Question

As we know that generally economic exposure can be managed by balancing sensitivity of revenue and expenses to exchange rate fluctuations. To accomplish this, however, the firm must first recognize how its revenue and expenses are affected by exchange rate fluctuations which in turn will affect the firm’s future cash flow. For some firms, revenue is more susceptible. These firms are most concerned that their home currency will appreciate against foreign currencies since the unfavourable effects on revenue will more than offset the favourable effects on expenses. Conversely, firms whose expenses are more sensitive to exchange rates than their revenue are most concerned that their home currency will depreciate against foreign currencies. When firms reduce their economic exposure, they reduce not only these unfavourable effects but also the favourable effects if the home currency value moves in the opposite direction. After comprehending the economic exposure assessment from the various perspectives, you are required to answer all the questions.

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.                                                   
3. 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

Ans.

a)

Forecasted Income Statement of Smith Co.
(figures are in millions)
	NZ$ - $0.48	NZ$ - $0.50	NZ$ - $0.54
Sales
US (in millions)	$            100	$          105	$           110
NZ (NZ$ 600 millions)	$            288	$          300	$           324
Total	$            388	$          405	$           434
Cost of goods sold:
US (in millions)	$              60	$            60	$             60
NZ (NZ$ 100 millions)	$              48	$            50	$             54
Total	$            108	$          110	$           114
Gross Profit	$            280	$          295	$           320
Operating Expenses:
US - Fixed	$              30	$            30	$             30
US - variable @ 20%	$              78	$            81	$             87
Total	$            108	$          111	$           117
Earning before Interest and Tax	$            172	$          184	$           203
Interest Expense:
US (in millions)	$              20	$            20	$             20
NZ (NZ$ 0 millions)	$              -	$             -	$             -
Total	$              20	$            20	$             20
Earning before Taxes	$            152	$          164	$           183

Also answer the following questions based on the rubric.

b)

Smith's forecasted income statements shows that this company the affect of  New Zealand dollar (i.e. increase in exchange rates) is in favor of company (because its NZ$ inflow payments exceed its NZ$ outflow payments). As the exchange rate increases ,earnings before taxes are also increases.

c)

Smith Company could reduce its economic exposure by continuing with same New Zealand revenues (i.e without reducing them) and 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 and this will setoff the economic exposure.