McDonalds Corporation (NYSE: MCD) is one of the worlds most recognized and valuable brands. But as McDonalds has grown and expanded globally, so have the investment risks associated with its investment in more than 100 countries. Like most multinational firms, it considers its equity investment in foreign affiliates capital at riskrisk of loss, nationalization, and currency valuation. McDonalds has been quite innovative in its hedging of these combined currency risks over time, finding new ways to construct old solutionssuch as Hoover Hedgesbut doing so with cross-currency swaps.

Hoover Hedges

A multinational firm that establishes a foreign subsidiary puts capital at risk, a long-time fundamental of international business. Financially, when the parent company creates and invests in a foreign subsidiary, it creates an asset, its foreign investment in a foreign subsidiary, which corresponds to the equity investment on the balance sheet of the foreign subsidiary. But the equity investment in the foreign subsidiary is now in local currency, the currency of the foreign business environment. If this is the predominant currency of this subsidiarys business, it is termed the functional currency of the subsidiary. Going forward, as the exchange rate between the two country currencies changes, the parent companys equity investment is subject to foreign exchange risk.

Many multinationals have attempted to hedge this equity investment exposure with what is described as a balance sheet hedge. Since the parent company possesses a long-term asset in the foreign currency, the company tries to hedge this asset by creating a matching long-term liability in the same currency. A long-term loan in the currency of the foreign subsidiary is typically used. The loan itself is often structured as a bullet repayment loan, in which interest payments are made over time, but the entire principal is due in a single final paymentbulletat maturity. In this way, the principal on the long-term loan acts as a match to the long-term equity investment.

These hedges are typically referred to as Hoover Hedges following the court case of Hoover Company (a vacuum cleaner manufacturer) versus the U.S. Internal Revenue Service. The primary issue in the case was whether the gains and losses from short sales in foreign currency that the Hoover Company used as hedges were to be considered to be, for tax purposes, ordinary losses, business expenses, or capital losses and gains. Although borrowing in the local currency is frequently used, there are a number of other potential hedges of equity investments, including short sales and the use of traditional foreign currency derivatives like forward contracts and currency options.

McDonalds Business Forms

McDonalds has structured its business in a variety of different ways depending on the marketplace. In the United States the company has utilized a franchising structure, where it awards a franchise to a private investor. That investor then has exclusive rights to the sale and distribution of McDonalds products and services within the designated franchise zone. McDonalds corporation owns the land and building, but the franchisee is responsible for the investment in all equipment and furnishings required for the restaurant under the franchise agreementfrom the paint-inas they describe it. This structure allows McDonalds to expand with a lower level of capital investment (the franchisee is investing a significant portion), and at the same time create a financial incentive for the franchisee to remain focused on and committed to the restaurants success and profitability. In return, McDonalds earns a royalty from the franchises sales, typically 5% to 5.5% of sales.

Alternatively, in markets where the company wishes to have more direct control and is willing to make substantially larger capital investments itself, McDonalds uses the more common form of direct ownership. Although having to put up all the capital needed for the establishment of these restaurants, it gains more direct control over operations. Much of McDonalds international expansion has been structured under this more common direct ownership approach, but at the risk of substantial amounts of capital, as the company seeks to gain a major presence in a growing number of countries.

The British Subsidiary and Currency Exposure

In the United Kingdom, McDonalds owns the majority of its restaurants. These investments create three different British pound-denominated currency exposures for the parent company.

The British subsidiary has equity capital, which is a British pound-denominated asset of the parent company. The parent company provides intracompany 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. An additional technical detail further complicates the situation. When the parent company makes an intracompany loan to the British subsidiary, it must designateaccording to U.S. accounting and tax law practiceswhether the loan is permanently invested in that country. Although on the surface it seems illogical to consider four years permanent, the loan itself could simply be continually rolled over by the parent company and never actually be repaid.

If the loan is not designated permanent, the foreign exchange gains and losses related to the loan flow directly to the parent companys income statement, according to U.S. accounting practices, which is the primary standard for U.S. foreign currency reporting. If, however, the loan is designated as permanent, then the foreign exchange gains and losses related to the intracompany loan flow only to the cumulative translation adjustment account (CTA), a segment of consolidated equity on the companys consolidated balance sheet. To date, McDonalds has chosen to designate these loans as permanent. The functional currency of the British subsidiary for consolidation purposes is the local currency, the British pound.

Cross-Currency Swap Hedging

Anka Gopi is an assistant manager in Treasuryand a McDonalds shareholder. She is currently reviewing the existing hedging strategy employed by McDonalds against its pound exposures.

McDonalds has been hedging the rather complex British pound exposure by entering into a cross-currency U.S. dollarBritish pound sterling cross-currency swap. The current swap is a seven-year swap to receive dollars and pay pounds. Like all cross-currency swaps, the agreement requires McDonalds (U.S.) to make regular pound-denominated interest payments and a bullet principal repayment (notional principal) at the end of the swap agreement.

provides a brief map of how the cross-currency swap strategy works. The cross-currency swap serves as a hedge of both the regular royalty and interest payments in British pounds made to the U.S. parent, and the outstanding swap notional principal in British pounds serves as a hedge of the equity investment by McDonalds U.S. in the British subsidiary. According to accounting practice, a company may elect to take the interest associated with a foreign currency-denominated loan and carry that directly to the parent companys consolidated income. This has been done in the past, and McDonalds benefitted from the inclusion.

One of Ankas concerns is that under FAS #133, Accounting for Derivative Instruments and Hedging Activities, the firm must mark-to-market the entire cross-currency swap position, including principal, and carry this to other comprehensive income (OCI). This has proven a bit troublesome in the past because cross-currency swaps are subject to so much volatility in value when marked-to-market, a direct result of the large notional principal bullet repayment feature they typically carry.

Anka wondered how important OCI was to investors. OCI was a measure of below the line income, income required under U.S. GAAP and reported in the footnotes to the financial statements. It was below net income (and therefore below earnings and earnings per share as reported to the markets), and included a variety of adjustments arising from consolidated equity (such as these gains and losses associated with hedging instruments and positions).

Anka Gopi wanted to reconsider the current hedging 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.

How does the cross-currency swap effectively hedge McDonalds three primary exposures relative to its British subsidiary? How does the cross-currency swap hedge the long-term equity position in the foreign subsidiary? To what degree, if at all, should Ankaand McDonaldsworry about OCI?