Long-term risk affecting firm value

1
Operating Exposure

• Long-term risk affecting firm value
• Managing operating exposure

2
Operating exposure

• exposure to changes in the PV of the firm
• Net Cashflows come from the Income Statement

3
Income Statement

• Revenues
• (Cost of goods sold)
• (Operating costs)
• (Capital cost allowances)
• Incidental income
• Incidental expenses
• (Taxes)
• Net Income

4
Profit variables
Labour Costs
COGS
Input prices
Overhead
Operating Costs
Administrative costs
5
Equilibrium case

• exchange rates accommodate changes in relative
  inflation
• relatively low inflation countries
• exchange rate appreciates
• to accommodate relative inflation
• transaction exposure can be hedged
• volatility

6
Disequilibrium case

• potential changes in real exchange rates
• assume real exchange rate appreciates
• Canadian dollar buys more in real terms
• transactions exposure is hedged
• typically 90 days forward
• Continuing exposure beyond 90 days cannot be
  hedged
• revenues will decrease (Canadian exports)
• (and) costs will decrease (Canadian imports)

7
Causes of disequilibrium

• governmental intrusion in normal goods market
  activity
• tariffs
• quotas
• subsidies
• governmental capital restrictions
• movement of capital out of the country
• exchange market restrictions

8
Tariffs
Pe
Qe
9
Tariffs

• marginal cost curve the supply curve
• equilibrium where marginal cost equals marginal
  revenue
• marginal costs curve shifts outward
• new equilibrium
• higher import prices renders them non-competitive

10
Quotas
Pe
Qe
11
Quotas

• government mandates limit to supply
• creates a vertical supply curve
• well short expected market equilibrium
• higher prices for imported products
• new equilibrium
• higher import prices renders them non-competitive

12
Subsidies
Pe
Qe
13
Subsidies

• Government gives cost advantage
• direct subsidy
• grants
• seed money
• indirect subsidy
• tax breaks/incentives
• lowers marginal costs to domestic firm
• more competitive relative to foreign competition

14
Regulatory intrusion

• restrict products for non-compliance
• labour laws
• environmental laws
• safety laws
• create bureaucratic barriers
• licensing
• customs declarations
• official delays

15
Monetary policy affects

• monetary policy, high relative inflation
• exchange rate depreciation
• high volatility
• higher costs of hedging
• exchange rate policy, high relative inflation
• frequent exchange market intervention
• attempts to peg
• frequent devaluations
• capital controls

16
Fiscal policy affects

• high deficits
• financing costs increase country risk
• higher interest rates
• exchange rate depreciation
• increased exchange rate volatility
• adds to normally high debt load
• higher taxes
• higher political risk

17
Managing Operating exposure - diversification

• diversifying operations
• multicountry sales
• multicountry production
• outsourcing
• diversifying financing
• reduce WACC

18
Managing operating exposure - changing operating
procedures

• leads/lags
• risk sharing
• Re-invoicing centers
• this is really transaction exposure
• matching currency flows
• loan in foreign currency
• seek inputs invoiced in foreign currency
• swaps

19
Operating exposure real exchange rate changes

• domestic firms with domestic market
• international competition
• real exchange rate changes affect competitiveness
• Canadian firms used to undervalued dollars
• exporters dont have to compete hard
• assume cd appreciates in real terms
• Canadian exports become more expensive
• foreign imports become less expensive