Transaction risk is one of the major risks faced by global business. Assume that you are an exporter of raw materials for the Apple Airpod 2 and you are paid in USD. Discuss approaches that you could take to hedge against currency risk and include the pros and cons of each. What qualitative consideration should you consider? Thoroughly but concisely discuss considerations when hedging this risk.

Currency risk

The currency risk is faced by many multinational organizations when they are considering investing in a new project or during routine transactions. The multinational organizations have a presence in different countries from where they send profit to the home country. The fluctuation in the foreign exchange rate can affect the profit of the organization up to a lot of extents. For managing the currency risk the multinational organizations use hedging techniques.

Hedging risk through forward: The forward contract is utilized by most of the international organizations for managing the exchange rate risks. The forward contract is considered an effective way of managing the foreign exchange rate. Through forwarding contract the multinational organization lock the exchange rate is present. The rate is locked for a predetermined time period. The benefit of the forward contract is that the value of the asset gets save from the exchange rate fluctuations.

Pros and Cons of the Forward contract: The major benefit of the forward contract is that it protects the asset of the payment from the exchange rate fluctuations. For instance, the multinational organization is receiving a huge payment from another country. If the payment is not protected through forwarding contracts than little changes in the foreign exchange rate can have a major impact on the payment and the organization might have to face financial loss. at the same time, the key drawback of the forward contract is that instead of a decline in currency value the value of a currency can go up which means that the company cannot take benefit from increased currency value because of the predetermined rate in the forward contract (Fridson & Alvarez, 2011).

Hedging risk through options: The options contract is also utilized by most of the international organizations for managing the exchange rate risks. The option contract is considered an effective way of managing the foreign exchange rate. Through the option contracts, the multinational organization locks the exchange rate is present. The rate is locked for a predetermined time period. The benefit of the forward contract is that the value of the asset gets save from the exchange rate fluctuations. There are two types of options put and call options. The put options save the organization from fall in the currency whereas the call options save from rally in currency (Chandra, 2011).

Pros and Cons of the option contract: The major benefit of the forward contract is that it protects the asset of the payment from the exchange rate fluctuations. The options contract has many benefits such as it protects the fluctuation in the exchange rate, cost-efficient and provides different strategic alternatives however it has some key drawbacks as well. The low amount of liquidity, complications, time decay and high commissions are some of the major drawbacks of options contracts.

 Hedging risk through futures: Future contracts are the commonly used derivatives used in the hedging risk. It is an agreement between the parties to buy and sell at a certain price at a certain time. The major purposes of the companies are to set the contracts to deal with the future risk and exposure limit after fluctuation in the price. The purposes of the investors are using the hedge risk in the perfect manner. In the life of the company, it is impossible to cover the fluctuation in the price to know about the hedging of the risk. When an organization has to come with the future contracts, it gets with the short position of the future contract. For instance, Company X must satisfy an agreement in a half year that expects it to sell 20,000 ounces of silver. Accept the spot cost for silver is $12/ounce and the prospects cost is $11/ounce. Organization X would short chances contracts on silver and close out the fates position in a half year. Currently, organization has diminished its risk by guaranteeing that it will get $11 for every ounce of silver it sells.

Pros and Cons of the Hedging risk through futures

Future contracts could be related with the risk factor as there are chances to get the high loss or high profit in the trading. The main benefit of contributing in the future contract to overcome the uncertainty in the investment projects by eliminating the ambiguity from the expected profit and loss. Some commodities are not to be hedge as these are not related with the future contracts. There may be something in the future contract to check the return on the profit in the production of future projects.

Final Thoughts: It is important for an exporter or investor to understand that there are a variety of qualitative factors, which are not easy to measure as compared to quantitative factors, which can easily be measured. But the role of these qualitative factors is also critical, like the role of quantitative is critical. There can be various internal or external elements, which may be affected by various reasons when different approaches are selected. It is not easy to make considerable decisions if qualitative factors are not properly identified. One of the qualitative factors is the long term basis effect on the company’s profitability in the future. It is important for stakeholders to understand that they should consider various options to remain on the right track, and one of such option is Hedging transaction exposure. So, when money is invested by the investor, he should make sure that risks are as minimum as possible. That’s why Hedging transaction exposure is a viable method to go with. This technique is very effective in mitigating and decreasing risks, which are related to transaction exposure.

1.      Discuss how capital budgeting differs between domestic-only and multinational corporations. Briefly describe the two approaches we used for a multinational corporation and how they determine whether or not you would accept or reject a project.

The capital budgeting in domestic only and multinational corporations differ due to the following reasons:

Legal and Tax regulations differences

The legal and tax regulations in different countries are different that must be considered while performing the capital budgeting. The multinational organization should consider the tax laws of different countries in capital budgeting so that the cash flows and profit can be efficiently maximized (Mohana, 2011).

Financial reporting standards: Although IFRS and GAAP are being implemented in different parts of the world some countries follow their own financial reporting standards. The change in the financial reporting standard can affect the interpretation of financial information (Warren, Reeve, & Duchac, 2016).

Currency risk: The currency risks should be considered while doing multinational capital budgeting. In the case of local capital budgeting, the organization or businesses does not have to consider currency risks but an organization that has operations in different countries has to consider the foreign exchange risk which can affect the profits or cash flows of the organization. Usually, the organizations manage the foreign exchange risk through currency hedges. The hedging instruments such as futures and options are used so that currency risk can be managed. Investing in different financial derivatives also helps the organization manage currency risk.

Borrowing costs: When the multinational organizations are performing capital budgeting the borrowing costs also be taken into consideration. The borrowing costs in different countries are different due to changes in interest rates, repayment terms and changes in collateral requirements. Therefore it is important to consider borrowing costs as well in capital budgeting (Mohana, 2011).

Raising capital differences: Raising capital in different countries is not going to be the same. The regulations in different countries might be different. The rights which the shareholders have can also be different in different regions around the world. The cost of capital can also be higher in some regions.

The two approaches we used for a multinational corporation

The value of the project is the present value of the discounted estimated cash flows from the investment. The project is accepted only if the present value of the future cash flows from the investment is higher than the cost of the investment. The capital budgeting approach utilized is known as NPV (net present value) approach. If the NPV is positive than the project is accepted however if the NPV is negative than the project is not accepted. It is recommended to use more than one capital budgeting approach for getting detail insights regarding the profitability of the project. The capital budgeting technique IRR (internal rate of return) is used with the NPV to know whether the project creates value for the organization or not. If the IRR is higher than the discount rate than the project should be accepted (Pandey, 2015).

Although NPV and IRR are considered good capital budgeting approaches there are several adjustments that are made for accurately performing capital budgeting. The adjustments regarding the exchange rate fluctuations and inflation are made for performing the above-discussed capital budgeting approaches. The weighted average cost of capital is calculated to get a better understanding of the firm’s cost of capital. WACC is usually used as a discount rate.

2.      Define leverage. Discuss why some firms have higher leverage than other firms. Within a multinational corporation, should subsidiaries have similar or different leverage ratios? Why?
Defining financial leverage

The financial leverage can be explained as financing the assets of the organization through debt. The higher the debt the higher will be the financial leverage of the organization.

Why Some Firms Have Higher Leverage than Other Firms

Growth phase: It is evident that the organizations that are in their growth phase need more financing or capital than those organizationsthat have become mature over the period of time. That is why the organizations that are in their growth phase are highly leveraged than those organizations that are at their maturity stage.

Reinvestment requirement: Some firms are highly leveraged than other firms because of reinvestment needs. There are many industries that require a significant amount of reinvestment so that those firms can expand their operations or can run their routine activities. Such industries include oil, gas, and infrastructure. Some industries, on the other hand, do not need much investment like the capital intensive industries. Industries such as technology services, management consultancy, etc. Does not need much investment and that is why they are less leveraged than other organization. The organizations that involve in confectionery businesses have a high cash conversation cycle. Such organizations have good relationship suppliers and do not need much investment for businesses. Businesses like confectionary businesses grow through internal accumulations. The changes in the capital structure of different companies make some companies high leverage and other low leverage (Fridson & Alvarez, 2011).

Cost of capital and earnings stability: The cost of capital can increase the overall cost of the organization. The interest tax shield and other benefits make the cost of debt less than the cost of equity. Therefore the organization uses debt financing so that they can lower there the cost of capital. The organizations, in other words, use financial leverage so that they can create optimum capital structure. Utility organizations, for instance, use debt financing so that cost of capital is being managed efficiently. The low cost of capital not only reduces the cost of the organizations but also enhance the profitability of the companies up to a lot of extents(Mohana, 2011).

Should subsidiaries have similar or different leverage ratios? Why?

The financial leverage of the multinational organization depends on the earnings of the organizations and the reinvestment needs of the organization. The subsidiaries of the multinational organization might involve in different industries that have different capital requirements. Therefore if different subsidiaries are going to have similar leverage ratios than not only their cost of capital will increase but also they might unable to finance their operations effectively. The end result of such a situation would be the insolvency of the subsidiary. Therefore it is recommended that each subsidiary should manage its leverage ratio according to its financial needs. Each subsidiary should keep its own capital structure (Mulford & Comiskey, 2011).

Maintain different financial leverage ratios can be understood from the following example. Berkshire Hathaway has many subsidiaries who work in different industries. The confectionary subsidiary of Berkshire Hathaway has lower financial leverage because as discussed earlier the confectionery industry is not capital intensive. At the same time, the financial leverage of Berkshire Hathaway energy has a high financial leverage ratio than its confectionary subsidiary. The reason is that the energy industry requires more financing than the confectionery industry.

3.      We used the figure above to discuss the role of financial management and how it differs for a domestic-only corporation relative to a multinational corporation. Discuss what the four curves represent. How can managerial decisions shift these curves? Please cite specific managerial decisions and which curve they would affect.

Managerial decisions have a huge impact on the financial management of organizations. Different decisions that the organization takes have a huge impact on the profitability, financial leverage, profitability and liquidity of the organization. In simple words from financial decisions, the profitability of the firm can increase or decrease. The costs of the organization also depend on managerial decisions (Chandra, 2011).

For instance, the organization wants to finance its assets through debt instead of equity. If the firm works in the confectionery industry than financing through debt would not be a good idea because in the confectionery industry extensive capital is not required and financing high financial leverage is not good. It means that the decisions regarding the raising capital can affect the capital structure of the firms and the cost of capital can increase or decrease due to different management decisions. Organizations should evaluate all the factors before making decisions (International Organizations, 2018).

The financial leverage of the multinational organization depends on the earnings of the organizations and the reinvestment needs of the organization. The subsidiaries of the multinational organization might involve in different industries that have different capital requirements. Therefore if different subsidiaries are going to have similar leverage ratios than not only their cost of capital will increase but also they might unable to finance their operations effectively. The end result of such a situation would be the insolvency of the subsidiary. Therefore it is recommended that each subsidiary should manage its leverage ratio according to its financial needs.

 References of Multinational Corporate Finance

Chandra, P. (2011). Financial Management. Tata McGraw-Hill Education.

Fridson, M. S., & Alvarez, F. (2011). Financial Statement Analysis: A Practitioner's Guide. John Wiley & Sons.

International Organizations. (2018). Retrieved from http://internationalrelations.org/international-organizations/

Mohana, R. P. (2011). Financial Statement Analysis and Reporting. PHI Learning Pvt. Ltd.

Mulford, C. W., & Comiskey, E. E. (2011). The Financial Numbers Game: Detecting Creative Accounting Practices. John Wiley & Sons.

Pandey, I. (2015). Financial Management. Vikas Publishing House.

Warren, C., Reeve, J. M., & Duchac, J. (2016). Financial & Managerial Accounting. Cengage Learning.