Assignment Title: “Ruritanian Project” Case Study
Table of Contents
2.Labour Cost Advantage
3.First Mover Advantages
4.Other advantages of FDI
5.Political and Country Risk
6.Foreign Exchange Rate Risk – Transaction Exposure
7.Foreign Exchange Rate Risk – Translation Exposure
8.Foreign Exchange Rate Risk – Economic Exposure
9.Other FDI Risks
The company headquartered in the U.K. is considering setting up a new manufacturing facility in Ruritania. As a new venture in the company’s history, this decision should be carefully evaluated based on its advantages and disadvantages. As the Treasurer, this report is produced in order to present a number of financial issues that are important to this decision. This report will mainly be divided into three sections. In the first section, the benefits that our company is likely to gain will be introduced, such as the lower labour cost, first mover advantage, and other benefits generated from foreign direct investment (FDI). Next, in the second section, various possible risks will be critically discussed including political risk, foreign exchange rate risk and currency risk. Finally, there is a recommendation part which concludes the essay and gives the final opinion to this proposal.
Labour Cost Advantage
One of the most important reasons to enter Ruritania is to benefit from its lower labour cost advantage. The United Kingdom is one of the countries with the highest labour cost as its minimum wage rose to £5.93 per hour from 1st October 2010 (BBC News, 2010). Hence, our company will benefit from a huge labour cost reduction by moving the manufacturing factory to Ruritania, which is a developing Eastern European country. In the current economic recessions, this benefit will allow us to increase the profit margin and make our products more competitive in the global business market.
First Mover Advantages
In addition, as the Ruritania is experiencing fast economic development with an average growth rate of 6% over the last five years, a lot of our global competitors are chasing the market as well to expand their businesses. If our company can be the first one to establish a presence in this region, we will enjoy considerable first mover advantages. Peng (2009) has argued that these advantages include technological leadership, pre-emption of scare resources, entry barriers to late movers as well as the relationships and connections with key stakeholders such as customers and governments.
Other advantages of FDI
Furthermore, by expanding business to another country, we can also benefit from advantages of FDI. FDI is defined as the ‘acquisition abroad of physical assets like plant and equipment, with operational control existing in the parent company in the home country’ (Buckley, 2004, p.382). Compared to other internationalization formats such as exporting, licensing and franchising, and joint ventures, FDI enjoys tremendous advantages (Hill, 2009). First of all, it provides a high degree of control in terms of physical and technological assets, minimizing the knowledge spillover in the operations. Secondly, it provides the ability to better know the local business environment and consumer preferences, which is essential for international business successes. Moreover, FDI is able to engage in global strategic coordination and achieve economy of scale (ibid). Finally, companies can realize valuable cost savings via the process of FDI according to the transaction cost theory that was first developed by Coase (1937). The basic idea of this theory is that whether firms choose intra-firm or arm’s length market exchange of production is based on relative costs. Internationalization can allow firms to use internal prices to overcome the excessive transaction costs if transaction takes place in the outsider market (Buckley, 2004). Nevertheless, FDI is very costly and it faces numerous risks. This will be explained in detail in the following section.
Political and Country Risk
In this section various risks our companies may face will be discussed, among which, the primary consideration relates to the country risk and political risk since they will directly influence the business operations. It is certain that in those political unstable countries with regular wars, riots and disorders, there is no chance for businesses to be successful. Additionally, businesses will also be either positively or negatively affected by government policies because in most countries governments usually directly intervene in their national economies, which increase the political risk that multinational firms face (Buckley, 2004). Some countries even design discriminative policies that specifically attack foreign-owned operations. For instance, a severe political risk called obsolescing bargain means that after multinational companies’ entry, host governments change their requirements by demanding a higher share profits or even confiscating foreign assets (Ghauri and Cateora, 2010). Especially in those countries with more than one political party, different parties have their own economic preferences, tax regulations and exchange controls, and multinational firms may not be aware of them (ibid). With regard to our case, Ruritania is a relative political stable country, though it does not have a long tradition of democracy. The country is negotiating for the membership of the European Union. If it successfully joins EU in 2014 as expected, its political stability is going to be consolidated. There are two major political parties in the countries and both of them are committed to democratic principles and a market based economy. The only concern is that the current out-party’s supporting rate is only 7% behind the present party. If this party succeeds in the election, it is likely that they will increase both corporate and personal tax in order to fund their proposed increasing social expenditure, which will definitely have a negative impact on us. A rising corporate tax reduces the profit margin of our factory, and the increased personal tax may also result in a requirement from workers of raising wages.
Foreign Exchange Rate Risk – Transaction Exposure
Besides, our company also faces the foreign exchange rate risk by establishing facilities abroad. It is pointed out by Buckley (2004) that the exposure to foreign exchange risks can be classified into three types: transaction exposure, translation exposure and economic exposure. Primarily, transaction exposure arises due to the cost of settlement of a future payment or receipt denominated in a currency other than the home currency may change according to the changes in exchange rates. In short, it is the result of the changes in spot rate – the price that is quoted for immediate settlement and will rise or fall due to the demand and supply (Investopedia, 2011). Spot rate is different from forward rate, which deals with the cost to deliver a currency or other assets sometime in the future (ibid). A bulk of empirical work have been done to investigate the relationship between spot exchange rate, forward exchange rate, interest rate and inflation rate, and Buckley has developed a well-known 4-way Equivalence Model through which the relationships can be well explained (See Figure 1). Among this, purchasing power party theory is the most famous one which attempts to predict in spot rates by comparing expected price inflation in two countries. For example, assuming that the present spot rate is USD 1.6 = GBP 1 and the price inflation rates in the UK and US are 2% and 3% respectively. Hence, one year later, USD 1.60 + (1.60 x 0.03) should be equal to GBP 1.00 + (1.00x 0.02). That is, USD 1.6157 = GBP 1, which means that the actual value of USD compared to GBP reduces. The failure to cover transaction exposure can be extremely dangerous since firms may suffer a huge loss on one single large transition denominated in a foreign currency, which may further lead to all kinds of financial distress within a particular financial period (Madura, 2008). Take a numerical example to address this again. If a British company export washing machine to Switzerland with the selling price of GBP 200, total cost of GBP 170 each and sport rate of GBP 1 = CHF 1.90. Then we can get the profit of each washing machine of GBP 30 or CHF 57. However, when the spot rate changes to CHF 2.20 = GBP 1, the sales revenue of CHF 380 will correspondingly change to GBP 172.72. By reducing the 170 GBP cost, the profit equals GBP 2.72, a 91% decrease in comparison to the previous one.
Foreign Exchange Rate Risk – Translation Exposure
Secondly, translation exposure arises owing to the process of consolidating foreign currency items into group financial statements based on the currency of the parent company (Buckley, 2004). It is also caused by the changes in spot rate, but different from transaction exposure, translation exposure deals with assets and liabilities and thereby causes a threat to the company’s balance sheet. For instance, our company buys expensive plants and machineries in Ruritania, while two years later the spot rate between Crown – the currency of Ruritania and Pound decreases. Consequently, we will suffer from the loss in the value of these assets in terms of Crown.
Foreign Exchange Rate Risk – Economic Exposure
BBC News (2010) Minimum wage up to £5.93 an hour (online). Available at: < http://www.bbc.co.uk/news/business-11446282> (Accessed: 16 April 2011)
Biz/ed (2011) The advantages and disadvantages of floating exchange rates (online). Available at: < http://www.bized.co.uk/virtual/bank/economics/markets/foreign/further2.htm> (Accessed: 16 April 2011)
Buckley, A. (2004) Multinational Finance (5th Edition). England: Person Education Limited.
Ghauri, P. N. and Cateora, P. (2010) International Marketing (3rd Edition). Maidenhead: McGraw-Hill.
Hill, C. W. L. (2009) International Business Competing in the Global Marketplace (7th Edition). New York: Mc-Graw-Hill.
Investopedia (2011) Spot Rate (online). Available at: < http://www.investopedia.com/terms/s/spot_rate.asp> (Accessed: 16 April 2011)
Investopedia (2011) Forward Rate (online). Available at: < http://www.investopedia.com/terms/f/forwardrate.asp> (Accessed: 16 April 2011)
Madura, J. (2008) International Financial Management (9th Edition). South-Western: Cengage Learning.
Peng, M. W. (2009) Global Strategic Management (2nd Edition). South-Western: Cengage Learning.