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Managing International Risk

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Introduction

Before venturing into the international market, business managers must be aware of all

the inherent risks associated with international business. Some examples of international risk

include; credit risk, Intellectual Property Risk, Foreign Exchange risk, Shipping risk and country

political risk. In this paper, we will investigate how international business is affected by the

exchange rate risk using the CarpetBagger Inc case.

Exchange rate risk is defined as the risk of loss that an organization bears when the

transaction is dominated by currency other than the money in which the company operates (

Toma, & Alexa, 2012). One of the major causes of the exchange rate risk is the currency

fluctuations which causes investment value to decrease due to change in the relative value of the

involved currencies. When investing in international markets, the appreciation and depreciation

of the dominant currency affect the company cash flows.

There are three types of exchange rate risk: transaction risk, translation risk, and

economic risk (Papaioannou, 2006). The transaction risk occurs when a company carries out a

transaction with a business in another country that uses a different currency. Any fluctuation in

the exchange rates has a very adverse effect on the transaction; for instance, an increase in the

exchange will force the buying company to increase the cost to cover the change in exchange

rates.

On the other hand, translation risk occurs when a company owns another subsidiary in

another country that reports using the local currency. The parent company will be forced to

translate the reported figures back to the parent company currency. The translation of the

financial reports may lead to certain inconsistencies in calculating the consolidated earnings of

the subsidiary if the exchange rates change during the period of translation.
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Lastly, the company faces an economic risk when the volatility in the exchange rates

market can cause a change in the market value of the company. The economic risk relates to the

effect of the exchange rates on the company revenue and expenses, which has an advance effect

on the company operating cash flows. For example, when the exchange rate increases, it

increases the price of goods and services, affecting the demand for goods, affecting the company

revenue and operating expenses.

For the CarpetBagger Inc case, the company would be affected by the transaction risk

since it considers whether to invest in Germany or Switzerland. The company’s dominant

currency is the United States Dollar. In contrast, Germany’s dominant currency is Euros with a

spot exchange rate of $1.3€, while the dominant currency for Switzerland is Swiss Francs and

the current spot exchange rate is CHF 1.5/$.

The company is considering constructing a new bagging plant in one of Europe, either in

Switzerland or in Germany. The cash flow generated from the two countries is as follows.

C0 C1 C2 C3 C4 C5 C6 IRR (%)

Germany (Euros) -60 10 15 15 20 20 20 15%

Switzerland (Swiss -120 20 30 30 35 35 35 12.80%

Francs)

Table 1: CarpetBagger Inc Cash Flows.

Moreover, the interest rates in the United States are 5% while 4% in Switzerland and 6%

in Germany. Since the company operates in the United States, the cash flow above should be

translated into USD for decision making, and the project will only be accepted if the rate of

return is higher than 10%.

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We will use the Net Present Value (NPV) to appraise the project in the two countries, and

the company will only invest in the country with the highest NPV in terms of USD.

Net Present Value for Germany

Index Cash Germany Cash Flow in Interest PVIF Present Value

Flow (Euros) USD Adjusted 10% of
Numbe (Euros*1.3) Cash Flow Cash Flow
r
0 C0 € (60.00) $ (78.00) $ (78.00) 1 $ (78.00)
1 C1 € 10.00 $ 13.00 $ 12.88 0.909091 $ 11.71
2 C2 € 15.00 $ 19.50 $ 19.13 0.826446 $ 15.81
3 C3 €15.00 $ 19.50 $ 18.95 0.751315 $ 4.24
4 C4 € 20.00 $ 26.00 $ 25.03 0.683013 $17.10
5 C5 € 20.00 $ 26.00 $ 24.80 0.620921 $ 15.40
6 C6 €20.00 $ 26.00 $ 24.56 0.564474 $13.86
5% NPV $10.12
United States Interest
Rates
German Interest Rates 6%
Table 2: Germany NPV Calculations

The Interest Adjusted Cash flow is calculated using the formulae below
n
1+USA i
Interest Adjusted Cash Flow= Cash Flow ∈USD∗ { 1+German i } i is the interest rate,

while n is the cash flow number.

The USD cash flow for Germany is 10.12, which is positive, implying that the company

return of investment is higher than the company discount rate. However, we need to find the

NPV for Switzerland and compare; the country with the highest NPV will be selected for

investment.
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Index Cash Switzerland Cash Flow Interest PVIF 10% Present Value of
Flow (Swiss Francs) in USD Adjusted
Number (Swiss*1.5) Cash Flow Cash Flow
0 C0 -CHF 120.00 -$80.00 -$80.00 1 $ (80.00)
1 C1 CHF 20.00 $13.33 $13.46 0.909091 $ 12.24
2 C2 CHF 30.00 $20.00 $20.39 0.826446 $ 16.85
3 C3 CHF 30.00 $20.00 $20.58 0.751315 $ 15.46
4 C4 CHF 35.00 $23.33 $24.24 0.683013 $ 16.56
5 C5 CHF 35.00 $23.33 $24.48 0.620921 $ 15.20
6 C6 CHF 35.00 $23.33 $24.71 0.564474 $ 13.95
United States Interest Rates 5% NPV $ 10.26
Switzerland Interest Rates 4%
Table 3: Switzerland NPV Calculations

The Interest Adjusted Cash flow is calculated using the formulae below
n
1+USA i
Interest Adjusted Cash Flow= Cash Flow ∈USD∗ { 1+Switzerland i } i is the interest

rate, while n is the cash flow number.

Conclusion

Since the NPV for the two countries is positive, the company will benefit from investing

in either of the two countries. However, since the company only needs to invest in one of the

countries, it should consider investing in Switzerland since the country has the highest NPV.
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Reference

Brealey, R. A., Myers, S. C., & Allen, F. (2019). Principles of corporate finance.

Papaioannou, M. G. (2006). Exchange rate risk measurement and management: Issues and

approaches for firms.

Toma, S., & Alexa, I. (2012). Different Categories of Business Risk. Annals of “Dunarea de

Jos” University of Galati Fascicle I. Economics and Applied Informatics, 2, 109-114.