Download Group 3 Presentation

INTERNATIONAL FINANCE
McDonald’s Corporation’s British Pound Exposure
GROUP 3
Made Yolanda Rizkita Margana
Nadhifah Almas
Navianra Pinchi
Putu Sekar Maitri Dewi
Romi Septa Muharram
Velicia Faustine Halim
2006553630
2006553832
2006553870
2006553990
2006499950
2006554500
CASE SYNOPSIS
McDonald’s parent company has three different pound-denominated exposures arising from its ownership
and operation of its British subsidiary.
1.
The British subsidiary has equity capital, which is a pound-denominated asset of the parent
company.
2.
The parent company provides intra-company debt in the form of a four-year £125 million loan.
The loan is denominated in British pounds and carries a fixed 5.30% per annum interest payment.
3.
The British subsidiary pays a fixed percentage of gross sales in royalties to the parent
company and it is also pound-denominated.
For intra-company loan, McDonald’s has chosen to designate the loan as permanent → the foreign
exchange gains and losses related to the intra-company loan would flow only to the CTA (cumulative
translation adjustment) on the consolidated balance sheet.
CASE SYNOPSIS
The company has been hedging the pound exposure by entering into a cross-currency U.S. dollar/British
pound sterling swap. The current swap is a seven-year swap to receive dollars and pay pounds, which the
agreement requires McDonald’s (U.S.) to make regular pound-denominated interest payments and a bullet
principal repayment (notional principal) at the end of the swap agreement.
The complexity of FAS #133, Accounting for Derivative Instruments and Hedging Activities, combined with
the workloads associated with Y2K (year 2000) risk controls, potentially will influence U.S.-based MNEs. So,
dozens of major firms persuaded the Financial Accounting Standards Board to delay FAS #133’s mandatory
implementation date indefinitely.
Anka Gopi, Manager for Financial Markets/Treasury and a McDonald’s shareholder, still wishes to consider
the impact of FAS #133 on the hedging strategy currently employed because the firm will have to
mark-to-market the entire cross-currency swap position, including principal, and carry this to other
comprehensive income (OCI).
Anka Gopi also wished to reconsider the current strategy. She began by listing the pros and cons of the
current strategy, comparing these to alternative strategies, and then deciding what if anything should be
done about it at this time.
1. How does the cross-currency swap effectively
hedge the three primary exposures McDonald’s
has relative to its British subsidiary?
There are three primary exposures which stated on the passage. Those are:
●
●
●
The British subsidiary has equity capital, which is a British pound-denominated asset
of the parent company.
The parent company provides intra-company debt in the form of a four-year loan.
The loan is denominated in British pounds, and carries a fixed rate of interest.
The British subsidiary pays a fixed percentage of gross sales in royalties to the parent
company. This too is pound-denominated.
Key Terms
Hedge
Pound-denominated
assets
Equity
Capitals
The purpose of this hedging is to lock in the dollar and avoid the increasing
cost of pounds in the seven years period. And, a cross-currency interest rate
swap allows a firm to alter both the currency of denomination of cash flows
in debt service and the fixed-to-floating or floating to-fixed interest rate
structure (Eiteman et al., 2016).
Our Explanation
The British subsidiary of McDonald's has a fixed interest rate denominated in the pounds.
Through cross currency swapping the subsidiary of McDonald's is able to break away from its
fixed interest rate and can adopt the floating interest rate from its US parent company; they are
participating in the swap of floating for fixed. In doing so, they assume that with that there will be
a drop in the floating interest rate reducing their fluctuating payments. This method also comes
with a large risk. The British subsidiary also takes on the added risk that the interest rate may
increase with the float.
Using this swap, McDonald's will be paying out pounds and slowly reducing their holdings of the
foreign currency. With each payment they are reducing the risk associated with the pounds and
their investment in a foreign country. McD uses currency swaps to alter the denomination of
cash flows in debt services to fix or alter interest rates which can change their interest payments.
These swaps are also used to avoid making high royalty or more expensive payments.
In short words, the cross-currency swap can hedge effectively three
primary exposures. Assets that have equity capital in nominal terms
using pounds here are very risky. Why is it at high risk? Because there
is floating interest, which makes the pound even more risky when its
interest increases. This shows that the pound is volatile to use.
We can see that McD wants to reduce holding foreign currency. It said
pay pounds and receive dollars. Of course, here it can be seen that the
swap strategy reduces risk, or in other words, it hedges effectively.
Our Team Members’ Thoughts
Our teams also thought the cross-currency swap can be an advantageous strategy for
parent’ company. It will be easier for them to use the money supply that mostly comes from
the parent’ company which here is using dollars. The dollar market, however, is much deeper
and less easily saturated (Henderson, 1986).
Therefore the dollar capital market would impose a larger spread in interest rates between
the two parties than the British Pounds capital market; the spread in the dollar market more
accurately reflects the real credit distinction between them (Henderson, 1986).
In this situation, the swap arbitrages the difference in spreads which results from the
difference in depth between various capital markets, enabling each party to obtain financing
in the market in which it is most favorably received (Henderson, 1986).
2. How does the cross-currency swap hedge the
long-term equity position in the foreign
subsidiary?
In this case, the seven-years agreement requires McD’s US to make
regular pound interest payments plus a bullet/final principal repayment at
the end of the agreement at swap term, and allows it (McD’s US) to
receive dollars for payment of pounds.
Cross currency swap hedges the long term equity position, as McD’s US
locks in the cost of payment over a seven-year agreement, takes
advantage of the current rate, locks in the dollar, and hedges that against
the risk of rising costs of paying the pounds.
2. How does the cross-currency swap hedge the
long-term equity position in the foreign
subsidiary? (Continue)
The notional principal involved in the swap however serves as a hedge of the equity
investment by McD’s US in the British subsidiary against changes in currency
values and protects McD’s US against the possibility of rising payment over time,
and hedges against losses in the value of the dollar when the cost of the pound
maybe higher.
Moreover, the total net interest settlements are recognized over the term of the
hedging instrument in other comprehensive income along with the gains and
losses on the hedging instrument. Both these amounts will be reclassified from
equity to OCI (e.g. under profit or loss on disposal of the foreign operation).
3. Should Anka—and McDonald’s—worry
about OCI?
Our considerations:
More Volatility and
Changes in OCI
Because of FAS #133
The Newly Proposed
Accounting Standard
Arguments about
OCI
Is An Accounting-based
Measurements Excluded
From Net Income
OUR ANSWER IS YES.
OCI Matters
It could predict future
cash flow
Consideration 1
More Volatility and Changes in OCI Because of FAS #133 The Newly Proposed
Accounting Standard
● Requires McDonald's
mark-to-market the
value of the outstanding
swap on a regular
(quarterly) basis,
● include the resulting
gains/losses on the
swap in Other
Comprehensive Income
(OCI)
● Combining the
Cumulative Translation
Adjustment (CTA) could
potentially result in
volatile movements in
the OCI.
● Long-term swaps with
large notional
principals outstanding
will change significantly
in value.
Consideration 2
Arguments: OCI Is An Accounting-based Measurements Excluded From Net Income
● Commonly, the
volatility in the OCI is
not the measure of
earnings which is
popularly reported and
focused on by most
analysts.
● Excluded from the net
income, whereas the
cash flow is more
important the
accounting-based
measurements
Consideration 3
OCI Matters About Future Cash Flow
● Once any derivative
contracts are settled,
those gains and losses
will be realised and
therefore will be
removed from the OCI
to be included in the
net income
● Significant deterioration in
its reported OCI as a result
of marking-to-market its
cross-currency swap
(hedge) position would
have a chance that the
firm will appeal less
interesting to the market.
Within these considerations, our answer is Yes.
Furthermore, McDonalds should continue to follow the FAS #133 closely and
continually reviews its currency hedging strategies and accounting policies and
practices.
Conclusions (1)
●
●
To conclude, we find from this case that the issue related to translation exposure is highly
relevant because financial statements of foreign subsidiaries, which are stated in their
local currency, must be restated in the parent’s reporting currency so that it can formulate
the consolidated financial statements. Translation exposure is the potential for an increase
or decrease in the parent’s net worth and reported net income that is caused by a change
in exchange rates which will be a concern when there are so much volatility and
fluctuations in the currency.
Therefore, it is a beneficial move for McDonald's corporation to utilize the cross-currency
swap to hedge against British pound exposure effectively because it can reduce the risk
associated with pounds. Furthermore, the strategy also can be used to avoid making high
royalty or more expensive payments.
Conclusions (2)
●
●
The Cross currency swap hedges the long-term equity position taking advantage of the current
lower rates and hedge that against the final payment when the cost of the pound may be
higher.
McDonald’s should worry about OCI since more volatility and changes will be created due to
the new accounting standard, FAS #133. Because it will require the firm to mark-to-market the
value of outstanding swap on regular basis, it will cause a large fluctuation from the gains and
losses on the swap in OCI through the CTA account. The changes will be potential for an
increase or decrease in the parent’s net worth and reported net income that is caused by the
foreign currency translation adjustment. If there are any extreme changes, there would be a
chance that the firm will appeal less interesting to the market.
Thank You