CHAPTER 5

Foreign Currency Debt

A recent study of manufacturing firms from 16 countries found that the average firm hedges 20 to 30% of its FX operating exposure by operational methods, such as operational hedging and FX pass-through. The study also found that the average firm mitigates its FX operating and business exposure a further 40% through financial hedging strategies, mainly with foreign currency debt.¹

This chapter shows how foreign currency debt works to hedge the effects of FX rate changes on a firm with a positive (long) FX business exposure to the foreign currency. As the FX price of the foreign currency changes, the value of the foreign currency debt, when measured in the firm’s home currency, changes in the same direction as the firm’s business value. So, the foreign currency debt dampens the impact of FX fluctuations on the firm’s equity value.

But debt in any currency also involves the risk connected with financial leverage, which can magnify FX business exposure in the manner we saw in the previous chapter. Therefore, we need to keep the financial leverage effect in mind when analyzing the use of foreign currency debt in the financial hedging of FX business exposure. The chapter also covers some accounting issues of foreign currency debt that managers should be aware of when making financial hedging decisions.

Foreign Currency Debt

How do spot FX rate changes affect the value of a firm’s debt? The answer depends on the currency denomination of the debt. For debt denominated in the firm’s home currency, spot FX changes do not affect the debt value. But for debt denominated in a foreign currency, FX changes do affect the value of the debt when viewed in the home currency, and in a pure FX conversion manner.

For example, assume that a U.S. firm currently has £625,000 in British pound debt, and the spot FX rate is 1.60 $/£. Thus, the value of the debt in US dollars is currently £625,000(1.60 $/£) = $1 million. Assume next that the British pound appreciates by 20%, to 1.92 $/£. The value of the firm’s £-debt in US dollars increases to £625,000(1.92 $/£) = $1.20 million. So, we see that the value of the £-debt in US dollars increases by 20% when the British pound appreciates by 20%. By itself, the $200,000 rise in the US dollar value of the £-debt is a loss to the shareholders.

An example of a foreign currency debt issue is the McDonalds yen bonds floated in 2000 for ¥15 billion (about $125 million); see Exhibit 5.1. Note that although the 10-year bond was denominated in yen, McDonalds could have exchanged the bond issue proceeds from yen into another currency in the spot FX market. In other words, the liability does not have to be denominated in the currency of the country where the proceeds of the issue will be used.

U.S. firms significantly increased their foreign currency debt from around $1 billion in 1982 to about $62 billion in 1998. Between 1993 and 2005, U.S. firms issued an estimated $200 billion worth of foreign currency bonds denominated in euros (or euro legacy currencies), British pounds, Japanese yen, and Swiss francs. The financial hedging of FX operating and business exposure appears to be the main reason for having debt denominated in a foreign currency. One survey found that over 85% of U.S. Chief Financial Officers say that financial hedging is a reason for foreign currency debt.² By hedging FX exposure, foreign currency debt can reduce financial distress costs relative to those faced by a firm that has only home currency debt.³

Exhibit 5.1 McDonalds’ 10-Year Global Bonds

This chapter focuses on the use of foreign currency debt in the financial hedging of FX business exposure, but there are other motivations for foreign currency debt. Some firms may want to have foreign currency debt when they think the currency is overvalued, hoping to capture a gain when the currency realigns with the intrinsic FX value. Of course, the issuer would need to trade-off the anticipated speculative FX gain against two downsides. The first is the risk that the foreign currency might appreciate instead of depreciate. Second, there may be undesirable accounting implications, which we cover later in the chapter. While some firms might speculate on foreign currency movements in this way, many firms would not consider this strategy.

However, researchers have reported that many companies issue foreign currency debt if the interest rate is low, under the apparent belief that the uncovered interest rate parity (UIRP) condition does not hold. The UIRP condition says that for two currencies, the lower interest rate currency should be expected to appreciate versus the higher interest rate currency. If corporate managers do not project this FX appreciation, the managers basically believe that the currency with the lower interest rate is overvalued, given the UIRP approach to intrinsic FX value.⁴

For example, the interest rate on the McDonalds yen bond in Exhibit 5.1 is low, 2%, compared to the interest rate on 10-year US dollar corporate bonds of around 6.50% at the time. Does this mean that McDonalds got a cut-rate deal by issuing bonds in yen rather than in US dollars? The answer would be “no” if the UIRP condition holds, because the yen would be expected to appreciate at a rate that offsets the interest rate differential. Thus, McDonalds would pay a low interest rate, but the value of the yen debt would be expected to rise in US dollars, which would be a loss that offsets the interest rate differential. But if McDonalds’ managers forecast the FX price of the yen (versus the US dollar) to change at a lower rate than expected under the UIRP condition, they would have been implicitly taking advantage of a perceived opportunity to issue bonds denominated in an overvalued foreign currency.

Foreign Currency Debt and FX Equity Exposure

As covered in a previous chapter, a firm’s FX equity exposure is the elasticity of the firm’s equity value to spot FX changes, viewed from the perspective of the firm’s home currency. A U.S. firm’s FX equity exposure to the euro is denoted by and is computed as %ΔS^$/x^$/€, the percentage change in the equity value in US dollars, given the euro’s percentage FX change versus the US dollar. Chapter 3 showed that when a firm’s net debt is entirely in the home currency, a firm’s FX equity exposure to a currency depends on the firm’s FX business exposure to the currency and the net financial leverage. Now we analyze the effect of net debt denominated in the exposure currency.

For example, assume that the U.S. firm Intex Co. has: (a) FX business exposure to the euro of = 1.20; (b) a business value in US dollars of = $2,000; (c) a net debt value in US dollars of ND^$ = $600, of which 75% ($450) is denominated in euros. Thus, the equity value is currently S^$ = $2,000 − 600 = $1,400, as shown in the top panel of Exhibit 5.2.

Assume a 5% “what if” depreciation of the euro versus the US dollar. Owing to the FX business exposure of 1.20, the business value drops by 1.20(5%) = 6%, to 0.94($2,000) = $1,880. From the US dollar perspective, the value of the euro-denominated net debt drops by 5%, from $450 to $427.50, whereas the value of the US dollar net debt stays at $150. The “what if” equity value is $1,880 − 427.50 − 150 = $1,302.50, as shown in the bottom panel of Exhibit 5.2.

Exhibit 5.2 Intex Co. Value Balance Sheet $450 Euro Net Debt

The percentage change in the equity value would be $1,302.50/ $1,400 − 1 = −0.0696, or −6.96%. The FX equity exposure to the euro is thus −0.0696/−0.05 = 1.39. If $450 (of $600 total debt), is euro- denominated, the FX equity exposure of 1.39 is lower than that found in Chapter 3 in the example where all $600 of the net debt is denominated in US dollars, 1.71.

Figure 5.1 shows Intex’s FX equity exposure for the two cases where the ratio of net debt to business value is 30% and the FX business exposure is 1.20. For the case where 75% net debt is denominated in euros, the FX equity exposure is lower, 1.39, than for the case of no euro-denominated net debt, 1.71.

To show this effect in an equation, let denote the value, measured in US dollars, of the firm’s euro-denominated net debt. ND^$ denotes the value of all the firm’s net debt, measured in US dollars, regardless of currency denomination. The relationship for FX equity exposure as a function of FX business exposure and capital structure is shown in equation (5.1).

Figure 5.1 FX equity exposure and denomination of debt

FX equity exposure for two cases with 30% net financial leverage and FX business exposure of 1.20. When 75% of net debt is denominated in euros, the FX equity exposure is lower, 1.39, than when none of the net debt is euro-denominated, 1.71.

Fx Equity Exposure & Foreign Currency Net Debt

We demonstrate equation (5.1) using the previous Intex example. Since 75% of Intex’s $600 in net debt is denominated in euros, the ratio of euro-debt to business value = = $450/$2,000 = 0.225, and the overall financial leverage ratio = ND^$ / = $600/$2,000 = 0.30; the FX equity exposure of 1.39 (found earlier) is consistent with equation (5.1): = [1.20 − 0.225]/[1− 0.30] = 1.39.

Equation (5.1) is a special case of equation (3.2), where all debt is in US dollars and thus = 0. Applying equation (5.1), we have that = [1.20 − 0]/[1− 0.30] = 1.71, as already found.

You can see from equation (5.1) that by setting the ratio of euro net debt to business value equal to the FX business exposure, , the FX equity exposure is 0. Thus it is possible, in principle, to completely hedge FX business exposure solely with foreign currency net debt.

If a company has FX business exposure to the euro of 0.20, for example, and it has €-net debt in the amount of 20% of business value, the company has zero FX equity exposure to the euro. Note that the book value of the business is irrelevant in finding the level of €-debt that eliminates FX equity exposure. The drivers are the firm’s business value and the FX business exposure.

FX business exposure to a currency may be relatively low, like 0.20, for a company with a relatively small proportion of business in an overseas market. But other companies have higher FX business exposures. A company with an FX business exposure to a foreign currency of 0.80 could, in principle, eliminate its FX equity exposure to the currency by having net debt denominated in the exposure currency in the amount of 80% of the firm’s business value. Then again, it may be unreasonable for a company to have net financial leverage as high as 0.80. The next chapter addresses this problem further with currency swaps.

It should now be clearer why we have delved into measuring FX exposure. A quantitative estimate of FX business exposure indicates the size of the financial hedge that will mitigate the FX risk. We need to acknowledge that real-world managers can at best come up with a crude estimate of their company’s FX business exposure to a currency. Still, it is useful for managers to understand the usefulness of a quantitative FX business exposure estimate.

Foreign Currency Debt and Hedge Accounting

We have seen that if the euro depreciates by 10% versus the US dollar, the US dollar value of euro-denominated debt drops by 10%. We have so far been thinking about this kind of change in debt value in an economic sense. We now want to compare this intrinsic value approach with how the accounting works for book values in a firm’s reported financial statements.

For a 10% drop in the euro versus the US dollar, the standard accounting treatment is to write down the book value (in US dollars) of euro-denominated debt by 10%. The drop in foreign currency debt book value, measured in US dollars, is a gain that results in an increase in the book value of the firm’s equity.

An important question is whether the gains/losses of changes in foreign currency debt book value are considered in the computation of the period’s current reported earnings or not. Accounting rules for foreign currency debt generally require that the FX gains/losses be included in current earnings, but an exception to the rule is granted if the foreign currency debt qualifies as a hedge under the rules for hedge accounting. Other things the same, managers would prefer to not have the additional earnings volatility created by including the FX gains and losses, and therefore would like to have foreign currency debt positions qualify for hedge accounting treatment.

The most common way for foreign currency debt to qualify for hedge accounting is as a net investment hedge. The idea is that if the foreign currency debt hedges the FX translation changes of the book value of a firm’s net investment in a foreign affiliate, the firm may elect to have the changes in the debt’s book value receive the same accounting treatment as the FX translation changes. In this treatment, the changes in the foreign currency debt book value by-pass current earnings and go directly to the cumulative translation adjustment (CTA) account in the equity section of the balance sheet. If the foreign currency debt book value, measured in the home currency, is equal to the book value of the net investment in the foreign affiliate, then the CTA account does not change, because the changes in the debt book value exactly offset the FX translation changes in the book value of the net investment in the foreign affiliate.

For example, say International Instruments owns a subsidiary in Spain, the subsidiary’s functional currency is the euro, and the net investment book value at time 0 is $10 million. Also, assume that International has euro-debt with a time-0 book value of $10 million. Assume that the euro depreciates by 10% versus the US dollar: (1) The net investment book value drops to $9 million, and the $100,000 FX translation loss, like all FX translation gains/losses, by-passes current earnings and goes to the CTA account. (2) The euro-debt book value drops to $9 million, and following hedge accounting, the $100,000 gain by-passes current earnings and goes to the CTA account. The CTA account does not change, because the gain on the euro-debt book value offsets the FX translation loss on the foreign asset.

Foreign currency debt automatically qualifies for hedge accounting as a net investment hedge for an amount up to the book value of the net investment. The excess of a firm’s foreign currency debt over the net investment book value does not qualify for hedge accounting as a net investment hedge. The gains/losses on any portion of foreign currency debt not qualifying for hedge accounting must be reported in current earnings. These gains/losses will implicitly go to the equity section of the balance sheet via retained earnings.

For example, say International Instruments has euro-debt with a time-0 book value of $15 million. Assume that the only Eurozone asset is the Spain operation, with net investment book value of $10 million. Any amount of €-debt up to the net investment automatically qualifies as a net investment hedge, but any €-debt above $10 million does not qualify as a net investment hedge. With $15 million in €-debt, the firm may elect for $10 million to receive hedge accounting treatment, but not the remaining €-debt, $15 million−10 million = $5 million.

The accounting treatment of the changes in the book value of $10 million of €-debt that receives hedge accounting is the same as described previously. Both changes by-pass current earnings and go directly to the CTA account, where they offset each other. The changes in the book value of the other $5 million of excess €-debt that does not qualify as a net investment hedge do figure into the reported earnings each period. For example, if the euro depreciates by 10% versus the US dollar, the book value of the $5 million “excess” €-debt drops by $500,000. This drop is regarded as a gain that needs to be included in the calculation of the reported earnings for the period.

What if International Instruments has only $5 million in €-net debt and $10 million in US dollar debt? In this case, there will be no impact of FX changes on reported earnings, because all the $5 million in €-net debt automatically qualifies for hedge accounting as a net investment hedge. However, there will be some FX translation exposure in the book value of the firm’s equity. The reason is due to the FX translation change on the $10 million book value of the net investment in the Spain operation, but only $5 million in €-net debt financial hedging position.

In principle, International Instruments might be able to get a higher amount of €-debt to qualify for hedge accounting as a cash flow hedge, perhaps because a different operation has some revenues denominated in euros. However, qualifying a financial position as a cash flow hedge is more difficult than as a net investment hedge. The accounting rules for cash flow hedges require proving that the cash flow is “highly predictable.” For U.S. firms, there is a heavy documentation burden in qualifying a financial position as a cash flow hedge. This issue is usually not as much of a problem for non-U.S. companies.

All-in-all, many managers may be discouraged from financial hedging of FX business exposure by the accounting implications. For example, assume that International Instruments’ FX business exposure is 0.30, the business value is $50 million, and so $15 million of euro net debt would make the FX equity exposure equal to 0. Since the net investment book value is only $10 million, International Instruments’ managers face a trade-off. If International Instruments chooses to hedge with only $10 million in euro-denominated debt, the company has no FX accounting exposure, but has FX equity exposure. That is, FX changes in the euro will not affect reported earnings or the book value of International Instruments’ equity period-by-period, but will affect the firm’s equity value.

Instead, if International Instruments chooses to hedge with $15 million in euro-denominated debt, the company has no FX equity exposure, but has FX accounting exposure in the form of higher volatility in reported earnings. Also, the gains/losses that go through current earnings are reflected in book equity in the accumulated retained earnings (ARE) account. So, there will be a negative FX accounting exposure of the book value of International Instruments’ equity. International’s managers would have to use their judgment in choosing the €-debt level, trading-off the benefits of hedging FX business exposure with the accounting implications. To avoid accounting distortions, many managers may tend to not use more foreign-currency debt than the amount that qualifies for hedge accounting. Companies with an indirect FX business exposure to a foreign currency face a similar situation. If the company has no foreign assets of foreign currency cash flows, the company must either accept the accounting implications or not use financial hedging.⁵

The next boxed example compares the accounting effects of financial hedging on a firm’s reported balance sheet with the “economic” effects on intrinsic values.

Hedging Negative FX Business Exposure

If a company’s FX business exposure to a currency is negative, positive net debt denominated in that currency does not hedge the FX exposure and in fact will exacerbate it. For example, recall from Chapter 3 the U.S. firm San Jose Scientific Co., with a natural short FX business exposure to the yen of −1.20. Assume that all San Jose’s net debt is denominated in yen, and the net financial leverage ratio is 0.30. The firm’s FX equity exposure to the yen, from equation (5.1), is equal to [−1.20 − 0.30]/[1 − 0.30] = −2.14. Thus, a classic importer, with a negative FX business exposure to a currency, cannot use positive net debt denominated in the exposure currency to manage its FX exposure problem.

In principle, one way for a firm to manage a negative FX business exposure is with negative net debt denominated in the exposure currency. For example, say San Jose’s business value is $2,000. From equation (5.1), the ratio of ¥-net debt to business value that eliminates FX equity exposure should be −1.20, implying that the ¥-net debt should be −1.20($2,000) = −$2,400, or $2,400 in ¥-cash. The company would have $4,400 in total value: $2,000 in business value and $2,400 in ¥-cash. The equity value is $4,400.

As Exhibit 5.3 shows, if the yen appreciates by 10% versus the US dollar, the US dollar value of the ¥-cash rises by 10%, to $2,640, while business value drops by 12%, from $2,000 to $1,760. So, equity value is unchanged. Of course, there are limits to a firm’s cash level, particularly if the cash is denominated in foreign currency. We’ll address this issue also with currency swaps in the next chapter.

Exhibit 5.3 San Jose Scientific Co. Value Balance Sheet

FX Business Exposure = −1.20; $2,400 ¥-Cash

A firm that has a negative FX business exposure to a foreign currency has a more challenging accounting problem than a firm with positive FX exposure. In principle, the firm can hedge the FX exposure with a foreign currency cash (“negative net debt”) position, but the accounting rules would not allow the position to qualify as a net investment hedge. So, unless the company is willing and able to get the position qualified as a cash flow hedge, the company has two choices. The first is to hedge and tolerate the effect on current earnings of the FX changes on the foreign currency cash position. The second is to not hedge.

FX Hedging and Financial Leverage

Equation (5.1) shows how two effects of foreign currency net debt interact. First, the FX hedging effect of net debt denominated in the exposure currency is seen in the numerator. The negative sign on the term implies that if a firm with positive FX business exposure uses a positive level of €-net debt, other things the same, the FX equity exposure is lower than using non-€-net debt. Second, the financial leverage effect of all net debt, denominated in the exposure currency or otherwise, is seen in the denominator. Higher net financial leverage causes a higher FX equity exposure, opposite to the direction of the FX hedging effect.

Unless net debt is higher than business value, the ultimate influence of foreign currency debt on a firm’s FX equity exposure depends on the firm’s FX business exposure to the currency. If the FX business exposure is higher than 1, the FX equity exposure is always higher than FX business exposure. In addition, we get the somewhat surprising result that the more net debt denominated in that currency in lieu of equity, the higher the FX equity exposure.

To illustrate, say Granger Controls Co. is initially an all-equity company with = S^$ = $2,000, and FX business exposure to the euro is 1.20. As Granger has no net debt, the FX equity exposure is initially equal to its FX business exposure, 1.20. Next, say Granger wants to try to hedge its FX business exposure to the euro by having some euro-denominated debt. Assume that at time 0, Granger recapitalizes by issuing euro debt with a value in US dollars of $500 and uses the proceeds to repurchase shares, making the new equity value $1,500. So the net financial leverage ratio, ND^$ / , is $500/$2,000 = 0.25, and the new ratio of €-net debt to business value, , is also $500/$2,000 = 0.25.

As shown in Exhibit 5.4, if the euro depreciates by 5% versus the US dollar, Granger’s business value drops by 6%, to $1,880. The value of the €-net debt in US dollars drops by 5%, from $500 to $475. The “what if” time-1 equity value is thus $1,880 − 475 = $1,405, and the percentage change in equity value is thus $1,405/$1,500 − 1 = −0.0633, or a 6.33% drop. The FX equity exposure to the euro is −0.0633/−0.05 = 1.267. Since = 0.25 and ND^$ / = 0.25, the FX equity exposure to the euro of 1.267 is consistent with equation (5.1): = [1.20 − 0.25]/ [1 − 0.25] = 1.267. Thus, by increasing the €-net debt and replacing equity, Granger would raise its FX equity exposure to the euro from 1.20 to 1.267. The reason is that the FX business exposure > 1.

Exhibit 5.4 Granger Controls Co. Value Balance Sheet

$500 Euro Net Debt

Issues in Financial Hedging

Using net debt to hedge FX business exposure is an application of financial hedging. In the theoretical world of perfect financial markets, financial hedging of FX operating/business exposure is “irrelevant” in that it does not affect the current intrinsic value of the firm’s equity. Academics recognize that in the real world however, hedging FX operating exposure will typically reduce the costs of financial distress, including the cost of the inability to carry out strategic plans. Moreover, Wall Street wants stability in reported earnings and growth rates, and thus stabilizing the cash flow stream has a desirable impact on the real-world stock price. So, the typical academic advice is that financial hedging of FX operating/business exposure is a good idea.

Still, some firms choose not to hedge FX operating and business exposure. Managers justify this decision in diverse ways: (a) Some think that the impact of FX changes will even out over time in the long run. These managers are not concerned about the costs of financial distress. (b) Others do not want to regret hedging, when it turns out that with “20–20 hindsight,” not hedging would have led to a better outcome. (c) Still others think that some shareholders want FX exposure and thus do not want hedging; and any shareholders who do not want FX exposure are free to use their own financial hedging. (d) Some are not willing to live with the accounting rules for financial hedging, as explained earlier. (e) If the hedging involves financial derivatives, like forward FX contracts, some managers may not hedge because derivatives are often viewed negatively by those who do not understand the useful role of derivatives in hedging.

But many firms do hedge FX operating and business exposure. Some hedge because in reality, a firm’s shareholders often cannot hedge FX exposure on their own even if they want to, as the firm’s FX exposures are too complex for them to understand. And providing shareholders with information on FX operating exposures would be expensive and might reveal strategic information to competitors. Other firms simply agree with the academic advice that in the imperfect markets of the real world, financial hedging will reduce the costs of financial distress.⁷

Some firms use financial hedging when operational strategies are not viable. For a mining company that cannot change the location of its operations, for example, there may be no way to do operational hedging. Other firms use financial hedging after all reasonable strategies for operational management of FX exposure have been implemented. Some firms use financial hedging of FX operating and business exposure as an alternative to operational strategies, sometimes in cases where operational hedging is too permanent and financial hedging is more flexible. Still other firms use financial hedging as an intermediate-term measure while more strategic operational solutions to FX operating and business exposure are being developed.⁹

Other Issues with Foreign Currency Debt

If a firm’s debt and equity are correctly valued in the financial market, the traditional “trade-off theory” of capital structure says that a firm’s optimal debt level is one that maximizes the difference between the tax shield benefits of debt interest and the costs of financial distress. Both variables get larger as a firm increases its net financial leverage. At relatively low debt levels, the tax shield benefits outweigh the financial distress costs, but at relatively high debt levels, the situation is reversed. The trick is to find the optimal debt level, where the net difference between the tax benefits and the financial distress costs is maximized. And if a firm’s debt and equity are not correctly valued in the market, this misvaluation is an additional factor that, in principle, managers should consider for a firm’s optimal capital structure. Ignoring misvaluation and tax issues, the optimal foreign currency debt level is the one that minimizes financial distress costs. Therefore, the idea would be to achieve an FX equity exposure of 0, which we demonstrated.

But as we said earlier, some managers may want to also consider an FX misvaluation in the foreign currency debt decision. Let us say that the business value is $10,000 and the FX business exposure to the euro is 0.30, so that $3,000 of net debt in euros would make the FX equity exposure equal to 0. If the euro is undervalued versus the US dollar, the firm may want to have less than $3,000 in net debt in euros. By the same token, the more undervalued the euro, the less net debt in euros that the firm would want to have. If the euro is overvalued versus the US dollar, the firm may want to have more than $3,000 in net debt in euros. The more overvalued the euro, the more net debt in euros that the firm would want to have. However, there is no formula for this trade-off at present, and so managers must use their own judgment on this matter.

Regardless of whether debt is issued by a subsidiary or the parent, the impact on hedging FX business exposure and the accounting implications are the same. Other factors may influence the choice, however. For example, sometimes a foreign subsidiary can issue parent-guaranteed debt denominated in the local currency at a lower interest rate than the parent would have to pay. In this case, a parent can have the subsidiary issue debt. Another reason to have a subsidiary issue its own debt locally is to manage “political risk exposure.” That is, being indebted to local country lenders may reduce the probability and magnitude of incurring “political problems” with the local government. Finally, corporate taxes may also have an impact on the decision as to which entity should issue the debt.

Regarding taxes, many countries, including the United States, are on a so-called worldwide tax system. In such a tax system, taxes are paid to a parent’s home government on the foreign income of a subsidiary, but credit is given for foreign taxes paid by the subsidiary. Therefore, if the foreign tax rate is higher than the parent’s home tax rate, there will be more than enough credit for foreign taxes paid to ensure that the parent will not have to pay any tax to its home country government on the foreign income of the subsidiary. On the other hand, if the foreign tax rate is lower than the parent’s home tax rate, the credit for the foreign taxes paid will not be as much as what would be owed to the parent’s government on the foreign income of the subsidiary. In summary:

Therefore, all else the same, if the foreign tax rate is higher than the home country tax rate, a U.S. company’s debt should be issued by the foreign subsidiary rather than the parent, because the tax benefits of the debt’s interest payments will be greater due to the higher effective tax rate. On the other hand, if the foreign tax rate is lower than the home country tax rate, it does not matter which entity issues the debt, because the effective tax rate is the same in either case.

In some of our earlier examples, the financing of a foreign subsidiary consists of equity owned by the subsidiary’s parent and possibly some external debt. Frequently, foreign subsidiaries are also financed with internal debt, that is, a loan from the parent. If there were no taxes and no restrictions on repatriation of income, an internal loan from a parent would be equivalent to equity. But sometimes a country’s rules on a subsidiary’s dividend payments to a parent are more restrictive than the rules on payment of interest. So the internal loan approach can be a way around the restrictions and tax problems on the repatriation of foreign income back to the parent.

Even if there are no restrictions on the repatriation of a foreign subsidiary’s income, tax differences can be a driver of a parent’s decision on how to structure its internal financing of a foreign subsidiary. Again, assume that the parent is domiciled in a country on a worldwide tax system. If the foreign tax rate is higher than the parent’s home tax rate, the parent should structure the internal financing with as much debt as possible. This way, the tax payments to the foreign country are minimized. The interest on the debt received by the parent is taxed at the parent country’s lower tax rate. On the other hand, if the foreign tax rate is lower than the parent’s home tax rate, the parent should structure the internal financing with as much equity as possible. The reason is that home country taxes on the foreign income can often be deferred into the future if not repatriated as dividends.

Summary Action Points

• Sometimes a firm can use foreign currency net debt to hedge FX business exposure to a foreign currency. Having foreign currency net debt involves a financial leverage effect in addition to an FX hedging effect.

• When FX business exposure is positive and less than 1, foreign currency net debt is often an effective way to hedge FX business exposure.

• When FX business exposure is negative, a foreign currency cash position can be an effective way to hedge the exposure.

• When FX business exposure is greater than 1, the financial leverage effect dominates the FX hedging effect, which may create problems when managers try to use foreign currency debt for hedging.

• The impact of FX changes on the book value of foreign currency net debt can make a firm’s reported earnings more volatile, unless the foreign currency debt qualifies for hedge accounting.

• Other than FX business exposure, some of the factors that managers should consider in deciding the optimal level of foreign currency debt for a given firm are financial distress costs, misvaluation of the currency, accounting implications, and taxes.

Glossary

Cash Flow Hedge: Financial instruments may, in some cases, be regarded as a hedge of foreign currency cash flows, and thus qualify for hedge accounting.

Financial Hedging of FX Exposure: Hedging FX risk using financial instruments instead of using operational strategies.

Hedge Accounting: An accounting treatment allowing the gains/losses on financial instruments to not affect current earnings when changes in the value of underlying asset being hedged do not affect current earnings.

Net Investment Hedge: Financial instruments that hedge the book value of a firm’s net investment in a foreign affiliate, which automatically qualify for hedge accounting treatment.

Worldwide Tax System: For a multinational company headquartered in a country on a worldwide tax system, taxes are paid to a parent’s home government on the foreign income of a subsidiary, but credit is given for foreign taxes paid by the subsidiary.

Problems

1. A U.S. company issues €20 million of euro-denominated debt when the spot FX rate is 1.25 $/€. (a) What is the value of the debt in US dollars? (b) What is the value of the debt in US dollars if the euro depreciates by 10% versus the US dollar?

2. Assume that a U.S. firm’s FX business exposure to the euro is 1.60. The firm’s net debt is entirely denominated in euros. (a) The ratio of net debt to business value is 40%. Find the firm’s FX equity exposure to the euro. (b) The ratio of net debt to business value is 70%. Find the firm’s FX equity exposure to the euro.

3. Assume that a U.S. company has an FX business exposure to the British pound of 0.40. The company wants no FX equity exposure to the pound. What amount of net debt should the firm denominate in British pounds if the firm’s business value is $2.50 million?

4. Assume that a U.S. company currently has = $10 million, ND^$ = $4 million, and thus S^$ = $6 million. Assume that the FX business exposure to the euro is 1.25. Assume that $3 million of the firm’s net debt is denominated in euros and the rest is in US dollars. Assume that the euro depreciates by 10% versus the US dollar. (a) Find the new equity value and the FX equity exposure to the euro using the “what if” method. (b) Verify the FX equity exposure using equation (5.1).

5. Assume that a U.S. firm’s business value is $20,000 and the FX business exposure to the yen is −0.35. (a) If the firm has $5,000 in yen cash and no other net debt, find the firm’s FX equity exposure to the yen. (b) Find the level of yen cash that makes the FX equity exposure to the yen equal to 0.

For 6–7: Sarnoff Industries is a U.S. company with business value of $500 million. Sarnoff has $25 million in cash denominated in US dollars. Sarnoff has US dollar-denominated debt of $100 million and euro- denominated debt of €20 million (note amount is given in euros). Assume that today’s spot FX rate is 1.25 $/€. Sarnoff has estimated its FX business exposure to the euro is 0.60.

6. Find Sarnoff’s new business value, the new value in US dollars of the €-debt, and the new equity value if the euro depreciates by 20% versus the US dollar?

7. Find Sarnoff’s FX equity exposure to the euro at time 0.

For 8–11: Randle Supply Company is a U.S. firm with a business value of $28.2 million. Randle has US dollar-denominated cash of $2 million, US dollar-denominated debt of $6 million, and euro-denominated debt of €3 million (note amount given in euros). Assume that today’s spot FX rate is 1.40 $/€. Randle’s FX business exposure to the euro is 0.60. Use the “what if” method with a euro depreciation of 25%.

8. Find Randle’s “what if” business value.

9. Find the “what if” value in US dollars of Randle’s euro-denominated debt.

10. Find Randle’s “what if” equity value.

11. Find Randle’s FX equity exposure to the euro at time 0.

12. Littell Co. is a U.S. firm that owns the Eurozone subsidiary TDL Ltd., and the functional currency is the euro. Littell has no other Eurozone subsidiaries. TDL has no debt and has a book value of total assets of €1,000. The spot FX rate is 1.35 $/€. Littell has $3,000 of its own euro-denominated debt, not on TDL’s balance sheet. (a) What is Littell’s net investment in TDL? For (b), (c), and (d), assume the euro appreciates by 10% versus the US dollar. (b) What is the new level of TDL’s assets shown on Littell’s consolidated balance sheet? (c) Find the change in Littell’s CTA account. (d) Ignoring the impact of the FX change on operating cash flow, what will be the impact on Littell’s reported current earnings?

13. SPG Ltd. is a Eurozone subsidiary of the U.S. multinational Davidson Company, with the euro as its functional currency. Davidson’s net investment in SPG is $2,000. Davidson’s FX business exposure to the euro is 0.40. Davidson’s reported (book) and value balance sheets are shown as follows. Assume that the euro depreciates by 10% versus the US dollar. (a) What will Davidson’s new book and value balance sheets look like? (b) Ignoring the impact on operating cash flow, what will be the impact of the FX change on Davidson’s reported current earnings?

Davidson Co. Time-0 Balance Sheets (in $s)

For 14–17: Langner Co. is a U.S. company. Assume that at time 0: (1) The book value of Langner’s net investment in Eurozone assets is $10 million. (2) The book value of all Langner’s other assets (in the United States and elsewhere) is $25 million. (3) Langner’s business value is $40 million. (4) Langner has $15 million in euro-denominated net debt and no other net debt. (5) Langner’s FX business exposure to the euro is 2.50. (6) The time-0 spot FX rate is 1.30 $/€.

14. What is Langner’s FX equity exposure to the euro?

15. If the euro depreciates by 10% versus the US dollar, what is Langner’s new equity value?

16. Langner cannot qualify any €-debt as a cash flow hedge, but Langner does qualify the maximum amount of €-debt as a net investment hedge. Assume the euro depreciates by 10% versus the US dollar. (a) What is the change in the book value of Langner’s equity? (b) Are the period’s current earnings affected by the FX change?

17. Langner’s CFO is considering issuing $5 million more of euro-denominated debt and using the proceeds of the debt issue to reduce outstanding equity by open market repurchase of equity shares. Will the financial restructuring reduce Langner’s FX equity exposure to the euro? Explain. Find the new FX equity exposure to the euro.

Answers to Problems

1. (a) $25 million; (b) $22.5 million.

2. (a) [1.60 − 0.40]/[1 − 0.40] = 2; (b) [1.60 − 0.70]/[1 − 0.70] = 3.

3. 0.40($2.5 million) = $1 million.

4. (a) The business value drops by 12.5%, to $8.75 million. The value of the euro-debt in US dollars drops by 10%, to $2.70 million, whereas the value of the other debt stays the same, $1 million. The “what if” equity value is $8.75 million − 2.70 million − 1 million = $5.05 million. The percentage change in equity value is $5.05 million/$6 million − 1 = −0.158, or −15.8%. So, the firm’s FX equity exposure is −0.158/−0.10 = 1.58. (b) As = 0.30 and = 0.40, the FX equity exposure of 1.58 is consistent with equation (5.1): = [1.25 − 0.30]/[1− 0.40] = 1.58.

5. (a) From equation (5.1), the FX equity exposure equals [−0.35 − (–0.25)]/[1− (−0.25)] = −0.08. (b) The ratio of net debt to business value needs to be −0.35, and thus the net debt in yen needs to be −$7,000, or $7,000 in yen cash. When the yen appreciates by 10%, the US dollar value of the yen cash rises by 10% to $7,700, and the business value drops by 3.5% to $19,300. Thus, the equity value is not changed.

6. New business value = 0.88($500 million) = $440 million; new value of €-debt = $20 million; New equity value = $440 million + 25 million − 100 million − 20 million = $345 million.

7. $345/$400 −1 = −0.1375; FX equity exposure = −0.1375/−0.20 = 0.6875;
Or, [0.60 − 0.05]/[1 − 0.20] = 0.6875.

8. 0.85($28.2 million) = $23.97 million.

9. $3.15 million.

10. $23.97 million + 2 million − 6 million − 3.15 million = $16.82 million.

12. 16.82/20 − 1 = −0.159; FX equity exposure = −0.159/−0.25 = 0.636. Or, [0.60 − 4.2/28.2]/[1 − 8.2/28.2] = 0.636.

13. (a) $1,350; (b) $1,485; (c) No net change, because there is (more than) enough debt to hedge the FX translation exposure of the foreign asset; (d) $165 loss, from the $1,650 of euro-denominated debt that does not follow hedge accounting.

14. (a) Business value drops by 0.40(10%), to $7,680. The book value of the net investment in SPG drops by 10%, to $1,800. In US dollars, the $1,000 in €-debt drops by 10%, to $900, both in book value and economic value. The FX translation loss of $200 goes to the AOCI account, but is offset (partially) by the $100 gain on the €-debt, because the debt qualifies as a net investment hedge. (b) Reported earnings do not change, because all the €-debt qualifies for hedge accounting.

Davidson Co. Time-1 Balance Sheets (in $s)

14. [2.5 − 0.375]/[1− 0.375] = 3.4.

15. Business value changes by 2.5(−10%) = −25%. New business value = 0.75($40 million) = $30 million; new value of net debt = 0.90($15 million) = $13.5 million; so, new equity value = $30 million − 13.5 million = $16.5 million. Or, old equity value was $40 million − 15 million = $25 million; equity changes by 3.4(−0.10) = −0.34; new equity value = 0.66($25 million) = $16.5 million.

16. (a) Old book equity = $35 million − $15 million = $20 million. New book equity = $34 million − 13.5 million = $20.5 million, an increase of 0.50 million; (b) Yes, the rise in the equity book value will be reflected in current earnings, because this change represents a drop in value of the debt that does not qualify for hedge accounting.

17. No, it will increase, due to the increase in financial leverage, because FX business exposure > 1. New FX equity exposure = [2.50 − 0.50]/ [1 − 0.50] = 4.

Discussion Questions

1. Why is borrowing in yen at 2% not necessarily advantageous to borrowing in US dollars at 6%?

2. Would foreign currency debt be an effective hedge for a company with an FX business exposure higher than 1? Explain.

3. When would using foreign currency debt as a hedge cause higher volatility in a firm’s current earnings? Discuss.

4. Give some examples of cases where financial hedging is useful instead of operational hedging or in addition to operational hedging.

5. Under what circumstances would it be advantageous for a foreign subsidiary to issue parent-guaranteed debt instead of the parent?

6. What is the impact on FX equity exposure and FX accounting exposure if a foreign subsidiary issues parent-guaranteed debt instead of the parent?

7. Explain why, in the absence of taxes, an internal loan from a parent to a subsidiary is the same as parent equity in the subsidiary.