International Business Finance at Vodafone Plc - Term Paper Example

international business finance at vodafone plc Preface The moment an entity crosses the geographical boundaries of the home nation, they are bound toface foreign exchange (forex) risk; even within staying within a country, the vulnerability cannot be avoided. The institutions that trade in the global markets are, therefore as well, bound to the forex vulnerability. Forex rate is defined as the units of one currency that can be purchased in terms of another. The general standard for the later is considered the US Dollar (USD). The problem complicates further if the organization deals in various countries with various currencies. The different structures of currency (fixed, pegged, etc.) also influence the risk. Fluctuations in forex rates have a direct impact on the sales revenues, and thus the profits of importers and exporters. This impact can be at all the three levels; short-run, inter-mediate term, and the long run. There are 4 factors that influence the fluctuation of forex rates: a) Interest Rates b) Inflation c) Balance of Trade d) Economic Growth Exposure and Forex Risk There are three types of Exposure related to the risk of foreign exchanger: 1 Accounting Exposure Transaction Exposure Operating Exposure Translation or Accounting Exposure: Is the sensitivity of the real domestic currency value of Assets and Liabilities, appearing Accounting Exposure It is defined as the elasticity of the real domestic currency value of Assets and Liabilities, appearing in the financial statements to unanticipated changes in exchange rates. This value serves as a standard to evaluate discounted cash-flow evaluation. It is used for income tax purposes and for legal obligation to combine financial statements. Accounting exposure cannot be managed. Selection of valuation technique is immaterial as the choice doesn't affect any real cash flow except for taxes; the only correct method is economic value anyway. For simplicity and a consistent method current rate method is used. Transaction Exposure It is defined as the elasticity of the real domestic currency value of Assets and Liabilities, when assets and liabilities are liquidated with respect to unexpected changes in exchange rates for exporting, importing, or import-substituting firms. As the name suggests, it is the exposure that rises due to trading of goods and services, borrowing and lending funds, etc. Forex transaction exposure can be dealt by with the usage of contractual, operating, and financial hedges. Contractual hedges employ the forward, futures, money and options market. Operating and financial hedges employ the use of risk-sharing agreements, some types of financial derivative, and other strategies. In this part, we focus on contractual hedges. Hedging implies replacement of an unlock future exchange risk with a presently known exchange rate where alternatives such as Forward/Future Market Hedge, Money Market Hedge, Risk shifting (price all products in home currency), Pricing Decisions, or Currency Risk Sharing can be used. Operating Exposure: It is defined as the elasticity of the real domestic currency value of Assets and Liabilities, or future operating incomes to unforeseen changes in exchange rates. They are based on the extent to which the value of the firm - as measured by the present value of its expected cash flows. Scenario I: Closed Economy Internal costs and prices are unaffected by exchange rate changes, therefore no exports or imports. Scenario 2: Open Economy Small, open economy and an international price for all goods and factors increase by 45%. Then, except for contractual exposure effects. There are two widespread misunderstandings about forex as follows: a) Only organizations having international operations are exposed to it b) Quoting prices for trade in local currency would eliminate the exposure. The true assumption that can be concluded from the two concepts is the fact that the structure is fairly static; however, it is not so. Competition from a foreign firm or exports may eventually cause problems for the local vendors as well. The magnitude of the effect is dependent on the magnitude of deviations; demand and supply elasticities; degree of competition; operating leverage; sourcing of inputs; taxes, etc. Thus, managing exposure requires realizing the dynamics of the market and disequilibrium in parity conditions to act in the most suitable manner. MNCs have the advantage of existence in several countries simultaneously, so they can diversify on a global basis. Here, diversifying in operation implies the diversification of logistics, inputs, and sales; while the diversification in financial aspect could be the raising of funds from a cheaper location to finance other ventures1 Companies are exposed to foreign exchange risk through the following types of channels2: Importers: If imports constitute the sales or parts of the sale, a forex impact would affect the firm's cost structure. An import of 160 US Dollars from US to UK (USD 1.6 = EUR 1) implies EUR 10. If the rate changes to 1.4, then the imports become expensive and vice versa. Exporters: If firms are producing locally to entertain the international markets, it is definite to be exposed to forex fluctuations and vulnerability. In the similar example as quoted above, the firm sending goods worth USD160 from US will be in trouble of the forex rate falls, and his commodities are worth just USD140 now, because his margins would shrink drastically. An increment however, i.e. to may be 1.8USD/EUR might see his customers switching because of expensive goods now. Multinationals: If a firm produces as well as sells its produce abroad then it is a multinational firm. Such firms usually create an operational hedge by producing as well as supplying all their produce in local markets. Such firms are therefore not exposed to foreign exchange risks. Forex exposure of all these firms differs largely from the large positive net exposure of exporting firms to the large negative net exposure of importing firms. The multinational firm, in contrast, protects itself from most of the exchange rate exposure due to its foreign sales by balancing foreign currency costs through manufacturing in foreign countries. Strategies for Managing Operating Exposure to Foreign Exchange Risk There are two fundamental strategic views for prevention of losses, these are: a) Fixing the forex rate at the time of transaction b) Hedging and its sub-types Fixing the forex rate at the time of transaction is the simplest phenomenon of all time. It eliminates absolute risk; it actually eliminates any chances of profit or loss due to currency fluctuations Following are the sub-types of h 1. Futures Market Hedging Futures also known as foreign currency future contracts are contracts that allow a company to receive a fixed quantity of future currency at a future time period. Specifically such contracts are accounts receivable for the company in foreign currency. An importer that has accounts payable in foreign currency may hedge its position by purchasing a similar dollar amount of futures. Thus its accounts receivable will then be equal to its accounts payable. Then, if the exchange rate rises, any losses on the foreign payables will be offset by a gain from the futures contract. 2. Forwards Market Hedging Forward contracts are agreements between two companies in which the seller and the buyer agrees to buy or sell an asset at a pre-agreed future date, at a specified price. The specified price is known as the forward price. Therefore the date on which the asset is sold is different from the date on which it is delivered. In such a transaction no cash changes hands. The expected cost of forward hedging is equal to the known cost of foreign currency of it is purchased forward, minus the expected cost of the foreign currency if it is bought spot. There are several advantages of hedging via forward contracts. For example, forward hedging reduces taxes if tax rates are progressive, reduces expected bankruptcy costs, has marketing and hiring benefits, and can improve information on profit centers. These benefits accrue because hedging reduces the volatility of receipts and payments. 3. Parallel (Back-to-back) Financing A back-to-back loan, also referred to as a parallel loan or credit swap, occurs when two business firms in separate countries arrange to borrow each other's currency for a specific period of time. At an agreed terminal date they return the borrowed currencies. Such a swap creates a covered hedge against exchange loss, since each company, on its own books, borrows the same currency it repays. 4. Swaps of Currency A currency swap resembles a back-to-back loan except that it does not appear on a firm's balance sheet. In a currency swap, a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time. 5. Re-scheduling of Loans: Leads and Lags Firms can reduce both operating and transaction exposure by accelerating or decelerating the timing of payments that must be made or received in foreign currencies. Intra-company leads and lags are more feasible as related companies presumptively adopt a common set of goals for the consolidated group. Inter-company leads and lags require the time preference of one independent firm to be enforced on another firm. 6. Re-invoicing center Re-invoicing Centers offer three basic advantages arising from their creation, which are as follows: 1. Managing foreign exchange exposure 2. Guaranteeing the exchange rate for future orders 3. Managing intra subsidiary cash flows Analysis of Vodafone Vodafone operates in a number of countries across the globe3; therefore, it is exposed to forex risks originating mainly from sales and imports4. Transactions in forex are recorded at the prevailing ex-rate on the date of transaction, accounted for the effects of any hedging provision. Foreign currency financial assets and liabilities are translated into sterling at year end rates. The outcome of undertaking global subsidiary, explicit conjunctions, etc turns into sterling at average rates of exchange. The modification, therefore, takes place in the reserves at each term end (usually a year) The forex differential and with-drawings during the fiscal year, are adjusted in the reserves primarily, and profit and loss account otherwise. Vodafone is in the process of using forex agreements, futures, and interest rate swaps to take care of its foreign currency and interest rate exposure. The book value of these is taken into a separate account in the balance sheet, while the true/fair value of these instruments is obtained using discounted cash flows method i.e. discounting the future cash flows to net present value based on a suitable interest rate.5 Vodafone can run its working exposure to forex utilizing anyone of the following strategies stated above. A list of Vodafone's subsidiary is accessible on page 9 of the annual report. To illustrate how some of the strategies can be used by Vodafone to minimize risks are as follows: Back to back loans An agreement in which two organization not in the same region scrounge each other's exchange for a given period of time, in order decrease foreign exchange risk for both of them, also known as called parallel loans. (http://www.investorwords.com/380/back_to_back_loans.html) In such an arrangement, Vodafone can easily access loans from any of the countries in which their subsidiary exists, and utilize in any other region, where the interest rates might be on the higher side Cross Currency Swap to Hedge Currency Exposure Vodafone can also try entering into a cross currency swap to hedge the currency exposure. This would assure them the utilization of foreign currency cash inflows to service debt. "Cross-currency swaps allow an organization to switch from one currency to another. For example, using a bond issue an institution can tap a source of fixed rate funds in the euro market, where its name may be well known and its credit well perceived, and swap into another market, dollars say, to achieve funding at a level significantly better than direct issuance offers. This type of liquidity arbitrage is a major source of supply in determining cross-currency swap levels. The converse of this, the asset swap or synthetic floater, works to counteract this price action, but as this market is smaller, the effect of new bond issuance tends to dominate". (http://www.financewise.com/public/edit/riskm/currencyrisk/crsr-currencyswapsprimer.htm) Read More