Universal Circuits Currency Exposure Should The Controller example essay topic

Real appreciation / depreciation of the Irish Punt, US Dollar, French Franc, Japanese Yen and Deutsche Mark The real exchange rate is the nominal exchange rate adjusted for changes in the relative purchasing power of each currency (Shapiro, 1999). This concept can be linked to the theory of Purchasing Power Parity ( ), first introduced by Gustav Cassel in 1918 and defined as: e (home) /e (foreign) = p (home) /p (foreign) (formula 1) e = spot rate p = Inflation In absolute terms, it states that currencies should have the same purchasing power all over the world. Transportation costs, tariffs, quotas, restrictions and product differentiation are ignored though. The relative version of states that the exchange rate between home and foreign currency will adjust to reflect changes in price levels of the two countries.

So, if inflation in the US is 5% and 3% in the UK, then sterling must rise by 2% in order to equalize the dollar price of goods in the two countries. Vice versa, when calculating real appreciation or depreciation, it is necessary to adjust for inflation rates. Therefore, real appreciation or depreciation of a currency is that adjusted for inflation and is calculated using the following formula: e (real) = e (nominal) [p (foreign) /p (home) ] (formula 2) Similarly, the real interest rate must be adjusted to reflect inflation. The real interest rate, according to the Fisher effect, measures the exchange rate between current and future purchasing power. Together with (expected) inflation, it represents the nominal rate. This can be approximated by the equation r = a + i, where r is the nominal rate, i is the rate of inflation, and a is the real rate of interest.

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 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 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 (Shapiro, 1999). Please see overleaf for calculations. 2. Universal Circuits' currency exposure Should the controller be concerned about the dollar's exchange rate?

Due to the US$ being the Irish's subsidiary functional currency, the controller should be concerned about the Punt/$ exchange rate. Although all the customers (independent sales representatives, US sales force and foreign sales affiliate) are billed in US$, with a direct effect to limit translation, transaction and economic exposure, the Irish subsidiary still incurs many Irish punt costs. Such costs are unmatched by any punt revenues and are thus subject to different types of exposures as it will be explained later. From the case (p. 255), we know that labour and locally sourced supplies account for 30% of direct cost of sales and that operating and other expenses are incurred in effect exclusively in Irish punt. Putting these figures into context by using exhibit 5 (p. 261), it is possible to calculate that the costs incurred in Irish punt amount to 51.4% (i.e. : 30% of cost of sales = 14.4% + operating expenses of 34% = 48.4% + other expenses of 3% = 51.4%) of total costs. Thus if the uprising trend of the US$ reverses, the effect will be that more US$ will have to be purchased on the foreign exchange market by the Irish subsidiary in order to service its punt costs.

The company therefore has a very large economic exposure (the change in the NPV of future cash flows of the firm as a result of unanticipated changes in real exchange rates) to the dollar that cannot be hedged using currency futures or FR As because such instruments are not long-term enough. Alternatively dynamic hedging could be used to limit the adverse impact of economic exposure. The only feasible solution to limit economic exposure would be to match punt costs with punt revenues. As most of Universal Circuit's costs are punt costs (i.e. : wages and general expenses), the Irish subsidiary might see its total costs rise if the US$ weakens against the punt and other main European currencies. Every month, the subsidiary has to pay for wages, other general expenses and materials sourced from outside the US by buying punt, DM and FF for example.

The danger here is that if between the time the company has incurred the costs and the time it has to pay for them, the US$ drops in value against any of these currencies then the bills will dramatically increase in US$ value (transaction exposure). What nature of currency exchange exposure does the Irish subsidiary face? There are three types of currency exchange exposures: translation (or accounting) exposure, transaction exposure, and economic exposure. Translation exposure Translation exposure arises from the need to convert the financial statements of foreign operations from the local currencies involved to the home currency (Shapiro, 1999). Whenever the exchange rate changes, assets, liabilities, revenues, expenses, gains or losses have to be restated. For Universal Circuits' Irish subsidiary, whose functional currency is the dollar and whose accounting standard is FASB No. 52, any changes of the Irish Punt will directly appear on the income statement as a gain or loss before interest and tax (the cumulative translation adjustment applies to the parent, not the foreign subsidiary), as the difference between translated net income before and retained earnings after currency gains.

Currency gains are likely to be high for the Irish subsidiary, but with foreign debt of $13.7 (Yen, FF, DM) this is not evident on the financial statements. Transaction exposure Transaction exposure stems from the possibility of incurring future exchange gains or losses on transactions already entered into and denominated in a foreign currency (Shapiro, 1999). This applies, for instance, where the exchange rate changes between submitting an order and the actual settlement date. This exposure largely overlaps with translation exposure, although items such as inventories and fixed assets are excluded, while contracts for future sales or purchases are excluded in the translation exposure. In Universal Circuits' case, transaction exposure is considered relatively low, with sales invoiced in dollars and average debtor days of 55 days. Economic exposure This exposure is by far the most serious of all currency exchange exposures because it is the most difficult to preview, estimate or remedy.

It consists of operating exposure - the extent to which currency fluctuations can alter a company's future operating cash flows (Shapiro, 2000) - and transaction exposure. In other words, economic exposure is the risk of a change in the value of a firm (measured by the present value of its expected cash flows) associated with a change in exchange rates. As the term suggests, economic exposure is linked to macroeconomic risks: a changing exchange rate often follows changes in interest rate and inflation (as suggested by the parity conditions). This risk also affects businesses solely operating in one country. In accounting terms, economic exposure cannot be minimised through retrospective accounting techniques because the real effect of currency changes is on a firm's future cash flows. Research by Duffy (1978) suggests that firms try to counter currency devaluations by minimising balance-sheet exposure (e.g. reducing working capital).

This can however limit a firm's ability to act or to take advantage of devaluations in other respects. Universal Circuits is evidently exposed to economic exposure. Its (relative) prices will affect its competitive position across the world, and prices depend on costs, making flexibility in production (e.g. the possibility to shift production from one country to another), and the product composition in terms of input mix (imported vs. exported components) prevalent. Functional currency - why the dollar and not the punt? In 1981, the Statement of Financial Accounting Standards No. 52 (FASB-52) replaced the old FASB-8. The new standard also set rules as to how to treat foreign currencies: firms must use the current rate method to translate foreign-currency denominated assets and liabilities into dollars, which means all foreign currency revenues and expenses must be translated at the rate of the date incurred or at a weighted average exchange rate for the period.

This has two advantages: one, translation gains and losses bypass the income statement, as they are listed on the balance sheet as 'cumulative translation adjustments'. Second, there is a distinction between reporting currency and functional currency. Functional currency is the currency of the primary economic environment in which the affiliate generates and expends cash. Generally, when the foreign affiliate's operations are a direct and integral component or extension of the parent company's operations, the functional currency would be that of the parent's home country (Shapiro, 1999). Since Universal Circuits' operations are split between the US and Ireland (see organisation chart) and since these are directly linked, it is appropriate that the Irish subsidiary should have the dollar as functional currency.

In addition, if all the bills and costs were made / incurred in punts, then the subsidiary would expose itself not only to a greater level of economic and transaction exposures, but also to greater translation exposure. That means that at the end of the accounting year when the subsidiary's profits are consolidated with its US parent, profits might appear much smaller in US$ terms if the US$ strengthened against the Irish punt. 3. Should the Punt be bought forward? In the light of a possible weakening of the dollar, the Irish controller should have approval for buying the punt forward. Still, it is necessary to consider costs and alternatives.

It should be examined prior to approval whether a money market hedge would be more favourable than a forward hedge or whether other hedging techniques such as the following funds adjustments should be applied: o Increase levels of local currency cash and marketable securities o Relax credit (reduce local currency receivables) o Speed up collection of hard-currency receivables o Reduce imports of hard-currency goods o Reduce local borrowing o Speed up payment of accounts payable o Delay dividend and fee remittances to parent and other subsidiaries o Delay payment of intersubsidiary accounts payable o Speed up collection of intersubsidiary accounts receivable o Invoice exports in local currency and imports in foreign currency It should be kept in mind though, that if a devaluation of the dollar is unlikely, such hedging methods are inefficient and costly, but if a devaluation is expected then the cost of using those techniques the cost of hedging rises to reflect the anticipated devaluation. Alternatives, such as pricing decisions, currency collars, risk sharing, or options, are not useful since Universal Circuit's revenues are in dollars anyway. Exposure netting, however, is a very efficient hedging tool, and Universal Circuit could offset its position in Ireland against that of Japan, for instance, but this would have to be done by the corporate controller rather than the Irish. If holds, the dollar is bound to depreciate against the punt. Then buying the punt forward is a feasible solution to protect the company's profits.

In the case of the dollar remaining stable or appreciating further, the company will not be able to realise any upside potential, but "a hedge is better than no hedge". Longer-term, the controller should also adjust his funds flows, but since the short-term outcome of the dollar weakening is obviously unclear, it makes sense to begin with a forward rather than going to great lengths to change funds flows. 4. General foreign exchange policy Currently, Universal Circuits (UC) has 40% of its sales made outside the US which means that 2/5 of its profits are exposed to currency fluctuations and hence to currency risk. In order to protect its profits in US$ terms, the company has to implement a strict foreign exchange policy. In order to determine what is the optimal general strategy, we shall look individually at the foreign production facilities (FPF) and at the foreign sales Affiliates (FSA).

As discussed above, the FPF consist mainly of the Irish plant, but production is also conducted in the UK, the Philippines and Japan. The main exposures for a FPF will therefore be economic and transaction, assuming that the US$ is the functional currency in all FPF. Transaction exposure arises whenever a company is committed to foreign currency denominated transactions, which is the case of every FPF when ordering for raw materials. Thus some sort of protective measures need to be taken against the risk of the local currency depreciating. Such measures involve entering into foreign currency transactions whose cash flows exactly offset the cash flows of the transaction exposure. They could include using currency options, borrowing or lending in the foreign currency, forward contracts and price adjustment clauses.

But it should be kept in mind that taking such precautionary measures while eliminating transaction exposure will not eliminate all foreign currency risk; currency risk on the present value of the FPF's future cash flows (economic exposure) will still be present. It is altogether much harder to hedge against economic exposure, thus the firm must adjust its long-term strategy in order to profit or limit losses arising from long lasting currency over or under-valuation. Such strategic changes need to stem from the marketing and the production function of the company. In terms of marketing initiatives this implies changes in marketing selection, product strategy, pricing strategy and promotional strategy.

For the changes in the production initiatives, it will involve product sourcing, input mix, plant location and raising productivity. For example, as UC has FPF in numerous countries, the firm can allocate production among its different plants in line with the changing US$ cost of production. Thus effectively increasing production in a nation whose currency has devalued and decreasing production in a country where there has been a revaluation. With regards to the FSA the question is what exposures are present and what type of currency policy should be implemented to protect their US$ value. In terms of exposure, the FSA are mainly concerned with transaction exposure. Thus in order to protect the US$ value of their sales, forward or money market hedges should be used.

If exchange risk is 'the element of cash flow variability attributable to unexpected currency fluctuation' (Shapiro, 1999), then the main foreign exchange risk policy of UC should be to arrange its financial affairs so that in whatever direction the exchange rates might move in the future, the US$ outcome will remain marginally unaffected. This can be brought into place in three ways: 1. Placing appropriate hedges on all sales whose payment is to be made in more than 10 days and whose value exceeds US$150,000.2. Placing appropriate hedges to limit translation exposure where present.

3. Allowing FPF to have sufficient flexibility in order to quickly adjust and capitalise on currency appreciations and depreciation. But the problem UC faces is who should be held responsible for the hedging strategies and decisions; should the process be centralised or decentralised? The main problem associated with decentralisation is that foreign subsidiaries might undertake hedging actions, either through lack of knowledge or lack of incentives, which increase rather than decrease the overall corporate exposure in a currency. But on the other hand, local managers can take advantage of certain situations that only they may be familiar with in a decentralised firm.

There is thus no clear answer to which approach gives better results. But perhaps UC could go "the middle way": allowing local managers to hedge their own exposure by engaging in forward contract with the prior notification and agreement of the central treasury. 5. Universal Circuit's foreign exchange strategy today Changes since 1985 There are three main changes since 1985 affecting Universal Circuits: 1. Introduction of the Euro 2.

Innovation in financial products - use of swaps, options, futures 3. Increased foreign investment in Ireland (American new economy) Looking at the exchange rate movements, one can see that the dollar has actually depreciated and that did hold in 1991 and 1993. Universal Circuits' exchange risk in 2001 Following the introduction of the Euro, Universal Circuits is facing slightly less translation exposure, since it can be assumed that fluctuations are flattened due to the size of the Euro zone and due to the diversity of currencies, which have joined the Euro. However, translation exposure is still present: what was Irish Punt / dollar is now simply Euro / dollar and if the Euro strengthens costs will increase in dollar terms. Within Europe, Universal Circuits is no longer facing transaction exposure relating to costs (if inputs are purchased within Europe), and - supposing customers are still invoiced in dollars - no transaction exposure regarding revenues.

Cash flows however are still exposed to economic exposure and especially in Ireland strong economic growth due to tax incentives is a trigger for inflation. When the euro was launched in January 1999, Ireland had a growth rate of 8% for the sixth year in a row. Attracting massive - mainly American - foreign investment in software and other new products, the prices of its traded goods and services were going to rise faster than those of its mature competitors in the rest of the euro zone (Minford, Daily Telegraph, 21 August, 2000). Therefore, European interest rates are too low to limit inflation. As to the current Euro / dollar exchange rate, the economic outlook suggests that the Euro should appreciate against the dollar. In other words, Universal Circuits is now likely to face the same situation as in 1985 and might consider buying forward the Euro.

Recommendations Because the Euro is expected to strengthen, Universal has to protect itself against a weakening dollar - long-term more than short-term. Its exposure is less due to the Euro but it still has to be managed (translation for $, transaction for $, yen, etc. ). Across the organisation, 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.

Controls and limitations should be put in place and clearly communicated, though. Overall, since customers pay in $ and if the dollar weakens, Universal Circuits will become more competitive inside Europe. Economic exposure can only be managed through long-term strategic 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. Efficient production and product innovation with the view to shorten life cycles also helps to protect profit margins and minimise substitution possibilities for customers (hence distracting them from contemplations about transaction costs and dollar payments).

Alternatively or additionally, Universal Circuits might decide to build its product range around standardised inputs: standardised procurement facilitates supplier shifting and bulk buying (too little orders too frequently are costly). More importantly, in order for foreign currency exposure to be managed in the most efficient way, it has to be done so across the organisation and in line with the company's strategy. The corporate controller at Universal Circuit should work closely with the Irish operations: while local initiative should be encouraged, clear strategies regarding the management of foreign currency exposure have to be communicated. The organisation chart suggests that the corporate controller's link to the Irish subsidiary is not sufficiently close. Senior management and top marketing and production managers should all be aware of the risks, which currency fluctuations entail when making decisions. It is the role of the CFO to: o Provide management with economic forecasts o Identify risks of competitive exposure o Structure evaluation criteria to avoid managers being penalised or rewarded Finally, the financial centre of the organisation should always be informed about the economic outlook and political risks where its operations abroad are.

Bibliography

Alan Shapiro, 1999, Multinational Financial Management, John Wiley Patrick Minford, 21/8/2000, Ireland's race against inflation can't be won with the Euro, URL: euro-know.
org / telegraph URL: oz forex. com Michael Pasko and Patricia Pollard, 1996, For here or to go? Purchasing Power Parity and the Big Mac, Review, Federal Reserve Bank of St.