Your boss has asked you for input before your company makes a significant invest

Question

Your boss has asked you for input before your company makes a significant investment in developing overseas markets. Intense competition at home is making it harder and harder to make a profit, so trying to attract foreign business seems like a positive strategic decision. In doing some research, your boss thinks there may be difficulties to developing sales to another country.

The product you offer is energy related, and your company is larger than most. The country your boss has chosen is under a command economy.

1) What can you tell your boss about possible problems the company may face when they try to sell their energy product to the other country? What kinds of obstacles might you have to overcome? How might other government “interfere” with your possible sale of product?

Your boss thinks your answers may have some validity. He or she is concerned that currency fluctuations may damage the possibility of the company making a profit.

2) If your product sells for $10,000 per unit, and the ratio of currency is $1 = .8724 other currency, then how much other currency does the buyer need to buy 6 units of your product?

3) If the dollar is trading at $1=.8724 today and is forecast to trade at $1=.8726 in 80 days , is the other currency trading at a premium or a discount to the dollar?

4) If the buyer from the other country decides to buy 100 units, using a rate of $1=.8726, what is the value of the sale? If the profit margin is 25%, what is the gross profit from the sale of 100 units?

5) Your company decides to open a futures contract to avoid any risks. The premium for the contract is 2%. The currency rate today is $1=0.8724 of the other currency. If the other currency exchanges at a rate of $1 = 0.8927 in 90 days, is the other currency trading at a premium or a discount to the USDollar?

6) If the contract stated in question 5 is exercised (paid) at 90 days at $1=0.8927, then what is the gross profit your company will make on the sale of 100 units?

Explanation / Answer

1) A command eonomy is one where allocation of resources, their consequent development into products and services and the resultant economic growth is all centrally planned, controlled and run. Selling an energy related product in such a country might be fraught with risk especially if the country under consideration is energy deficient. Energy deficient means a country which is net importer of energy needs such as curde oil, natural gas, power,processed gasoline and more.

In such a energy deficient scenario a command economy will most probably set price controls or price ceilings on the company's products so as to make its products affordable even at the cost of economic loss to the company. The country might also impose tariff barriers such as higher excise duties, entry taxes, import duties,etc and non tariff barriers such as import quotas on the company's products so as to protect their own domestic competing industry. Further, command economies usually have controlled exchange rates to keep their exports cheap and imports costlier (so as to promote domestic production fueled consumption), thereby leading to the company's products being relatively costlier in the command country. There might also be foreign capital controls such as minimum domestic equity participation by a local partner for setting up operations in the command country, which might not be palatable to the expanding company. Command economy company's tend to be less efficient in terms of operations owing to the high degree of state protection and monopolistic business conditions and hence might not be competitive enough to form a effective partnership with this company.

Additionally, all local resource allocation will be controlled by the country through a string of licence, permits, production quotas, import restrictions on technology, capital and labour, which again might hamper the company's effeciency and profitability in the country.

2) Cost of one unit of product =$10000

Cost of 6 units in dollars = 6 x 10000 = $60000

$1 = 0.8724 of local currency

Therefore, $60000 = 0.8724 x 60000 = 52344 of local currency

Therefore 6 units of the product can be purchased for 52344 of the local currency.

3) Current Exchange Rate $1 =0.8724

Exchange Rate 80 days from now ( forward exchange rate ) $1=0.8726.

This essentially means that a dollar can buy 0.8724 of the local currency today and 0.8726 of the local currency in future, Since $1 can buy more of the local currency in the future as compared to today, the $ is appreciating with respect to the local currency, This means that the local currency is depreciating (losing value) over time and hence is trading at a discount. In case the local currency appreciated it would have been said to be trading at a premium.

4) Cost of one Unit $10000 = 8726 of the local currency

Cost of 100 Units = 100 x 10000 = $1000000 = 0.8726 x 1000000 = 8726000 of local currency

Therefore, value of sale = 8726000 in local currency = $1000000

Profit Margin =25% of sale. Therefore, Gross Profit = 0.25 x 1000000 =$ 250000

Gross Profit in Local Currency = 250000 x 0.8726 = 218150 in local currency.

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