McDonald’s Corporation has investments in over 100 countries The company conside
ID: 2801937 • Letter: M
Question
McDonald’s Corporation has investments in over 100 countries The company considers its equity investment in foreign affiliates capital which is at risk, subject to hedging depending on the individual country, currency, and market. McDonald’s parent company has three different pound-denominated exposures arising from its ownership and operation of its British subsidiary First, the British subsidiary has equity capital which is a pound-denominated asset of the parent company. Secondly, in addition to the equity capital invested in the British affiliate, the parent company provides intra-company debt in the form of a 4-year £125 million loan. The loan is denominated in British pounds and carries a fixed 5.30% per annum interest payment. Third, the British subsidiary pays a fixed percentage of gross sales in royalties to the parent company. This too is pound-denominated. The three different exposures sum to a significant exposure problem for McDonald’s. The company has been hedging the pound exposure by entering into a cross-currency U.S. dollar/British pound sterling swapCross-Currency Swap: Pay Pounds – Receive Dollars The current swap is a 7-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. Anka Gopi is both the Manager for Financial Markets/Treasury She 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 How does the cross currency swap effectively hedge the three primary exposures McDonalds has relative to its British subsidiary. How does the cross-currency swap hedge the long-term equity exposure in the foreign subsidiary? Should Anka – and McDonalds – worry about OCI?
Explanation / Answer
Case Overview:
McDonald's British Pound Exposure
MCD uses currency swaps to alter the denomination of cash flows in debt services to fix or alter interest rates which can change their interest payments. These swaps are also used to avoid making high royalty payments.
Cross currency swaps
Hedging
FAS #133
FAS #52
P&L Statements
OCI
Yes and no; more yes than no
OCI is essentially the normal consolidated profits of the firm plus change in retained earnings.
The newly formed accounting practice, FAS #133, requires that McDonald’s mark-to-market the value of the outstanding swap on a regular basis, which will include the gains and losses on the swap in OCI.
Continued
thus, marking-to-market a cross currency swap will likely result in large swings in the value from period to period.
No, because OCI is not the measurement of earnings reported by analysts (Wall Street).
Analysts tend to weigh cash flow statements more heavily than the accounting-based measurements
Overall, McDonald's should regularly monitor hedging practices, FAS #133, and other accounting practices.
Case topics defined
Hedge gain (losses)
MCD has a 7yr swap where they pay pounds and receive dollars, MCD US makes pound interest payments and bullet principle repayment at each swap term. This principle payment is viewed as a hedge.
Since the MCD parent company has chosen to designate their loan as permanently invested in the country of their foreign subsidiary, foreign exchange gains and losses will only be only reported on the parent companies consolidated balance sheet
This allows the subsidiary to swap according to what decision can benefit them the most (fixed / floating interest rate).