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Case Analysis
Submitted by :
Abhimanyu Kr. Singh MP15002
Abhinandan Singh MP15003
Kumar Gopal MP15017
Shipra MP15041
Subrata Basak MP15043
Introduction:
Universal Circuits is a component supplier for the measurement and control industry. There were two
manufacturing plants, one in US and other in Ireland. Ireland was selected for a manufacturing location due
to various factors like capital grant and attractive tax inducements. The output of the plant was exported to
Universal’s Circuits foreign sales affiliates, the US sales force and independent manufacturer’s
representatives. The US sales quotes were made in the local currency for the customer, based upon the
standard US transfer price plus some modifications to adjust tax, duty and competitive pressure. They had
recently experienced that local currency prices could be increased from 60% to 90% of foreign sales, to offset
a weakening of the local currency after the initial quotation. Only 10% to 20% of foreign sales were made on
long term contracts at fixed local currency prices and another 10 to 20% were priced in US dollars.
The Irish Branch of company was doing well and had grown at twice the rates of the broader markets. The top line of
the company was growing at a CAGR of ~27%. The net profit margin of the Irish operations is at an all-time high of
8.6%.
Problem Identification:
(i) Risk Identification: Is there a threat to US Dollar to get weaken further?
What nature of currency exchange exposure does the Irish subsidiary face?
(ii) Risk Measurement: How do they measure risk against foreign currency?
(iii) Risk Management: How do they manage risk against foreign currency? Should the Punt be bought
forward?
(iv) Do they need to centralize Treasury?
Analysis:
Risk Identification:
The strong US Dollar has contributed to excellent profitability but same could be a concern tomorrow. A
telex had been received from the controller urging to be allowed to buy punt forward to protect his 1985
budgeted profits. Also, American trade deficits of 100 Bn Dollars means imports is more than exports and
excess demand of foreign currency against US dollar can weaken the US dollar. This is also evident from
movement of Punt against Dollar.
Foreign Currency/USD
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0.00
1960 1970 1980 1984
So, it is estimated from Irish Punt continuous strengthening and American trade deficits can lead to severe
risk against foreign exchange. This in turn can affect Cash flows and income statement and can result in
currency loss severely.
From 1980 to 1984 the dollar appreciated against the punt by about 50% and interest rate averaged 12.6%
during the same period. These high interest rates have caused the dollar to appreciate against other
currencies and slowed down the high inflation rate (10% in 1981) during that same period of time. Irish
controller’s main worry was that the dollar will be likely to depreciate. Over the last 2 years inflation has
fallen to 5%, much lower than the 10% rate in 1981. A lower inflation rate could result in the US government
lowering interest rates, which could cause the US dollar to decline. Increasing trading deficit, lower inflation,
and lower interest rate signals a possible weakening dollar. US trade deficit is currently in excess of $100
billion and growing. When compared to the Irish punt, which the controller and the company have a vested
interest in it is clear that over the last twenty years the dollar has been decreasing in value. Another part of
Exhibit 1 that indicates that the increasing trade deficit is weakening the dollar, primarily when comparing it
to the Irish Punt, is the Relative Industrial Prices section.
Risk Measurement:
Factors affecting decision to hedge foreign exchange risk:
FORWARDS: This is a made-to-measure agreement between two parties either to buy or sell a
specified amount of currency at specified rate on a particular day in future. The depreciation is
protected by selling a currency forward. Its main advantage is that it can be tailored to specific needs
of the firm.
FUTURES: This contract is similar to forward contract but is more liquid because it is traded in an
organized exchange, i.e., the futures market. Again, depreciation of a currency can be hedged by
selling futures though this is available in standard form only.
OPTIONS: This is a contract giving the right but not the obligation, to buy/sell a specific quantity of
one foreign currency in exchange for another at a fixed price, called the Exercise price or strike price.
SWAP: A swap is a foreign currency contract whereby the buyer as well as seller exchanges equal
initial principal amounts of two different currencies at the spot rate.
FOREIGN DEBT: It can be used to hedge foreign exchange exposure by taking advantage of the
International Fischer Effect relationship. The exporter stands to lose if the domestic currency
appreciates against that currency in the meanwhile, so to hedge this, he could take a loan in the
foreign currency for same duration and convert the same into domestic currency at the current
exchange rate.
Do they need to centralize Treasury?
The corporate treasurer for international group of companies will be faced with problems relating specifically
to the international spread of investments responsible for setting transfer prices to reduce the overall tax
bill, transferring of cash across international borders and Deciding currency exposure policies and
procedures. If centralized, then each operating company holds only the minimum working capital, remitting
the surplus to center for overall management. This process is sometimes known as cash pooling. This will
allow regional teams to improve operational parameters. If managed properly then treasury can turn out to
be profit center, otherwise it shall be a cost center.
Moreover, Transaction risks that Universal Circuits is exposed to in providing an extended period of credit
(up to 100 days) can be minimized and agreement to have adjustment in price at time of payment may also
help the firm.
Conclusion:
Having a bare minimum accounts receivable will ensure that currency risks are minimized. Coupled with an
agreement of alteration of price at the time of payment would provide additional safeguard. Across the
organization, it should be attempted to employ exposure netting. Universal Circuits might also include
hedging tools such as futures, swaps or Options in its transaction exposure management. Control and
Limitations should be put in place and clearly communicated. Overall since customers pay in dollars and if
dollar weakens, Universal Circuits will become more competitive inside Europe. Economic exposure can only
be managed through long term strategies initiatives, such as marketing or production. In terms of market
selection, it is advisable to stay in Europe and maintain flexible production facilities to diversify risk:
whenever the dollar is weak, primary inputs should be purchased in US, and abroad when the dollar is
strong. Buying the punt forward would be optimal, as it would reduce the possible loss due to weakening of
the dollar. If PPP holds, the dollar is bound to depreciate against punt. Then buying the punt forward is a
feasible option to protect the firm’s profit. In case of dollar remaining stable or appreciating further, the firm
will not be able to realize any upside potential, a hedge option will be better than no hedge option here. In
long term, controller should also adjust his funds flows, since the short term outcome of the dollar
weakening is unclear; it makes sense to begin with a forward. Go for forward rate of exchange of Irish Punt
to mitigate the Forex risk the firm faces.