Assignment 8: Universal Circuits Inc | Sidharth Mehta B17115

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Universal Circuits, Inc.
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 Assignment 8: Universal Circuits Inc | Sidharth Mehta B17115

Introduction:

The manager of international finance of Universal circuits organization is concerned about

the exposure of the firm to change in exchange rates. The particular concern is the exposure
of operations to changes in real exchange rates. Universal circuits is a leading supplier of
components for the measurement and control industry. The application of the products
includes blood analysers, industry automation systems, process controls, environmental
controls, pollution control, cancer research, oil exploration etc. The products were widely sold
by extensive sales force. UC got is 40% sales from outside US, where it wholly owned with
sales subsidiaries in 11 countries and another independent sales representative in 17
countries.
UC faced challenges from competitors as well where its relative strength lies in the technical

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innovation, quality and reliability etc. while price is the most important competitive factor but

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customers can pay for higher price as well. Most of the suppliers for UC are from US only,

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though it is expanding. 25% of UC’s manufacturing is done in Ireland where raw materials are
supplied from US counterparts.

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The targeted return on capital is 19% and the growth is largely self-financed. On sales front,
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UC has more than tripled to $214 million in fiscal 1983 and share prices have tenfold, which
made an equity issue of $37 million successful at a price of $37.5/share.
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UC started business in Ireland due to the attractive schemes given by the Irish Development
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Authority in the form of attractive tax inducements. To facilitate intercompany funds

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transfers, Irish operation was established as branch of Dutch Holding company. The Irish
branch was a fully integrated research and manufacturing operation, responsible for design
and development. Labor and locally owned sourced supplies accounted for 30% of direct cost
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of sales. Most of the raw material supplies were from US and the prices were based on US
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dollar prices.
Now, based on the philosophy of the organization, some members of the senior management
felt that the responsibility of exchange rate fluctuations and gains/losses from it should be
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centralised. The calculations are done monthly about exchange rates while it is believed that
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the rates won’t change drastically between the order placement and shipment of the order.
Thus, to align the sales with the order placement is important.
After receiving a telex from the controller of Irish plant, who is an integral employee at
Universal Circuits, a tough decision for hedging against the depreciation of US Dollar. If dollar
depreciates, manufacturing would be shifted from his Irish plant to the US plants, which in
turn would negatively affect his performance.

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 Assignment 8: Universal Circuits Inc | Sidharth Mehta B17115

Critical Problems with the case:

1) US Dollar is greatly overvalued in 1984:

US had 100 Billion US Dollar trade deficit in the past year. It can be calculated from
the given data from Exhibit 2 of the case that the US Dollar is greatly over valued by
36%. This signifies that the exchange rate differential is greater than the relative
inflation between the USA and Ireland. So, it can be assumed that if the purchasing
power parity comparison between USA and Ireland holds true then the Irish Plant are
right to be concerned in regards to their fear of the US Dollar weakening against the
Irish Punt. On the other hand PPP generally does not hold for major currencies bought
for investment purposes such as the US Dollar in the short run, it only holds in the long

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run.

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2) US Dollar Vulnerable position

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The controller of the Irish division is not right in predicting US dollar being at
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vulnerable position due to the fact that its trade deficit is currently in excess of $100
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billion and growing. Thus, yes as the dollar is going down but that may just be in a
particular cycle. According to relative price theory the cost of a certain good should be
equivalent in all currencies. In relative purchasing power parity, the exchange rate
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between the home and foreign currency should adjust to indicate changes in the price
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levels of the two countries. In this specific scenario if the theory were to hold true for
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the ratio to be behaving the way the value of the currency must be acting in an
appropriate manner. Therefore, as the dollar depreciates and the relative costs
incurred to
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3) Labour and supply costs:

Labour and locally sources supplies account for 30% of direct cost of sales and that
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operating and other expenses are incurred in Irish punt. Thus, effectively the costs in
Irish punt amount to 51.4% (30% cost of sales = 14.4% + operating expenses of 34% =
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48.4% expenses + other expenses of 3%=51.4%) of total costs. This presents a risk for
the company to give wages of workers at the right time.

4) Gap between Onsite plant and Senior Management:

Organization’s efficiency depends on the deals which they do. The company heavily
believed in decentralisation maintained a strong entrepreneurial mentality at the
divisions by granting them full managerial responsibility. But the CFO of the company
on the other hand felt the plants needed to focus on operations and sales divisions to
focus on pricing and sales margins rather than “mess around with currencies”. On the
other hand the Irish plant expressed concern with the added expenditure they would
incur added cost of sales which would bring down their budget profit. The point of the

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 Assignment 8: Universal Circuits Inc | Sidharth Mehta B17115

CFO of universal circuits is that no one really knows in which direction the dollar will
go and therefore speculating on this issue was of no real interest to those in the
manufacturing business.

5) Difficulty in hedging and its risks:

Thus, in an uprising trend of $US reserves, more $US would have to be purchases on
foreign exchange market to service the Irish subsidiary. Thu the future or profitability
depends on the changes in the real exchange rates which cannot be hedged using
currency futures due to it being short term channels. Thus, Irish subsidiary is left with
only option to match the costs in punt to revenues in punt. Also, between the time
the company has incurred the costs and time for payment, if the $US drops, the order
bill will change drastically which is assumed to be constant in the case.

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6) High Currency gains:

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The organization is built as a subsidiary of Dutch to save on the tax benefits, but with

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the change in currency exchange rates the total benefits from currency are much more

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than the tax benefits. Currency gains cannot be shown on the income statement which
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are likely to be high but with foreign debt of $13.7, this is not evident in the financial
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statements.

7) Choosing the financial instrument to hedge against the Currency risk

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Forecasts are susceptible to being incorrect. There is no guarantee that the

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expectations as to the foreign currency movement shall turn out to be accurate.

Hedging is conservative method of making investments that reduce the risk of the
portfolio. The pricing of hedging instruments is related to the potential downside
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risk in the underlying security. As a rule, the more downside risks the purchaser of the
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hedge seeks to transfer to the seller, the more expensive the hedge will be.

1) Hedging through asset allocation: by diversifying your portfolio with more than one
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type of asset to create a balanced portfolio.

2) Hedging through Structures: by investing a portion of the portfolio in derivatives and
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the other in debt. Here derivatives help in protecting from downside risks and debt
brings stability.
3) Hedging through options: by buying a call option and selling a put option and vice-
versa. This helps directly in protecting the portfolio, especially the equity portfolio.
4) Selective Hedging: making investments that reduce the risk to part of one’s portfolio,
but not the whole portfolio. In this case, selective hedging would imply reducing only
a part of the risk of depreciation in the dollar value and not the entire risk.
5) Staying in cash: It is a ‘No Investment’ strategy. Here, the investor does not make an
investment in any asset and thereby keeps his cash in hand.

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 Assignment 8: Universal Circuits Inc | Sidharth Mehta B17115

Analysis and Interpretations

The case is on managing foreign currency risks in business. The real exchange rate is the
nominal exchange rate adjusted for changes in the relative purchasing power of each
currency, which can be linked to the concept of Purchasing Power Parity.
S = P1 / P2
Where S represents the exchange rate of currency 1 to currency 2
P1 represents the cost of good x in currency 1
P2 represents the cost of good x in currency 2

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Spot rate = e (country 1)/ e (country 2) = Inflation (country 1)/ Inflation (country 2)

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The basic idea is to show the difference in the purchasing power, which according to

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economists should be same in all countries.

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Thus, in calculation of real appreciation or depreciation, it is necessary to adjust for inflation
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rates. Thus, the real appreciation or depreciation of a currency is calculated as follows:
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e (real) = e (nominal)*[ p (foreign)/p(home)]
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Also, the real interest rate must be adjusted for inflation, which measures the exchange rate
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between the current and future purchasing power, which when added to expected inflation
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gives the nominal rate.

Year 1960 1970 1980 1984

Relative Industrial
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Prices 100 80 53 41
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Exchange Rates 0.36 0.42 0.53 1.01

Real Interest Rates 0.52 1 1.31
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Foreign currency exposures are generally categorized into the following three distinct types:
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transaction (short-run) exposure, economic (long-run) exposure, and translation exposure.

Short-Run

A firm has transaction exposure/ short-term exposure whenever it has contractual cash flows
(receivables and payables) whose values are subject to unanticipated changes in exchange
rates due to a contract being denominated in a foreign currency. To realize the domestic value
of its foreign-denominated cash flows, the firm must exchange foreign currency for domestic
currency. As firms negotiate contracts with set prices and delivery dates in the face of a
volatile foreign exchange market with exchange rates constantly fluctuating, the firms face a
risk of changes in the exchange rate between the foreign and domestic currency.

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 Assignment 8: Universal Circuits Inc | Sidharth Mehta B17115

An operating exposure is the measurement of the extent to which the firm’s operating cash
flows are affected by the exchange rate. Operating exposure is the degree to which
exchange rate changes, in combination with price changes, will alter a company’s future
operating cash flows, and in turn profitability.

Long-Run

A firm has economic exposure / long-term exposure to the degree that its market value is
influenced by unexpected exchange rate fluctuations. Such exchange rate adjustments can
severely affect the firm’s position with regards to its competitors, the firm’s future cash flows,
and ultimately the firm’s value. Economic exposure can affect the present value of future cash
flows. Any transaction that exposes the firm to foreign exchange risk also exposes the firm
economically, but economic exposure can be caused by other business activities and

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investments which may not be mere international transactions, such as future cash flows
from fixed assets. A shift in exchange rates that influences the demand for a good in some

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country would also be an economic exposure for a firm that sells that good.

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Translation
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A firm’s translation exposure is the extent to which its financial reporting is affected by
exchange rate movements. As all firms generally must prepare consolidated financial
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statements for reporting purposes, the consolidation process for multinationals entails
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translating foreign assets and liabilities or the financial statements of foreign subsidiaries
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from foreign to domestic currency. While translation exposure may not affect a firm’s cash
flows, it could have a significant impact on a firm’s reported earnings and therefore its stock
price. Translation exposure is distinguished from transaction risk as a result of income and
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losses from various types of risk having different accounting treatments. Translation gives
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special consideration to assets and liabilities with regards to foreign exchange risk, whereas
exposures to revenues and expenses can often be managed ex ante by managing
transactional exposures when cash flows take place.
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Labour and locally sourced supplies account for 30% of direct cost of sales and that
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operating and other expenses are incurred in effect exclusively in Irish punt. Putting these
figures into context by using exhibit 5, it is possible to calculate that the costs incurred in
Irish punt amount to 51.4%.

US Dollar Valuation
From the above data, as the supply of raw material has been from US, the prices would have
thus increased from Year 1980 to 1984 by 100/53 to 100/41
With this, the effective change in inflation is: = 2.44 - 1.89 = .55 or .55/1.89 = 29.26% in 4 years
from 1980 to 1984

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 Assignment 8: Universal Circuits Inc | Sidharth Mehta B17115

Thus, the annual rate of inflation is 29.26%/4 = 7.31%

With this the conservative expected value of Dollar in 1984= .53*(1+1.0731) ^ 4/1 = .743
With the current real value of exchange rate of 1.01 Irish Punt per dollar, US dollar is highly
overvalued by
= (1.01-.743)/.743 = 35.9%
Based on these calculations, it clearly emerges that the US$ is overvalued by about 36% since
the exchange rate differential is greater than the relative inflation between the USA and
Ireland. We can thus assume that if PPP holds, the controller has a convincing argument with
regards to his fears of the US$ weakening against the punt. But it is widely accepted that PPP
generally does not hold for major currencies bought for investment purposes such as the US$,
and that if it does hold, it will only do so over the long term.

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Recommendations and Conclusions:

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The senior management should consider going forward with selective hedging as not all the

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components are responsive to change in the Punt to USD exchange rate. Since only 51.4% of

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the total revenue received is responsive to the fluctuation in the exchange rate, they just need
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to hedge only that part of the expenses of the Ireland based manufacturing facility. Thus, by
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regressive analysis, they should consider selective hedging by buying Forwards with the at
rate of 0.93 Irish pounds per $US. They should hedge only 51.4% of the cash inflows of $US.
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Currency Impacts offset each other in the long run and the gains or losses on currency
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exposure average out in the long run, due to the cyclical nature of exchange rates. Further
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the impact on economies and individual firms within the economy are different. While a weak
currency will be a cause of gain for local exporters, importers will face losses, the impact on
the government portfolio too shall be negative. Another choice would be conservative limited
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currency hedging in equity funds.

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Universal Circuits is highly exposed to the risks of currency. To reduce this the company must
choose on changing the methods of payment of wages and workers in punts to other forms
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of the payment. One of the forms which can be adopted by the organization is to pay people
in equity. Since based on the exchange rates it is seen that punts is growing over dollar, it
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would significantly advantage the organization to deal in punts for sales. This would boost the
income and show further positive statement. This is also pro-decentralization.
The company started in 1976 with bleak future in Ireland and thus tax benefits were
necessary, but as the company grows and is coming closer to the switching of tax benefits, it
would be great if the organization forms an independent entity rather than a holding entity
of Dutch Holding company.
The organization can scout for suppliers from a different country where they would get
significant advantages, if the currency of US is overvalued.

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