Loans and money issues

I have allowed our corporation to be multinational, but I have silently sneaked in one big assumption—that you are a U.S. corporation, living in a U.S. CAPM world, working on behalf of U.S. shareholders who consumes in U.S. dollars. This is a reasonable assumption if your share- holders (owners) are all Americans who are not otherwise internationally diversified, perhaps because they have a strong home bias that makes them hold the U.S. stock market portfolio only. These investors naturally like projects that help them reduce the U.S. stock market risk— and in the end, they care only about consuming in U.S. dollars. This was the scenario that you have worked out above.
But what if your investors are not Americans, concerned only with their opportunities in the U.S. financial markets? What if your U.S. company shares are held by Chinese investors, and you are now considering an investment in a German plant? How should you think about the risk contribution of your investment projects now? The answer is surprisingly clear. Ultimately, as a corporation, you exist for the benefit of your owners. Your goal is to earn a rate of return on the money handed to you that exceeds the opportunity cost of capital otherwise available to your investors. This is how your corporation adds value. If your owners are Chinese investors, who otherwise have access only to the Chinese stock market (plus your firm’s shares now) and who only consume in Chinese yuan, then your appropriate cost of capital would be determined by the Chinese stock market. You would have to compute the beta of the German plant opportunity with respect to the overall Chinese stock market, measuring the returns produced in euro after translation into yuan.
In an even less plausible scenario, your Chinese investors would want to consume all their . returns in British pounds, but still remain restricted to investment in the Chinese stock market, plus your single firm. In this case, your opportunity cost of capital is still determined by the alternative investments (the Chinese stock market), but all calculations, including measurement of the expected rate of return in the Chinese stock market, should now be done in British pounds. After all, this is what your investors care about in the end.
We forgot one “little detail,” though: what if Chinese investors are not allowed to invest in American companies? Like investors in many countries, Chinese investors suffer from capital controls. And, even when there are no formal capital controls, investors in many countries fail to diversify themselves internationally. Even U.S. investors are often not diversified, although international diversification is no longer difficult: there are U.S. traded funds that hold foreign stocks. If your U.S. investors “forget” about foreign investment opportunities, your U.S. corporation might still be able to do it for them through foreign operations, and thereby expand your investors’ investment opportunity set.
One final task. As a corporate manager, you know that you must think of the opportunity cost of capital of your underlying corporate owners when you decide on projects. But, who are your investors, and what do they care about? In the CAPM, you could just assume that they cared about the portfolio with the highest expected rate of return, given minimum overall portfolio risk. Now, you may have Chinese investors, who care about the best Chinese yuen portfolio in the context of the Chinese financial markets, but who ultimately want to consume in Canadian dollars; British investors, who care about the best British pound portfolio in the context of the British financial markets, but who ultimately want to consume some goods sold in/priced in euro and other goods priced in British pounds; and other investors who are represented by funds, and are thus totally anonymous. In short, the possibilities are endless. What opportunity sets are your investors really facing, and how can your projects improve them? In what currency should you determine the optimal alternative investments? What kind of CAPM world do you live in? For a manager, these are not easy questions. Most managers appropriately focus only on the project opportunities that they are providing to their domestic investors. Given home bias, this is a reasonable assumption, even if this is not perfectly correct. Fortunately, I am just an academic, and therefore do not have to make such difficult decisions!

Hedging can reduce the volatility of cash flows. But does this add shareholder value? Maybe, but  it should not usually be a first-order effect for two reasons. First, our shareholders should care little about the idiosyncratic currency risk our corporation faces, because they are heavily diversified. As long as the foreign currency does not comove with the (U.S.) stock market, any extra currency risk should not change the U.S. market beta. For our investors’ portfolio, currency fluctuations across many different companies—some net exporters, some net importers—should mostly wash out. Second, if our shareholders dislike the risk of losing money when the euro goes up or down, they can themselves buy the proper currency forward hedges to neutralize any such risks.
Still, many corporations hedge currency fluctuations. Why? There are a number of possible  explanations, but they are probably only second-order effects. Here are some examples.
• If adverse currency fluctuations could lead a firm to incur financial distress, the resulting costs to handle the financial distress are quite real. (In a sense, hedging is really just like capital structure policy—the first-order effect should be that firms should be worth what the underlying operations are worth, which should not strongly depend on how the firm is financed. But if a firm is close to financial distress, too much debt can cost value.)
• Managerial and corporate performance may be easier to evaluate if the firm can reduce the effects of unexpected currency fluctuations. This can reduce agency problems.
• Managers may just not like the uncertainty of currency fluctuations, and try to neutralize this risk even if it does not increase value.
Sadly, many firms hedge because they believe they can outguess the financial markets and thereby increase their profits. This is often a sign of poor control, because the compensation of lower-level employees who handle the hedging often implicitly or explicitly depends on the profitability of their hedges. Therefore, these employees often participate more in the upside than in the downside of their contracts. Thus, they may be quite willing to gamble with shareholders’ money.