Macroeconomic Factors and Company Earnings

Although often neglected in a transaction-oriented focus on privatization, macroeconomic policy has a major effect on enterprise performance. Monetary and fiscal policies, through their affect on financial markets, have major significance for firms' cost of capital. Monetary and fiscal policies are also key determinates of inflation, which can generate business uncertainty, confound firm's accounting systems, and affect the relative prices that firms face. In addition, political instability or a general economic recession may significantly reduce demand for a firm's products. A simple regression suggests that in the U.S. from 1964-1983, economy-wide variation in firms' earnings explain 17% of the variation in a individual firm's earnings. Macroeconomic factors are likely to be even more important in countries that have less macroeconomic stability than the U.S. did during the time period covered in the above study. More generally, World Bank research shows that macroeconomic stability is a crucial prerequisite for successful enterprise restructuring. Projections of a company's earnings play an important role in planning privatization and enterprise restructuring. The simple model below demonstrates the importance of macroeconomic factors for a company's earnings. This model is for an imaginary company, Virtual African Airways (VAA), which is the flag carrier of an imaginary African country, Economia. The numbers in the tables below, unless otherwise specified, are in Afros, the imaginary currency of Economia. Thus the exchange rate represents the price in Afros of a unit of foreign currency, and a 10% increase in the exchange rate represents a depreciation of the Afro. The inflation, exchange rate, and demand growth baseline could be considered to be normalized relative to a base projection over a given planning horizon. The financial structure of VAA is realistic, as is apparent from a comparison with Kenya Airways' balance sheet and operating statement. Baseline Macro Inflation 0% Exchange Rate 1 Demand Shock 0 VAA Financials Under Baseline Macro F-X Category Value share Revenue Operating Cost Fixed Costs excl. finance Long-term debt 1 Alternative Macro Inflation -20% -10% 0% 10% 20% Ex. Rate -20% -10% 0% 10% 20% Demand -20% -10% 0% 10% 20% VAA Financials under Alternative Macro Category % Chng/Base % Change in Revenue % Change in Operating Cost % Change in Fixed Cost % Change in Long-term Debt

% Change in Earnings Before

Interest Rate

Earnings Before Interest Interest Cost Net Earnings First consider the effect of over-all economic conditions on demand growth. Suppose that political instability in Economia significantly lowers the attractiveness of Economia as a destination for tourism, reducing demand for air transport by 10%. Click on the -10% button in the alternative macro panel. The bottom line in the VAA alternative financials shows a reduction in VAA earnings of 24.1%. VAA's earnings fall by a greater percentage than the reduction in demand for two reasons. First, fixed costs magnify the impact of demand shocks because fixed costs do not vary with demand. This effect is called operating leverage. Second, debt magnifies the impact of demand shocks because it requires interest payments that do not vary with demand. This second effect is called financial leverage. By changing the values for fixed costs and debt in the baseline financials you can see how these factors effect the relative impact of demand shocks. Now consider the effect of a change in the exchange rate. VAA financials are presented in terms of the home currency. An exchange rate depreciation increases the value, in home currency, of revenues and costs incurred in foreign currency. In the above model, the foreign currency share of revenue is about three percentage points greater than the foreign currency share of total costs. Hence an exchange rate depreciation increases earnings (in home currency) before interest costs. However, all long-term debt is denominated in foreign currency, and an exchange rate depreciation increases the home currency cost of servicing this debt. The over-all impact on net earnings depends on the sum of the above effects. You can explore the effects of a currency appreciation or depreciation in the above model. Note that given a significant cash flow in foreign currency, a significant share of working capital is likely to be held in foreign currency. Financial statements generally note separately (unrealized) changes in value of this working capital as a result of exchange rate movements. Inflation can also affect company earnings. In the model above, inflation is assumed to increase all home-currency denominated values in proportion to the inflation rate, but inflation is assumed not to affect the nominal value in foreign currency of foreigncurrency denominated flows. Note that such inflation effects are analogous to an exchange rate movement. As you can verify, equal changes in inflation and the exchange rate produce a uniform change in all nominal financials. An equal change in inflation and the exchange rate implies a constant real exchange rate, and hence a constant real value of earnings. Given a fixed nominal exchange rate, inflation in this model affects the company's international competitiveness. Other costs of inflation, such as uncertainty, tax distortions, and misaccounting, are not captured in this model. The most important implication of the above model is that the macroeconomic context can have a significant effect on a company's financials and hence on its prospects for

Interest % Change in Interest Cost % Change in Net Earnings

successful privatization and restructuring. Establishing a sound macroeconomic framework is a crucial part of privatization policy. Questions for Discussion 1. Is private companies' ability to borrow on international capital markets influenced by their government's fiscal position? Why or why not? 2. How does inflation affect company debt denominated in the home currency? 3. What are the different risks associated with company debt denominated in domestic currency versus debt denominated in foreign currency?
Mr. Gulu. Mirchandani, Chairman & Managing Director , MIRC Electronics Ltd.

India Infoline / 00:00 , Dec 19, 1999

Mirc Electronics are makers of ?Onida? brand of TVs - a premium brand in the colour TV market. The company?s brand value is estimated to be around Rs9-10bn. Despite raging price wars and commodification of television in domestic market, Onida has maintained its premium image. Worldclass quality of Onida has enabled the company to make a breakthrough on the export front. Onida is a leading brand in the Gulf market. For UK market the company is likely to make inroads with its 14-inch television sets. MIRC has a technical tie up with JVC, Japan. Mr Gulu Mirchandani, Chairman & Managing Director of MIRC Electronics Limited, is an Engineer from BITS, Pilani and holds a degree in Mechanical Engineering. Mr. G. Mirchandani along with Mr S.L Mirchandani and Mr Vijay Mansukhani were instrumental in setting up MIRC Electronics way back in 1981. Mr. Mirchandani has been actively involved in the development of consumer electronics industry in India. He was at the helm of the Consumer Electronics & TV Manufacturers Association during the period 1992-94. The company came out with an IPO in 1990. Promoters hold around 60% of the shares and the rest by public. In a discussion with Atul Rastogi and Suma Nair of Indiainfoline, Mr G. Mirchandani has expressed his views on the Color TV industry and future performance of MIRC Electronics Ltd. What in your opinion are the key factors driving the current boom in color TVs? Are there some macro-economic factors involved as well ? Is the growth in unit sales happening across the product lines or in a certain price bandwidth ? Channel explosion, rising local language content, large disposable income are some of the reasons for boom in CTV market. Though World cup did contribute in increasing sales of colour TVs in the first half of FY00, the main contributor to a boom is growing nuclear families and consumers priorities for owning television sets over other consumer durables. Reduction in CTV prices in real terms is yet another factor driving the boom in this industry. Sales of CTV has been rising very sharply in last two years. Unit sales of CTV for year 2000, is expected to be around 5mn. The industry is expected to grow at a rate of 25-30%yoy. As for Black &White TVs it?s a declining market.

Do you see the current boom in TVs continuing ? CTVs continues to be an untapped market with a penetration level of 12% as against China with a penetration of about 25%. Therefore the market is young with ample room for growth. All the players in this market will survive and grow in next couple of years. Do you expect multinational companies to gain share from domestic companies? What impact will the entry of the Chinese brands have on the TV market? Will they help growth in the market, or basically cut into the sales of other brands ? When Panasonic entered India, the company captured 1-2% share but could not move beyond that. The needs of Indian consumers vary from region to region, which can be satisfied only by a deep understanding of Indian markets. Kalyani Sharp is yet another company, which met with similar fate. Onslaught of Chinese TV manufacturers is not a major threat, since Indian consumers are very smart and would rather pay slightly higher for quality, additional features and services. Further the brand perception of Chinese make is rather low. MIRC has a good understanding of Indian markets. our superior sound delivery system designed as per specific regions requirements is an excellent example of the same. Our competitors are domestic companies and not MNCs. Which product do you see as the new opportunity market? What about products like flat screen, super slim etc ranges? There are no entry barriers in this field. It?s a flat technology. The success lies in hitting the market first with innovative product. Candy- 14 inch CTV for example is a huge success and would be contributing to about 15% of the third quarter sales. Candy is priced 40% above other 14inch CTVs. We plan to launch a product extension in Candy, which will help us increase unit realizations. What do the companies generally do with TVs got through exchange schemes? It?s a misconception that companies upgrade such second hand TVs. No Company is involved in further processing of such TVs. Its usually sold out to dealers catering to rural markets. Company plans to introduce new products every 2-3mths. Are these introductions in some specific ranges, any technology tie-ups for same? We have technological tie-up with JVC, however almost 70% of the innovation are in-house. The company spends about 1.5% of its sales on R&D. We have two major brands - 1) Onida Unique collection series ?catering to higher end market and encompasses Home theatre, Wall screen, KY Rock etc. and 2) Onida IGO series catering to the mass market. The company has presence in all the ranges and sells at a premium of about 10% to BPL and Videocon. To ensure lead in the market we plan to introduce fashion products and good sound system tailor made as per the requirements of customers in particular regions. The company will be soon launching 500 watts TV, which would be first of its kind in the Indian market. Most of the CTV manufacturers have felt backward integration as a competitive edge, while MIRC believes in outsourcing. Could you elaborate? Manufacturing of components and picture tubes are capital intensive activities where we are unlikely to be globally competitive as our scale would be small in global terms. Also, these components are easily available at competitive prices, both in India and abroad. Thus, we would

manufacture only those components which are highly specialised- for instance, special voice circuits. Manufacturing picture tubes and components would mean diversion of funds and focus. Currently the company has a good vendor network. Most of its picture tubes are sourced through Samtel and other global manufacturers. For specialized tubes we generally import in which case custom duty amounts to 45%. Will the topline growth of 30% as expected by the company be volume driven or price driven? Is there any capacity expansion, takeover, mergers on the anvil? The company has no plans of any take over currently. We will never enter into commodification of our product. Nor will we encourage constant discount activities, which in a way delays the purchase decision of a buyer. We would like to be another SONY, which has the highest price and highest sales. We will be achieving 30% growth without compromise on value. One important question in the minds of several investors is, will there be equity dilution to meet your objective in being zero debt company? MIRC has the lowest capital base in the industry. We are looking at equity placement but at most there would be a dilution of about 30%. The company has a strong cash position but has not yet entered into any capex because we are concerned about our bottomline growth. We would be showing a bottomline growth of 50%yoy. We expect our net profit to improve to Rs600mn in FY01. And our advertisement and promotion expenditure would be about 5-6% of the sales.