Foreign exchange denominated borrowings and corporate profits: evidence from Turkey

Abstract

In modern finance literature, value maximization is accepted as the primary goal of corporations. To attain this goal, firms try to decrease their cost of capital as much as possible, since firm value is calculated by discounting expected cash flows at cost of capital.

Borrowing in foreign currencies is one of the tools used by firms to decrease their cost of capital. However, although firms are able to realize large spread gains in times of relative purchasing power disparity, foreign exchange risks are difficult to cover in periods of crisis where local currency depreciates. Thus, foreign exchange risks are considered one of the most important reasons of the financial fragility in times of crisis.

The purpose of this study was to investigate the magnitude of foreign exchange denominated financial borrowings of Turkish manufacturing companies and the impact of these borrowings on company profits and corporate risks. It was hypothesized that companies with low operating profits and low operating risks tend to borrow in foreign currency to decrease their cost of capital and increase their after tax return in times of purchasing power disparity. However, this creates an important source of financial fragility.