Chapter 12: Operating Exposure

Operating Exposure measures any change in the present value of a firm resulting from changes in the future operating cash flows caused by any unexpected change in exchange rate. Also, operating exposure deals with the firm’s operations over the coming months and years, and its competitive positions in relative to other firms.

Attributes of Operating ExposureA firm like Coca Cola, for example, has sales in the US, China, and Europe.

Sales and expenses already contracted are traditional transaction exposure. Sales and expenses that are highly probable are anticipated transaction exposures

Operating and Financing Cash FlowsOperating Cash flows arise from intercompany( between unrelated companies) and intracompany (between units of the same company) receivables and payables, rent and lease payments, royalty and license fees, and assorted management fees.

Financing Cash Flows are payments for the use of inter- and intra company loans and stockholder equity.

Expected vs. Unexpected Changes in Cash FlowsOperating exposure is about unexpected changes in the value of future cash flows. Expected changes in exchange rate, interest rates, inflation rates are not a problem because such changes should have already been factored into management’s evaluation of future cash flows. However, unexpected changes in exchange rate impact a firm’s expected cash flows at four levels, depending on the horizon used

1. Short run: time is less than one year; prices are fixed/ contracted2. Medium run/ equilibrium: time is 2-5 years; prices are completely pass- through of exchange rate

changes.3. Medium run/ disequilibrium: time is 2-5 years; prices are partially pass- through of exchange rate

changes4. Long run: time is over 5 years; prices are completely flexible

Measuring Operating Exposure: Coke GermanyCoke is a MNE based in Atlanta, GA, USA. It has sales and services subsidiaries in China and Germany. Unexpected changes in the value of the Euro will affect the value of the firm’s subsidiaries in these countries, and thus the value of Coke as a whole.

The Base Case: Assumptions for the 2014 - 2018 (5 year ) period. Sales Volume (Q): 1 million units per yearSales Price (P): € 12.80 per unitDirect Cost (C) : € 9.60 per unitEt = $1.20/€Discount rate ( i ): 15% per yearCorporate tax rate (t) in Germany: 29.5%Cash Operating Expense (F): €890,000 per year (given/fixed)Depreciation (D): €600,000 per year (in net working capital (NWC))

Coke Germany’s expected cash flow from operations (CFO) in 2014 is …CFO = (1 - t) (PQ - CQ - F - D) + D        = (1 - 0.295) ((12.8-9.6) x 106 - 890,000 - 600,000) + 600,000       = €1,805,550 x $1.26/€ = $2,166,660

PV at 15% = €1,805,550 + (   ) + (   ) + (   ) + (   ) = € 6,052,484 x $1.2/€ = $7,262,980 (1.15)           (  )2    (  )3   (  )4   (  )5

To illustrate the effect of various post- depreciation scenarios on Coke Germany’s operating exposure, consider the following four cases:

Case 1: €↓ , everything else is constant. Suppose the euro falls from $1.2/€ to 1.0/€ on January 1, 2014 and expected to remain at this level over the next 5 years. Therefore,

PV of operating cash flows is $6,052,484, which is a loss of $1,210,497

Case 2: Increase in Sales Volume (Q)Suppose sales increase by 40%, to 1,400,000 units following the Euro depreciation. Cash flow from operation (2015- 2018) would be:CFO = (1 - t) (PQ - CQ - F - D) + D               = (1 - 0.295) ((12.8-9.6) x 1.4 x 106 - 890,000 - 600,000) + 600,000   = €2,707,950 x $1.0/€ = $2,707,950

This increase in sales requires a change in net working capital (NWC). In this case, it is €203,397 (which equals to A/R + Inventory)     PV = CFO 2015-2018 x [(1 - (1/1.15)5) / 0.15] - NWC x [(1 / 1.15) - (1 / 1.15)8]       = € 2,707,950 x [(1 - (1/1.15)5) / 0.15] - € 203,397 x [(1 / 1.15) - (1 / 1.15)8]       = € 8,900,601 x $1.0/€ = $8,900,601

Case 3: Increase in Sales Price (P)Suppose the Euro sales price (P) is raised from €12.80 to €15.36 per unit to maintain the same US dollar equivalent price.

CFO = (1 - t) (PQ - CQ - F - D) + D= €3,610,350 = $3,610,350PV = € 3,610,350 x  [(1 - (1/1.15)5) / 0.15] - €49,096 x [(1 / 1.15) - (1 / 1.15)8]

     = €12,059,761 =$12,059,761

Case 4: Price, Cost, and Sales Volume IncreaseP↑ by 10% to €14.08C↑ by 5% to €10.00Q↑ by 10% to 1,100,000 units

CFO2014 = $2,623,683 and CFO2015-2018 = $2,713,590PV = $9,018,195

Therefore, PV = $7,262,980 → %△ in PV:Case 1= -16.7%    Case 2= 22.5%    Case 3= 66.0%    Case 4=  24.2%