Operating Exposure

1. Operating Exposure Long-term risk affecting firm value Managing operating exposure Operating Exposure

2. Operating exposure • exposure to changes in the PV of the firm • Net Cashflows come from the Income Statement Operating Exposure

3. Income Statement Revenues (Cost of goods sold) (Operating costs) (Capital cost allowances) Incidental income Incidental expenses (Taxes) Net Income Operating Exposure

4. Profit variables Labour Costs COGS Input prices Overhead Operating Costs Administrative costs Operating Exposure

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 Operating Exposure

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) Operating Exposure

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 Operating Exposure

8. Tariffs Pe Qe Operating Exposure

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 Operating Exposure

10. Quotas Pe Qe Operating Exposure

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 Operating Exposure

12. Subsidies Pe Qe Operating Exposure

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 Operating Exposure

14. Regulatory intrusion • restrict products for non-compliance • labour laws • environmental laws • safety laws • create bureaucratic barriers • licensing • customs declarations • official delays Operating Exposure

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 Operating Exposure

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 Operating Exposure

17. Managing Operating exposure - diversification • diversifying operations • multicountry sales • multicountry production • outsourcing • diversifying financing • reduce WACC Operating Exposure

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 Operating Exposure

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 don’t have to compete hard • assume cd appreciates in real terms • Canadian exports become more expensive • foreign imports become less expensive Operating Exposure