CHAPTER 3

FX Business and Equity Exposure

This chapter looks at two more types of FX exposure. The first is FX business exposure, which is the effect of FX rate changes on an operation’s business value. Business value is what an operation would be worth if it has no debt and no cash and marketable securities. The second is FX equity exposure, which is the sensitivity of a firm’s equity share value to unexpected FX rate changes.

Business Value

Finance theory tells us that a firm’s intrinsic business value is the present value of the firm’s future expected operating cash flow stream. Let denote business value in US dollars; the expected operating cash flow in US dollars at time t; the business’s cost of capital (discount rate to apply), based on the risk of the operating cash flows; and N the number of years that operating cash flows are expected. The present value in US dollars of the expected operating cash flow stream is thus = .

For simplicity, the examples use the standard constant growth model, which assumes that the cash flow stream is expected to grow at a constant rate into perpetuity. Given that a firm’s operating cash flows (measured in US dollars) are expected to grow perpetually at a constant rate, g^$, and letting E(O^$) be the initial operating cash flow, the intrinsic business value is shown in the formula in equation (3.1):

Constant Growth Model

In words, equation (3.1) says that business value is equal to the capitalized value of the expected operating cash flow stream that grows at the rate g^$, where the capitalization rate (or discount rate) is . For example, assume that RPC Company’s future operating cash flows are expected to start with $200 and grow perpetually at an annual rate of 6%. RPC’s managers estimate the business’s cost of capital (discount rate) in US dollars, is = 11%. Applying equation (3.1), the intrinsic business value in US dollars is $200/[0.11 − 0.06] = $4,000.

FX Business Exposure

If a firm has FX operating exposure to the British pound, the projected operating cash flow (in home currency) changes as the spot FX rate for the pound changes. A change in the spot FX rate tends to also affect the forecast of future spot FX rates, which in turn affects the projected future operating cash flows (in home currency). So, a change in the current spot FX rate will affect the entire stream of projected future operating cash flows and thus their present value. The term FX business exposure describes the elasticity of the business value to changes in the spot FX price of a foreign currency. We’ll use the notation for the FX business exposure to the British pound of a firm with a US dollar home currency.

For simplicity, we assume from here on that an operation’s FX business exposure is the same number as its FX operating exposure. That is, . One way to justify this assumption is to say that if the spot FX rate changes, the expected level of all future expected operating cash flows changes by the same percentage as the initial operating cash flow, and the discount rate is not affected by FX rate changes.

Suppose for example that a U.S. firm has a projected operating cash flow stream of $1,000 per year into perpetuity (zero growth rate) and the discount rate is 10%. Thus, the intrinsic business value is initially $1,000/0.10 = $10,000, using equation (3.1). Assume further that the firm’s FX operating exposure to the British pound, , is 1.20. So, we know that if the British pound unexpectedly depreciates versus the US dollar by 15%, the initial operating cash flow (in US dollars) will change by 1.20(−0.15) = −0.18, or a drop of 18%, to 0.82($1,000) = $820. Given that the projected future operating cash flows will each be lower by 18%, the new projected future operating cash flow stream is $820 per year into perpetuity. Given that the discount rate is unaffected by the spot FX change, the new intrinsic business value is $820/0.10 = $8,200. So, the percentage change in the intrinsic business value is $8,200/$10,000 − 1 = −0.18, or −18%, the same as the percentage change in the initial operating cash flow.

Business Value and Enterprise Value

Business value is almost the same as enterprise value, which is equal to equity market cap plus net debt. Equity market cap refers to the market capitalization value of the firm’s equity, which is equal to the market price per share times the number of shares outstanding. Net debt is debt minus cash, where cash includes marketable securities. For example, assume that Midwest Scientific Co. has 10 million shares outstanding. The share price is $40, so the firm’s equity market cap is $400 million. The firm has $100 million in cash and $250 million in debt, so the net debt is $150 million. The enterprise value is $400 million + $150 million = $550 million. The difference between Midwest Scientific’s enterprise value and its total value is shown below in Exhibit 3.1.

Exhibit 3.1 Midwest Scientific Co. Value Balance Sheet

Researchers have found that the average U.S. industrial firm’s cash balance grew steadily since the 1980s, and by 2006 the cross-sectional corporate average net debt was zero.¹ In fact, these days it is more and more common for a company’s risk management strategy to include little or no debt and a relatively large cash balance. If a firm’s cash exceeds the firm’s debt, then net debt is negative, but the arithmetic for enterprise value is the same. For example, assume that a firm has an equity market cap of $400 million, $100 million in debt, and $250 million in cash. The net debt is −$150 million, and the enterprise value is $400 million − $150 million = $250 million.

Since firms differ in their debt and cash levels, both business value and enterprise value are meant to strip those choices out and give an idea of the value of a business, ignoring debt and cash positions. In principle, there is a technical difference between a firm’s business and enterprise values: enterprise value implicitly includes the present value of the firm’s expected future debt tax shields, but business value does not. Business value is what the equity market cap would be if there were no net debt. The recent U.S. corporate trend toward reduced net debt levels suggests that firms do not think that debt tax shield value is critically important. For this reason and to focus more clearly on international finance issues, this text ignores debt tax shield value, and regards business value and enterprise value as generally the same.²

FX Business Exposure of a Multinational

Many real-world companies have multiple operations, and each operation may have a different FX business exposure to a given currency. The overall company’s FX business exposure to the currency is thus a combination of the FX business exposures of the individual operations.

Consider International Materials Company, a hypothetical U.S. multinational consisting of three different business operations that sell industrial materials in three different countries: The United States, Italy (in the Eurozone), and Spain (also in the Eurozone). Assume that the U.S. operation has a business value of $35 million and a FX business exposure to the euro of −0.20, due to importing of parts from the Eurozone. The Italian subsidiary sells materials in Italy that are produced entirely in the United States and has a business value in US dollars of $5 million. From the US dollar perspective, the Italian business’s FX business exposure to the euro is 2.50. The Spanish business operates entirely in Spain and has a business value in US dollars of $10 million. From the US dollar perspective, the Spanish operation’s FX business exposure to the euro is 1. What is International Materials’ overall FX business exposure to the euro?

To answer the question, view the overall multinational company as a portfolio of its business operations. The portfolio weights are based on the business values. The total value of all the businesses is $35m + 5m + 10m = $50m. The portfolio weights are: $35m/$50m = 0.70 for the US business; $5m/$50m = 0.10 for the Italian business; and $10m/$50m = 0.20 for Spanish business. Using the portfolio weights and FX business exposures, International’s overall FX business exposure to the euro is 0.70(−0.20) + 0.10(2.50) + 0.20(1) = 0.31.

FX Equity Exposure

A firm’s FX equity exposure to a foreign currency is the elasticity of the equity value to changes in the spot FX price of the currency, viewed from the perspective of the firm’s home currency. We use “S” (for “stock”) for equity notation, so S^$ denotes the equity value in US dollars. A U.S. firm’s FX equity exposure to the euro is denoted and is computed as %ΔS^$/x^$/€, the percentage change in the equity value in US dollars, given the percentage change in the euro versus the US dollar.

Three elements determine a firm’s FX equity exposure to a currency: (a) the firm’s FX business exposure to the currency; (b) the net financial leverage ratio, which is the ratio of net debt to business value; and (c) the relative amount of net debt denominated in the exposure currency. We’ll look at the effects of foreign currency net debt in the next chapter. For this chapter, we focus on the case where net debt is entirely in the home currency. FX changes have no impact on the home currency value of net debt that is denominated in the home currency.

Assume that the U.S. firm Intex Co. has: (a) an FX business exposure to the euro, , of 1.20; (b) a business value in US dollars of $2,000; and (c) net debt, ND^$, of $600. Thus, the equity value is initially S^$ = $2,000 − 600 = $1,400, as shown in the top panel of Exhibit 3.2.

Owing to the FX business exposure of 1.20, a “what if” 5% depreciation of the euro versus the US dollar will cause a 6% drop in the business value, to 0.94($2,000) = $1,880. Since Intex’s $600 in net debt is denominated entirely in US dollars, the FX change has no impact on the net debt. So, Intex’s “what if” equity value is $1,880 − 600 = $1,280, as shown in the bottom panel of Exhibit 3.2. Equity value changes by $1,280/$1,400 − 1 = −0.0857, or −8.57%. In short, a 5% depreciation of the euro results in an 8.57% drop in the equity value, so the FX equity exposure to the euro, , is −0.0857/−0.05 = 1.71.

Exhibit 3.2 Intex Co. Value Balance Sheet: $600 Net Debt

Intex’s FX equity exposure to the euro, 1.71, is higher than its FX business exposure, 1.20, due to the impact of the financial leverage. To see the impact of financial leverage, consider the same company with the same business value, $2,000, and a higher net financial leverage ratio, 0.40 instead of 0.30. So, the initial net debt is $800 and initial equity value is $1,200, as shown in the top panel of Exhibit 3.3. Since the net debt stays at $800 when the spot FX rate changes, the “what if” equity value is $1,880 − 800 = $1,080, as in the bottom panel of Exhibit 3.3. The percentage change in equity value is $1,080/$1,200 − 1 = −0.10, or a 10% drop. So, a 5% depreciation of the euro versus the US dollar results in a 10% drop in equity value, implying FX equity exposure to the euro = −0.10/−0.05 = 2. This example shows that a higher net financial leverage ratio implies a higher FX equity exposure for a given FX business exposure.

Exhibit 3.3 Intex Co. Value Balance Sheet: $800 Net Debt

Now we’ll create a scenario where the net debt is negative. In this case, we’ll see that the FX equity exposure is lower than the FX business exposure. Consider the same Intex Co. as before, except with ND^$ / = −0.40. Now the initial net debt is −$800 and equity value is $2,800, as shown in the top panel of Exhibit 3.4. Since the net debt stays at −$800 when the spot FX rate changes, the “what if” equity value is $1,880 − (−800) = $2,680. See the bottom panel of Exhibit 3.4. The percentage change in equity value is $2,680/$2,800 − 1 = −0.043, or a 4.3% drop. So, a 5% depreciation of the euro results in a 4.3% drop in the equity value, implying an FX equity exposure to the euro is equal to−0.043/−0.05 = 0.86.

Exhibit 3.4 Intex Co. Value Balance Sheet: −$800 Net Debt

A formula for FX equity exposure as a function of FX business exposure and the net financial leverage ratio, ND^$ / is shown in equation (3.2) using the US dollar as the home (pricing) currency and the euro as the exposure currency:³

FX Equity Exposure

We demonstrate equation (3.2) using the Intex examples. If net debt is $600 and equity value is $1,400, ND^$ / = $600/$2,000 = 0.30. Using equation (3.2), we get = 1.20/[1 − 0.30] = 1.71, as seen earlier. In the second scenario, where net debt is $800 and equity value is $1,200, ND^$ / = $800/$2,000 = 0.40. Using equation (3.2), = 1.20/[1 − 0.40] = 2, as seen earlier. In the third scenario, net debt is −$800 and equity value is $2,800, so ND^$ / = −$800/$2,000 = −0.40. Using equation (3.2), = 1.20/[1 − (−0.40)] = 0.86.

Financial leverage also magnifies a negative FX business exposure. For example, assume that the U.S. firm San Jose Scientific Co. has an FX business exposure to the yen of −1.20, a business value of $2,000, and a net debt of $600. Thus, the equity value is currently $2,000 − 600 = $1,400, as shown in the top panel of Exhibit 3.5. Assume a 5% depreciation in the yen versus the US dollar. Owing to the negative FX business exposure of −1.20, the spot FX change implies a rise in the business value by 6%, to 1.06($2,000) = $2,120. If San Jose’s $600 in net debt is denominated entirely in US dollars, the net debt does not change, so San Jose’s “what if” equity value is $2,120 − 600 = $1,520, as shown in the bottom panel of Exhibit 3.5. The percentage change in San Jose’s equity value is $1,520/$1,400 − 1 = 0.0857, or 8.57%. In short, a 5% depreciation in the yen versus the US dollar results in an 8.57% rise in the equity value, implying that San Jose’s FX equity exposure to the yen is 0.0857−0.05 = −1.71, which confirms equation (3.2): −1.20/[1 − 0.30] = −1.71. In this case, the firm’s FX business exposure is −1.20, but the FX equity exposure is higher (in absolute value), −1.71, due to the firm’s net financial leverage.

Exhibit 3.5 San Jose Scientific Co. Value Balance Sheet: FX Business Exposure = −1.20; $600 Net Debt (US Dollars)

Regression Estimates of FX Equity Exposure

FX equity exposure is sometimes empirically estimated with actual stock returns. For Gillette, Merck, and General Electric, we see below the estimated FX equity exposures to the yen, the British pound, and the euro, which were computed by regressing monthly stock returns on monthly percentage spot FX changes, using data for 1999 to May 2004.

Source: Author’s estimates using monthly data for 1999 to 2004.

FX equity exposure estimates like these should be taken with a grain of salt. A firm’s FX exposure to a currency applies to a given operating and financial structure at a given time, but time series observations may span a period when a firm’s operating structure, capital structure, or financial risk management strategy changes. Still, FX equity return exposures estimated this way might be useful. You may want to use returns for periods longer than one month, because empirical research suggests that equity prices do not respond to FX changes as quickly as they should in an efficient market. This is possibly due to investors’ inability to rapidly grasp the complex implications of FX changes. Similarly, estimated FX equity exposures tend to be higher the longer the horizon for the returns used in the estimation process.

Exhibit 3.6 shows the empirical FX equity exposure estimates to a major currency index (MCI) for 70 selected U.S. companies. These estimates were calculated with roughly 30 years of quarterly equity rate of return observations from 1981 through 2010. The 35 companies shown on the left in Exhibit 3.6 have a negative estimated FX equity exposure to the MCI, while those on the right have a positive estimated FX equity exposure to the MCI.

The FX exposure estimates in Exhibit 3.6 tend to have smaller magnitudes than the ones in the chapter’s hypothetical examples. This is likely due, at least in part, to the use of a currency index instead of an individual currency. Companies might have a large FX equity exposure to a given currency, but a smaller FX exposure to a currency index. In addition, many of the companies are large firms, and so many may have implemented risk management programs to deal with FX business exposures.

You can observe some interesting trends in the data in Exhibit 3.6. For example, airline companies (American, Alaska, and Southwest) tend to have negative FX exposure estimates. The negative FX equity exposure estimates for the aircraft producers (Lockheed and Northrop) make sense when we note that aircraft revenues are generated in US dollars, but some inputs are likely priced in foreign currencies. Retailing and apparel companies also tend to have negative FX exposure estimates. Some domestic “food” companies, especially supermarket chains, tend to have negative FX exposure estimates, while multinational “food” companies such as McDonalds and Coca Cola have positive FX equity exposure estimates. Other companies with positive FX equity exposure estimates include those in industries such as mining (Newmont, Coeur d’Alene, and Hecla), paper (Boise Cascade and International Paper), petroleum (Ashland, Amerada Hess, Tesoro, and Phillips), chemicals (Dow and DuPont), heavy machinery (Halliburton, Schlumberger, Deere, Textron, and Caterpillar), and industrial metals (Alcoa and Nucor).

Exhibit 3.6 Regression Estimates of FX Equity Exposure to Major Currency Index (MCI): Selected U.S. Stocks

Family Dollar Stores Inc	−1.42	McDonalds Corp	0.29
Astronics Corp	−1.30	Coca Cola Co	0.39
Genesco Inc	−1.14	Becton Dickinson & Co	0.51
American Biltrite Rubr Inc	−1.09	Tesoro Petroleum Corp	0.52
Bowmar Instrument Corp	−1.04	Alberto Culver Co	0.55
Spectrum Control Inc	−1.03	Nike Inc	0.55
Goldfield Corp	−0.99	Kellogg Co	0.56
La Barge Inc	−0.96	Air Products & Chemicals	0.57
Graham Manufacturing	−0.96	Schlumberger Ltd	0.57
Advanced Micro Devices	−0.94	Alabama Gas Corp	0.58
Continental Materials	−0.93	Murphy Oil Corp	0.62
Haverty Furniture Cos Inc	−0.90	American Greetings Corp	0.64
Home Depot Inc	−0.89	Eastman Kodak Co	0.66
Lowes Companies Inc	−0.86	Amerada Hess Corp	0.69
Arden Mayfair Inc	−0.83	Ingersoll Rand Co	0.70
Zayre Corp	−0.73	Lubrizol Corp	0.72
Todd Shipyards Corp	−0.72	Texas Instruments Inc	0.74
American Airls Inc	−0.68	Textron Inc	0.74
Lockheed Aircraft Corp	−0.64	Aluminum Company Amer	0.75
Vicon Industries Inc	−0.64	Phillips Petroleum Co	0.77
Dayton Hudson Corp	−0.63	Archer Daniels Midland Co	0.78
Hasbro Industries Inc	−0.62	National Semiconductor	0.80
Alaska Airls Inc	−0.58	Deere & Co	0.81
Southwest Airlines Co	−0.52	Nucor Corp	0.83
K R M Petroleum Corp	−0.51	Newmont Mining Corp	0.84
Boothe Computer Corp	−0.48	International Paper Co	0.90
Alpha Industries Inc	−0.48	Ashland Oil Inc	0.96
Kroger Company	−0.48	Unit Drilling & Expl Co	0.96
Limited Stores Inc	−0.47	Caterpillar Tractor Inc	0.99
International Rectifier	−0.46	Boise Cascade Corp	1.17
Winnebago Industries Inc	−0.46	Dow Chemical Co	1.21
Leggett & Platt Inc	−0.46	Halliburton Company	1.24
Northrop Corp	−0.44	Rite Aid Corp	1.26
Hershey Foods Corp	−0.43	Coeur D Alene Mines Corp	1.51
Gap Inc	−0.43	Hecla Mining Co	2.24

Source: Alain Krapl, with quarterly data from 1981 to 2010.

Summary Action Points

• A firm’s FX business exposure to a currency measures how FX movements affect the firm’s business value, and is based on the firm’s FX operating exposure.

• A company’s FX business exposure to a currency is a combination of the FX business exposures to that currency of the individual operations.

• Two of the factors affecting a firm’s FX equity exposure are the firm’s FX business exposure and the firm’s net financial leverage.

Glossary

Business Value: The value of an operation if it has no net debt, also known as unlevered value.

Enterprise Value: The market capitalization of the firm’s equity plus the firm’s total debt minus the firm’s cash and marketable securities, or equivalently, equity market cap plus net debt; the same as levered value.

FX Business Exposure: The variability in a firm’s business value caused by uncertain FX rate changes.

FX Equity Exposure: The variability in the intrinsic value of a firm’s equity caused by uncertain FX rate changes.

Intrinsic Business Value: The intrinsic value of an operation if with no net debt; the present value of the operation’s future operating cash flows.

Net Debt: A firm’s total debt minus cash and marketable securities.

Net Financial Leverage: The ratio of net debt to business value.

Problems

1. Creighton Co. expects a future operating cash flow of $200,000 initially and a constant perpetual growth rate of 4% per annum. The discount rate is 8%. Find Creighton’s intrinsic business value.

2. Creighton Co. in the previous problem has estimated its FX business exposure to the euro is 0.60. What would be Creighton’s new intrinsic business value if the euro depreciates by 20% versus the US dollar?

3. Quadroplex Manufacturing Company has 50 million shares outstanding. The share price is $20. The company has $50 million in cash and $150 million in debt. Find Quadroplex’s enterprise value.

4. Great Lakes Industries has 50 million shares outstanding. The share price is $20. The company has $150 million in cash and $50 million in debt. Find Great Lakes’ enterprise value.

5. Transatlantic Company is a U.S. multinational consisting of businesses that sell industrial materials in three countries, the United States, Portugal (in the Eurozone), and France (in the Eurozone). Assume that the U.S. subsidiary has a business value of $40 million and an FX business exposure to the euro of 0.20, due to a competitor from the Eurozone operating in the United States. The business that sells in Portugal is an export company that produces entirely in the United States with a business value of $10 million and FX business exposure to the euro of 2. The business that sells in France consists of two operations; the first produces raw product in the United States, which is shipped to other in France for finishing and distribution. The two French operations have a total business value of $30 million with a FX business exposure to the euro of 1.40. Find Transatlantic’s overall FX business exposure to the euro.

6. The U.S. firm Carolina Plastics Co. has = $5,000, ND^$ = $1,000, and thus S^$ = $4,000. All of Carolina Plastics’ net debt is US dollar-denominated. Carolina Plastics has an FX business exposure to the euro of 1.25. (a) Use the “what if” approach to find the new value of Carolina Plastics’ equity, and the FX equity exposure to the euro, given a 20% depreciation in the euro versus the US dollar. (b) Verify the FX equity exposure using equation (3.2).

7. The U.S. firm Carolina Plastics Co. has = $5,000, ND^$ = $1,500, and thus S^$ = $3,500. All of Carolina Plastics’ net debt is US dollar-denominated. Carolina Plastics has an FX business exposure to the euro of 1.25. (a) Use the “what if” approach to find the new value of Carolina Plastics’ equity, and the FX equity exposure to the euro, given a 20% depreciation in the euro versus the US dollar. (b) Verify the FX equity exposure using equation (3.2).

8. The U.S. firm Carolina Plastics Co. has = $5,000, ND^$ −$1,000, and thus S^$ = $6,000. All of Carolina Plastics’ net debt is US dollar-denominated. Carolina Plastics has an FX business exposure to the euro of 1.25. (a) Use the “what if” approach to find the new value of Carolina Plastics’ equity, and the FX equity exposure to the euro, given a 20% depreciation in the euro versus the US dollar. (b) Verify the FX equity exposure using equation (3.2).

9. The U.S. firm Carolina Plastics Co. has = $5,000, ND^$ = −$1,000,and thus S^$ = = $6,000. All of Carolina Plastics’ net debt is US dollar-denominated. Carolina Plastics has an FX business exposure to the euro of −1.25. (a) Use the “what if” approach to find the new value of Carolina Plastics’ equity, and the FX equity exposure to the euro, given a 20% depreciation in the euro versus the US dollar. (b) Verify the FX equity exposure using equation (3.2).

Answers to Problems

1. $200,000/[0.08 − 0.04] = $5 million.

2. 0.88($5 million) = $4.40 million.

3. Equity market cap is $1 billion. The net debt is $100 million. The enterprise value is $1 billion + $100 million = $1.1 billion.

4. Equity market cap is $1 billion. The net debt is −$100 million. The enterprise value is $1 billion − $100 million = $900 million.

5. 0.50(0.20) + 0.125(2) + 0.375(1.40) = 0.875.

6. (a) Business value drops by 1.25(20%), or 25%, to $3,750, if the euro depreciates by 20% versus the US dollar. The net debt stays at $1,000. The new equity value is $3,750 − 1,000 = $2,750. The equity value changes by $2,750/$4,000 − 1 = −0.3125, or −31.25%. The FX equity exposure equals −0.3125/−0.20 = 1.5625. (b) Since ND^$ / = −0.20, the FX equity exposure is consistent with equation (3.2): = 1.25/[1 − 0.20] = 1.5625.

7. (a) Business value drops by 1.25(20%), or 25%, to $3,750, if the euro depreciates by 20% versus the US dollar. The net debt stays at $1,500. The new equity value is $3,750 − 1,500 = $2,250. The equity value changes by $2,250/$3,500 − 1 = −0.357, or −35.7%. The FX equity exposure equals −0.357/−0.20 = 1.79. (b) Since ND^$ / = 0.30, the FX equity exposure is consistent with equation (3.2), because = 1.25/[1 − 0.30] = 1.79.

8. (a) Business value drops by 1.25(20%) = 25%, to $3,750, if the euro depreciates by 20% versus the US dollar. Net debt remains −$1,000. New equity value = $3,750 − (−1,000) = $4,750, a change of $4,750/$6,000 − 1 = −0.208, or −20.8%. = −0.208/−0.20 = 1.04. (b) With ND^$ / = 0.20, the FX equity exposure reconciles with equation (3.2): = 1.25/[1 − (−0.20)] = 1.04.

9. (a) Business value rises by 1.25(20%) = 25%, to $6,250, if the euro depreciates by 20% versus the US dollar. Net debt remains −$1,000. New equity value = $6,250 − (−1,000) = $7,250, a change of $7,250/$6,000 − 1 = 0.208, or 20.8%. = 0.208/−0.20 = −1.04. (b) Since ND^$ / = −0.20, the FX equity exposure reconciles with equation (3.2): = −1.25/[1 − (−0.20)] = −1.04.

Discussion Questions

1. Explain the difference between business value and enterprise value.

2. Suppose an overseas subsidiary of a U.S. multinational reinvests all cash flows in its own growth, rather than repatriating any to the parent. Does the parent have FX business exposure to the foreign currency? Discuss.

3. What are some of the reasons corporations might be able to do a better job at managing FX operating and business exposure than their investors?