Question: McDonald's Corporation's British Pound Exposure
McDonald's Corporation has investments in more than 100 countries. It considers its equity investment in foreign affiliates capital that is at risk, subject to hedging depending on the individual country, currency, and market. British Subsidiary as an Exposure McDonald's parent company has three different pounddenominated 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. In addition to the equity capital invested in the British affiliate, the parent company provides intracompany 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. This too is pound-denominated. These three different exposures sum to a significant exposure problem for McDonald's. An additional technical detail further complicates the situation. When the parent company makes an intracompany loan to the British subsidiary, it must designate-according to U.S. accounting and tax law practices-whether the loan is considered to be 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 not considered permanent, the foreign exchange gains and losses related to the loan flow directly to the parent company's profit and loss statement (P&L), according to FAS #52.
If, however, the loan is designated as permanent, the foreign exchange gains and losses related to the intracompany loan would flow only to the CTA (cumulative translation adjustment) on the consolidated balance sheet. To date, McDonald's has chosen to designate the loan as permanent. The functional currency of the British affiliate for consolidation purposes is the local currency, the British pound. Anka Gopi is both the Manager for Financial Markets/ Treasury and a McDonald's shareholder. She is currently reviewing the existing hedging strategy employed by McDonald's against the pound exposure. The company has been hedging the pound exposure by entering into a crosscurrency U.S. dollar/British pound sterling swap. The current swap is a seven-year swap to receive dollars and pay pounds. Like all cross-currency swaps, 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. McDonald's considers the large notional principal payment a hedge against the equity investment in its British affiliate. According to accounting practice, a company may elect to take the interest associated with a foreign currencydenominated loan and carry that directly to the parent company's P&L. This has been done in the past, and McDonald's has benefited from the inclusion of this interest payment.
FAS #133, Accounting for Derivative Instruments and Hedging Activities, issued in June 1998, was originally intended to be effective for all fiscal quarters within fiscal years beginning after June 15, 1999 (for most firms this meant January 1, 2000). The new standard, however, was so complex and potentially of such material influence to U.S.-based MNEs, that the Financial Accounting Standards Board has been approached by dozens of major firms and asked to postpone mandatory implementation. The standard's complexity, combined with the workloads associated with Y2K (year 2000) risk controls, persuaded the Financial Accounting Standards Board to delay FAS #133's mandatory implementation date indefinitely. Issues for Discussion Anka Gopi, however, still wishes to consider the impact of FAS #133 on the hedging strategy currently employed. Under FAS #133, the firm will have to mark-to-market the entire cross-currency swap position, including principal, and carry this to other comprehensive income (OCI). OCI, however, is actually a form of income required under U.S. GAAP and reported in the footnotes to the financial statements, but not the income measure used in reported earnings per share. Although McDonald's has been carrying the interest payments on the swap to income, it has not previously had to carry the present value of the swap principal to OCI. In Anka Gopi's eyes, this poses a substantial material risk to OCI. Anka Gopi also wishes to reconsider the current strategy. She begins 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.
Case Questions: 1. How does the cross-currency swap effectively hedge the three primary exposures McDonald's has relative to its British subsidiary?
2. How does the cross-currency swap hedge the longterm equity position in the foreign subsidiary?
3. Should Anka-and McDonald's-worry about OCI?