Corporate Financial Decision Making - Example

Corporate Financial Decision Making School Table of contents Introduction………………………………………………………………………………………3 Company Analysis………………………………………………………………………………..3 Major Foreign Exchange Exposure………………………………………………………………4 Transaction Exposure………………………………………………………………………….4 Operating Exposure……………………………………………………………………………4 Translation Exposure…………………………………………………………………………..4 Institutional Practices of Foreign Exposures Risk Management…………………………………5 Operating Exposures……………………………………………………………………………...6 Case study……………………………………………………………………………………..6 Management of Operating Exposure……………………………………………………………..7 Hedging Exposures……………………………………………………………………………….7 Currency Futures or Options……………………………………………………………………..9 Future Contracts……………………………………………………………………………….9 Options………………………………………………………………………………………..10 Recommendations……………………………………………………………………………….10 Conclusion……………………………………………………………………………………….11 List of References……………………………………………………………………………….12 1. Introduction This report is aimed at assessing the risks attached to the currency dealt in by M/s. Bright limited. The report will help elaborate the key points, tools, instruments and techniques used in making corporate financial decisions. Being in operations worldwide, M/s. Bright limited mostly faces foreign exchange exposure and hence needs to make quality financial decisions to prevent losses due to such risks. Financial decision making is the analysis of financial problems that are being faced by the company and then deciding about what action should the company take to solve these problems. To make such financial decisions, a company must have the capability of identifying the potential financial issues and analyzing the outcomes that the alternatives adopted would have. Hence, it is important for a decision maker to have a good ability to use his analytical techniques of financial data. 1. Company Analysis M/s. Bright limited company is incorporated as a public company and it deals in all major operations relating to oil industry. It is a well reputed company and is highly involved in the main oil services. It also provides oil equipment to other small company like rig machines and drilling equipment for the exploration and preparation of oil wells. It started its operations 15 years back and now also deals in other countries same sort of companies so are subject to foreign currency fluctuations and regulations. Any change in those foreign currencies also affects their financial position as receipts and payments from foreign debtors and creditors are affected when foreign currency fluctuation occurs. Company has some professionals relating to the foreign exchange regulations who have wide and diversified knowledge so they avoid major penalties and non-compliances with those regulations. Company’s upper level management is also well aware of such foreign exchange regulations so they had an eye on the accounting treatment and financial disclosures relating to these foreign exchanges. Company’s major debtors and creditors are from foreign countries so the company payments and receipts are widely affected from such foreign exchange regulations. 2. Major Foreign Exchange Exposures Foreign exchange exposure measures the potential for net cash flow, profitability, and market value to adjust due to a change in exchange rates of a firm (Austin, 2002). As M/s. Bright limited is a multinational company, it is always challenged by the foreign exchange exposures. Translation and operating or economic exposures affect the company most. The company has some short term investment in foreign countries yet for the company, it is not a substantial investment. Conversely, the company’s profit after tax showed an increase of almost 9% which was due to the effects of both the negative currency translation and long term investment (economic or operating exposure). Transaction exposure The M/s. Bright limited quotes that the transaction exposure or total credit was 19,322 million USD in total for the year ended 2013. Exposure from accounts receivables, short term investments and others was 5,233 million, 5,888 million and 393 million USD respectively. Operating exposure Increase in the prices of products and also the inflation rate in majority of the supplier countries has also increased the economic exposure. Additionally, as the company’s transactions are in USD mainly, the USD’s fluctuations against the home currency of the main supplier affect the purchasing negatively. Furthermore, the company’s operating results also got affected by 381 million Euros. On the other hand, according to annual report 2012, exposure on the assets was 24329 million USD. Translation exposure Despite the fact that M/s. Bright limited is a multinational business, it major accounts are kept in Euros which signifies this company to have massive translation exposure as all the currency would be needed to be translated into the home currency. Annual report of 2012 mentioned that the company had negative outcomes of translation exposure 504 Million Euros. 3. Institutional Practices of Foreign Exposures Risk Management The FOREX (Foreign Exchange market) is a marketplace in which the members/participants sell, buy, speculate and exchange on currencies. Members/participants include businesses, banks, hedge funds, investment management firms, and retail FOREX brokers (Brian Coyle (Series Editor), 2001). Looking at the Canadian markets, 87% of the Small-to-Medium Enterprise Business (SME) market, in Canada, either export or import, which indicate quite clearly that Canada strongly depends on a foreign trade activity (Brian Coyle (Series Editor), 2000). Currency markets are volatile or "risky" as they are highly liquid, with fluctuating exchange rates. This volatility results in companies making losses and gains in the foreign exchange markets. To avoid losses arising due to these risks, the multinational companies adopt solid measures. These measures include: Institutional tools or practices Financial tools Financial tools include Future contracts, options, SWAP and so on. While the institutional tools are discussed in brief as follows: Currency invoice: here the invoices are issued in one unique/common currency. Matching receipts and payments: in this method, inflows in foreign currency are matched by the company with the outflows in the foreign currency. Leading and lagging: another technique to tackle such risks is the leading and lagging. In leading, the companies pay and collect early while in lagging the companies pay or collect late. Netting: in netting process, the credit balances are set of/netted of against each other so that the parties are required to pay only the net amounts by actual currency flows. Matching assets and liabilities: this technique involves the financing of a company’s assets with oversees borrowings. 4. Operating Exposures Operating exposure analysis calculates the effect of changes in exchange rates on the operations of a firm over the coming future and upon its rivalry position with the other firms. Both transaction exposure and operating exposure are interrelated in a sense that both they deal with the future cash flows (Baker & Powell, 2005). They differ from each other in terms as to which cash flows are considered by the management and why changes occur in those cash flows change when exchange rate changes (Pike & Neale, 2008). Let suppose the exchange rate of Euro changes from 78.2 to 110. The effect of such a change will be shown in three different perspectives: Customers Two scenarios may be discussed in this regard. Scenario 1 Assume that market in a foreign country is very competitive and any increase in price will result in loss of customers. Converts $1000000/120 8333 Less cost 9000 Profit margin (667) (loss) Scenario 2 Let suppose a unique product has been designed by the company and even an increase in price would not let the customers switch out due to the uniqueness of the poroduct. New price in that foreign country = 1500000 Convert to $1500000/120 12500 Less cost (9000) Profit margin 3500 Conclusion Here it is concluded that the exposure level in the market is determined by the elasticity of demand. The more elastic is the demand for a product the more likely are the consumers to shift with an increase in the price of that product. Competitor Two scenarios can be quoted for competitors also. Scenario 1 Since the competitors of M/s. Bright limited also trade in the same countries and the same currency as M/s. Bright limited does, therefore any increase in prices by the competitors will enable the company to increase its prices and vice versa. Scenario 2 If Bright Limited’s competitors belong from the same market as the company deals in, then the competitors need not increase their prices and Bright limited will find it very difficult to increase prices. Supplier Suppose if Bright limited operates in a single country and all its input and output is in the same country, then it will have not to face any change in the production costs due to fluctuations in the exchange rate. Now, let assume that Bright limited produces in a country in Europe and supplies in the same country. Here, the company’s input used will be locally sourced. Sales price 1000000 Cost (9000*78.2) (703800) Profit margin 296200 In the base cost, the effect of exchange rate is zero but the profit will get affected. 296200/120 = 2468.33 Conclusion Whenever the revenue and cost are in the same country, operating exposure will be low/ reduced. 5. Management of Operating Exposure Management of operating exposure is a very important task when a company deals in foreign exchange markets. A successful management of operating exposure always yields good results and perfect profits history. To hedge operational management’s risk is essential in order to have a competitive advantage by reducing operational exposure. Three different techniques/tools are used to manage operational exposure: Structural tools Structural tools are related with changing the strategic decisions of organizations. They are used in minimizing operational exposures. These tools include: Diversification of market Bright limited is operating in many countries and have an expanded business. However, some areas are untouched where it is very necessary for the company to operate to have progress. Diversification of Finance Bright limited borrows money from USA and invests the same in different countries. There is always a risk as these steps increase the exposure of the money. Borrowings in the same currency in which the amount is then invested will reduce the risk and help the company in gaining a competitive advantage. Financial tools An entity may use several financial tools to hedge currency. These may include: Forward currency Future contracts Options SWAP As Bright limited has its receivables distributed with a small amount among large number of customers, the company is facing a huge expense as it relies either on future contracts or options. The company needs to switch to Cross currency SWAP which will be beneficial to the company. 6. Hedging Exposures Trading in futures and betting on the futures prices movements are the same. If the said betting is for the purpose of protecting a position - either short or long - in the principal asset, it is named as hedging (Cesari, Aquilina, Charpillon, Filipovic, Lee & Manda, 2010). If, on the other hand, the activity is carried out only for the purpose of generating profits from relative or absolute price movements, it is then called as speculation (Rajwade, 2010). For a good understanding, we shall quote a case study of the company he case study emphasizing the foreign risk arising because of its operations at numerous geographical locations and dealings in various foreign currencies. Corporate hedging policy exists in this respect yet there is a special case that is addressed in this case study. Special consideration is required by the matter as the existing policy does not much suit the matter. The case issue is that the foreign exchange risk exposure of the company arises from a Canadian subsidiary which operates in the functional currency USD therefore CAD is a foreign currency in case of this subsidiary. Two types of risks are faced by the company in this situation; one is transaction risk and the other translation risk. The company looks forward at various hedging strategies in order to diminish the risks and deal with the issue as deviated from the company’s original policy. In order to that various tools (forward and options contracts) should be studied for various level of hedge ratio as well as satisfactory and opposed situations. Translation risks also need to be discussed and their impact on income statement to be assessed. Forward rates contract is very popular and a greatly used hedging tool. It has both advantages and disadvantages. The major drawback of this type of contract is that it is a binding one which confirms that the company cannot benefit from favorable activities. It is generally used when the company has no interest in gains somewhat pure hedging. Options mean the options to purchase or dispose of specific currency and are generally costly than other tools as they give benefit of realizing positive exposure. The company uses distinct hedging strategies for the aforesaid Canadian dollar risk. Mainly options and forward rates contracts are used. The purpose of these calculations is to shrink the total sum paid by the company against 1.7 billion CAD cash to the sellers. First we find out the most gainful hedging tool on a hedge ratio of 50% and then we approximate the total price paid in using a hedge ratio of 75% and 50 %. Using the relevant given data, we can assess the total price that the company should pay using hedge ratio of 50%. The graph drawn from the same data indicates that the options are more gainful at exchange rate of 1.6. At the said exchange rate of 1.6 both the lines meet each other. These evidences enable us study the gain/ (loss) in the income statement for the 2 situations for hedge ratios of both 50% and 75%. The level of both gain and loss is more in hedge ratio 50% compared to the hedge ratio 75%. Similarly, the volatility of EPS is also more in 75% than that in 50%. The distinction in volatility is due to the higher level of ambiguity involved in non-hedged amount. Translational risk is generally not hedged by the businesses but if its influence is substantial on the incomes of a business then hedging it is a better and safer option. Transaction risks need to be hedged if a high level of instability in the foreign exchange rates is there as the same is in the Canadian subsidiary’s case. 7. Currency Futures or Options Future Contract Now, let us have a look at the analysis of options or currency futures as a speculator. Current analysis: Yearly data March Exchange rate €/$ 2009 1.15850 2010 1.19575 2011 1.13133 2012 1.24479 2013 1.16929 Monthly data 2014 Exchange rate January 1.22326 February 1.21944 March 1.19254 It is clear after analysis of the above data that Euro comparatively depreciates in the month of June. Conversely, Euro has been depreciating from the very start of the year (January). Moreover, inflation rate has also moved from 1.9% to 1.7%. For the above data, the speculated price shall be €1.6923/£ Settle price in June 2014 equals to €1.14325/£ Spot rate €1.20996/£ National principal €2000000 (assumed) National principal €2000000 (assumed) 2000000/1.20996 = 1625947 As the contract size of standardized £ is £62500, therefore number of contract 1625947/62500 = 27 Buy 27 * 62500 = 1687500 So, 1687500 * (€1.16923 - €1.14325) = 43841 (profit) Now, using options, and the same speculation: Strike price in June = €1.14325 Assumed premium = £0.025/€ If exercise: Strike price €1.14325 Payment to be made = €2000000/1.14325 = €1749398 Less premium = €50000 Net payment = 1699398 At the expected rate: €2000000/1.16923 = €1710527 – €50000 = €1660627 Therefore Receipt = 1660627 Less Payment (1699398) (8771) (Loss) Converting it into € (£8771 * 1.16923) = (10225) (loss) Strategy Profit or loss Future €43841 profit Option (call) €10225 loss From the above table and calculations, it is advisable for the company to invest using the future market as the call option will result into a loss of the investors. 8. Recommendations Since, M/s. Bright limited is mostly dependent on European market; it needs its business to be extended to the emerging markets also. To hedge exposures, the company should use Matching Receipts and payments techniques because its financial management is quite complicated. Financial tools SWAP can also be used by the company as its receivables comprise of a large number of customers. Introducing online shopping could also be a very useful step for the company as consumer shopping trend is changing fast. 9. Conclusion Financial position of M/s. Bright limited is already good but consideration of the above mentioned recommendations is still needed. With the fact of changing market, the company should also change some of its strategies. Hedging has some effects on the financial conditions of companies; it reduces exposure, but does not help in increasing expected cash flows of the company. In fact, it reduces the shareholders’ dividend. References Austin J.E. (2002) Managing in Developing Countries: Strategic Analysis and Operating Techniques. Free Press Bychuk O.V., Haughey B.  (2011) Hedging Market Exposures: Identifying and Managing Market Risks. Wiley; 1 edition Brian Coyle (Series Editor) (2000) Hedging Currency Exposures: Currency Risk Management (Risk Management Series). Global Professional Publishing; Revised edition Brian Coyle (Series Editor) (2001) Hedging Interest- Rate Exposures: Interest-Rate Risk Management (Risk Management Series). Global Professional Publishing; Revised edition Baker H. K., Powell G. (2005) Understanding Financial Management: A Practical Guide Wiley-Blackwell; 1 edition Giovanni Cesari, John Aquilina, Niels Charpillon, Zlatko Filipovic, Gordon Lee, Ion Manda (2010) Modelling, Pricing, and Hedging Counterparty Credit Exposure: A Technical Guide (Springer Finance). Springer; 2010 edition Kim, Yong-Cheol & McElreath R. 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