Rolls Royce example
Rolls Royce sells aero engine in a number of foreign currencies, principally in US$ and GBP.Revenues are therefore earned in foreign currencies which, when converted to $, are subject to movements in foreign exchange rates. Rolls Royce face several financial risks which include unfavourable movements in interest rate and foreign exchange rates. A firm is said to exhibit exchange rate exposure if its share value is influenced by changes in currency values (Michael Adler and Bernard Dumas (1984)).There are a number of channels through which the exchange rate might affect the profitability of a firm.
Firms that export to foreign markets may benefit from a depreciation of the local currency if its products become more affordable to foreign consumers. On the other hand, firms that rely on imported intermediate products may see their profits shrink as a consequence of increasing costs of production.
Even firms that do no international business may be influenced indirectly by foreign competition. Furthermore, firms in the nontraded as well as the traded sectors of the economy compete for factors of production, whose returns may be affected by changes in the exchange rate.
Hedging, in terms of currency terms, is the attempt to anticipate, or at least avoid suffering from, future exchange rate movements ; hedging instuments can also be used speculatively , to benefit from exchange rate movements. This essay discusses in a first part how as a financial Chief officer should consider the general issues when deciding whether to hedge foreign exchange rate exposure. Following to that, Rolls Royce has a significant amount of transaction exposure and in order to reduce it, an appropriate method to hedge that exposure is needed.
1.Discuss the general issues that should be considered when deciding whether to hedge foreign exchange rate exposure . It is widely believed that exchange rate changes have important implications for financial decision-making and for firm profitability. Changes in foreign exchange rate can influence company cash flows positively or negatively, especially if an organisation has receivables or payables in a foreign currency.
In our case, Rolls Royce has all its costs in GBP exports its product to the US with its receipt in Usdollar, its profits will fall if the dollar will depreciate against the sterling and vice versa. However the company can’t increase its selling price in dollars without losing revenue unless there is a inelastic demand in USA and Rolls Royce could have increase its prices in the first place.That’s why it is important to BP either to accept this variability or to hedge these cash flows.
In order to implement the strategy of protecting these cash flows, it is important as a chief financial officer to consider the general issues when deciding whether to hedge foreign exchange rate exposure. The theory of risk management implies that some companies should hedge all financial risks, other firms should worry about only certain kinds of risks and still others should not worry about risks at all. When deciding whether or not to hedge, management should keep in mind that risk management can be used to change both a company’s capital structure and its ownership structure (R.M.Stultz 1996)
Before addressing the pros and cons of Rolls Royce ‘s decision whether to hedge or not , it first of all has to be recognised that there is an important difference inside a company between the owners or shareholders and the managers or directors, who represent the company and implement the strategy including hedging decisions. Even though shareholders could tie managers income to their personal objectives and are ultimately maximise shareholder wealth objective.
For instance, according to Stultz, Finance theory says that the stock market, in setting the values of companies, effectively assigns minimum required rates of retrun on capital that vary directly with the companies levels of risk. In general, the greater a company’s risk, the higher the rate of return it must earn to produce superior returns for its shareholders eg. RoCE (Return on Capital Employed), it sometimes impossible to exactly match shareholder objectives with those of management. The reason for that is most corporate financial exposures represent “non-systematic” or “diversifiable” risks that shareholders can eliminate by holding diversified portofolios.
The fundamental question to this discussion is whether companies hedging decision increase shareholder value. At first, let see the theoritical perspective on why hedging does not benefit shareholders. According to the Capital Asset Pricing Model a well diversified investor is unwilling to pay a premium for a specific company (share), just because it hedges its exposure. Infact this shareholders may not be concerned about the cash flow variability caused by swings in Financial exchange rates or commodity price. It is only the risk they can’t get rid off that counts. They will become concerned if such variability materially raises the probability of financial distress.
Individual investors can easily themselves reduce to get rid off their exposure risks through adjusting theri portfolios and thus compensate for the volatile behaviour of one specific investment. So if a company want to reduce its systematic or unsystematic risks through hedging, this will not only reduce risk but also the expected return and thus not influence the value of the firm. It can actually be argued that engaging in these hedging activities will destroy shareholder value. It may also decrease the cash flow of the company, thus in conjunction with the reduced cost of capital, due to the reduced risk, at best it will not affect the value of the company.
It can also be argued that hedging is unnecessary as the theory of PPP (Purchasing Power Parity) expects exchange rate movements to just compensate for inflation differentials and thus changes in nominal values (prices). PPP is the low of one price, which means that in theory all commodities and goods should have the same price in all markets, as people otherwise could gain from arbitrage which means that the purchase of goods on one market for immediate resale on another country in order to profit from a price discrepancy.
The problem with PPP is that there are time lags between the changes of price levels and the changes in exchange rates which could leave importing companies exposed in the short term. An exporter will remain exposed even if exchange rates more in line with general inflation, if the price of this expecting product does not increase by as much as inflation. In a neoclassical, Modigliani-Miller type of world, management could not increase firm value by engaging into risk management activities. In such a perfect world without any information asymetrics, transaction costs or taxes, all hedging activities by the firm could be done or undone in the same way by investors. The reason for this is that the firm does not have any.
On the other hand, having looked at the more theoritical arguments mainly taking the view that hedging at the best doesn’t influence company value at the worst reduces shareholder value, we will now look at the pros on why a company should involve itself in hedging activities and the benefits for shareholders. The primary purpose of foriegn exchange hedging is to reduce the cashflow volatility caused by precisely these kinds of foreign exchange movements.