Homework answers / question archive / CASE STUDY PART A

CASE STUDY PART A

Finance

Share With

CASE STUDY

PART A. The impact of FX uncertainty on firm profits

We consider the strategy of a Norwegian multinational corporation that produces propulsion systems and auxiliary power units for marine and industrial utilization. You have just been appointed as CEO of this firm and you are assessing the competitive position of the company in the global markets.

Your firm currently produces in Norway 12,000 advanced gearboxes for boats, which are all sold in France, for a unit price of 4,000 EUR. In addition, your firm sold a quantity of 8,000 propellers to the same customers for a unit price of 6,000 EUR. All the production and assembly of the components is performed in the West coast of Norway, whereas most of your competitors, who sell the same products in the same export markets as your company, import from German suppliers. The company faces total labor costs equal to 300,000,000 NOK, administrative costs equal to 70,000,000 NOK, and unit production costs equal to 19,000 NOK for the gearboxes and 21,000 NOK for the propellers. You have fixed assets for a total book value of 400,000,000 NOK that you amortize at a fixed depreciation rate with a useful life of 5 years. The corporate tax rate in Norway is 22%. The spot exchange rate at time t, expressed in units of domestic currency per unit of foreign currency, is NOK 9.80/EUR. Throughout this assignment, we will define the after-tax profit and profit margin as follows. If the gross profit is positive, the after-tax profit is the difference between profits and corporate taxes, while if the firm has losses, for the sake of simplicity we assume that no tax is paid and there is no tax loss carry-forward. The profit margin is the ratio between total profits and total revenues.

Question Al: Compute your after-tax profit margin in NOK at year t, assuming that your firm sells all the produced gearboxes and propellers. Please summarize in a table all your computations.

You now plan your strategy for the following year t + 1. The finance department of your company informs you that inflation in Norway between year t and t + 1 is expected to be 3.5%, while inflation in France between year t and t + 1 is expected to be 1.1%. We assume that all monetary revenues and costs in each country, in this exercise, are impacted by the exact amount of inflation in that specific country, which is reported above.

Question A2: What should be the value of the exchange rate in t+l under which the expected profit margin will be positive? What is the economic explanation of this result?

Question A3: What should be the new exchange rate in t+l under which the expected profit margin will be the same as the one observed at time t? Under which theoretical condition would you obtain such a result? Elaborate in detail.

Due to persistently higher oil and electricity prices between years t and t+l, together with a bullish stock market, you observe that the NOK strengthens and reaches a value of NOK 9.0/EUR in t+l. Everything else stays constant.

Question A4: Compute the profit margin in t+l with the new observed exchange rate. Is this result expected or surprising? Why?