Blades Inc. Case, Assessment of Risk Exposure, (Jeff Madura, International Financial Management)

Case Summary Blades Inc. is a U.S based company that has been incorporated in the United States for three years. Blades is a relatively small company, with total assets of only $200 million. The company produces a single type of product, roller blades. Blades Inc. exports to Thailand and a retailer in UK to supplement declining U.S. sales. Blades Inc. has suppliers in US and Thailand. All exports and imports denominated in respective foreign currency. Decision to export to Thailand was supported as Thailand is one of the fastest growing economies. There was an importer committing itself to annual purchase of 180,000 pairs of Blades “Speedos”. The commitment began last year and will last another 2 years and has renewal option. As committed, Blades is selling its roller blades for 4,594 baht per pair (approximately $100 at current exchange rate) instead of usual $120 per pair. Although discounted price but it still constitutes a considerable markup. As there were no interested importers for such commitment in Asia, it was decisive factor to export to Thailand. Although Ben Hold, CFO of Blades, believes that market for sports products is growing is Asia, Blades has started exporting to Jogs Ltd. a British retailer. Jogs has a commitment with Blades to purchase 200,000 pairs of Speedos at 80 pounds per pair. In near future, Blades forecasted to import supplies from Thailand for producing 80,000 pairs of Speedos, at a cost of 3,000 baht per pair of Speedos. Blades’ financial analyst pointed out the recent economic condition of Asian countries, including Thailand which may cause substantial depreciation of Thai Baht and Thai importer may not renew commitment. But Ben Holt, CFO, being optimistic, has no doubt about renewal of the contract by Thai importer. Financial analyst thinks, Ben Holt is ignoring the future of Blades after renewal is made and effect of high level of inflation. Following information is available: •

Forecasted sales=> in the USA, 520,000 pairs@$120 per pair. In Thailand, 180,000 pairs@4,594 baht a pair. In the UK,200,000 pairs@80 pounds per par.

•

Cost of goods sold for 80,000 pairs incurred in Thailand and remaining in USA@$70 per pair

•

Fixed cost $2,000,000 and variable cost is 11% of US sales.

•

Current spot rate of baht is $.022 and for pound is $1.50

Scenario

Effect on baht

Average value of baht

Average

1 2 3

No change 5% depreciation 10% depreciation

$.00220 $.0209 $.0198

pound $1.530 $1.485 $1.500

•

value

of

No debt in capital structure but additional funds can be borrowed in Thailand if a subsidiary is established

1. How will Blades be negatively affected by the high level of inflation in Thailand if the Thai customer renews its commitment for another three years? As business becomes increasingly global, the volatility of exchange rates become more important, even for a purely domestic firm operating in a global market. Firms have to pay more attention to exchange rate risk. Changes in exchange rates expose a MNC to currency risk. Inflation has a direct relation to exchange rates and these changes affects a firm’s competitiveness, increases or decreases sales revenue, affects the cost of goods sold, input prices, operating profits, market share, stock price, market value, etc. all these are referred to as a firm’s economic exposure. As with Blades Inc, having the parent operation in USA and with contractual sales in both UK and Thailand, it can easily be assumed that the economic conditions of the countries of operation will have some effect on Blades Inc. the high level of inflation in Thailand is our major concern. According to the contract, Blades Inc. USA sells 180,000 pairs of Blades “Speedos” annually to the importer. As per the contract, Blades is selling the roller blades for 4594 Baht which is approximately $100 at current exchange rates. But the usual price is $ 120. Stipulating that the contract is renewed for another three years, Blades Inc. will have to sell the roller blades as 4594 Baht or $100. This means that the high level of inflation in Thailand will have no impact on the cash inflow from that subsidiary. Blades Inc, also purchases some supplies from Thailand. Therefore, the cost of goods sold incurred in Thailand will be subject to the high level of inflation. This signifies that the cash outflow will increase for Thailand. Also, the inflation will have some effect on the Thai baht, further depreciating its value. This will reduce the dollars received from baht denominated sales to Thailand. According to the given circumstances the future expenses of Blades Inc are more sensitive than future revenue to the possible values of a Thai baht. Being in the contract, Blades has no control over the sensitivity of foreign revenue. Extending the contract further for three years during an inflating economy will further increase the economic exposure of Blades Inc.

2. Holt believes that the Thai importer will renew its commitment in two years. Do you think his assessment is correct? Why or why not? Also, assume that the Thai economy returns to the high growth level that existed prior to the recent unfavorable economic events. Under this assumption, how likely is it that the Thai importer will renew its commitment in two years? To make a correct assumption on the decision of whether the importer will renew the contract or not we need to view it from the perspective of the importer as well as that of Blades Inc. Currently the contract has gone through the initial year and two more years remain until its expiration. We need to analyze the potentials of the contract if it is to be renewed by the importer. Renewing the contract after the expiration period has both advantages and disadvantages for the importer. If the contract is renewed, the importer will have some cost benefit over the price of the Speedos roller blades. As the contract specifies, the importer will be able to import the roller blades at the price of 4594 baht even when the Thai economy is facing high level of inflation. So this proves as an advantage for the importer allowing him to import at a secured price; as the cost incurred by the importer is denominated in Thai baht which is not subject to the high level of inflation. But the contract renewal may also prove as a disadvantage for the importer. If the Thai economy continues through high level of inflation after the contract is renewed, the importer will be able to import products at the predetermined rate, but the high inflation may provoke consumers in Thailand to reduce their spending on leisure products. So the inflation in Thailand may lead the Thai sales towards a steady decline. Thus the Thai firm may not be able to sell all of the products it has purchased from Blades. Considering the above facts, we can assume that the importer will renew the contracts only if the decline in sales is offset by the advantage of cost incurred. Renewing the contract will provide benefit to the importer over its competitors as they are prone to the high level of inflation. So the importer can attain a benefit over its competitors in the cost department. Extending the contract will also reduce the economic exposure of the importer even during inflation periods. But this will occur only when the costs incurred by the importer in Thai baht is offset by its revenue. Assuming that the Thai economy returns to a high growth level, there is likelihood of the Thai customer renewing its commitment. This is because it can be reasonably certain that it will sell all of the products it has committed itself to purchase from Blades. Furthermore, the costs it incurs are still not subject to the high level of inflation prevailing in Thailand.

3. For each of the three possible values of the Thai baht and the British pound, use a spreadsheet to construct a pro forma income statement for the next year. Briefly comment on the level of Blades’ economic exposure. Blades, Inc. does not appear to be subject to a high level of economic exposure based on the analysis. If Thai baht and British pound depreciate by 5 percent then UK and Thai sales reduce when converted into US dollars, as a result total sales decreases. However, cost of goods sold also decreases when baht depreciates but this reduction can not outperform the reduction in sales which results in lower earning before taxes. Nevertheless, a depreciation of the Thai baht by 10 percent to an average level of $.0198 over the year would decrease its earnings before taxes by approximately 5 percent. Thus, Blades, Inc. is subject to some economic exposure.

Sales (1) U.S. (520,000 units × $120/pair) (2) Thai (180,000 units × THB4,594 × Exchange Rate) (3) British (200,000 units × 80 pounds × Exchange Rate) (4) Total Cost of goods sold: (5) U.S. ([900,000 – 80,000] units × $70) (6) Thai (80,000 units × THB3,000 × Exchange Rate) (7) Total (8) Gross profit Operating Expenses: (9) U.S.: Fixed (10) U.S.: Variable (11% of U.S. sales) (11) Total (12) Earnings before taxes

THB=$0.0220 BP=$1.530

THB=$0.0209 BP=$1.485

THB=$0.0198 BP=$1.500

$ 62,400,000 $ 18,192,240

$ 62,400,000 $ 17,282,628

$ 62,400,000 $ 16,373,016

$ 24,480,000

$ 23,760,000

$ 24,000,000

$105,072,240

$103,442,628

$102,773,016

$ 57,400,000 $ 5,280,000

$ 57,400,000 $ 5,016,000

$ 57,400,000 $ 4,752,000

$ 62,680,000 $ 42,392,240

$ 62,416,000 $ 41,026,628

$ 62,152,000 $ 40,621,016

$ $ $ $

$ $ $ $

$ $ $ $

2,000,000 6,864,000 8,864,000 33,528,240

2,000,000 6,864,000 8,864,000 32,162,628

Earnings before taxes reduced by: $33,528,240 − $32,162,628 * 100 = 4.07% $33,528,240 $33,528,240 − $31,757,016 % ∆ in 10 percent depreciation = *100 = 5.28% $33,528,240 % ∆ in 5 percent depreciation =

2,000,000 6,864,000 8,864,000 31,757,016

In this scenario, •

Earnings before taxes reduced by approximately 4 percent since both baht and pound have depreciated against US$

•

Earnings before taxes reduced by approximately 5 percent since 10 percent depreciation in baht has outperformed the appreciation of pound against US$.

So, we can conclude that, since the cash flows of Blades inc. are affected by exchange rate fluctuations, Blades Inc. certainly have economic exposure but to a limited extent.

4. Now repeat your analysis in question 3 but assume that the British pound and the Thai baht are perfectly correlated. For example, if the baht depreciates by 5 percent, the pound will also depreciate by 5 percent. Under this assumption, is Blades subject to a greater degree of economic exposure? Why or why not? If the British pound and the Thai baht are perfectly correlated, as a result Blades’ level of economic exposure increases. This is because Blades generates inflows in both pounds and baht. So if, the pound and baht tend to appreciate then more cash will flow in to Blades in US$ and if these currencies depreciate against US$ then less cash will flow in to company causing intense economic exposure.

THB=$0.0220 BP=$1.50 Sales (1) U.S. (520,000 units × $120/pair) (2) Thai (180,000 units × THB4,594 × Exchange Rate) (3) British (200,000 units × 80 pounds × Exchange Rate) (4) Total Cost of goods sold: (5) U.S. ([900,000 – 80,000] units × $70) (6) Thai (80,000 units × THB3,000 × Exchange Rate) (7) Total (8) Gross profit Operating Expenses: (9) U.S.: Fixed (10) U.S.: Variable (11% of U.S. sales) (11) Total (12) Earnings before taxes

THB=$0.0209 BP=$1.425

THB=$0.0198 BP=$1.350

$ 62,400,000 $ 18,192,240

$ $

62,400,000 17,282,628

$ $

62,400,000 16,373,016

$ 24,000,000

$

22,800,000

$

21,600,000

$ 104,592,240

$

102,482,628

$

100,373,016

$ 57,400,000 $ 5,280,000

$ $

57,400,000 5,016,000

$ $

57,400,000 4,752,000

$ 62,680,000 $ 41,912,240

$ $

62,416,000 40,066,628

$ $

62,152,000 38,221,016

$ 2,000,000 $ 6,864,000 $ 8,864,000 $ 33,048,240

$ $ $ $

2,000,000 6,864,000 8,864,000 31,202,628

$ $ $ $

2,000,000 6,864,000 8,864,000 29,357,016

Earnings before taxes reduced by:

%∆ in 5 percent depreciation =

$33,048,240 − $31,202,628 *100 = 5.58% $33,048,240

% ∆ in 10 percent depreciation =

$33,048,240 − $29,357,016 * 100 =11.17% $33,048,240

Under this scenario, •

A depreciation of the pound and the baht by 5 percent would reduce Blades’ earnings before taxes by approximately 6 percent.

•

A depreciation of the pound and the baht by 10 percent would reduce Blades’ earnings before taxes by approximately 11 percent.

As a result, Blades’ sensitivity to economic exposure increases significantly. In depth, depreciation in one currency causing less cash flow for Blades Inc. would show more adverse effect on Blades along with depreciation in another currency. So, economic exposure risk would be more and in addition, both currencies fluctuate by same degree. If Thai Baht depreciate, then cash flow inflow from Thailand would be affected and same applies for UK business if British pound depreciates. Here, Blades will have fewer earnings from both UK and Thailand whenever pound and baht depreciate against US$.

5. Based on your answers to the previous three questions, what actions could Blades take to reduce its level of economic exposure to Thailand? Economic exposure can be managed by balancing the 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. For some firms, revenue is more susceptible. These firms are most concerned that their home currency will appreciate against foreign currencies since the unfavorable effects on revenue will more than offset the favorable 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 unfavorable effects but also the favorable effects if the home currency value moves in the opposite direction. There are several actions Blades could take. The analysis above illustrates that economic exposure can be reduced by the following strategies: •

Diversification of International Business: Conducting its international business in countries whose currencies are not highly correlated. Thus, Blades could be exporting to or importing from other countries besides Thailand and the United Kingdom. o

Limitations: Other macro economic variables such as inflation, interest rates, competition, market condition, government regulations may have their individual effect on sales and the MNC’s value.

•

Financing with Foreign Funds: Another action Blades could take is to borrow in baht, which would reduce the number of baht that would have to be converted to dollars, as the baht receivables could be used to repay to baht-denominated loans. The borrowed funds could then be converted to dollars to pay for U.S. supplies. o

•

Limitations: The high level of interest rates may not make this a feasible alternative.

Purchasing Foreign Supplies: To further reduce its economic exposure, Blades could also buy more supplies from Thailand instead of the U.S. in order to create more cash outflows in baht. This would further reduce the level of economic exposure, as more baht revenues could be used to buy Thai supplies. o

Limitation: The success of this approach depends on the impact of the high level of inflation in Thailand on market prices for the imported components.