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Part III Case Studies


Case III.1

Rolls-Royce Limited

Rolls-Royce Limited, the British aeroengine


manufacturer, suffered a loss of 58 million in
1979 on worldwide sales of 848 million. The
companys annual report for 1979 (page 4)
blamed the loss on the dramatic revaluation of
the pound sterling against the dollar, from 1
 $1.71 in early 1977 to 1  $2.12 by the
end of 1979.
The most important reason for the loss was
the effect of the continued weakness of the
U.S. dollar against sterling. The large civil
engines that Rolls-Royce produces are supplied to American air frames. Because of U.S.
dominance in civil aviation, both as producer
and customer, these engines are usually priced
in U.S. dollars and escalated accordingly to
U.S. indices. . . .

A closer look at Rolls-Royces competitive


position in the global market for jet engines
reveals the sources of its dollar exposure. For
the previous several years Rolls-Royces export
sales had accounted for a stable 40% of total
sales and had been directed at the U.S. market.
This market is dominated by two U.S. competitors, Pratt and Whitney Aircraft Group (United
Technologies) and General Electrics aerospace
division. As the clients of its mainstay engine,
the RB 211, were U.S. aircraft manufacturers
(Boeings 747SP and 747,00 and Lockheeds
L1011), Rolls-Royce had little choice in the currency denomination of its export sales but to
use the dollar.
Indeed, Rolls-Royce won some huge engine
contracts in 1978 and 1979 that were fixed
in dollar terms. Rolls-Royces operating costs,
on the other hand, were almost exclusively
incurred in sterling (wages, components, and
debt servicing). These contracts were mostly

pegged to an exchange rate of about $1.80 for


the pound, and Rolls-Royce officials, in fact,
expected the pound to fall further to $1.65.
Hence, they didnt cover their dollar exposures.
If the officials were correct, and the dollar
strengthened, Rolls-Royce would enjoy windfall
profits. When the dollar weakened instead, the
combined effect of fixed dollar revenues and
sterling costs resulted in foreign exchange losses
in 1979 on its U.S. engine contracts that were
estimated by the Wall Street Journal (March 11,
1980, p. 6) to be equivalent to as much as
$200 million.
Moreover, according to that same Wall Street
Journal article, the more engines produced and
sold under the previously negotiated contracts,
the greater Rolls-Royces losses will be.
Questions
1. Describe the factors you would need to

2.
3.

4.

5.

know to assess the economic impact on


Rolls-Royce of the change in the dollar:
sterling exchange rate. Does inflation affect
Rolls-Royces exposure?
Given these factors, how would you calculate
Rolls-Royces economic exposure?
Suppose Rolls-Royce had hedged its dollar contracts. Would it now be facing any economic
exposure? How about inflation risk?
What alternative financial management strategies might Rolls-Royce have followed that
would have reduced or eliminated its economic
exposure on the U.S. engine contracts?
What nonfinancial tactics might Rolls-Royce
now initiate to reduce its exposure on
the remaining engines to be supplied under
the contracts? On future business (e.g., diversification of export sales)?

417

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Part III Case Studies

418
6. What additional information would you

sold under the previously negotiated


contracts, the greater Rolls-Royces losses
will be?

require to ascertain the validity of the statement that the more engines produced and

Case III.2

The Mexican Peso

The basic purpose of this case is to have you


conduct an in-depth analysis of government
macroeconomic policies on firms and banks doing
business with Mexico. The vehicle being used is
the Mexican peso. See Exhibit III 2.1 for statistics
related to exchange rates and price indexes in
the United States and Mexico for the period
1976 1997. Using these data, please address the
following questions.

5.

6.

Questions
1. What are the causes of the continuing devalua-

tion of the peso since August 1976? Analyze


both the immediate causes (e.g., balance-ofpayments deficits) and longer-term, more fundamental causes (e.g., inflation, the political
and economic environment). Concentrate especially on the 1982 and 1994 1995 devaluations of the peso.
2. What role did oil price changes play in Mexicos
difficulties?
3. What indicators of peso devaluation prior to
1982 and 1994 were there?
4. What were the likely effects of the peso devaluation between 1976 and January 1982 on
a. Mexican companies?
b. Foreign firms operating in Mexico?

7.

8.

9.

10.

c. U.S. companies in border towns catering to


Mexicans?
Redo question 4, focusing on the effects of
peso devaluation subsequent to February 1982
and prior to December 1994.
In August 1982, the Mexican government
devalued the peso, froze all dollar accounts in
Mexican banks, and imposed currency controls. What are the governments objectives?
How did these actions affect the black market
value of the peso? Why?
How did the Mexican governments expropriation of Mexico City real estate, following
the September 1985 earthquake, affect the
value of the peso and why?
Consider the trust factor with respect to
Mexican policies. What have been the probable effects of trust or its lack on investment in
Mexico, Mexican citizens investment choices,
and the pesos value?
Are dollar loans to the Mexican government
and Mexican companies exposed to exchange
risk? Explain.
How did Mexicos economic policies contribute
to its debt crisis? How have subsequent government policies affected Mexicos financial
health?

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Case III.2 The Mexican Peso


Exhibit III 2.1

419

The Mexican Pesos Key Statistics: 1975 1997

Nominal Exchange Rates (period average)


Year:Quarter
75:1
75:2
75:3
75:4
76:1
76:2
76:3
76:4
77:1
77:2
77:3
77:4
78:1
78:2
78:3
78:4
79:1
79:2
79:3
79:4
80:1
80:2
80:3
80:4
81:1
81:2
81:3
81:4
82:1
82:2
82:3
82:4
83:1
83:2
83:3
83:4
84:1
84:2
84:3
84:4
85:1
85:2
85:3
85:4
86:1

Peso:Dollar
12.5
12.5
12.5
12.5
12.5
12.5
19.9
20.0
22.7
23.0
22.7
22.7
22.7
22.8
22.7
22.7
22.8
22.8
22.8
22.8
22.9
22.9
23.1
23.3
23.8
24.4
25.2
26.3
45.5
48.0
50.0
96.5
102.0
120.0
132.0
143.9
155.8
167.6
179.6
192.6
208.9
228.0
305.1
371.7
473.6

Dollar:Peso

CPI Mexico

CPI United States

$0.08000
$0.08000
$0.08000
$0.08000
$0.08000
$0.08000
$0.05038
$0.05013
$0.04407
$0.04348
$0.04407
$0.04399
$0.04398
$0.04384
$0.04399
$0.04401
$0.04380
$0.04378
$0.04390
$0.04386
$0.04376
$0.04361
$0.04337
$0.04301
$0.04209
$0.04103
$0.03968
$0.03804
$0.02198
$0.02082
$0.02000
$0.01036
$0.00980
$0.00833
$0.00758
$0.00695
$0.00642
$0.00597
$0.00557
$0.00519
$0.00479
$0.00439
$0.00328
$0.00269
$0.00211

100.0
103.2
107.0
110.4
115.2
118.2
122.0
137.3
149.1
155.7
162.4
168.6
177.7
183.9
191.4
197.6
209.5
217.0
225.2
235.6
256.8
271.5
289.3
303.9
328.5
348.4
365.9
389.4
435.0
501.5
606.1
730.8
926.2
1,076.9
1,217.2
1,369.6
1,601.9
1,807.3
1,987.7
2,196.5
2,552.7
2,800.9
3,097.0
3,527.5
4,254.7

100.0
101.9
104.1
105.8
106.8
108.2
109.8
111.0
113.0
115.5
117.1
118.5
120.4
123.6
126.5
129.0
132.3
136.8
141.3
145.4
151.1
156.6
159.4
163.7
168.0
171.9
176.9
179.3
180.9
183.5
187.0
187.5
187.3
189.7
191.9
193.6
195.7
197.9
200.1
201.5
202.8
205.3
206.7
212.6
213.1
(Continued)

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Part III Case Studies

420
Nominal Exchange Rates (period average)
Year:Quarter

Peso:Dollar

Dollar:Peso

CPI Mexico

CPI United States

86:2
86:3
86:4
87:1
87:2
87:3
87:4
88:1
88:2
88:3
88:4
89:1
89:2
89:3
89:4
90:1
90:2
90:3
90:4
91:1
91:2
91:3
91:4
92:1
92:2
92:3
92:4
93:1
93:2
93:3
93:4
94:1
94:2
94:3
94:4
95:1
95:2
95:3
95:4
96:1
96:2
96:3
96:4
97:1
97:2
97:3
97:4

575.4
752.0
923.5
1,126.0
1,353.7
1,570.8
2,209.7
2,281.0
2,281.0
2,281.0
2,281.0
2,369.0
2,460.0
2,551.0
2,641.0
2,733.0
2,817.0
2,890.6
2,945.4
2,981.0
3,018.2
3,055.8
3,071.0
3,083.5
3,122.3
3,116.3
3,115.4
3,097.6
3,121.2
3,117.8
3,105.9
3,359.8
3,391.8
3,404.0
5,325.0
6,817.5
6,309.2
6,419.5
7,642.5
7,547.9
7,610.8
7,537.4
7,850.9
7,890.5
7,958.0
7,819.9
8,136.0

$0.00174
$0.00133
$0.00108
$0.00089
$0.00074
$0.00064
$0.00045
$0.00044
$0.00044
$0.00044
$0.00044
$0.00042
$0.00041
$0.00039
$0.00038
$0.00037
$0.00035
$0.00035
$0.00034
$0.00034
$0.00033
$0.00033
$0.00033
$0.00032
$0.00032
$0.00032
$0.00032
$0.00032
$0.00032
$0.00032
$0.00032
$0.00030
$0.00029
$0.00029
$0.00019
$0.00015
$0.00016
$0.00016
$0.00013
$0.00013
$0.00013
$0.00013
$0.00013
$0.00013
$0.00013
$0.00013
$0.00012

4,957.8
5,930.4
7,164.7
8,909.4
11,120.8
13,889.6
15,228.2
29,116.0
32,453.0
33,924.0
34,968.1
36,943.5
38,435.6
39,687.9
41,501.0
45,621.2
48,104.5
50,789.0
53,783.8
57,724.0
59,806.8
61,443.3
64,270.0
67,741.4
69,576.3
70,964.8
72,750.1
75,130.5
76,519.0
77,758.8
79,048.2
80,585.5
81,825.3
83,015.4
84,552.8
92,685.7
109,447.5
117,630.0
125,713.4
137,218.5
146,789.6
153,533.9
161,071.8
172,180.2
178,031.9
182,991.0
188,793.2

212.6
214.3
215.4
217.8
220.7
223.1
225.0
229.4
232.2
235.3
237.7
240.5
244.3
246.4
248.7
253.0
255.5
260.0
264.3
266.4
267.9
270.0
272.1
274.0
276.3
278.1
280.1
282.5
284.5
285.3
288.5
290.4
292.5
295.4
296.3
299.8
302.4
303.7
305.3
307.9
311.0
313.1
314.7
315.7
316.6
317.6
318.5