Many companies that have significant foreign operations derive a high percentage of their sales overseas. Financial manager of the company require an understanding of the complexities of international finance to make sound financial and investment decisions. International finance involves consideration of managing working capital, financing the business, control of foreign exchange and political risks, and foreign direct investments. Most importantly, the financial manager has to consider the value of the US dollar relative to the value of the currency of the foreign country in which business activities are being conducted. Currency exchange rates may materially affect receivables and payables, and imports and exports of the US company in its multinational operations. The effect is more pronounced with increasing activities abroad.
Types Of Foreign Operations
Companies involved in foreign operation business may structure their activities in the following three ways:
- Wholly owned subsidiaries – A large, well-established company with much international experience may eventually have wholly owned subsidiaries.
- Import/export activities – A small company with limited foreign experience operating in “risky areas’’ may be restricted to export and import activity. If the company’s sales force has minimal experience in export sales, it is advisable to use foreign brokers when specialized knowledge of foreign markets is needed. When sufficient volume exists, the company may establish a foreign branch sales office, including sales people and technical service staff.
- Joint ventures – A joint venture with a foreign company is another way to proceed internationally and share the risk. Some foreign governments require this to be the path to follow to operate in their countries. The foreign company may have local goodwill to assure success. A drawback is less control over activities and a conflict of interest.
Three Main Issues of Company With Foreign Operation
- Multiple-currency problem – Sales revenues may be collected in one currency, assets denominated in another, and profits measured in a third.
- Various legal, institutional, and economic constraints – There are variations in such things as tax laws, labor practices, balance-of-payment policies, and government controls with respect to the types and sizes of investments, types and amount of capital raised, and repatriation of profits.
- Internal control problem – When the parent office of a foreign operation company and its affiliates are widely located, internal organizational difficulties arise.
Currency Risk Management
Foreign exchange rate risk exists when a contract is written in terms of the foreign currency or denominated in the foreign currency. The exchange rate fluctuations increase the riskiness of the investment and incur cash losses. The financial manager must not only seek the highest return on temporary investments but must also be concerned about changing values of the currencies invested. You do not necessarily eliminate foreign exchange risk.
In countries where currency values are likely to drop, financial managers of the subsidiaries should:
- Avoid paying advances on purchase orders unless the seller pays interest on the advances sufficient to cover the loss of purchasing power.
- Not have excess idle cash. Excess cash can be used to buy inventory or other real assets.
- Buy materials and supplies on credit in the country in which the foreign subsidiary is operating, extending the final payment date as long as possible.
- Avoid giving excessive trade credit. If accounts receivable balances are outstanding for an extended time period, interest should be charged to absorb the loss in purchasing power.
- Borrow local currency funds when the interest rate charged does not exceed US rates after taking into account expected devaluation in the foreign country.
Impacts of Changes in Foreign Exchange Rates
The impacts of changes in foreign exchange rates on the company’s products and financial transactions are summarized below:
Weak Currency Strong Currency
Imports More Expensive Cheaper
Exports Cheaper More Expensive
Payables More Expensive Cheaper
Receivables Cheaper More Expensive
Types of Foreign Exchange Exposure (Risk)
Companies with foreign operations are faced with the dilemma of three different types of foreign exchange risk. They are:
1. Translation Exposure – It is often called accounting exposure, measures the impact of an exchange rate change on the firm’s financial statements. An example would be the impact of an Euro devaluation on a US firm’s reported income statement and balance sheet. A major purpose of translation is to provide data of expected impacts of rate changes on cash flow and equity. In the translation of the foreign subsidiaries’ financial statements into the US parent’s financial statements, the following steps are involved:
- The foreign financial statements are put into US generally accepted accounting principles.
- The foreign currency is translated into US dollars. Balance sheet accounts are translated using the current exchange rate at the balance sheet date. If a current exchange rate is not available at the balance sheet date, use the first exchange rate available after that date. Income statement accounts are translated using the weighted-average exchange rate for the period.
Current FASB rules require translation by the current rate method. Under the current rate method:
- All balance sheet assets and liabilities are translated at the current rate of exchange in effect on the balance sheet date.
- Income statement items are usually translated at an average exchange rate for the reporting period.
- All equity accounts are translated at the historical exchange rates that were in effect at the time the accounts first entered the balance sheet.
- Translation gains and losses are reported as a separate item in the stockholders’ equity section of the balance sheet.
- Translation gains and losses are only included in net income when there is a sale or liquidation of the entire investment in a foreign entity.
2. Transaction Exposure – It measures potential gains or losses on the future settlement of outstanding obligations that are denominated in a foreign currency. An example would be a US dollar loss after the Euro devalues, on payments received for an export invoiced in francs before that devaluation. Foreign currency transactions may result in receivables or payables fixed in terms of the amount of foreign currency to be received or paid. Transaction gains and losses are reported in the income statement. Foreign currency transactions are those transactions whose terms are denominated in a currency other than the entity’s functional currency. Foreign currency transactions take place when a business:
- Buys or sells on credit goods or services the prices of which are denominated in foreign currencies.
- Borrows or lends funds, and the amounts payable or receivable are denominated in a foreign currency.
- Is a party to an unperformed forward exchange contract.
- Acquires or disposes of assets, or incurs or settles liabilities denominated in foreign currencies.
Example: Dharma Trading Company imports French cheeses for distribution in the US. On July 1, the company purchased cheese costing 100,000 Euro. Payment is due in Euro on October 1. The spot rate on July 1 was $1.20 per Euro, and on October 1, it was $1.25 per Euro. The exchange loss would be:
Liability in dollars, October 1 = $20,000 (100,000 x $1.20)
Paid in dollars, October 1 = $25,000 (100,000 x$1.25)
Exchange Loss = $ 5,000
Note that transaction losses differ from translation losses, which do not influence taxable income.
3. Operating Exposure – It is often called economic exposure, is the potential for the change in the present value of future cash flows due to an unexpected change in the exchange rate. Operating (economic) exposure is the possibility that an unexpected change in exchange rates will cause a change in the future cash flows of a firm and its market value. It differs from translation and transaction exposures in that it is subjective and thus not easily quantified. Note: the best strategy to control operation exposure is to diversify operations and financing internationally.
Key Questions to Ask That Help to Identify Foreign Exchange Risk
A systematic approach to identifying a foreign operation exposure to foreign exchange risk is to ask a series of questions regarding the net effects on profits of changes in foreign currency revenues and costs. The questions are:
- Where is the company selling? (Domestic versus foreign sales share)
- Who are the firm’s major competitors? (Domestic versus foreign)
- Where is the firm producing? (Domestic versus foreign)
- Where are the firm’s inputs coming from? (Domestic versus foreign)
- How sensitive is quantity demanded to price? (Elastic versus inelastic)
- How are the firm’s inputs or outputs priced? (Priced in a domestic market or a global market; the currency of denomination)
Five Ways to Neutralize Foreign Exchange Risk
Foreign exchange risk can be neutralized or hedged by a change in the asset and liability position in the foreign currency. Here are some ways to control exchange risk:
1. Entering a Money-market Hedge – Here the exposed position in a foreign currency is offset by borrowing or lending in the money market.
Example: XYZ, an American importer, enters into a contract with a British supplier to buy merchandise for £4,000. The amount is payable on the delivery of the good, 30 days from today. The company knows the exact amount of its pound liability in 30 days. However, it does not know the payable in dollars. Assume that the 30-day money-market rates for both lending and borrowing in the US and UK are 0.5% and 1%, respectively. Assume further that today’s foreign exchange rate is $1.50 per pound. In a money-market hedge, XYZ can take the following steps:
- Step-1. Buy a 1-month UK money market security, worth of 4,000/(1+0.005)=£3,980. This investment will compound to exactly £4,000 in 1 month.
- Step-2. Exchange dollars on today’s spot (cash) market to obtain the £3,980. The dollar amount needed today is £3,980 x $1.7350 per pound = $6,905.30.
- Step-3. If XYZ does not have this amount, it can borrow it from the US money market at the going rate of 1%. In 30 days XYZ will need to repay $6,905.30 x (1 + 0.1) = $7,595.83. Note: XYZ need not wait for the future exchange rate to be available. On today’s date, the future dollar amount of the contract is known with certainty. The British supplier will receive £4,000, and the cost of XYZ to make the payment is $7,595.83.
2. Hedging by Purchasing Forward (or futures) Exchange Contracts – Forward exchange contracts are a commitment to buy or sell, at a specified future date, one currency for a specified amount of another currency (at a specified exchange rate). This can be a hedge against changes in exchange rates during a period of contract or exposure to risk from such changes. More specifically, you do the following: (1) Buy foreign exchange forward contracts to cover payables denominated in a foreign currency and (2) sell foreign exchange forward contracts to cover receivables denominated in a foreign currency. This way, any gain or loss on the foreign receivables or payables due to changes in exchange rates is offset by the gain or loss on the forward exchange contract.
Example: In the previous example, assume that the 30-day forward exchange rate is $1.6153. XYZ may take the following steps to cover its payable:
- Step-1. Buy a forward contract today to purchase £4,000 in 30 days.
- Step-2. On the 30th day pay the foreign exchange dealer £4,000 x $1.6153 per pound = $6,461.20 and collect £4,000. Pay this amount to the British supplier.
Note: Using the forward contract XYZ knows the exact worth of the future payment in dollars ($6,461.20). The basic difference between futures contracts and forward contracts is that futures contracts are for specified amounts and maturities, whereas forward contracts are for any size and maturity desired.
3. Hedging by Foreign Currency Options – Foreign currency options can be purchased or sold in three different types of markets: (a) Options on the physical currency, purchased on the over-the-counter (interbank) market; (b) options on the physical currency, on organized exchanges such as the Philadelphia Stock Exchange and the Chicago Mercantile Exchange; and (c) options on futures contracts, purchased on the International Monetary Market (IMM) of the Chicago Mercantile Exchange.
Note: The difference between using a futures contract and using an option on a futures contract is that, with a futures contract, the company must deliver one currency against another, or reverse the contract on the exchange, while with an option the company may abandon the option and use the spot (cash) market if that is more advantageous. Repositioning cash by leading and lagging the time at which a foreign operation makes operational or financial payments. Often, money- and forward-market hedges are not available to eliminate exchange risk. Under such circumstances, leading (accelerating) and lagging (decelerating) may be used to reduce risk.
A net asset position (i.e., assets minus liabilities) is not desirable in a weak or potentially depreciating currency. In this case, you should expedite the disposal of the asset. By the same token, you should lag or delay the collection against a net asset position in a strong currency.
4. Maintaining Balance between Receivables and Payables Denominated in a Foreign Currency – Foreign operation company typically set up ‘‘multilateral netting centers’’ as a special department to settle the outstanding balances of affiliates of a foreign operation company with each other on a net basis. It is the development of a ‘‘clearing house’’ for payments by the firm’s affiliates. If there are amounts due among affiliates they are offset insofar as possible. The net amount would be paid in the currency of the transaction. The total amounts owed need not be paid in the currency of the transaction; thus, a much lower quantity of the currency must be acquired.
Note: The major advantage of the system is a reduction of the costs associated with a large number of separate foreign exchange transactions.
5. Positioning of Funds Through Transfer Pricing – A transfer price is the price at which an company sells goods and services to its foreign affiliates or, alternatively, the price at which an affiliate sells to the parent. For example, a parent that wishes to transfer funds from an affiliate in a depreciating-currency country may charge a higher price on the goods and services sold to this affiliate by the parent or by affiliates from strong-currency countries. Transfer pricing affects not only transfer of funds from one entity to another but also the income taxes paid by both entities.
Long versus Short Position
When there is a devaluation of the dollar, foreign assets and income in strong currency countries are worth more dollars as long as foreign liabilities do not offset this beneficial effect. Foreign exchange risk may be analyzed by examining expected receipts or obligations in foreign currency units.
A company expecting receipts in foreign currency units (‘‘long’’ position in the foreign currency units) has the risk that the value of the foreign currency units will drop. This results in devaluing the foreign currency relative to the dollar. If a company is expecting to have obligations in foreign currency units (‘‘short’’ position in the foreign currency units), there is risk that the value of the foreign currency will rise and it will need to buy the currency at a higher price.
If net claims are greater than liabilities in a foreign currency, the company has a ‘‘long’’ position, since it will benefit if the value of the foreign currency rises. If net liabilities exceed claims with respect to foreign currencies, the company is in a ‘‘short’’ position because it will gain if the foreign currency drops in value.
Monetary balance is avoiding either a net receivable or a net payable position. Monetary assets and liabilities do not change in value with devaluation or revaluation in foreign currencies. A company with a long position in a foreign currency will be receiving more funds in the foreign currency. It will have a net monetary asset position (monetary assets exceed monetary liabilities) in that currency. A company with net receipts is a net monetary creditor. Its foreign exchange rate risk exposure has a net receipts position in a foreign currency that is susceptible to a drop in value. A company with a future net obligation in foreign currency has a net monetary debtor position. It faces a foreign exchange risk of the possibility of an increase in the value of the foreign currency.
Forecasting Foreign Exchange Rates
The forecasting of foreign exchange rates is a formidable task. Most foreign operation companies rely primarily on bank and bank services for assistance and information in preparing exchange rate projections. The following economic indicators are considered to be the most important for the forecasting process:
- Recent rate movements
- Relative inflation rates
- Balance of payments and trade
- Money supply growth
- Interest rate differentials
Analysis Of Foreign Investments
Foreign investment decisions are basically capital budgeting decisions at the international level. The decision requires two major components:
1. The estimation of the relevant future cash flows – Cash flows are the dividends and possible future sales price of the investment. The estimation depends on the sales forecast, the effects on exchange rate changes, the risk in cash flows, and the actions of foreign governments.
2. The choice of the proper discount rate (cost of capital) – The cost of capital in foreign investment projects is higher due to the increased risks of:
3. Currency risk (or foreign exchange risk) – changes in exchange rates. This risk may adversely affect sales by making competing imported goods cheaper.
4. Political risk (or sovereignty risk) – possibility of nationalization or other restrictions with net losses to the parent company. Examples of Political Risks:
- Expropriation of plants and equipment without compensation or with minimal compensation that is below actual market value.
- Non-convertibility of the affiliate’s foreign earnings into the parent’s currency – the problem of ‘‘blocked funds.’’
- Substantial changes in the laws governing taxation.
- Government controls in the host country regarding wages, compensation to the personnel, hiring of personnel, the sales price of the product, making of transfer payments to the parent, and local borrowing.