FNCE 4103 Week 7 Operating Exposure Analysis Example

Lakeland's Operating Exposure to a Sustained Euro Move: A Map of Revenue and Costs by Currency, Four Channels a Lasting Change Travels Through and Why a Stronger Euro Could Help More Than It Hurts

Student Name

Walden University

FNCE 4103: International Finance

Instructor Name

Month Day, Year

Lakeland's Operating Exposure to a Sustained Euro Move: A Map of Revenue and Costs by Currency, Four Channels a Lasting Change Travels Through and Why a Stronger Euro Could Help More Than It Hurts

The Map

Operating exposure is the effect of a lasting exchange rate change on a firm's future cash flows through its prices, costs and competitive position, not just on contracts already signed (Shapiro & Hanouna, 2019). The first step is to see where Lakeland Process Equipment, the composite Minneapolis maker of food-processing lines used throughout this course, earns and spends by currency.

The map shows a mismatch. Lakeland spends about $85 million a year in euros but earns only $60 million in euros: a net short position of about $25 million. On this view alone, a stronger euro raises costs more than revenue and hurts profit.

Table 1

Lakeland's Annual Revenue and Costs by Currency (in millions of dollars)

Composite company. Revenue and costs by currency of denomination; figures summarized from a case of the kind a segment disclosure would support.

Four Channels

A sustained 10 percent rise in the euro, held for several years, would work through four channels.

Euro input costs. The $45 million of German components would cost about $4.5 million more a year. Lakeland could switch some purchases to U.S. or Mexican suppliers over two to three years, but the specialized pumps it buys have few alternatives.

Euro revenue. European sales of $60 million would be worth about $6 million more in dollars if Hamburg held its euro prices. The Hamburg subsidiary's costs would rise in dollar terms by about $4 million, leaving a net gain of about $2 million from the European business.

Competitors' costs. Lakeland's main U.S. competitor is a German-owned firm that builds most of its lines in Germany and ships them to American customers. A stronger euro raises that competitor's costs in dollars. If it raised U.S. prices by even half the currency move, Lakeland could raise its own U.S. prices by a smaller amount and still win more orders. On $210 million of U.S. revenue, a 2 percent price increase would add about $4 million.

Volume. Lakeland's European customers might buy more if Lakeland held euro prices while its German rivals raised theirs, but the European business is small. In the United States, a cost advantage over the German competitor could add orders.

Netting the Channels

The simple currency map suggested a stronger euro would hurt Lakeland. After the competitive channel is included, it may help modestly. That conclusion rests on the assumption about the competitor's pricing, which is the most uncertain line. If the competitor absorbed the currency move instead, holding its U.S. prices to protect market share, the price and volume lines would shrink to almost nothing and the net effect would turn negative, at about $2.5 million a year. The sign of the answer depends on one rival's behavior.

Table 2

Estimated Annual Effect of a Sustained 10 Percent Euro Rise (in millions of dollars)

Estimates rest on stated assumptions about pricing and volume; see text.

What the Analysis Shows

Operating exposure cannot be hedged precisely with forwards or options, because the amounts and dates are uncertain and depend on how competitors and customers respond. It is managed through operating choices. Bodnar et al. (2002) found that a firm's ability to pass currency changes through to its prices depends on how differentiated its product is and on the structure of its industry. For Lakeland, the most useful steps are structural: qualifying a second, non-euro supplier for its pumps, which would reduce the largest negative channel, and tracking the German competitor's U.S. prices so that pricing decisions can follow a currency move quickly. Hedging the known payables, as the earlier memo recommends, remains sensible, but it addresses a different and smaller exposure (Madura, 2021).

References

Bodnar, G. M., Dumas, B., & Marston, R. C. (2002). Pass-through and exposure. The Journal of Finance, 57(1), 199-231. https://doi.org/10.1111/1540-6261.00420

Madura, J. (2021). International financial management (14th ed.). Cengage Learning.

Shapiro, A. C., & Hanouna, P. (2019). Multinational financial management (11th ed.). Wiley.