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The target capital structure for a subsidiary is the mix of financing, stated in market values, that it would maintain in the long run on a stand-alone basis. The actual capital structure imposed on the subsidiary by its parent may depart widely from the subsidiary's target. For tax reasons, the subsidiary may be loaded up with debt. The tax effect of this type of transfer-pricing arrangement is captured when expected cash flow is estimated and should not be double counted when estimating the discount rate.
Discount Free Cash Flow
Having determined the subsidiary's weighted average cost of capital, you are ready to discount the free cash flow forecasted in step 2 and convert it to your domestic currency. Exhibit 17.9 shows the expected free cash flow to our example subsidiary in England. It is discounted to the present at the subsidiary's WACC, assumed to be 11.8 percent, and then converted to dollars by multiplying the present value in pounds sterling by the spot exchange rate, 0.63 pounds/dollar.
One caveat is in order: Because we have discounted cash flow to the subsidiary, its present value in the domestic currency (dollars in our example) to the parent may be different if a country has restrictions that limit the expatriation of cash flow to the parent. Although ways around these constraints can sometimes be found—for example, barter or transfer pricing—keep in mind that the value to the parent depends on the quantity and timing of free cash flow (or cash equivalents) that can actually be paid out.
The Effects of Foreign Exchange Hedging
Hedging is a conceptually difficult topic mainly because it is hard to justify on theoretical grounds as beneficial to shareholders. It is not unusual for multinational companies to take large positions in foreign exchange forward contracts to hedge against unexpected changes in exchange rates. Though designed to reduce currency risk, this practice is often risky in itself. It has
Exhibit 17.9 English Subsidiary Valuation
Free cash flow (?) Present value factor at 11.8% foreign rate Present value (?)
2000 100 0 8945 89.45
2001 115 0.8000 92.01
2002 130 0.7156 93.03
2003 142 0.6401 90.89
2004 160 0.5725 91.60
2005 130 0.5121 92.18
2006 1% 04580 89.78
2007 225 0.4097 92.18
2006 252 0.3665 92.35
2009 230 0.3278 91.78
Continuing value 2,653 0.3278 869.61
PV in ? ?1,784.86
Spot rate ?/S +0.63
PV in $ $2,833.3
Exhibit 17.10 Use of Derivatives
resulted in many well-publicized disasters. Volkswagen lost $200 million and Spectra Physics had an entire year's profits wiped out by inappropriate foreign exchange trading positions. Management either hedged the wrong exposure, or forgot that hedge positions that are too large are actually speculation. Also, other ways of hedging exist. If the local currency might decline in value, a company can reduce holdings of local currency cash and marketable securities, delay accounts payable, invoice exports in the foreign currency and imports in the domestic currency, tighten trade credit in the foreign currency, and borrow more in the foreign currency.
Until the 1990s, the literature on hedging was sparse and relatively incomplete. Most authors wrote about hedging individual transactions (such as the sale of a product with a deferred payment) or reducing the variance of cash flows (variance reduction). Recently, these approaches have been superceded by value maximization approaches that compare the benefits and costs of hedging programs. The implication is that not every company should hedge. Not every company does. The problem to which we now turn our attention is how do you decide whether or not your company should hedge, what approach should be used, and if so, what hedge ratio is appropriate? Exhibit 17.10 shows the results of a survey of 530 nonfinancial firms by Bodnar, Hayt, Marston, and Smithson4 regarding their use of financial
4 Bodnar, Hayt, Marston, and Smithson, ''Wharton Survey of Derivatives Usage by U.S. Nonfinancial Firms," Financial Management (summer 1995), pp. 104-114.
Exhibit 17.11 Reasons for Using Derivatives
Firms that use derivatives (percent)
Hedge economic exposure Hedge anticipated transaction1 Hedge anticipated transaction2 jg/f Hedge firm commitment transaction Hedge foreign dividends
Frequently transact for this reason
Sometimes transact for this reason
Hedge balance sheet |
Reduce funding cost by expressing a view
Reduce funding costs by arbitrage
1 >12 months.
2 <12 months.
Source: Bodnar. Hayt, Marston, and Smithson. "Wharton Survey ot Derivatives Usage by U.S. NonfinaiKial Firms’; Financial Management, Summer, 1995, pp. 104 114.