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Exchange rate risk

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DFI Location Decision.

Decko Co. is a US firm with a Chinese subsidiary that produces cell phones in China and sells them in Japan. This subsidiary pays its wages and its rent in Chinese yuan, which is stable relative to the dollar. The cell phones sold to Japan are denominated in Japanese yen. Assume that Decko Co. expects that the Chinese yuan will continue to stay stable against the dollar. The subsidiary's main goal is to generate profits for itself and reinvest the profits. It does not plan to remit any funds to the US parent.

a) Assume that the Japanese yen strengthens against the US dollar over time. How would this be expected to affect the profits earned by the Chinese subsidiary.
b) If Decko Co. had established its subsidiary in Tokyo, Japan, instead of China, would its subsidiary's profits be more exposed or less exposed to exchange rate risk?
c) Why do you think that Decko Co. established the subsidiary in China instead of Japan? Assume no major country risk barriers.
d) If the Chinese subsidiary needs to borrow money to finance its expansion and wants to reduce its exchange rate risk, should it borrow US dollars, Chinese yuan, or Japanese yen?

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a. If Yen strengthens against the dollar, it would also strengthen against the Yuan. Therefore the cash flow from sales when converted to Yuan from Yen would be higher. Thus the profits of the firm would increase since it would get more Yuan for the same ...

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The solution explains various questions relating to exchange rate risk

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Exchange rate risk & capitalization

Your next meeting is with the head of treasury to discuss the international impact to the firm's capital structure. Toto Matsui, the head of treasury, wants you to analyze what would be the implications to the firm's capital structure if the company took on debt denominated in some currency other than U.S. dollars. In particular, he wants you to analyze the following:

1) What risks will the company incur if it increases its long-term debt from US$100 million to US$150 million by taking on 40 million in euro debt based on current exchange rates of 0.80 euros to US$1? (The euro debt will pay a 7% coupon.)
How would changes in exchange rates between the euro and U.S. dollar impact the firm's capital structure and interest payments on the euros?

2.) Mr. Matsui tells you to assume the company's equity will remain at US$150 million and will not change when the euro debt is issued. He wants you chart (graph) how exchange rates will impact the capital structure of the firm and interest payments on the euro-denominated debt. In addition, he wants you to explain the graphs in a bulleted PowerPoint presentation.

Use Microsoft Excel to graph the capital structure of the firm in U.S. dollars based on changes in exchange rates. Use two scenarios: U.S. dollar appreciation against the euro and U.S. dollar depreciation against the euro. For capital structure, graph to total capital structure, debt, and equity.

Below is my Scenario:

As a senior financial analyst for Fresh Juices, Inc., the largest fresh fruit drink company in the United States, you are a key player in corporate finance for the business. You are consulted on major capital projects, prepare analysis for executive officers, present material at senior management meetings, and play the overall role of advisor to executive and senior officers.

Fresh Juices, Inc. has witnessed its sales grow from US$1 million in the first year of operations in 1970 to US$1.5 billion last year. The company started as a regional supplier of fresh fruit drinks in California and initially expanded in the West. However, over the last 15 years, the company has moved further east, north, and south. Today, the company's lines of products can be found on the shelves of any major grocery store in the U.S., and its market share of fresh fruit drinks is 80% in the United States.

The Drive to Expand Internationally

On a recent trip to Canada and Latin America, Hector Vasquez, the company's chief executive officer (CEO), noted the lack of fresh fruit drinks in the supermarkets. When he returned, he brought in all of his senior officers and said, "I want to be international in a year. We have a great product, and I think we can compete effectively in North and South America, Europe, and Asia. My recent travels confirmed my suspicion that fresh fruit drinks like ours do not exist outside the U.S.," he said. "Furthermore, with the U.S. market growing at 2% annually, we need to find other markets that have the potential to grow at a faster pace."

Mr. Vasquez asked your boss, Bonita Galloway, to head up the team to do the analysis on international opportunities and report back to him in the coming weeks. With that, he dismissed the meeting, and the senior officers left.

The Meeting

The U.S. business was so mature and was not growing rapidly, so Ms. Galloway thought international expansion might be just what the company needed. She was concerned that the company's profit margins would start to be squeezed in the company years if the firm did not find other sources of revenue growth. This would force the company to make drastic cost cuts and could potentially impact Fresh Juices' ability to compete.

Given your role in the organization, Ms. Galloway immediately thought of you as the finance lead on this project. She called you to her office to discuss what happened at the meeting with Mr. Vasquez.

After briefing you, she said, "I want you to be the primary contact on this. I will need you to work closely with the various departments that will be involved with this effort. Specifically, I need to lean on your analytical capabilities because we need to make objective decisions. I need you to give me the facts?not what you think I want to hear. This is important to the future of the company. I know I can count on you."

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