Operational Issues The report is the main document that counts for the grading

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Operational Issues

• The report is the main document that counts for the grading. It is not mandatory to submit an Excel file with all the computations. However, if you decide to submit an Excel file, this spreadsheet will be used only to determine whether there is plagiarism, and to check the computations that you did to get your empirical results. Hence, please make sure that the report contains all the information that you would like to be considered for the grading. As a consequence, you are not allowed to refer to any results that are not explicitly presented in the report and that might be contained in some Excel files.
• The report must be in PDF format and cannot be longer than 5 pages, including all the tables and graphs that you decide to insert. You must use a 12-point font size. Margins must be 3cm on the left, 2cm on top, and 2cm on the right. Line-spacing must be 1.15 cm. Please note that precise and concise answers will be awarded. Imprecise and long answers will be penalized.
• As far as tables (or graphs) are concerned, they will positively contribute to the final score if they will be clear, precise and well structured. Being able to present in few clear tables the relevant results will be positively evaluated. Each table must be accompanied by a short caption to describe the numbers that it reports. The related explanation should be inserted in the main text. This is consistent with top finance journals, where all tables are usually purely descriptive of their content, without any explanation of the relevant findings in their captions.
• If you need, you are allowed to have an Appendix at the end of your report which can include as many tables as you want. You can decide to include in the Appendix any additional tables that, according to you, may reinforce your findings. There is no space limit for the Appendix, which must include only tables and/or graphs. Please note that it is forbidden to add any explanation or answer in the Appendix. In the 5-page report, you can refer to any table that you may have included in the Appendix, explaining the related results. As mentioned above, however, please remember that being able to include all the necessary information in few tables in the report is awarded. Adding other information in the Appendix is fine, but no explanation, discussion or comment included in the Appendix will be taken into consideration when grading. Please upload the Appendix in the same PDF file.
• In the grading process, remarkable emphasis will be given to the interpretation of your quantitative results, rather than on the numbers themselves. It will be crucial for the evaluation how you relate your findings to the theories and topics discussed in class. The focus will be mainly on your discussion and comments concerning your quantitative findings. Hence, any link to the explanations provided in class will very positively contribute to the final score.
• Please make sure that you show all the computations that drive to your final results. Presenting all the computations in clear and concise equations and tables will be awarded.
• Try to be critical and think out of the box. Since this is a case-study, if there are ideas or thoughts that you may have about how to approach the problem that the firm is facing, please do not hesitate to explain all this in the report.

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?

As the top manager of your firm, you reflect on how to optimally react to this shock to the exchange rate. You hire a famous consultancy firm that advises you on implementing either of the following two alternatives.

Question A5: The consultant first suggests that you should modify your pricing policy. You evaluate whether to change the EUR price of the two types of engines that you sell in France by the same percentage amount. What is the new price of each of the two types of cars that will allow you to reach a profit margin that is equal to the value that you would have gotten in t+l, had the exchange rate stayed constant at NOK 9.8/EUR? The consultant recommends that you change the prices and adopt those that you have just computed, in order to be able to keep the profit margin unchanged. She claims that she advised several other firms many years ago about similar pricing policies, and she is optimistic that her advice will turn out to be correct this time as well. Would you agree with her? Why?

Question A6: The same consultant also suggests that you could sell all your gearboxes and propellers to some potential new customers in Norway, instead of selling them to your usual French clients. She argues that she did market research and found new Norwegian customers who would be willing to buy the same amount of gearboxes and propellers at the same NOK prices that your French customers paid at time t. She also claims that the Norwegian potential customers pay at the same time as the French clients, and they are interested in a long-term collaboration, much like your current French clients. Hence, she concludes that with this option you should not be concerned anymore by exchange rate risk, as both revenues and costs will be fully denominated in NOK, and you will be more competitive on the market. Would you agree with her? Why?

From now onwards, we assume that you do not decide to modify your prices following your discussion at step A6, but we stick to the original prices in t+l, which are the prices in t adjusted for inflation between t and t+l.

Question A7: Without doing any calculation specific to the income statement of the firm, given the inflation rates provided above, would you have preferred a situation where relative PPP holds between t and t+l? Please provide only a short theoretical answer without updating the income statement of the firm.

PART B. Hedging exchange rate risk

We now assume that we are still in t+l, and that you are sure that between time t+l and t+2 the inflation rates for Norway and France will be the same as those between t and t+l. We assume that you have certainty about the quantities that you will sell in t+2, which do not change, as well as the EUR prices at which you sell, which depend on your estimated future inflation.

Question Bl: Compute the expected profit margin in t+2 if, in t+l, you believe that the exchange rate follows a random walk.

You now decide to evaluate if and how to hedge against exchange rate risk. In order to investigate the impact of exchange rate risk on your operating cash-flows, the finance department of your company tries to estimate the possible spot exchange rate in time t+2, and it comes up with four estimates for four different states of the world, each of which has an associated probability of occurrence displayed in the table below.

Question B2: How does the expected future exchange rate in t+2 affect your profit margin? Answer this question by computing the new expected profit margin using the expected exchange rate. Comment by comparing your result with your previous finding at step Bl and explain.

Question 83: Compute the expected operating cash-flows and the expected profit margin (using aftertax profits) in t+2 for each state of the world. Please show the full income statement with your computations. Are you naturally hedged against FX risk? Why?

Question 84: If in B3 you answered that you are hedged against FX risk, explain why you are hedged. If in B3 you answered that you are not hedged, which derivative would you decide to buy or sell in order to hedge? Imagine that you could choose the quantity of EUR that represents the notional amount of this derivative contract: how many EUR would you want to buy or sell from your counterparty?

Question 85: Assume that you will be able to find options with a strike price equal to the expected spot exchange rate at time t+2, and that, likewise, you will be able to negotiate a forward contract with a counterparty at a price exactly equal to the same expected spot exchange rate. With your choice, can you obtain a good hedge? Show all the computations that support your answer. Is this a perfect hedge? Why?

Alternatively, you can try to hedge using a money-market hedge. We assume that the yearly interest rate in Norway is 3%, whereas it is equal to 1% in France.

Question B6: You are strongly bullish on the Norwegian stock market and you expect a 12% annual return from an equity investment from t+l to t+2. Your strategy is to anticipate some amount of money that is due in the future in order to invest it in an ETF tracking the performance of the OSEAX index until t+2. How many NOK do you expect the strategy to yield in t+2?