Operating Exposure Essay Example

Operating Exposure Essay Example Operating Exposure Paper Operating Exposure Paper Xian- Janssen Pharmaceutical (China) and the Euro INTERNATIONAL FINANCIAL MANAGEMENT Case Questions and Answers 1. How significant an impact do foreign exchange gains and losses have on corporate performance at XJP? What is your opinion of how they structure and manage their currency exposures? During 2003, the dramatic raise in the value of Euro against the dollar resulted in foreign exchange losses of Rmb 75 billion, out of which Rmb 60 billion were charged as 2003 cost of hedging. The year of 2003 proved to be fortunate for the XJP Company, housing fund adjustment and inventory valuation reversal recorded extraordinary gains of Rmb 70 billion. These gains had lessened the negative influence of the foreign exchange losses on the company’s net earnings resulting in a net increase of Rmb 10 billion. In 2004, The Company estimated the Euro to further appreciate relative to the US dollar. Estimated foreign exchange losses were Rmb 75 billion. Since the year 2004 is unlikely to be fortunate like 2003, the appreciation of the Euro is estimated to affect the profitability of the company and result in a reduction of 4. 6% in net earnings. I think XPY Company should consider getting raw material and finished products from suppliers, other than JJ, specifically who are based in countries where currencies are pegged to the US dollar. Moreover, the company should negotiate and discuss the possibility of setting lower internal transfer prices and applying centralized hedging practices where the parent company attempt to net transaction exposure of all its subsidiaries. . JJ has roughly 200 foreign subsidiaries worldwide. It has always pursued a highly decentralized organizational structure, in which the individual units are responsible for their own performance from the top to the bottom line of the income statement. How is this reflected in the situation XJP finds itself? Examining the case of XJP along with the losses generated from FX movements and hedging costs, decentralized organizational structure proved to be inefficient. In this example, granting XJP Company the full responsibility to manage currency risks and bear hedging costs negatively affected the company’s profitability. However, I still believe that the management of XJP Company should be given a room of freedom (decentralization) in other areas like deciding from where to import and with whom to deal. Moreover, the company should be given the opportunity to produce more than just generic products, to positions its differentiated products and to market them. 3. What is the relationship between actual spot exchange rate, the budgeted spot exchange rate, the forward rate, and the expectations for the Chinese subsidiary’s financial results by the U. S. parent company? Actual spot exchange rate is defined as rate of a foreign-exchange contract for immediate delivery. It’s basically the actual and current price of one currency in terms of the other. The budgeted spot exchange rate is estimated by the company to be the rate of a foreign-exchange contract for immediate delivery at a certain point of time. Normally, companies estimate or forecast the spot exchange rate to plan, budget and form expectations and strategic plans. This rate can be estimated by the company’s researchers, economists or third party consultants. The forward rate is the rate of a foreign-exchange contract for future delivery With regards to the case study of XJP Company, the forecasted or budgeted spot exchange rates proved to be deviating from the actual average forward rates. For example, in 2003, the company budgeted spot exchange rate (euro/Rmb) at 8. and since the expected import purchase was million 121 euros, the company estimated import purchases to be (8. 6 X million 121 euro), which is Rmb 1. 0406 billion. However, as the actual average forward rate of the euro reached 9. 22, the company’s actual cost of imports recorded Rmb 1. 11562 billion, resulting in Rmb 75. 020 million losses due to cost of hedging. With regard to 2004 budget figures, the company budgeted spot exchange rate (euro/R mb) at 9. 8 and since the expected import purchase was million 145 euros, the company estimated import purchases to be (9. X million 145 euro), which is Rmb 1. 42296 billion. However, as the actual average forward rate of the euro reached 10. 5, the company’s actual cost of imports recorded Rmb 1. 5246 billion, resulting in Rmb 101. 64 million losses due to cost of hedging. Analyzing the effect of the exchange rate movement and cost of hedging on the financial figures of XJP, JJ underestimated the significant role played by exchange rate movement and cost of hedging on the gross cost of product sold of its subsidiary. It’s obvious that the parent company had set the objective of 20% growth in earning without considering the high cost of hedging and foreign exchange losses. 4. If you were Paul Young, what would you do? The answer to this question depends on whether Paul wants to tradeoff risk for return, in other words, it depends on whether he is concerned about meeting JJ’s objective of achieving 20% growth rate. If he decided to fulfill the JJ’s objected growth rate, then he is advised not to hedge against foreign exchange movements. Under this situation, he will expose the company to a greater currency risk, while at the same time, he would be able to meet and fulfill the required growth rate by the parent company. On the other hand, if Paul decided to hedge XJP’s position and its gross cost of goods sold against currency risk, he would definitely fail to meet JJ’s expectations due to high cost of hedging, while at the same time, he will expose his company (XJP) to a much lower currency risk. In other words, if Paul happened to be a conservative manager, he will most probably favor hedging the company’s gross cost of products sold against currency movements, therefore, sacrificing high profit rates. However, if he happened to be an aggressive and risk taking manager, them he would choose to unhedge the company’s gross cost of products sold therefore, exposing XJP Company to a much greater currency risk.