Question

Smith Co. operates business in the United States and New Zealand. In attempting to assess its economic exposure, it compiled the following information.

      i.    Smith’s U.S. sales are slightly influenced by the New Zealand dollar (NZ$) value, due to confronts rivalry from New Zealand exporters. It estimates the U.S. sales based on the following three exchange rate scenarios:

                                                                               Revenue from U.S. Business

                        Exchange Rate of NZ$                             (in millions)

                                   NZ$ = $.48                                              $100

                                   NZ$ =   .50                                                105

                                   NZ$ =   .54                                                110

      ii.    Revenues for Smith Co. in New Zealand dollars are projected to be NZ$600 million.

      iii.   Cost of goods sold is projected at $60 million from the U.S. materials purchase and NZ$100 million from the New Zealand materials purchase.

      iv.  Fixed operating expenses are valued at $30 million.

v.   Variable operating expenses are projected at 20 percent of total sales (after including New Zealand sales, translated to a dollar amount).

vi.  Interest expense is projected at $20 million on prevailing U.S. loans, and the company has no existing New Zealand loans.

Questions:

1. Generate a forecasted income statement for Smith Co. under each of the three exchange rate scenarios.                                                               

Also answer the following questions based on the rubric.                     

2. Discuss how Smith’s projected earnings before taxes are influenced by the vital of exchange rate forecasting. Justify your viewpoints.                                                    

Describe how Smith Co. can restruc­ture its operations to minimize the earnings sensitivity to the degree of exchange rate movements without reducing its business volume in New Zealand.

Answer 1

a.)

Forecasted Income Statements for St. Paul Company
(Figures are in millions)
	NZ$ = $.48	NZ$ = $.50	NZ$ = $.54
Sales
U.S		$100		$105		$110
New Zealand	NZ$600=	288	NZ$600=	300	NZ$600=	324
Total		$388		$405		$434
Cost of goods sold
U.S.		$60		$60		$60
New Zealand	NZ$100=	48	NZ$100=	50	NZ$100=	54
Total		$108		$110		$114
Gross profit	$280		$295		$320
	NZ$ = $.48	NZ$ = $.50	NZ$ = $.54
Operating expenses
U.S.: Fixed	$30		$30		$30
U.S.: Variable (20%of total sales)	78		81		87
Total		$108		$111		$117
Earnings before interest and taxes	$172		$184		$203
Interest expense
U.S		$20		$20		$20
New Zealand	NZ$0=	0	NZ$0=	0	NZ$0=	0
Total		$20		$20		$20
Earnings before taxes	$152		$164		$183

a.)

The forecasted income statements show that St. Paul Company is favorably affected by a strong New Zealand dollar (since its NZ$ inflow payments exceed its NZ$ outflow payments). St. Paul Company could reduce its economic exposure without reducing its New Zealand revenues by shifting expenses from the U.S. to New Zealand. In this way, its NZ$ outflow payments would be more similar to its NZ$ inflow payments.