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CASE STUDY REPORT Abstract

CASESTUDY REPORT

Abstract

Thispaper analysis the foreign exchange risks associated with Zircon Carsplc. Intended investment in a South Korean company which makes thecomposite body shells used for the ZC500 F1, as a way of reducingproduction costs. From an integrated perspective the paper examinesmajor foreign exchange exposures the company faces as well aseffective mitigation measures to be adopted by the firm to reducethese risks. The case study presents transactional risks,translational risks, economic and country risks as major foreignexchange exposures Zircon Cars Plc. would face. In the analysis thepaper presents strategies that would minimize the foreign exchangerisks and better manage foreign exchange dealings.

KeywordsForeign exchange risks, transactional risks, translational risks,economic and country risks, hedging policies, currency forwards andcurrency options

ConceptualBasis

Thisreport focuses on financial management of international business fromthe perspective of Zircon Cars Plc. Investing in South Korea, enablesZircon firm get closer to the source of other major productioncomponents and market, however, this investment in the South KoreaCompany presents possible foreign exchange risks which could hurt thefirm objective of reducing production costs, expanding its market andincreasing profits. There exists foreign exchanges risks associatedwith the management and operating an oversee investment. The mainchallenge for the investment is unpredictable exchange rates whichcould have severe impacts on business transactions in regard toimport and export.

Inaddition, other factors such as country risks economic and politicalfactors could expose the investment to operational risks therebylimiting its productivity. From the case study, the overallproduction costs might not reduce as expected due to foreign exchangerisks i.e., the composite body shell production might increase to 20%, which would consequently increase the assembly costs to 30% giventhe dynamics of operating an investment in a foreign country. Thiswould in turn affect the selling price of ZC500 F1 which wouldsignificantly affect sales output volume. The resultant effect willroll back to the market favoring Zircon Competitors as customersmight prefer to buy the competitors products if the firms’ pricesare high.

Itis on this basis that the management of Zircon Cars Plc. investmentneeds to critically assess the foreign exchange rates dynamics,countries economic and political factors which might impede efficientinvestment operation. It also means setting adequate strategicmeasures by the management to cushion their investment in the eventthe subsidiary company facing foreign exchange risks.

Zircon’sForeign Exchange Risk

TransactionalRisks

Inits quest to buy and invest in the South Korean company, Zircon CarsPlc. may face financial risks associated with financial transactionsif the denominated currency used by Zircon Company belongs to SouthKorean. When conducting foreign imports and export, there areinvestment risks as well as opportunities encountered than whenoperating investments at home. Most importantly, despite theopportunities available in reducing production cost through buyingthe South Korean firm, there exist exchange risks which would havesevere financial impact on the manufacturing company. Zircon facesthese possible foreign exchange exposures currency exchange raterisks which involve translation exposure, transaction exposure andeconomic exposure, it also faces country risks political andeconomic risks. However, with astute step by step financialmanagement, these exchange exposures can be minimized or eliminated(Christoffersen, et al. 1998, pg 234).

ZirconCars Plc, foreign exchange risk may arise from transaction exposurewhen making contractual cash flows payables and receivables inwhich case the denomination currency might get affected due tounanticipated changes in exchange rates. Zircon Cars Plc bearstransactional risks if agrees to use South Korean Won in payments forimports and exports while operating in the South Korean Company. Inorder to realize domestic value of cash transactions, Zircon Cars Plcwill therefore need to exchange their foreign currency to getdomestic currency value (Schmit and Roth, 1990, pg 223).

Incases where Zircon Company need to make foreign purchases and exportsfrom its production investment in South Korea, during negotiationprocess of imports and exports prices and delivery dates, thevolatile foreign exchange market may change thereby affecting theexchange rate between the foreign and domestic currency. This is aprevalent risk which is common during transactional exchanges fordomestic and foreign investors. As such the management of Zircon CarPlc needs to have financial risk management practice that will createeconomic value of their investment in South Korea using financialinstruments that reduce transactional risks (Crabb, 2001, pg 133).

Hedgingpolicies

Inthe same cue, to mange this risk the management of Zircon Cars Plc.need to have a strategy of selecting their billing and pricing ofcurrency, considering their currency when conducting business withinthe South Korean country. This helps eliminate transactional currencyrisks associated with contractual deals. However, in most cases thisoption may not be available based on the country’s tax regimes andregulations(Wang, 2005, pg 142).If this strategy is not effective, Zircon management need to addbuffer margin on all invoices quoted in foreign currency or create acontractual agreement in which both the buyer and the seller sharethe risks associated with fluctuations in foreign exchangesoccasioned by lapse in time during negotiations, delivery of goodsand the eventual payment of the goods (Bing, et al. 1999, pg 280).

Similarly,Zircon Cars Plc can employ the passive transaction managementstrategy in which they denominate all transaction contracts indomestic currency (Euro) as a buffer if the market power is strong inthe region or do nothing about the transactions if there are manysmall transactions when operating the South Korean Investment (Smithand Stulz, 1985, pg 321). Another strategy that Zircon managementneeds to employ to safeguard their investment and improve on theoutput is through hedging transactional contracts. This meansinsuring transactions against possible unexpected fluctuations in theexchange rates when exporting the body shells back to UK or importingother operational items from UK. As such hedging will help toeliminate losses but not make profits (Rees &amp Unni, 1999, pg231).

Theunderlying, strategy of hedging is to manage Zircon Company foreignexchange risks by minimizing Zircon Company UK currency outflows(Liabilities /payables) and maximize inflows(assets/receivables).Furthermore, a natural transaction risk hedgingstrategy can be adopted to centralize all cash transactionsmanagement in order to net all transactions which are short and longusing the same currency. This will help to offset time and leadbusiness transactions using the same currency(Dunn, et al. 2004, pg 243).

Differentcountries have different tax regimes in which income earned fromacross the boundaries is taxed which results to double taxations.Zircon Cars Plc faces such risk when it invests in South Korea itwill be taxed by home government when importing back assemblycomponents from the Southern Korean plant and face same tax regimefrom the South Korean government when exporting the components to UK(Pilbeam,2006, pg 78).As such, in the absence of intergovernmental treaties or deferraltaxes, the Zircon parent plant in UK can centralize deposits holdingall cash balances in the parent company would help manage liquid cashflows risks and have a higher chance of investing the money in longterm reserves for high interest rates. Multilateral netting can alsobe adopted by Zircon Company to reduce its transactional cost whicharises from the subsidiary investment in South Korea(Eun,et al. 2011, pg 211).

Translationalrisks

Theseare exposures that Zircon Cars plant in UK might face whenconsolidating income statements and balance sheets from thesubsidiary plant in South Korea using its home currency, due tovolatility of exchange rates which might cause decrease in assets andincrease in liabilities when measured using home country currency.While this may not affect its home country cash flow, there would besubstantial impact on the overall firm net earning. To illustratethis, Zircon Cars Plc faces translation risks when consolidatingfinanancial statements from the South Korean firm. Therefore, thisrevaluation will create a loss or gain considering exchange ratesfluctuate(Homaifar, 2004 pg 145).

Mitigationmeasures Hedging policies, currency forwards, currency options

Toavert this exposure risk, Zircon Cars Plc. can adopt the hedgingstrategy. Alternatively, the firm can reduce the foreign exchange forall transactions receivables and payables by managing and timingreceivables and payments depending on the expected exchange rates.Timing is an important aspect that can accelerate payments from weakcurrency to strong currency and delaying inflows when one country hasstrong currency compared to the other with low currency. Otherfinancial instruments such as foreign exchange forwards, currencyoptions and currency future can be adopted to forestall possibleexchange differences that may arises when operating the investmentin South Korea (Ihrig, 2011, pg 111).

EconomicRisks

Theseare the operating risks that Zircon might face in its investment inSouth Korea. Unexpected exchange rate changes may change the longterm expected in the home country. This may result from changes inmarket competitiveness that results in buying and selling abroad oreven competing with foreign companies. By investing in South Koreanfirm to cut on the production costs may face economic risks fromforeign firms offering low prices for the same products they areproducing in South Korea, this may have an eventual impact on thefinished product competitiveness if its value is higher than those ofcompetitors (Jacques, 1981, pg 109).

Economicrisks affects the future cash flows by exposing the firm to foreignexchanges which in turn lead to economic exposures a change inexchange rates in South Korea would have great impact on the overalldemand of Zircon Cars Plc, since the production of the bodycomponents would rise incase of fluctuating foreign exchange rates.In short, fluctuating exchange rates might affect the overallcompany’s market value, which results in changes in production costand sales prices and consequently profits (Au and Au, 1983. pg 123).Managing these economic risks goes beyond the financial managementrealm of Zircon Cars Plc. both at home and the foreign investment inSouth Korea. Such economic exposure risks can be ameliorated throughdistributing the firm’s assets in different locations (Jacques,1978, pg 245).

CountryRisks South Korea political and Economic issues

ZirconCars Pl. might face other risks associated with the political andeconomic nature of South Korea. In the political aspect, change ingovernment financial regulations, war, trade and investment barriers,terrorism and military coups might present the Zircon Company withuncertainty. However, major risks fall in the government of the hostcountry which may impose unfavorable taxes on Zircon investment anddemand a certain percentage of cash flows. While these regulationsmay not affect the project net value in the host country, they havean indirect impact in the parent company cash liquidity. As suchwhile Zircon Cars Plc. considers buying and investing in the SouthKorean company, an analysis of political and economic aspect in thebusiness environment is necessary(Levi, 2005, pg 342).

Politicalrisks are associated with changing policies, regulations and lawswhich may affect import and export and funding from the mother plantcompany. In addition, political tensions may lead to increased taxes,imposition of exchange controls and interference with existingoperation contracts which can impair investment in the country.Similarly, there are risks associated with economic mismanagement ofthe subsidiary investment which can hurt the overall performance ofthe parent firm. Inflation in the country might lead to fall in cashflows received by the subsidiary investment as the currencydepreciates (Lopez, 1998, pg 256).

AnalysisForeign Risk Zircon Faces

ZirconCars Plc. faces myriads of foreign risks in its investment in SouthKorea. These foreign exchange exposures range from transactional,translational, economic and country economic and political risks.Transactional exposure might affect production costs in thesubsidiary firm where changes in exchange rates between UK and SouthKorea be results in depreciating value of cash flows from Zirconparent firm in UK to South Korea or vice versa. This means that,contrary to the parent’s firm objective of minimizing productioncosts, the opposite would happen due to inconsistency in exchangerates (Marshall, 1999, pg 324).

Furthermore,any transactional and contractual deal made using the host country’sdenomination may present loss risks in the event of low valueexchange rate between the Won and Pounds. In the event of highinflation in South Korea, more pounds would be required in carryingtransactional deals especially when importing in the country. Further to this, economic risks in South Korea might expose Zirconinvestment to uncertainities in its production. This means thatincase of fluctuating prices, costs and contracts may have a directimpact on the production cost of carbon fiber body parts(Moffett, 2009, pg. 241).

Countriesrisks such as tax regimes may also have negative impact on theoverall investment. Zircon Cars Plc. may face double taxation whenconducting production in South Korea and exporting the finishedproduct back to UK assembly plant. This affects the production costsas well as the profit margin when selling the assembled product. Ifthe tax imposed for foreign investment in South Korea is high,combined with fluctuating forex exchange rate might significantlyaffect Zircon business. Furthermore, political risks uncertaintiespresents Zircon with a challenge, unfavorable tax rates, demand fora percentage in the cash flow of the project invested in the hostcountry and policies regulating project funding may affect theproduction unlike in the home country or directly importing thefinished body parts(Moosa, 2003, pg 112).

Conclusion

Internationalbusiness investments especially the complex nature of manufacturingthat Zircon Cars Plc. deals with need careful decisions in theinvestment, financing and money management. Myriad foreign exchangerisks face Zircon Cars Plc in their investment in South Korea. Inbroader sense, Zircon Cars acquisition and managing the South KoreanCompany is guaranteed to face, transactional, translational,operation economic risks as well as the countries risks associatedwith government business regulations. Unstable Foreign exchangesrates affects receivables and payable cash flows where depreciatingvalue of the denominating currency used in business or contractualtransactions can lead to losses. In all these risks, adequatedecisions are needed to reduce the effects of these risks onbusiness. Good financial management for foreign investments helpsachieve competitive advantage among the competitors but also reducerisks associated with forex exchange fluctuations. Zircon Cars Plc.move to buy and invest in South Korea is a good strategic move,which, helps the firm to strategically position itself near thesource of major components for its manufacturing plant. However, theforeign investment success in South Korea will largely depend on howthe management of the parent firm in UK oversees all the operationsat the subsidiary Southern Korean firm especially with regard tofinding ways to eliminate or reduce currency exchange risks.

Recommendationsto Zircon on South Korea Investment and Foreign Exchange Risks

ZirconCarsPlc. needs to establish a mechanism that will ensure maintaining thenecessary mix of strategies and tactics for reducing its foreignexchange exposure. The central strategy that can ameliorate andprotect parent firm resources is ensuring that the South Koreaninvestment is integrated in the appropriate strategies and tactics. Secondly, the before actual operations, the Zircon Firm needs todistinguish between transactional and translational risks on one sideand economic risks on the other side. It is common for many companieswith foreign investments to focus on translational and transactionalrisks at the expense of economic risks which are long term risks withsevere implications on the parent firm.

Thirdly,its imperative for Zircon management, assess the fundamental economicfactors in South Korea with specific focus in inflation rates theyplay critical role in exchange rate fluctuations. Lastly, Zirconparent firm should adopt a central deposit and reporting system tokeep vigil on its exposure risks from its investment in South Korea.Zircon will need to produce regular reports on exposure risks whichcan be used to mitigate, adopt strategies, tactics and hedges fromundue foreign exchange exposures.

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