Mark Sexton and Todd Story, the owners of S& S Air, have been in discussions wit

Question

Mark Sexton and Todd Story, the owners of S& S Air, have been in discussions with an aircraft dealer in Europe about selling the company’s Eagle air-plane. The Eagle sells for $ 98,000 and has a variable cost of $ 81,000 per airplane. Amalie Diefenbaker, the dealer, wants to add the Eagle to her current retail line. Amalie has told Mark and Todd that she feels she will be able to sell 15 airplanes per month in Europe. All sales will be made in euros, and Amalie will pay the company € 75,384 for each plane. Amalie proposes that she order 15 aircraft today for the first month’s sales. She will pay for all 15 aircraft in 90 days. This order and payment schedule will continue each month. Mark and Todd are confident they can handle the extra volume with their existing facilities, but they are unsure about the potential financial risks of selling their aircraft in Europe. In their discussion with Amalie, they found out that the current exchange rate is $ 1.30/€. This means that they can convert the € 75,384 per airplane paid by Amalie to $ 98,000. Thus, the profit on the international sales is the same as the profit on dollar- denominated sales. Mark and Todd decided to ask Chris Guthrie, their financial analyst, to prepare an analysis of the proposed international sales. Specifically, they ask Chris to answer the following questions.

1. What are the pros and cons of the international sales? What additional risks will the company face?

2. What happens to the company’s profits if the dollar strengthens? What if the dollar weakens?

3. Ignoring taxes, what are S& S Air’s projected gains or losses from this proposed arrangement at the current exchange rate of $ 1.30/€? What happens to profits if the exchange rate changes to $ 1.37/€? At what exchange rate will the company break even?

4. How could the company hedge its exchange rate risk? What are the implications of this approach?

5. Taking all factors into account, should the company pursue the international sales deal further? Why or why not?

Explanation / Answer

Pros of international sales is that the market is new and there is a lot of scope and the con would also be the same that the market is new and might face new laws and regulation. The company may expose themself to the risk of being sued in a different country and their own. Also the dealer does not belong to the country from which the company operates and might not be subject to local laws.

If the dollar strengthens the commodity (i.e. Euro) that the company is earning is falling compared to dollar and hence would hurt the company profit. However, if the dollar weakens the company stands to gain from the exchange as the commodity it is earning is appreciating in value.

Current gain = 75384 * 1.3 - 81000 = 17000

Gain at $1.37 = 75384*1.37 - 81000 = 103276

Break even Exchange rate = 81000/75384 = 1.0744 or 1.07

The company can hedge its exposure by selling euro at today's future rate. This would mean paying a small fee for hedging and also alongwith cutting the risk limits any upside gain from exchange rate.

The company should pursue international sale because as per given data current rate is 1.30 and their break even is at 1.07 ( keeing all cost and price same) and thus risk of a loss is on the lower side.

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