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.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 foreign-currency 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 successful privatization and restructuring. Establishing a sound macroeconomic framework is a crucial part of privatization policy.