Reference no: EM133092304
Case: Managing Foreign Currency Exposure at 3M is one of America's oldest and most venerable diversified industrial corporations. The company is known for its strong con-sumer brands, such as Scotch, Scotchgard, Post-it, Scotch-Brite, and ACE Bandages, but in truth its consumer business only constitutes a small part of its activities. The company also has many product offerings with applications in industrial areas such as automotive, health care, electronics, and energy, as well as safety and graphics. 3M has a well-earned reputation for being an innovation machine, plowing 6 percent of its annual revenues back into R&D. A long history of innovation has given 3M a port-folio of 55,000 products, many of which command high margins. Some 30 percent of its sales come from products introduced in the last five years.In addition to being an innovation machine, 3M is also one of the most international of all U.S. companies. The company gen-erates around 60 percent of its $32 billion in annual revenues from sales outside of the United States. This large global businesshas sales in 200 countries and operations in 70. The company has 200 plants around the world; manufactures many of its owninputs in addition to final products; and has built up networks of regional supply chains to better manage inventory, improvecustomer responsiveness, achieve economies of scale, and realize the productivity gains that come from manufacturing productsin the optimal location.Dealing with this vast array of international sales, as well as intra-company transactions, creates a problem for 3M. Specifically,changes in the value of currencies against each other can significantly affect its earnings and revenues when translated back intoU.S. dollars, affect the value of intracompany transactions, and alter the attractiveness of different nations as possible locationsfor manufacturing activities. 3M estimates that adverse movements in currencies decreased the company's pretax profits by $42million in 2018 and $111 million in 2017. (As an American company, 3M reports its financial results in U.S. dollars.) Theseestimates include the effect of translating profits from local currencies back into U.S. dollars, the impact of currency fluctuationson the transfer of products between 3M operations located in different nations, and transaction gains and losses including thoseon derivative instruments designed to reduce foreign currency exchange rate risk. For example, in 2018, an increase in the valueof the U.S. dollar against the currencies of many other countries reduced 3M's foreign sales (when they were translated backinto U.S. dollars) by some 2.3 percent. Of course, the opposite can also occur.Foreign currency risk arises because the value of currencies will fluctuate against each other over time, and it is not easy toforecast how they will move against each other. In 2018, for example, the U.S. dollar increased in value by 5.2 percent against a trade-weighted basket of other currencies, which included the euro, yen, British pound, Swiss franc, and Australian dollar. Theimplication is that foreign sales, when translated back into U.S. dollars, will have fallen, on average, by 5.2 percent over the year.Like many companies, 3M tries to reduce its exposure to such adverse effects by hedging its foreign exchange risk. The companyenters into what are known as foreign exchange forward contracts, in advance of a foreign transaction, to "lock in" the exchangerate. The company may lock in exchange rates as much as 36 months in advance. For example, if 3M is exporting a product tothe euro zone with payment in euros expected in three months, and it thinks that the U.S. dollar might appreciate against theeuro over the next three months but it's not sure about this, 3M might purchase a three-month forward contract that locks in acertain dollar-euro exchange rate. By doing this, 3M knows what revenue it will get from the sale at that time in terms of dollars,and dollar sales are not reduced by a rise in the value of the dollar against the euro over the next three months. Of course, suchforward contracts are not free, nor are they perfect. In the face of uncertainty, the company may bet incorrectly and lose out. Ifthe dollar falls against the euro over the next three months, instead of rising as 3M expected, 3M would have been better off nothedging because the unhedged dollar value of its euro sales would have increased.As circumstances warrant, 3M also uses foreign currency forward contracts and foreign currency debt as hedging instrumentsto protect the value of portions of the company's net investments in foreign operations. For example, in 2018, its European oper-ations were partly financed by €4.1 billion in euro-denominated debt. If that debt were denominated in U.S. dollars, but had tobe serviced by 3M's European operations, then the cost of servicing that debt in euros for the European subsidiaries would goup if the euro declined in value against the dollar, thereby reducing 3M's euro-zone profits when denominated in U.S. dollars. Itis by actions such as these that 3M reduces its exposure to the unpredictable movements in currency exchange rates over time.
Questions
1. If the dollar appreciates in value against most other countries over the next year, what will the impact of this be on 3M?
2. If the dollar depreciates in value against most other countries over the next year, what will the impact be on 3M?
3. Should 3M hedge against adverse movements on foreign exchange rates? How should it do this?
4. Should it hedge all of its foreign exchange transactions, or just a subset?