Questions
1. Why does Porsche face more operating exposure than Mercedes or BMW?
2. Is Porsche really fully hedged through July 31, 2007? Suppose that gains on all its outstanding options were included in reported earnings for its fiscal year ended July 31, 2004.
3. Why would analysts be nervous if up to 75% of Porsche’s pretax profit for fiscal year 2004 came from gains on foreign currency options?
The implementation of a hedging policy is likely to be quite difficult in practice, if only because the specific cash-flow effects of a given currency change are hard to predict. Trained personnel are required to implement and monitor an active hedging program. Consequently, hedging should be undertaken only when the effects of anticipated exchange rate changes are expected to be significant.
A highly simplified example can illustrate the application of the financing rule developed previously—namely, that the liability structure of the combined MNC—parent and subsidiaries—should be set up in such a way that any change in the inflow on assets resulting from a currency change should be matched by a corresponding change in the outflow on the liabilities used to fund those assets. Consider the effect of a local currency (LC) change on the subsidiary depicted in Exhibit 11.12. In the absence of any exchange rate changes, the subsidiary is forecast to have an operating profit of $800,000. If a predicted 20% devaluation of the local currency from LC 1 = $0.25 to LC 1 = $0.20 occurs, the subsidiary’s LC profitability is expected to rise to LC 3.85 million from LC 3.2 million because of price increases. However, that LC profit rise still entails a loss of $30,000, despite a reduction in the dollar cost of production.
Suppose the subsidiary requires assets equaling LC 20 million, or $5 million at the current exchange rate. It can finance these assets by borrowing dollars at 8% and converting them into their local currency equivalent, or it can use LC funds at 10%. How can the parent structure its subsidiary’s financing in such a way that a 20% devaluation will reduce the cost of servicing the subsidiary’s liabilities by $30,000 and thus balance operating losses with a decrease in cash outflows?
Actually, a simple procedure is readily available. If S is the dollar outflow on local debt service, then it is necessary that 0.2S, the dollar gain on devaluation, equal $30,000, the operating loss on devaluation. Hence, S = $150,000, or LC 600,000 at the current exchange rate. At a local currency interest rate of 10%, that debt-service amount corresponds to local currency debt of LC 6 million. The remaining LC 14 million can be provided by borrowing $3.5 million. Exhibit 11.13 illustrates the offsetting cash effects associated with such a financial structure.