International Finance Problem
Analyze the attached case, along the lines indicated by the Assignment questions listed at the end of the case. Since you will have plenty of time to complete your analysis, take the time to read and reflect upon the case before beginning to write. Your analysis should be restricted to 6 pages, including any exhibits you wish to provide. Take this restriction as a firm maximum--not merely a suggestion.
When Raymond Morgan entered his office on Friday, October 15, 2010, his secretary handed him a cable indicating acceptance of his firm's offer to supply Hartmund GmbH, a West German distributor, with approximately $500,000 of radios and related equipment for the remote opening of gates and garages in industrial plants and parking lots. The cable also indicated that Hartmund would wire the requested deposit of 60,000 directly to FibuDoor's California bank that same day. Morgan, president and majority owner of FibuDoor, hoped the German export order would mark the beginning of a return to more satisfactory levels of sales and profits for the firm.
FibuDoor was founded in the late 1990's to manufacture radio-activated controls for opening residential garage doors. California's continuing residential construction boom and the increase in suburban single-family residences with two-car and three-car garages created a potential demand for the product, and the level of affluence of new home buyers created a willingness to spend several hundred dollars to be able to open a garage door without having to get out of one's car. Sales had grown nicely and profits were more than adequate for roughly a decade. By 2008, however, the housing boom had ended and FibuDoor's high level of product quality meant that the replacement market for its products was virtually nil. Consequently, sales began to slip.
Morgan suspected that his market would not soon regain its former strength, and he turned to the development of an industrial version of his basic product. The industrial model was for use by delivery trucks and other vehicles entering or leaving warehouse loading docks or storage compounds where security was important. An approaching or departing truck would notify plant security by radio of a desire to pass through a gate, but final control of the gate remained with plant security. Security could either activate the gate to open automatically on radio request, a common procedure during busy daylight hours, or control the gate directly by opening it after verification by inspection that the vehicle and driver were in fact authorized to enter or leave. The industrial model proved particularly useful in inner-city areas where crime was a problem.
Sales of the industrial model were good at first, but total sales volume remained flat while costs continued to rise. In 2009, FibuDoor suffered its first net loss. In order to use idle capacity, Morgan decided to try to develop an export market. Although a few foreign sales had been made, they had not been the result of any concerted sales effort. After discussion with the U.S. Department of Commerce's international marketing representatives in Los Angeles in April 2010, Morgan contacted Hartmund GmbH, an industrial electronics distributor in Hamburg, Germany. In May, Morgan flew to Hamburg to meet the company's officers and explore the export potential of FibuDoor's industrial model. Hartmund expressed an interest in becoming FibuDoor's German distributor, and he suggested that Morgan prepare a firm offer.
On June 10, 2010, Morgan offered to send Hartmund a shipment of industrial model gate-openers for a price of 410,000. The offer requested the following payment schedule:
60,000 as cash down payment at the time the offer was accepted by Hartmund;
175,000 to be paid three months after the offer was accepted, by which time the first half of the order would have been shipped to Germany;
175,000 to be paid six months after the offer was accepted, by which time the remainder of the order would have been shipped.
The offer specified payment in euros, which Morgan felt from his earlier meeting with Hartmund was an important selling point. Shipment would be by air freight.
Morgan had been impressed by Hartmund's management and facilities. This was later confirmed by FibuDoor's Los Angeles bank, which reported that Hartmund's credit rating was considered excellent. For this reason, Morgan decided that it was unnecessary to request any credit guarantee arrangements beyond the down payment. Morgan's quoted offer price for the order was computed as follows:
Raw Materials and Components $220,000
Direct Labor 80,000
Factory Overhead 100,000
Administrative Overhead 30,000
Total Estimated Costs $450,000
Target Profit Margin (10%) 50,000
Dollar Price of Bid $500,000
/$ Exchange Rate = 0.819
Price, Rounded Off 410,000
Costs were estimated on the assumption that those incurred in manufacturing for export would run approximately the same as for domestic business.
As soon as Morgan read the cable from Hartmund accepting the offer, he began to think about foreign exchange risk. Since June, when the offer had been made, the dollar had tended to weaken against several major currencies, although the movement had been erratic (see Exhibit 1). Picking up Friday's edition of the Wall Street Journal, Morgan noted that euros were quoted at 0.7190 per dollar the previous day in New York. A quick calculation showed him that his order from Hartmund was now worth over $570,000--some $70,000 more than when the bid was made. Needless to say, he was elated.
Nevertheless, Morgan decided to consult his banker to ask advice about whether or not the future receipts of euros from the order should be hedged in the foreign currency market. From this conversation, there appeared to be at least three direct strategies that could be adopted:
(1) Do nothing, and let exchange rates evolve as they might;
(2) Cover in the forward market;
(3) Cover using a money market hedge.
As to the third of these, Morgan's banker indicated that FibuDoor would be able to arrange to borrow euros from the bank's London branch. The loan would be at a fixed rate for both three-month and six-month maturities, and would be priced at 150 basis points above euro LIBOR.
Morgan told his banker that he could use the proceeds of the loan to finance working capital needs over the next six months or so. He asked if the balance could be used to repay part of FibuDoor's currently outstanding short-term dollar bank loans. The banker indicated that this would be possible, or that the balance could be invested in a Eurodollar time deposit in London. Interest rate and exchange rate data as of October 2010 are contained in Exhibit 2.
The cash down payment of 60,000 was converted on the spot market at once, netting $83,500 at the spot price of 0.7186/$ which prevailed on Monday, October 18, 2010. These funds were to be used for working capital needs.
The existing short-term loans from the company's California bank represented a draw-down of FibuDoor's credit line of $1,000,000. The loan was priced at US prime plus 275 basis points. The loan agreement called for the rate to be adjusted quarterly--on the 15th of March, June, September, and December. At the date of the most recent adjustment, the prime rate was 3.25 percent.
(1) Describe fully, at the conceptual level, the nature of the three strategies FibuDoor can follow to deal with possible changes in the /$ exchange rate over the life of the contract with Hartmund. Indicate what risks are borne under each, and what conditions establish which would be preferable in any given situation.
(2) Analyze in detail the relative costs and desirability of those three alternative strategies for the specific situation faced by FibuDoor in the case at hand.
(3) Of what relevance to those strategies is the information in the Exhibits to the case about yen exchange rates and interest rates?
(4) Discuss the general nature, causes, and consequences of currency exchange risk, as faced by companies such as FibuDoor who are engaged in export business.
(5) Describe what is meant by the term "real option". How can the existence of such options affect a company's capital expenditure decisions? Give concrete examples of the latter effects.