Translation risk: This is the risk that the concern will make exchange loses when accounting results of its overseas branches or subsidiaries are translated into home currency. For Big White Mountain plc this can occur while it takes account of profits from its joint venture in China or accounts of factories in Taiwan and India (Homaifar, 2003).
Transaction exposure: This is the risk of unfavourable exchange rate changes occurring during regular international trading transactions. This arises when the prices of import or exports are fixed in foreign currency terms and there is a movement in exchange rates between the date when the price is decided and the date when the cash is paid or received in settlement. This risk is present for the company presently as it is currently operating in EU only but as it expands its operations to the US this risk will become very threatening (Herring, 1986).
Economic risk: this refers to the impact of exchange rate changes on international competitiveness of a company and refers to the effect of the present value of normal term cash flows. Big White Mountain exports its products in EU so an appreciation of sterling against other EU currencies will erode the competitiveness of the company economic exposure can be difficult to steer clear of although diversification of supplier and customer base across different nations will reduce this kind of exposure to the risk. With the company expanding to the United States of America diversification will take place hence this risk exposure can be reduced (Frydman & Goldberg, 2007).
Payments Risk is a risk associated with international trade. There is a great risk during a business dealing that after BMW has completed its part of the deal, that is, perhaps, delivered the goods on time but the customer is unable to make the payment perhaps due to the fact that it has gone bankrupt from the time delivery is made to the time of payment, assuming credit trading is taking place or because the banking system has due to some reason restricted the supply of pound sterling. Thus, payment risk is assumed until the currency is exchanged for a tangible good or service; at that time the risk is passed on to the individual or institution receiving the currency (Trace Mayor, 2008).
Risk due to loss can be threatening when the a large amount of goods, for example, is burned due to fire or the stock or there is some restrictions, locally or internationally, on the luggage that can be carried during travel, as BMW produces travel clothes, footwear and backpacks and other travel luggage.
Ways in which company can manage its currency risk exposure
Three a company can use to manage its exchange rate risk are:
Forward exchange contracts
Money market hedge
Foreign currency derivatives
Forward exchange contracts manage transaction risk by allowing the exporter to arrange for a bank to sell or buy a quantity of foreign exchange currency at future date, at a rate of exchange determined when the forward contract is made. The trader will know in advance either how much local currency he will receive or how much he must pay (Andersen, 1993). A forward exchange rate is an immediately firm and binding agreement between, for instance, between a bank and its customer. It is for the purchase of or sale of a specified quantity of foreign currency. In the case of Big White Mountain plc, it can be used for payment in factories in India and Taiwan and for receipts from its customers in EU. Forward exchange contract has a rate of exchange fixed at the time contract is made. It is made for performance at a future time when the contract is made. The forward rate can be calculated today without making any estimates of future exchange rates. Future exchange rates depend largely on future events and will often turn out to be very different from forward rates. For Big White Mountain plc cash flows and profits while making budgets might be made certain to a large extent as it will hedge it foreign exchange risk as it will only be only market risk that it will have to face. However, the forward rate exchange rate is probably the unbiased predictor of the future exchange rates based on the information available presently (Derosa, 1996).
Money market hedge: includes borrowing in one currency transferring the money borrowed in to another currency and placing the money for investment in anticipation of the time the transaction is completed, expecting to take benefit of unfavourable exchange rate movement. This is made possible because of the close relationship of the exchange rate and the interest rate in two currencies so that it is possible to manufacture a forward exchange rate and money market lending or borrowing. For instance, in this case when the company will be receiving sales receipt the company can borrow an appropriate amount of foreign currency that can be enough to cover the receipts that it is expecting to receive in the near future (Pecchenino, 2001). It will than convert the money immediately to pound sterling after that it can deposit it in UK so that when the cash is received the foreign currency loan can be repaid and it can withdraw cash from home currency deposit account in order to make use of is sales receipts not only from EU but also from its joint venture in China. This process can be reversed for payments it may have to make to its production units (Drobny, 2006).
Foreign currency derivatives: foreign currency derivatives are used to hedge foreign currency risk. It has a few techniques one of them is Currency options which protect against adverse exchange rate movements while allowing it to take advantage of favourable exchange rate movements. They are particularly useful where the cash flows are not certain (Taylor, 2004). The currency option is a right of the currency holder to buy or sell foreign currency at a specific exchange rate at a future date. The exercise price for the option may be the same as the current spot rate, or it may be more favourable or less favourable to the option holder than the current spot rate. Perhaps one of the biggest advantage of using currency options is that they are tradable from an exchange is bought. They are usually available for all the currencies in EU as well as pound sterling and dollar (Cofnas, 2010). Buying a currency option involves paying a premium, which is the most a buyer of the currency option can lose. The problem of the currency option is t, as discussed above is to reduce or eliminate exposure to currency risk, and they are particularly used in companies, not unlike Big White Mountain plc where there is a uncertainty about foreign currency receipts or payments, either in timing or amount. As it is so the receipts and payment in Big White plc, that is, the sales that will occur are unpredictable. It is favourable because if a foreign currency transaction doesn't materialise option can be sold on options market or exercise if this would make a profit. Also it will allow Big White Mountain plc the publication of a price list for its goods in foreign currency to protect the import or export the foreign currency goods. In such situation the company would know whether it would have any sales or any foreign currency sales at the time it announces selling prices. It can not make a foreign currency exchange contract to sell with out becoming exposed to the currency. Although the currency options has certain drawbacks including the dependence on the expected volatility of the exchange rate, the options must be paid for as soon as they are bought and tradable options are not available in every currency, for example, as the company is considering establishing its production in brazil it is highly probable that the currency options are not available in the market (Graham, 2001).
Finance for expansion
As the expansion being considered is major so their will be considerable sum of finances required and it will not be possible to raise it through internal sources, overdraft and trade credit will also not be sufficient enough to fulfil the need so external sources of finance will need to be considered.
There are two types of external finance for a company one Equity finance (shares) or Debt Finance (Bonds and bank loans). As BMW is a stock exchange listed company it can issue both equity and debt finance.
If the company chooses to raise fiancé through debt it may be able to take advantage of less cost and easier availability and enjoy tax relief on interest payment. If the company does decides to issue debt fiancé it will need to consider what type of finance it will need to finance expansion it is considering. If it considers medium or short term loan feasible enough bank may be the best authority however for long term loans stock exchange might be a better option. Once decided that long term debt will be issued it must decide with loan will be repaid, whether their will be conversion rights attached and whether warrants will be attached. If it decides to issue loan notes then as is known that the loan notes have a nominal value which is debt owed by the company and interest rate is paid at a stated coupon on this amount. The rate is quoted at gross rate before tax. The debt is commonly issued at par where the coupon rate is fixed at the time of the issue and will be set according to the prevalent market conditions given the credit rating of BMW.
Deep discount bonds are a type of loan notes issued at price which offers a large discount to the nominal value of the loan notes, and which will be redeemed at par (or above par) when they eventually mature. Investors might be attracted to buy the large capital gain offered by the bonds, which is the difference between the issue price and the redemption value. However, deep discount bonds will carry a much lower rate of interest than other loan notes. The only tax advantage is that the gain gets taxed (as income) in one lump on maturity or sales not as amounts of interest each year. The buyer however can deduct notional interest each year in computing profits (Faerber, 2001).
Zero coupon bonds are bonds that are issued at a discount to their redemption value but no interest is paid on them. The investor gains from the difference between the issue price and the redemption value. There is an implied interest rate in the amount of discount at which the bonds are issued (or subsequently resold on the market). BMW this way can raise cash immediately and there is no cash redemption until redemption date. The cost of redemption is known at the time of the issue. The company can have funds available to redeem bonds. Hence, no initial cost will have to be born by BMW when it makes the investment for extension. The lenders however will be restricted and might not find this very attractive (Maturi, 1995).
Convertible loan notes, another type of debt, give the holder the right to convert to other securities normally ordinary shares, at a pre-determined price/rate and time. Conversion terms can vary overtime. The current market value of ordinary shares in to which a loan note may be converted is known as the conversion value. The conversion value will be below the value of the note issue but will be expected to improve as the date of the conversion approaches on the assumption that the company's shares ought to increase in the market value over time. The company will aim to issue loan notes with the greatest possible conversion premium (difference between current market value and current conversion value) as this will mean that, for the mount of capital raised , it will, on conversion, have to issue the lowest number of new ordinary shares. As the company has a recognised brand and given its expansion plans in consideration so there is great growth potential so the premium that will be accepted by the potential investors will not be that much as a sizeable increase in the price of the shares can be expected.
Equity finance will involve either an Initial Public Offering (IPO), if BMW has not issued shares to the public already, or a rights issue if it has already issued shares through an IPO also a placing can be considered.
An initial public offer is a method of offering the shares of an entity to the public at large. When entities go public initially, a large issue will most likely take the shape of an IPO. Subsequent issues are likely to be placings or right issues. As BMW is already a public listed company it is more than probable that it will have issued shares (Kleeburg, 2005).
With the arrangement of placing the shares are not all offered to the public, but in its place, arrangement is made by the sponsoring market maker for the majority of the issue to be purchased by few sponsors, usually institutional investors for example pension funds and insurance companies. Placings are much cheaper. Approaching institutional investors privately is a much cheaper way of obtaining finance, and thus placings are often used for smaller issues. The company will have to decide whether placings will be enough to gather finances for its expansion. Placings are likely to be quicker, and are likely to involve less disclosure of information. As the company is considered to be top brand disclosure of information might not be problem as a competitor is unlikely to threaten its current market standing. However, majority of the shares will be placed with relatively a small number of share holders, this denotes that most of the shares are improbable to be accessible for trading subsequent to their issue and the institutional shareholders will have the control of the company. Existing shareholders will not like this as it will mean that they might lose the control of the company.
A rights issue provide a way of raising new share capital by way of an offer to current shareholders, asking them to subscribe cash for new shares in ratio to their existing holdings.
There are number of advantages of rights issue including:
Rights issues are cheaper than general public offering. Prospectuses that are issued for public offering are very expensive and for rights issue they are not normally required, partly because the administration is simpler and also because underwriting cost will be less.
Existing shareholders will be benefited more from right issue than public offering. Discount is usually given on new shares issued is considerable as compared to the current market price to make it more appealing for the investors. Shareholders after exercising their rights can either sell their shares if they wish at the prevalent market price that is taken to secure the discount.
Voting rights relatively are not affected if share holders take up all the rights
Finance raised may be used to decrease gearing in book value terms this will be by increasing share capital or by paying off long term loan resulting in the reduction of gearing in market value terms.
Appendix
Graph 1: Exchange rate of GBP against Euro
http://uk.finance.yahoo.com/q/bc?s=GBPEUR=XHYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPEUR=X&t=5y&l=on&z=m&q=l&c"&HYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPEUR=X&t=5y&l=on&z=m&q=l&c"t=5yHYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPEUR=X&t=5y&l=on&z=m&q=l&c"&HYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPEUR=X&t=5y&l=on&z=m&q=l&c"l=onHYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPEUR=X&t=5y&l=on&z=m&q=l&c"&HYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPEUR=X&t=5y&l=on&z=m&q=l&c"z=mHYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPEUR=X&t=5y&l=on&z=m&q=l&c"&HYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPEUR=X&t=5y&l=on&z=m&q=l&c"q=lHYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPEUR=X&t=5y&l=on&z=m&q=l&c"&HYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPEUR=X&t=5y&l=on&z=m&q=l&c"c=
Graph 2: Exchange rate of GBP against USA Dollar
http://uk.finance.yahoo.com/q/bc?s=GBPUSD=XHYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPUSD=X&t=5y&l=on&z=m&q=l&c"&HYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPUSD=X&t=5y&l=on&z=m&q=l&c"t=5yHYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPUSD=X&t=5y&l=on&z=m&q=l&c"&HYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPUSD=X&t=5y&l=on&z=m&q=l&c"l=onHYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPUSD=X&t=5y&l=on&z=m&q=l&c"&HYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPUSD=X&t=5y&l=on&z=m&q=l&c"z=mHYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPUSD=X&t=5y&l=on&z=m&q=l&c"&HYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPUSD=X&t=5y&l=on&z=m&q=l&c"q=lHYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPUSD=X&t=5y&l=on&z=m&q=l&c"&HYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPUSD=X&t=5y&l=on&z=m&q=l&c"c=
Graph 3: Exchange rate of GBP against TAIWAN Dollar
http://uk.finance.yahoo.com/q/bc?s=GBPTWD=X&t=5y&l=on&z=m&q=l&c=
Graph 5: Exchange rate of GBP against CHINA Yuan
http://uk.finance.yahoo.com/q/bc?s=GBPCNY=XHYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPCNY=X&t=5y&l=on&z=m&q=l&c"&HYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPCNY=X&t=5y&l=on&z=m&q=l&c"t=5yHYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPCNY=X&t=5y&l=on&z=m&q=l&c"&HYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPCNY=X&t=5y&l=on&z=m&q=l&c"l=onHYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPCNY=X&t=5y&l=on&z=m&q=l&c"&HYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPCNY=X&t=5y&l=on&z=m&q=l&c"z=mHYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPCNY=X&t=5y&l=on&z=m&q=l&c"&HYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPCNY=X&t=5y&l=on&z=m&q=l&c"q=lHYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPCNY=X&t=5y&l=on&z=m&q=l&c"&HYPERLINK "http://uk.finance.yahoo.com/q/bc?s=GBPCNY=X&t=5y&l=on&z=m&q=l&c"c=
Graph 6: Exchange rate of GBP against INDIA INR
http://uk.finance.yahoo.com/q/bc?s=GBPINR=X&t=5y&l=on&z=m&q=l&c=
Graph 7: Exchange rate of GBP against Brazilian Real (BRL)
http://uk.finance.yahoo.com/q/bc?s=GBPBRL=X&t=5y&l=on&z=m&q=l&c=
