How Exchange Rate Fluctuations Lead to Economic Exposure

This report discusses the impact of exchange rate fluctuations on economic exposure and cash flow. It explores the relationship between exchange rates and the growth of an economy, as well as the factors that contribute to economic exposure. The report also provides recommendations for managing exchange rate risks and discusses the issues related to financing a project.

Assessment

Contents
INTRODUCTION.....................................................................................................................................3
MAIN BODY.............................................................................................................................................3
(a) Explain how exchange rate fluctuations may lead to economic exposure....................................3
(b) Preparation of discussion paper:..................................................................................................4
CONCLUSION..........................................................................................................................................8
REFERENCES..........................................................................................................................................9

INTRODUCTION
The report is based on an engineering company that is SIRI BHD. Currently company is
planning to invest in a larger project which is needed an investment of RM 400 million. In
addition to this, company wants that the funding of such project must be fulfilled by sale of its
equity investment in a USA company and from cash flows generated from its normal business
activity. For this purpose, various kinds of aspects are evaluated in order to take decision
whether above company needs to make investment in larger project or not. In detailed manner,
the project is divided into two parts in which first part contains information about impact of
change in exchange rate on economic exposure. While in second part different kinds of elements
are included like calculation of dividend capacity, selection of hedging technique and many
more.
MAIN BODY
(a) Explain how exchange rate fluctuations may lead to economic exposure.
The term economic exposure is known as extent to which a business’s cash flow is
affected due to changes in exchange rates (Prasad and Suprabha, 2015). In other words,
the economic exposure raises as foreign exchange volatility raises and decreases as it
drops. This is defiantly higher for global companies which have different kinds of
subsidiaries companies and higher volume of transactions including foreign currencies.
In the case when PPP (Purchasing power parity) holds, then companies might not get
affected due to change in exchange rates as low currency value may be compensated
through efficiency to increase prices because of higher level of inflation. In addition to
this, if one nation has increases rate of inflation instead to other then its currency is
estimated to reduce during entire time. Though, as the PPP (Purchasing power parity) the
rule of one price contains because any issue in one currency will be compensated by rate
of inflation in currency’s nation or any group of nation in the case of USD. Though, a
regular change in exchange rate can occur but due to relative inflation rate differentials.
In the case when rule of one price will not be considered and prices re-changed to a new
or larger or fixed rate. For instance, the United Kingdom to USA rate dropped in the 20th
century, as USA’s economy raised in an effective manner as compared to United
Kingdom. The rate approximately reached at parity in 1985 just before recovering.

Though, till monetary crises during year 2009, this has changed between approximately
$1.5 to 1 pound and $1.7 to 1 pound. In such aspects in which a firm achieves enough
value of sales by their companies which are based in nations with relative to poor
economies (Dong, Kouvelis and Su, 2014). This can be find that it is facing economic
exposure and its cash flow dropped during longer amount of time period.
Basically, there is a significant relation between exchange rate and growth of economy.
In the case when there is exchange rate appreciation than there will be slower growth of
real GDP due to decrease in net volume of exports. And increase in demand for imports
(a raised leakage in circular of flow). A decrease in demand and production can lead to
issue of loss of job as company manage to control the expenses. Some losses of jobs are
temporary leading to brief term variation in export of demand and import of penetration
(Korhonen, 2015). The rest of aspects are permanent in the case when imports consider a
fixed high share of domestic market. So overall, this can be stated that an increased
exchange rate may put an adverse impact on economy of a nation. Though some sectors
are highly exposed instead to other fluctuation of currencies like sectors in which there is
a higher percentage of total production is exported and demand is higher price sensitive
which is also known as price elasticity.
(b) Preparation of discussion paper:
(i) Estimation of Siri BHD’s dividend capacity as at 28 February 2018
Dividend capacity- The term dividend capacity can be defined as the amount of cash
available to stakeholders after managing all kinds of expenses at the end of financial
year. This is also known as free cash flow to equity (Ahmed and Murtaza, 2015).
Under this the computed value is considered as a net amount which is remained only
to pay preference shareholders as per their share in respective company. With
rationale to above company, below calculation of dividend capacity has been done
which is as follows:
Anticipated dividend capacity before large project investment-
Operating profit (15%*(1.08*RM 3 Million) 48600000
Less: Interest (5% of RM 70 Million) -3500000

Less: Taxation (25% * (RM 48.6 Million-3.5 Million) -11275000
Less: Investment in working capital ($0.10*(0.08*RM 3 Million) -2400000
Less: Investment in additional non-current assets ($0.20*(0.08*RM 300
Million) -4800000
Less: Investment in projects -8000000
Cash flow from domestic operations 18625000
Cash flow from TTY Co dividend remittances 3297000
Additional profit on TTY Co profits (5% * $5.6 Million) -2800000
Dividend capacity 21642000
Dividend settlements anticipated from TTY Co
Total contribution ($60*4000000 units)
2400000
0
Less: Fixed cost 4000000
Less: Taxation (20%*5.6 Million) 1120000
Profit after tax 4480000
Remitted to SIRI BHD (80%*$4.48 Million *92%) 3297280
(ii) Advises SIRI BHD on, and recommends, an appropriate hedging strategy for the
USD receipt:
In the aspect of SIRI BHD, this can be stated that can emphasis on one of the suitable
forward contracts, futures contracts or option contracts to hedge USD receipt-
Forward contract-
Though, this is a $ receipt, the 3.8559 rate will be applied.
$200,000,000*3.8559= $771,180,000
Future contract-
In order to secure against poor USD and using the June month contract to hedge as
receipt is estimated at May 2017 or starting of June 2017 (Within period of 3
months).

The contracts of June month will be ended before one-month period of expiration,
hence estimated future prices (In accordance of Linear narrowing) is: RM 3.8538 +
[(2/3*(RM 3.8552-RM 3.8535)] = RM 3.8547
Estimated receipts: $200000000/RM 3.8547= $51884712.00
Number of contracts purchased: $51884712.00/$125000= 415 contracts
(Approximately)
Option contract-
Bought call option of June in order to secure poor performing value of $ and receipt is
estimated at the end of May 2017 or starting of June 2017.
The price of exercise is of 3.8500, thus estimated receipt is $200,000,000/3.8500=
$51,948,051.00
Contracts purchased = $51,948,051.00/$125,000 = 415
Amount hedged = $125,000 x 415 = $51,875,000
Premium payable = 415 x 125,000 x 0.0135= $700,312
Premium in $ = $700,312 x RM 3.9618 = RM2,774,496
Amount not hedged = USD200,000,000 – (415 x 125,000 x 3.8500) = $281,250
The forward contracts are not used to hedge $ 281,250.
$281,250* RM 3.8559= RM1,084,471.87
Total receipts = $51,875,000+ $1,084,471.87– $2,774,496= $ 50,184,975.87
Recommendation: Under different types of option, there is distinct value of receipts.
As by using options contract, there will be lower receipt at $50,184,975.87 through
selling of investment. On the other side, using future contract for hedging will offer
higher receipt at $51,884,712.00. In the forward contract, the value of receipts is of $
771,180,000.
The lowest receipt under option contract is because of value of premium payable that
permits option purchaser to let the option lapse must the $ strengthen. In such context,
option contract will be allowed to lapse and SIRI BHD will transfer $ into MYR at

the rate of prevailing spot rate during time period of 3 months. Though, it is important
to strengthen $ effectively before expense of option is covered.
(iii) Assesses whether or not the project would add value to Siri BHD:
In according to given information in brief about dividend and calculated values in
above parts this can be recommend that project will not add value to Siri BHD. This
is so because dividend capacity of above company has been reduced after making all
settlements. In addition to this, receipt value is too lower under option contract. So
looking at these aspects this can be stated that dividend capacity value is low as
compare to given value of dividend in brief. If above company will make investment
in larger project than this will lead to less earnings and financial losses in upcoming
time period so they should not make investment in such project due to above
mentioned reasons.
(iv) Discusses the issues of proposed methods of financing the project
In the case when larger project is not considered and dividend growth rate is managed
at historical level:
Dividend history:
Year to end of February 2013 2014 2015 2016
Number of $1 equity shares in
issue (000)
600000 600000 600000 600000
Total dividends paid ($000) 128320 136020 192240 203370
Dividend per share $0.214 $0.227 $0.240 $0.255
Average dividend growth rate = (0·254/0·213)1/3 – 1 = 1·0602 (6%)
Expected dividend in February 2019 = $0·255 x 1·06 = $0·270
SIRI BHD projection of value if larger project is not considered = $0·270/ (0·12 –
0·06) = $4·50 per share
In the case when larger project is considered:
Needed funds for project $400,000,000

Funds through selling of investment $771,180,000
Funds needed by dividend capacity cash
flows
(371,180,000)
Dividend capacity funds before transfer
to project
$216,420,000
Dividend capacity funds remained after
transfer
($154,760,000)
Annual dividend per share after transfer $0·193
Annual dividend paid (end of February
2019 and February 2020
$0·193
Dividend paid (end of February 2021) $0·3100
New growth rate 7%
In accordance of above done analysis, this can be inferred that there will be negative
value if SIRI BHD will undertake larger project. It has been justified by above table
that there is negative value of dividend capacity fund which is of ($154,760,000). If
above company will make investment in such project than this will be a drawback for
them in order to gain higher return in long run. As well as this might also lead to a
range of expenses in upcoming time period.
CONCLUSION
On the basis of above mentioned project report this can be concluded that Siri BHD should not
make investment in larger project. This is so because there is negative value of dividend capacity
fund which is of -$154,760,000. If they will make invest in such project than there will be loss to
company. In addition to this, option contract is suitable among different kinds of alternatives
available for hedging of receivables. Along with, report concludes that exchange rate fluctuations
have a significant impact on economic exposure this is so because various elements of an
economy are linked with exchange rates. It depends on efficiency of government of a particular

company that how well they are dealing with significant changes in exchange rates and
overcoming its adverse impact on various aspects of a nation.

REFERENCES
Prasad, K. and Suprabha, K.R., 2015. Measurement of exchange rate exposure: Capital market
approach versus cash flow approach. Procedia Economics and Finance, 25, pp.394-399.
Dong, L., Kouvelis, P. and Su, P., 2014. Operational hedging strategies and competitive
exposure to exchange rates. International Journal of Production Economics, 153, pp.215-
229.
Korhonen, M., 2015. The relation between national stock prices and effective exchange rates:
Does it affect exchange rate exposure? Global Economy Journal, 15(2), pp.241-256.
Ahmed, S. and Murtaza, H., 2015. Critical analysis of the factors affecting the dividend payout:
Evidence from Pakistan. International Journal of Economics, Finance and Management
Sciences, 3(3), pp.204-212.