Chapter 9

Operating Exposure

◼ End-of-Chapter Questions
1. Definitions. Define the following terms:
(a) Economic exposure.
Answer: Economic exposure emphasizes that the exposure is created by the economic
consequences of an unexpected exchange rate change. Economic consequences, in turn,
suggests that the impact is due to the response of external forces in the economy, rather
than, say, something directly under the control of management.
(b) Competitive exposure.
Answer: Competitive exposure suggests that the consequences of an unexpected exchange rate
change are due to a shift in the competitive position of a firm, vis-á-vis its competitors.
(c) Strategic exposure.
Answer: Strategic exposure suggests that matters of long-range cost changes and price setting,
needed to anticipate or adjust to an unexpected change in exchange rates, are matters of
corporate strategy; i.e., how the company positions itself in anticipation of risks caused by
exchange rate changes.

2. Operating versus transaction exposure. Explain the difference between operating exposure and
transaction exposure.
Answer: Both exposures deal with changes in expected cash flows. Transaction exposure deals
with changes in near-term cash flows that have already been contracted for (such as
foreign currency accounts receivable, accounts payable, and other debts). Operating
exposure deals with changes in long-term cash flows that have not been contracted for but
would be expected in the normal course of future business. One might view operating
exposure as “anticipated future transactions exposure,” although the concept is broader
because the impact of the exposure might be through sales volume or operating cost
changes.
Given a known exchange rate change, the cash flow impact of transaction exposure can be
measured precisely whereas the cash flow impact of operating exposure remains a
conjecture about the future.
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3. Unexpected exchange rate changes;

(a) Why do unexpected exchange rate changes contribute to operating exposure, but expected
exchange rate changes do not?
Answer: An expected change in foreign exchange rates is not included in the definition of operating
exposure, because both management and investors should have factored this information
into their evaluation of anticipated operating results and market value. From a
management perspective, budgeted financial statements already reflect information about
the effect of an expected change in exchange rates. For example, under equilibrium
conditions the forward rate might be used as an unbiased predictor of the future spot rate.
In such a case management would use the forward rate when preparing the operating
budgets, rather than assume the spot rate would remain unchanged.
(b) Explain the time horizons used to analyze unexpected changes in exchange rates.
Answer: An unexpected change in exchange rates impacts a firm’s expected cash flows at four
levels, depending on the time horizon used.
The first-level impact is on expected cash flows in the one-year operating budget. The
gain or loss depends on the currency of denomination of expected cash flows. The
currency of denomination cannot be changed for existing obligations, such as those
defined by transaction exposure, or even for implied obligations such as purchase or sales
commitments. Apart from real or implied obligations, in the short run it is difficult to
change sales prices or renegotiate factor costs. Therefore realized cash flows will differ
from those expected in the budget. However, as time passes, prices and costs can be
changed to reflect the new competitive realities caused by a change in exchange rates.
The second-level impact is on expected medium-run cash flows, such as those expressed
in two- to five-year budgets, assuming parity conditions hold among foreign exchange
rates, national inflation rates, and national interest rates. Under equilibrium conditions the
firm should be able to adjust prices and factor costs over time to maintain the expected
level of cash flows. In this case the currency of denomination of expected cash flows is
not as important as the countries in which cash flows originate. National monetary, fiscal,
and balance of payments policies determine whether equilibrium conditions will exist and
whether firms will be allowed to adjust prices and costs.
If equilibrium exists continuously, and a firm is free to adjust its prices and costs to
maintain its expected competitive position, its operating exposure may be zero. Its
expected cash flows would be realized and therefore its market value unchanged since the
exchange rate change was anticipated. However, it is also possible that equilibrium
conditions exist but the firm is unwilling or unable to adjust operations to the new
competitive environment. In such a case the firm would experience operating exposure
because its realized cash flows would differ from expected cash flows. As a result, its
market value might also be altered.
The third-level impact is on expected medium-run cash flows assuming disequilibrium
conditions. In this case the firm may not be able to adjust prices and costs to reflect the
new competitive realities caused by a change in exchange rates. The firm’s realized cash
flows will differ from its expected cash flows. The firm’s market value may change
because of the unanticipated results.
 Chapter 9 Operating Exposure 63

The fourth-level impact is on expected long-run cash flows, meaning those beyond five
years. At this strategic level a firm’s cash flows will be influenced by the reactions of
existing and potential competitors to exchange rate changes under disequilibrium
conditions. In fact, all firms that are subject to international competition, whether they are
purely domestic or multinational, are exposed to foreign exchange operating exposure in
the long run whenever foreign exchange markets are not continuously in equilibrium.

4. Macroeconomic uncertainty. Explain how the concept of macroeconomic uncertainty expands the
scope of analyzing operating exposure.
Answer: Macroeconomic uncertainty is the sensitivity of the firm’s future cash flows to
macroeconomic variables in addition to foreign exchange, such as changes in interest rates
and inflation rates.

5. Strategic response. The objective of both operating and transaction exposure management is to
anticipate and influence the effect of unexpected changes in exchange rates on a firm’s future cash
flows. What strategic alternative policies exist to enable management to manage these exposures?
Answer: Diversifying operations and diversifying financing.

6. Managing operating exposure. The key to managing operating exposure at the strategic level is for
management to recognize a disequilibrium in parity conditions when it occurs and to be pre-
positioned to react in the most appropriate way. How can this task best be accomplished?
Answer: The key to effective preparations for an unexpected devaluation is anticipation. Major
changes to protect a firm after an unexpected devaluation are minimally effective.
Diversifying operations: World-wide diversification in effect pre-positions a firm to make
a quick response to any loss from operating exposure. The firm’s own internal cost control
system and the alertness of its foreign staff should give the firm an edge in anticipating
countries where the currency is weak. Recognizing a weak currency is different from
being able to predict the time or amount of a devaluation, but it does allow some defensive
planning. If the firm is already diversified, it should be able to shift sourcing, production
or sales effort from one country/currency to another in order to benefit from the change in
the post-devaluation economic situation.
Diversifying financing: Unexpected devaluations change the cost of the several
components of capital—in particular, the cost of debt in one market relative to another. If
a firm has already diversified its sources of financing, that is, established itself as a known
and reputable factor in several capital markets, it can quickly move to take advantage of
any temporary deviations from the international Fisher effect by changing the country or
currency where borrowings are made.

7. Diversifying operations.
(a) How can a MNE diversity operations?
Answer: If a firm’s operations are diversified internationally, management is pre-positioned both to
recognize disequilibrium when it occurs and to react competitively. Consider the case
where purchasing power parity is temporarily in disequilibrium. Although the
disequilibrium may have been unpredictable, management can often recognize its
symptoms as soon as they occur. For example, management might notice a change in
comparative costs in the firm’s own plants located in different countries. It might also
observe changed profit margins or sales volume in one area compared to another,
depending on price and income elasticities of demand and competitors’ reactions.
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Recognizing a temporary change in worldwide competitive conditions permits

management to make changes in operating strategies. Management might make marginal
shifts in sourcing raw materials, components, or finished products. If spare capacity exists,
production runs can be lengthened in one country and reduced in another. The marketing
effort can be strengthened in export markets where the firm’s products have become more
price competitive because of the disequilibrium condition.
 Chapter 9 Operating Exposure 65

(b) How can a MNE diversify financing?

Answer: If a firm diversifies its financing sources, it will be pre-positioned to take advantage of
temporary deviations from the international Fisher effect. If interest rate differentials do
not equal expected changes in exchange rates, opportunities to lower a firm’s cost of
capital will exist. However, to be able to switch financing sources, a firm must already be
well known in the international investment community, with banking contacts firmly
established. Once again, this is not an option for a domestic firm that has limited its
financing to one capital market.
Diversifying sources of financing, regardless of the currency of denomination, can lower a
firm’s cost of capital and increase its availability of capital. It could also diversify such
risks as restrictive capital market policies, and other constraints if the firm is located in a
segmented capital market. This is especially important for firms resident in emerging
markets.

8. Proactive management of operating exposure. Operating and transaction exposures can be partially
managed by adopting operating or financing policies that offset anticipate foreign exchange
exposures. What are four of the most commonly employed proactive policies?
Answer: The four most common proactive policies and a brief explanation are:
(1) Matching currency cash flows: The essence of this approach is to create operating or
financial foreign currency cash outflows to match equivalent foreign currency inflows.
Often debt is incurred in the same foreign currency in which operating cash flows are
received.
(2) Risk-sharing agreements: Contracts, including sales and purchasing contracts,
between parties operating in different currency areas can be written such that any gain
or loss caused by a change in the exchange rate will be shared by the two parties.
(3) Back-to-back loans: Two firms in different countries lend their home currency to
each other and agree to repay each other the same amount at a latter date. This can be
viewed as a loan between two companies (independent entities or subsidiaries in the
same corporate family) with each participant both making a loan and receiving 100%
collateral in the other’s currency. A back-to-back loan appears as both a debt (liability
side of the balance sheet) and an amount to be received (asset side of the balance
sheet) on the firm’s financial statements.
(4) Currency swap: In terms of financial flows, the currency swap is almost identical to
the back-to-back loan. However in a currency swap, each participant gives some of its
currency to the other participant and receives in return an equivalent amount of the
other participant’s currency. No debt or receivable shows on the financial statements
as this is in essence a foreign exchange transaction. The swap allows the participants
to use foreign currency operating inflows to unwind the swap at a later date.
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9. Matching currency exposure.

(a) Explain how matching currency cash flows can offset operating exposure.
Answer: One way to offset an anticipated continuous long exposure to a particular currency is to
acquire debt denominated in that currency.
(b) Give an example of matching currency cash flows.
Answer: Exhibit 9.4 depicts the exposure of a U.S. firm with continuing export sales to Canada. In
order to compete effectively in Canadian markets, the firm invoices all export sales in
Canadian dollars. This policy results in a continuing receipt of Canadian dollars month
after month. If the export sales are part of a continuing supplier relationship, the long
Canadian dollar position is relatively predictable and constant.

Exhibit 9.4 Matching: Debt Financing as a Financial Hedge

Canadian Canadian
Corporation Bank
(buyer of goods) Exports (loans funds)
goods to US Corp borrows
Canada Canadian dollar debt
from Canadian Bank

U.S.
Corporation Principal and interest
Payment for goods
in Canadian dollars payments on debt
in Canadian dollars

Exposure: The sale of goods to Canada creates a foreign

currency exposure from the inflow of Canadian dollars
Hedge: The Canadian dollar debt payments act as a financial
hedge by requiring debt service, an outflow of Canadian dollars

10. Risk sharing. An alternative arrangement for managing operating exposure between firms with a
continuing buyer-supplier relationship is risk sharing. Explain how risk sharing works.
Answer: Risk-sharing is a contractual arrangement in which the buyer and seller agree to “share” or
split currency movement impacts on payments between them. If the two firms are
interested in a long-term relationship based on product quality and supplier reliability and
not on the whims of the currency markets, a cooperative agreement to share the burden of
currency risk management may be in order.
 Chapter 9 Operating Exposure 67

If Ford’s North American operations import automotive parts from Mazda (Japan) every
month, year after year, major swings in exchange rates can benefit one party at the
expense of the other. (Ford is a major stockholder of Mazda, but it does not exert control
over its operations. Therefore, the risk-sharing agreement is particularly appropriate;
transactions between the two are both intercompany and intracompany. A risk-sharing
agreement solidifies the partnership.) One potential solution would be for Ford and Mazda
to agree that all purchases by Ford will be made in Japanese yen at the current exchange
rate, as long as the spot rate on the date of invoice is between, say, ¥115/$ and ¥125/$. If
the exchange rate is between these values on the payment dates, Ford agrees to accept
whatever transaction exposure exists (because it is paying in a foreign currency). If,
however, the exchange rate falls outside this range on the payment date, Ford and Mazda
will share the difference.

11. Back-to-back loans. Explain how back-to-back loans can hedge foreign exchange operating exposure.
Answer: A back-to-back loan, also referred to as a parallel loan or credit swap, occurs when two
business firms in separate countries arrange to borrow each other’s currency for a specific
period of time. At an agreed terminal date they return the borrowed currencies. The
operation is conducted outside the foreign exchange markets, although spot quotations
may be used as the reference point for determining the amount of funds to be swapped.
Such a swap creates a covered hedge against exchange loss, since each company, on its
own books, borrows the same currency it repays. Back-to-back loans are also used at a
time of actual or anticipated legal limitations on the transfer of investment funds to or
from either country.

12. Currency swaps. Explain how currency swaps can hedge foreign exchange operating exposure. What
are the accounting advantages of currency swaps?
Answer: A currency swap resembles a back-to-back loan except that it does not appear on a firm’s
balance sheet. The term swap is widely used to describe a foreign exchange agreement
between two parties to exchange a given amount of one currency for another and, after a
period of time, to give back the original amounts swapped. Care should be taken to clarify
which of the many different swaps is being referred to in a specific case.
In a currency swap, a firm and a swap dealer or swap bank agree to exchange an
equivalent amount of two different currencies for a specified period of time. Currency
swaps can be negotiated for a wide range of maturities up to at least ten years. If funds are
more expensive in one country than another, a fee may be required to compensate for the
interest differential. The swap dealer or swap bank acts as a middleman in setting up the
swap agreement.
A typical currency swap first requires two firms to borrow funds in the markets and
currencies in which they are best known. For example, a Japanese firm would typically
borrow yen on a regular basis in its home market. If, however, the Japanese firm were
exporting to the United States and earning U.S. dollars, it might wish to construct a
matching cash flow hedge which would allow it to use the U.S. dollars earned to make
regular debt-service payments on U.S. dollar debt. If, however, the Japanese firm is not
well known in the U.S. financial markets, it may have no ready access to U.S. dollar debt.
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One way in which it could, in effect, borrow dollars, is to participate in a cross-currency

swap. The Japanese firm could swap its yen-denominated debt service payments with
another firm which has U.S. dollar-debt service payments. This swap would have the
Japanese firm “paying dollars” and “receiving yen.” The Japanese firm would then have
dollar-debt service without actually borrowing U.S. dollars. Simultaneously, a U.S.
corporation could actually be entering into a cross-currency swap in the opposite
direction—”paying yen” and “receiving dollars.” The swap dealer is taking the role of a
middle man.
Accountants in the United States treat the currency swap as a foreign exchange transaction
rather than as debt and treat the obligation to reverse the swap at some later date as a
forward exchange contract. Forward exchange contracts can be matched against assets,
but they are entered in a firm’s footnotes rather than as balance sheet items. The result is
that both translation and operating exposures are avoided, and neither a long-term
receivable nor a long-term debt is created on the balance sheet. The risk of changes in
currency rates to the implied collateral in a long-term currency swap can be treated with a
clause similar to the maintenance-of-principal clause in a back-to-back loan. If exchange
rates change by more than some specified amount, say 10%, an additional amount of the
weaker currency might have to be advanced.

13. Leads and lags. Many treasury experts criticize the use of leads and lags by multinational companies
because they claim that it requires a directional view on the local currency. How would you respond
to this criticism?
Answer: Although leads and lags are frequently used when the company possesses a directional
view, they may also be used when altering the net working capital and/or credit positions
of units within the same company.

14. Reinvoicing centers. Probably the most elaborate device used by some MNEs for managing operating
exposure is the reinvoicing center. Explain the variety of purposes for which such a center can be
used.
Answer: The Reinvoicing Center can be used to reposition cash because the center can buy or sell
foreign exchange in its possession as it deems best for the worldwide corporate operation.
By netting it probably accomplishes this at a lower cost than if each transaction were paid
for with foreign exchange purchased from the banking system. There is no apparent tax
advantage in the U.S. for having the Reinvoicing Center reposition cash.
(Many non-U.S. countries do not tax profits of foreign holding or finance companies (such
as reinvoicing centers) unless their profits are remitted to the home country. Such non-
taxation of foreign financial subsidiaries is believed to give their MNEs a comparative
advantage over U.S. MNEs.)

15. Contractual hedging. Eastman Kodak is a MNE that has undertaken contractual hedging of its
operating exposure.
(a) How do they accomplish this task?
Answer: Eastman Kodak is another MNE that has in the past undertaken contractual hedging of its
operating exposure. Kodak management believes its markets are largely price-driven and
is aware that its major competitor, Fuji, has a Japanese cost base. If the U.S. dollar were to
strengthen in the medium to long term, Kodak’s market share in the United States and in
foreign markets would decline. Kodak leadership also believes that whatever sales Kodak
loses, its competitors will gain. Kodak has therefore also purchased long-term put options
on foreign currencies, which would replace long-term earnings if the value of the U.S.
dollar rose unexpectedly.
 Chapter 9 Operating Exposure 69

(b) What assumptions do they make in order to justify contractual hedging of their operating
exposure?
Answer: The magnitude of the option position depends on the nature of desired replacement. For
example, if Kodak wished to insure only the lost net earnings from exchange rate–induced
losses, the option position would be considerably smaller than a position attempting to
replace gross sales revenues. Given the premium expenses associated with long-term put
option positions of this type, replacing earnings is preferred to replacing sales.
(c) How effective is such contractual hedging in your opinion? Explain your reasoning.
Answer: 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 have occurred, the firm is competitively disadvantaged.
The capital outlay required for the purchase of such sizeable put option positions is capital
not used for the potential diversification of operations, which in the long run might have
more effectively maintained the firm’s global market share and international
competitiveness.

◼ Mini-Case: Porsche Exposed

1. Do you believe that Porsche’s management is appropriately concerned with stockholder wealth? Does
Porsche’s ownership structure work to the benefit or detriment of public shareholders?
Answer: Although Porsche is publicly traded, the company is controlled by only two stockholders,
the Porsche and Piéch families. As the quotation by Holger Härter makes clear, the two
families hold exclusive shareholder influence over management. An interesting point for
class discussion is whether the families actually ever exercise these rights. It is not clear
from the information or evidence presented that they influence or direct current
management headed by Dr. Wendelin Wiedeking. They may simply agree with current
leadership and therefore remain quietly in agreement.
What this means for minority shareholders is that they do participate in the distributed
profits and any and all capital gains (losses) which the traded preference shares provide, but
they have no voting rights and therefore no ability to act as owners in whole. It also explains
in part the company’s relatively uncooperative response to the requests of analysts and stock
exchanges for more frequent reporting (as well as more detailed disclosure in their financial
reporting). A final related component of this governance discussion is the structure of
management compensation. The compensation packages of senior management were nearly
exclusively focused on the recorded profitability of the firm from year to year, and not on
the market’s assessment of that performance, the share price.

2. In your opinion is Porsche’s current currency hedging strategy protecting it from adverse exchange
rate changes? Will it work as well in the long run as in the short run? Evaluate the other hedging
strategies available to the firm and compare and contrast alternatives.
Answer: (a) Exposure: Porsche’s currency exposure is fundamentally a long-term operating
exposure arising from where and how it operates its business. Because the company is
relatively simple in structure compared to most multinationals, and transparent in the
type of currency exposure it incurs, most of its currency exposure can be viewed as a
series of transaction exposures, both existing (already an existing account receivable
or inventory line item on the company’s balance sheet) and anticipated (not yet
contractually existing, but with a high likelihood that they will occur).There are a
number of alternatives, which we cover here in brief.
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(b) Pass-through: The discussion of exchange rate pass-through is relevant, but not really a hedging
solution. Pass-through does exactly what it says, it passes on to the buyer a portion of the
exchange rate movement. This is in effect what Porsche has already done to some degree as
described previously. As always, at some point the price elasticity of demand for the product
changes so that further price increases through pass-through result in declining sales revenue.
(c) Diversifying operations: If the company believed that it would be continuing to generate
significant proportions of its sales in US dollar markets, it could match these sales values with
production values by manufacturing in a US dollar environment. Other auto companies like
BMW (produces today in South Carolina) and Mercedes (produces today in Alabama) have
pursued this strategy successfully.
The obvious advantage of this strategy is that production and sales are effectively matched, the
company’s operations and operating results are insulated from major currency movements (not
counting translation and consolidation impacts of reporting US dollar sales in consolidated
earnings in euros.) The obvious argument against this approach is that building cars anywhere
other than where they are currently manufactured and assembled would result in either real or
perceived decreases in quality or related performance.
(d) Diversifying financing: This strategy is actually easier and cheaper to implement, and would
require Porsche to either acquire new debt which was US dollar denominated or alter existing
non-dollar debt into dollar-servicing (through cross currency swaps). The objective would be to
match dollar cash inflows from US sales with dollar cash outflows in US dollar debt service
(principal and interest).
Porsche has chosen not to use this approach most likely because it does not “do debt.” The firm
has not needed debt to finance its operating activities and investing activities under the current
management team (since 1993), and it also does not philosophically believe in using debt (see
page 5 of the case). A good point of discussion with students, however, is that a company does
not necessarily need debt to use debt. The benefits of leverage are well known, and although
many successful companies today do not choose to use debt (Intel, Dell, Exxon-Mobil, Microsoft
to name a few), this does not necessarily prevent Porsche from revisiting this judgement. The
benefit of using a financing hedge like dollar-denominated debt is that it would take less active
management and would not require a major outlay of capital out front like currency options
require (option premiums).
(e) Current Strategy: The company has been hedging the US dollar long position by estimating its
annual US dollar sales and hedging that exposure by purchasing put options on the US dollar (the
right to sell US dollars for euros at a specific exchange rate). The company has been purchasing
these options in what it refers to as a “three-year rolling hedge” in which it hedges expected US
dollar sales three years out into the future. As each year matures, and the associated options
expire, the company has replaced them with a new three-year option position. (The three-year
time horizon may actually be longer, but Porsche has not been willing to describe in any adequate
detail the nature of how their hedging program is structured or operated.)
 Chapter 9 Operating Exposure 71

3. Do you think Porsche’s currency hedging strategy reflects a particular bias of management and
ownership regarding shareholder value creation? Do you believe that Porsche can continue to predict
the future movement of the euro?
Answer: Students generally seem to come to a conclusion that, although the current hedging
program is expensive to purchase and operate, it has done well to date. Also, although
other premium-priced automobile manufacturers have chosen to diversify operations, and
seemingly successfully maintained the consumer’s faith in their quality and brand, this is a
choice of management, and difficult to second-guess. That said, in the end, the enormity
of Porsche’s exchange rate exposure is not going to go away. Hedging it with financial
derivatives is inherently a stop-gap measure, and does nothing to restructure or prepare the
company for the long-term. Therefore, the possibility of a financing hedge, dollar-
denominated debt, should clearly be reconsidered.
Post Script: In January 2004 the following article appeared in the Financial Times
(Porsche itself did not make any press release related to this issuance). It seems that
Porsche was beginning to increase the use of US$ debt.

Car Sector Groups Busy in Wake of Daimler Deal New Issues

“More car sector names appeared on the bond market yesterday in the wake of DaimlerChrysler’s deal
earlier in the week, with small transactions from Toyota and BMW and an announcement by the luxury
car maker Porsche. BMW US Capital, guaranteed by the German car maker BMW, added Pounds 100m to
its outstanding 4.625 per cent 2006 bond. The issue, which carried an A1 rating from Moody’s, was led by
ABN Amro and JP Morgan. Toyota Motor Credit Corporation, rated triple-A by both Moody’s and S&P,
offered a Euros 100m bond maturing in January 2008. UBS was sole lead.”

“In the pipeline, Porsche announced it had mandated Merrill Lynch and ABN Amro for a bond issue worth
several hundred million dollars, to be placed with US private investors. The German company, which has
the highest profit margins in the auto sector, said the bond would be used for its long-term financing needs
and would replace a Euros 256m issue—nicknamed the “SUV bond”—launched in 1998 to fund the
development of its Cayenne sports-utility vehicle. But Porsche said the new issue would not be used to
fund the development of an updated version of its 911 sports car, widely expected later this year, or a
possible fourth model range.”

Source: By Adrienne Roberts, The Financial Times, January 16, 2004, p. 43.

◼ Mini-Case: Toyota’s European Operating Exposure

1. Why do you think Toyota had waited so long to move much of its manufacturing for European sales
to Europe?
Answer: Automobile manufacturing is a very complex and capital intensive industry. Toyota, like
most manufacturers, wished to continue to enjoy the benefits of scale and scope
economies in manufacturing as long as possible, and had resisted the movement of more
and more of its manufacturing into the local and regional markets. Time, however, was
now running out.

2. If the British pound were to join the European Monetary Union would the problem be resolved? How
likely do you think this is?
Answer: The British joining the EMU would eliminate the currency risk between the UK and
Europe, but not between Japan and Europe. The UK joining the EMU would eliminate the
deviations in currency value between the British pound and the euro only.
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Although there has been continuing and heated debate over the possibility of Britain
joining the EMU, there is at present no specific plan to do so. In many ways the UK
believes itself to be somewhat the beneficiary of being the single large “European”
country which is not euro-based.

3. If you were Mr. Shuhei, how would you categorize your problems and solutions? What was a short-
term and what was a long-term problem?
Answer: The problems, at least on the basis of the data presented, appear to be primarily exchange
rate-induced pricing problems. The fall in the value of the euro against the yen throughout
1999 and early 2000 was significant (for example calculate the percentage change in the
value of the euro between January 1999 and July 2000). For some unknown reason most
of Toyota’s North American operations had moved to manufacturing bases in North
America, while Toyota had continued to try and service European sales via exports from
Japan. The recent decision to manufacture a new European-targeted product, the Yaris,
from production in Japan was in the continuing strategy. It did not appear to be a good
strategy given the recent direction of exchange rate movements.
The primary short-term solution was to continue to absorb yen-based cost increases in
lower margins on European sales—assuming that the market would not bear passing-
through the exchange rate changes. In the medium-to-long-term, Toyota must inevitably
move more of the automobile’s content into manufacturing operations within the EMU
(and not the United Kingdom).

4. What measures would you recommend Toyota Europe take to resolve the continuing operating
losses?
Answer: If Toyota was willing to continue incurring the operating losses in Europe, and put market
share goals above profit goals, then continuing the current operating and pricing policy
would be in order. The euro had regained some of its weakness against the yen in the
recent year.
The fact that significant Toyota operations existed in the United Kingdom would be a
continuing dilemma as long as the UK stayed out of the EMU. The strength of the pound
against the euro—and the new-found stability in that rate seen in 2000 and 2001—did not
bode well for UK-based operations for European sales. In the longer-term, Toyota, like
many other multinationals, would have to consider moving more of its manufacturing and
cost structure to within the EMU, not in Japan and not in the UK.