Mini Case: Brexit and Rolls-Royce

MC1) Why do you think Rolls has continued to bear this structural currency mismatch so long? Why hasnt it done what many automobile companies have done, and move some of their manufacturing and assembly to the country in which the customer resides?

MC2) Why are Rolls-Royces foreign currency hedges performing so poorly? Shouldnt the hedges be protecting its sales and earnings against exchange rate movements?

MC3) If you were a member of the leadership team at Rolls-Royce, what would you recommend the company do to manage the risks arising from Brexit?

Fundamentals of Multinational Finance Sixth Edition, Moffett, Stonehill, Eiteman. Chapter 12 page 339-343

339 CHAPTER 12 Operating Exposure A significant question remains as to the true effectiveness of hedging operating exposure with contractual hedges. The fact remains that even after feared exchange rate movements and put option position payoffs, the firm is competitively disadvantaged. The capital outlay required for the purchase of such sizeable put option positions is capital not used for the poten- tial diversification of operations, which in the long run might have more effectively maintained the firm's global market share and international competitiveness. Summary Points Operating exposure measures the change in value of the firm that results from changes in future oper- ating cash flows caused by an unexpected change in exchange rates changes in exchange rates on a firm's future cash flow, rather than being forced into passive reaction to such changes Proactive policies include matching currency cash Operating strategies for the management of operating exposure emphasize the structuring of firm operations order to create matching streams of cash flows by currencyContractual approaches (i.c., options and forwards) flows, currency risk-sharing clauses, back-to-back loan structures, and cross-currency swap agreements The objective of operating exposure management is to anticipate and influence the effect of unexpected sure but are costly and possibly ineffetual. have occasionally been used to hedge operating expo- MINI-CASE Brexit and Rolls-Royce The Business and Currency Hedging Rolls-Royce Holdings PLC is a U.K.-based multinational Rolls said it "remains committed to the UK where we are headquartered, direcily employ over 23,000 talented group that designs, manufactures and distributes power sys- tems to the aviation (civil and defense), marine, nuclear,and and connnited workers and where we carry out sig- other mdustries2 It s listed on the London Stock Exchange nificant majority of our research and development. The SE: RR) and is a member of the FTSE 100 index. It is the UK's decision will have no immediate impact on second largest manufacturer of aircraft engines in the world, day-to-day businessBusines Royce as it remains on course despite Brexit, The Telegraph, 28 June 2016. and closed 2015 with 13.725 billion in revenuc and 0.084 billion in net income. In recent years nearly all of its profits have come from the aerospace sector The decision by the people of the United Kingdom to leave But Rolls had a serious, long-term, structural cur- the European Union-Brexit- in June of 2016 raised many rency problem. Although based in the UK, with most o uestions over the future of many of the U.K 's multina ts manufacturing operations in British pounds, its global the limelight was Rolls Royce, sales were dominated by the U.S. dollar. This reflected the ce engine manufacturers in the location and identities of its major customers like Boe world. Rolls was one of Britain's major exporters, credited ing and Airbus. As illustrated in Exhibit A, this structural ly 2% of the country's annual exports Following currency mismatch mcant the company had a sgificant .S. dollars and curos. (Because many alter the company's business, and how the company's lead of the pieces parts and subcomponents used by Rolls were sourced from Continental Europe, the curo was a net short tional firms. One firm in Brexit, and the sharp decline in the British pound sterling. operating exposure problem,earning primarily analysts were attempting to gauge how the EUl exit would when paying out British pounds ership was likely to react. Copyright 2016 Thunderhird School of Global Management. All rights reserved. This case was prepared by Professor Michael Moffett for the purpose of classroom discussion only and not to indicate either etlective or ineffective management. 2 Note that Rolls-Royce Automobiles is not a part of the company, having been sold off in 1973. Today the automotive unit is owned by BMW ol Germany. 339 CHAPTER 12 Operating Exposure A significant question remains as to the true effectiveness of hedging operating exposure with contractual hedges. The fact remains that even after feared exchange rate movements and put option position payoffs, the firm is competitively disadvantaged. The capital outlay required for the purchase of such sizeable put option positions is capital not used for the poten- tial diversification of operations, which in the long run might have more effectively maintained the firm's global market share and international competitiveness. Summary Points Operating exposure measures the change in value of the firm that results from changes in future oper- ating cash flows caused by an unexpected change in exchange rates changes in exchange rates on a firm's future cash flow, rather than being forced into passive reaction to such changes Proactive policies include matching currency cash Operating strategies for the management of operating exposure emphasize the structuring of firm operations order to create matching streams of cash flows by currencyContractual approaches (i.c., options and forwards) flows, currency risk-sharing clauses, back-to-back loan structures, and cross-currency swap agreements The objective of operating exposure management is to anticipate and influence the effect of unexpected sure but are costly and possibly ineffetual. have occasionally been used to hedge operating expo- MINI-CASE Brexit and Rolls-Royce The Business and Currency Hedging Rolls-Royce Holdings PLC is a U.K.-based multinational Rolls said it "remains committed to the UK where we are headquartered, direcily employ over 23,000 talented group that designs, manufactures and distributes power sys- tems to the aviation (civil and defense), marine, nuclear,and and connnited workers and where we carry out sig- other mdustries2 It s listed on the London Stock Exchange nificant majority of our research and development. The SE: RR) and is a member of the FTSE 100 index. It is the UK's decision will have no immediate impact on second largest manufacturer of aircraft engines in the world, day-to-day businessBusines Royce as it remains on course despite Brexit, The Telegraph, 28 June 2016. and closed 2015 with 13.725 billion in revenuc and 0.084 billion in net income. In recent years nearly all of its profits have come from the aerospace sector The decision by the people of the United Kingdom to leave But Rolls had a serious, long-term, structural cur- the European Union-Brexit- in June of 2016 raised many rency problem. Although based in the UK, with most o uestions over the future of many of the U.K 's multina ts manufacturing operations in British pounds, its global the limelight was Rolls Royce, sales were dominated by the U.S. dollar. This reflected the ce engine manufacturers in the location and identities of its major customers like Boe world. Rolls was one of Britain's major exporters, credited ing and Airbus. As illustrated in Exhibit A, this structural ly 2% of the country's annual exports Following currency mismatch mcant the company had a sgificant .S. dollars and curos. (Because many alter the company's business, and how the company's lead of the pieces parts and subcomponents used by Rolls were sourced from Continental Europe, the curo was a net short tional firms. One firm in Brexit, and the sharp decline in the British pound sterling. operating exposure problem,earning primarily analysts were attempting to gauge how the EUl exit would when paying out British pounds ership was likely to react. Copyright 2016 Thunderhird School of Global Management. All rights reserved. This case was prepared by Professor Michael Moffett for the purpose of classroom discussion only and not to indicate either etlective or ineffective management. 2 Note that Rolls-Royce Automobiles is not a part of the company, having been sold off in 1973. Today the automotive unit is owned by BMW ol Germany