Alaska’s cash flows be favorably or unfavorably affected if the Mexican peso depreciates
over time?
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Managing Economic Exposure and Translation Exposure 5
b. Assume that Alaska considers partial financing of this subsidiary with peso loans from Mexican
banks instead of providing all the financing with its own funds. Would this alternative form of
financing increase, decrease, or have no effect on the degree to which Alaska is exposed to
exchange rate movements of the peso?
13. Hedging Continual Exposure. Consider this common real-world dilemma by many firms that rely on
exporting. Clearlake Inc. produces its products in its factory in Texas, and exports most of the
products to Mexico each month. The exports are denominated in pesos. Clearlake Inc. recognizes that
hedging on a monthly basis does not really protect against long-term movements in exchange rates. It
also recognizes that it could eliminate its transaction exposure by denominating the exports in dollars,
but that it still would have economic exposure (because Mexican consumers would reduce demand if
the peso weakened). Clearlake Inc. does not know how many pesos it will receive in the future, so it
would have difficulty even if a long-term hedging method were available. How can Clearlake
realistically deal with this dilemma and reduce its exposure over the long-term? [There is no perfect
solution, but in the real world, there rarely are perfect solutions.]
14. Sources of Supplies and Exposure to Exchange Rate Risk. Laguna Co. (a U.S. firm) will be
receiving 4 million British pounds in one year. It will need to make a payment of 3 million Polish zloty
in one year. It has no other exchange rate risk at this time. However, it needs to buy supplies and can
purchase them from Switzerland, Hong Kong, Canada, or Ecuador. Another alternative is that it could
also purchase one-fourth of the supplies from each of the 4 countries mentioned in the previous
sentence. The supplies will be invoiced in the currency of the country where they are imported from.
Laguna Co. believes that none of the sources of the imports would provide a clear cost advantage. As
of today, the dollar cost of these supplies would be about $6 million regardless of the source that will
provide the supplies.
The spot rates today are as follows:
British pound=$1.80
Swiss franc=$.60
Polish zloty=$.30
Hong Kong dollar=$.14
Canadian dollar =$.60
The movements of the pound and the Swiss franc and the Polish zloty against the dollar are highly
correlated. The Hong Kong dollar is tied to the U.S. dollar and you expect that it will continue to be
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Managing Economic Exposure and Translation Exposure 6
tied to the dollar. The movements in the value of Canadian dollar against the U.S. dollar are not
correlated with the movements of other currencies. Ecuador uses the U.S. dollar as its local currency.
Which alternative should Laguna Co. select in order to minimize its overall exchange rate risk?
ANSWER: After one year, assuming that today’s spot rates hold as the spot rates one year from now,
15. Minimizing Exposure. Lola Co. is (a U.S. firm) that expects to receive 10 million euros in one year. It
does not plan to hedge this transaction with a forward contract or other hedging techniques. This is its
only international business, and it is not exposed to any other form of exchange rate risk. Lola Co.
plans to purchase materials for future operations and it will send its payment for these materials in one
year. The value of the materials to be purchased is about equal to the expected value of the
receivables. Lola Co. can purchase the materials from Switzerland, Hong Kong, Canada, or the U.S.
Another alternative is that it could also purchase one-fourth of the materials from each of the 4
countries mentioned in the previous sentence. The supplies will be invoiced in the currency of the
country from which they are imported.
The movements of the euro and the Swiss franc against the dollar are highly correlated and will
continue to be highly correlated. The Hong Kong dollar is tied to the U.S. dollar and you expect that it
will continue to be tied to the dollar. The movements in the value of Canadian dollar against the U.S.
dollar are independent of (not correlated with) the movements of other currencies against the U.S.
dollar. Lola Co. believes that none of the sources of the imports would provide a clear cost advantage.
Which alternative should Lola Co. select for obtaining supplies that will minimize its overall exchange
rate risk?
16. Financing to Reduce Exchange Rate Exposure. Nashville Co. presently incurs costs of about 12
million Australian dollars (A$) per year for research and development expenses in Australia. It sells the
products that are designed each year, and all of the products sold each year are invoiced in U.S. dollars.
Nashville anticipates revenue of about $20 million per year, and about half of the revenue will be from
sales to customers in Australia. The Australian dollar is presently valued at $1 (1 U.S. dollar), but it
fluctuates a lot over time. Nashville Co. is planning a new project that will expand its sales to other
regions within the United States, and the sales will be invoiced in dollars. Nashville can finance this
project with a 5-year loan by (1) borrowing only Australian dollars, or (2) borrowing only U.S. dollars,
or (3) borrowing one-half of the funds from each of these sources. The 5-year interest rates on an
Australian dollar loan and a U.S. dollar loan are the same.
a. If Nashville wants to use the form of financing that will reduce its exposure to exchange rate risk
the most, what is the optimal form of financing? Briefly explain (one or two sentences should be
sufficient if your explanation is clear).
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Managing Economic Exposure and Translation Exposure 7
b. Now assume that Nashville expects that the Australian dollar will appreciate over time. Suppose
the company wants to maximize its expected net present value of its new project and is not
concerned about its exposure to exchange rate risk. Under these conditions, which financing
alternative is most appropriate? Briefly explain.
ANSWER:
CRITICAL THINKING
Creating Cash Outflows to Match Inflows in the Same Currency Consider MNCs that produce products
in the United States and export the products to developing countries. The MNCs could reduce their exposure
to exchange rate risk if they set up their operations in the countries to which they export. Such a restructuring
would cause a shift in expenses to the developing countries, and those expenses could be paid for with
revenue earned in the same currency. Write a short essay in which you explain the practical limitations of this
solution, which can help to explain why some MNCs do not pursue this strategy.
ANSWER
Solution to Continuing Case Problem: Blades, Inc.
1. How will Blades be negatively affected by the high level of inflation in Thailand if the Thai customer
renews its commitment for another three years?
2. Holt believes that the Thai importer will renew its commitment in two years. Do you think his
assessment is correct? Why or why not? Also, assume that the Thai economy returns to the high growth
level that existed prior to the recent unfavorable economic events. Under this assumption, how likely is
it that the Thai importer will renew its commitment in two years?
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Managing Economic Exposure and Translation Exposure 8
3. For each of the three possible values of the Thai baht and the British pound, use a spreadsheet to
estimate cash flows for the next year. Briefly comment on the level of Blades’ economic exposure.
Ignore possible tax effects.
THB=$0.0220 THB=$0.0209 THB=$0.0198
BP=$1.530 BP=$1.485 BP=$1.500
Sales
(1) U.S. (520,000 units × $120/pair) $ 62,400,000 $ 62,400,000 $ 62,400,000
(2) Thai (180,000 units × THB4,594 ×
$ 18,192,240 $ 17,282,628 $ 16,373,016
4. Now repeat your analysis in question 3 but assume that the British pound and the Thai baht are
perfectly correlated. For example, if the baht depreciates by 5 percent, the pound will also depreciate
by 5 percent. Under this assumption, is Blades subject to a greater degree of economic exposure? Why
or why not?
THB=$0.0220 THB=$0.0209 THB=$0.0198
BP=$1.50 BP=$1.425 BP=$1.350
Sales
Exchange Rate)
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Managing Economic Exposure and Translation Exposure 9
5. Based on your answers to the previous three questions, what actions could Blades take to reduce its
level of economic exposure to Thailand?
ANSWER: There are several actions Blades could take. The analysis above illustrates that economic
exposure can be reduced by conducting its international business in countries whose currencies are not
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
