None of our client companies operate in a foreign country. They don’t sell into a foreign market. Nor do they manufacture in a foreign market. So we will use a hypothetical manufacturing company, Daewoo, for the assignment.
Daewoo is an American automobile manufacturing company that makes cars in the U.S. and sells in the U.K. market. Assume that a majority of its revenue comes from the U.K. market. Read the attached article, and answer the following questions.
What if, instead, Daewoo made cars in the U.K. to sell in the U.S. market? How would your answer above change? Elaborate.
Dawoo needs to be aware that Bank of New England is currently increasing interest rates . Due to the rise in inflation and consumer prices rising 9.9% in August from a year earlier the rates are expected to continue to go up. British policymakers have decided to put a cap on bills for households and businesses, start new energy policies, and cut taxes. The purpose of this move is to fight inflation by lowering tax rates to make the effects of high inflation hurt less in the future. At the same time the government’s expansive energy policies and its broader fiscal plans, which include a package of tax cuts and hopes of quickly increasing economic growth, have the potential to raise longer-term inflationary pressures. This will decline Daewoo’s profits massively since sales will be expected to decline. Not only will sales decline but potentially so will the company’s production costs. If I were in charge of this company I would start following its contingency plan. The first step in the plan is to start building flexibility where possible. For this industry, I would ensure raw materials supplier contracts and manufacturing plant leases are renegotiated through strong long-term contracts. Daewoo should also cut capital spending and start collecting accounts receivable as soon as possible. As sales begin to drop I would also stop hiring new employees, especially sales employees since they aren’t expected to rise for quite a while.
Switching the topic to foreign exchange risk it is also important to know the British pound is decreasing against the US dollar drastically. Reports showed that the British pound weakened 17% this year against US Currency. Otherwise, the British pound has fallen to its weakest level since 1985, trading with the US dollar at $1.12. Due to the fluctuations in the UK to US dollar exchange rate, the conversion to US dollars results in a lowered than expected amount. What this means for Daewoo’s profits is that they will fall eventually due to the rapid fall in the value of British currency. I believe Daewoo should look in hedgeing their foreign exchange risk using derivatives. Which means payoffs derived from value of financial asset or something else of value. This will attempt to maintain more of the earnings from the foreign country in an asset, which they could then sell for the same amount of dollars at more ease. I Also believe that Daewoo should look to switch to local and dollar pay mixes so employee are insured to be payed in their currency. Switching to local and dollar pay mixs allows for employees to not have to worry about the exchange rate between British pounds and dollars. Overall Daewoo should try and make sure there profits aren’t crushed by a bad exchange rate that doesn’t go in their favor
If Daewoo made cars in the U.K. to sell in the U.S. market interest rates for Daewoo wouldn’t be anymore favorable than it is in the US. At this time in the US interest rates are rising and the economy is also about to go into a recession. I would advise that the company responds the same way and act as conservative as possible since a recession is most definitely going to happen in the future either way. How I would change is I would need to look more to the policy the US is implimenting currently due to the weakened economic times. On the other hand the foreign exchange risk would not be as high since Daewoo would be getting payed in US dollars which is a much stronger currency. This is because the pound-to-dollar exchange rate in the UK is can be better than some of the rates offered by providers in America. I would still advise that Daewoo continues to review the exchange rate between the US dollar and the British pound to insure profit are safe.