GMP – Tata Steel (2019-20)

Universal Circuits, Inc.

Team Members
CGT19003: Anil Kumar Nayak
CGT19004: Animesh Kumar Singh
CGT19005: Ankit Bansal
CGT19009: Bhavani Shankar
1|Page GMP – Tata Steel (2019-20)

Contents
Introduction ............................................................................................................................................. 2
Company Background ........................................................................................................................ 2
Ireland Subsidiary ............................................................................................................................... 2
The Sales Affiliates ............................................................................................................................. 3
The Issue ............................................................................................................................................. 3
Key Financial Problems: ......................................................................................................................... 3
1. Long Run Exposure of Irish Plant to Exchange Rate Risk ......................................................... 3
2. Overvalued US Dollar................................................................................................................. 4
3. Different views of Irish Plant Management & Group CFO ........................................................ 4
4. Difficulty in hedging the long run exposure ............................................................................... 4
Analysis .................................................................................................................................................. 5
1. Identifying Exchange Rate Risk to Irish Plant ............................................................................ 5
2. Assessment of exchange rate risk ............................................................................................... 5
3. Mitigation of Exchange Rate Risk .............................................................................................. 7
Summary and Conclusion ....................................................................................................................... 7

Team Members:
Anil Kumar Nayak (CGT19003) | Animesh Kumar Singh (CGT19004)
Ankit Bansal (CGT19005) | Bhavani Shankar (CGT19009)
2|Page GMP – Tata Steel (2019-20)

Introduction

Company Background

Universal circuits, Inc is a leading supplier of components of measurement and control.

Products of the company are sold through extensive sales force. Total foreign sales
accounts for 40% of total sales. The principle competitors are US based companies that
supply their worldwide operations almost entirely from US plants. Though price
remains the most important competitive factors, consumers are willing to pay more for
superior performance and reliability. Most of the raw material and input supplies comes
from suppliers in US and Europe. Management’s goals include annual sales growth of
25 to 35%, nearly twice the growth of the broad markets served.

Ireland Subsidiary

Approximately 25% of Universal Circuit’s manufacturing is conducted in Ireland.

Ireland is the largest of the offshore plants with fully integrated research and
manufacturing facilities. Ireland operations were set up as a subsidiary of a Dutch
holding company, UCNV Netherlands, to facilitate tax -free intercompany funds
transfers. As part of special grants from the government, manufacturing profits at
Ireland were being taxed at effective rate of 0% for first 14 years (1976-1990). The
manufacturing profits of Ireland branch were not subjected to tax in Netherlands as they
had already been subjected to tax in Ireland. All dividends paid to US parent were
subjected to full US tax rate. Alternatively, the Dutch holding company could invest the
funds in operations outside US, tough this could result in a currency exposure. Plant’s
output was exported to Sales Affiliates in US and other foreign countries. Transfer
prices were based on US dollar price list with some flexibility to meet competitive
pressures. All sales were invoiced in US dollars.

Team Members:
Anil Kumar Nayak (CGT19003) | Animesh Kumar Singh (CGT19004)
Ankit Bansal (CGT19005) | Bhavani Shankar (CGT19009)
3|Page GMP – Tata Steel (2019-20)

The Sales Affiliates

The total company sales force included the US sales force, wholly owned sales affiliates
in eleven countries and independent sales representatives in seventeen other countries.
Quote to customers were made in local currency based on US transfer price plus
shipping cost from US plus import duty plus target sales mark-up. Quotes and final
prices were flexible as per exchange rate, thus Universal was insulated from exchange
rate fluctuations.

The Issue

Labour and locally sourced supplies at Ireland plant accounted for 30% of direct cost
of sales. Operating and other expenses were also occurred in Irish punt. Thus, a total
51.4% of total sales amount is being spent in Irish punts at Ireland plant. Strong US
dollar prices in present has been contributing excellently to the profitability but this also
means that profitability of Irish plant was highly vulnerable to any weakening in US
dollar.

Key Financial Problems:

1. Long Run Exposure of Irish Plant to Exchange Rate Risk

Labour and locally sourced supplies at Ireland plant accounted for 30% of direct cost
of sales. Operating and other expenses were also occurred in Irish punt. Thus, a total
~51.4% of total sales amount is being spent in Irish punts at Ireland plant. Strong US
dollar prices in present has been contributing excellently to the profitability but this also
means that profitability of Irish plant was highly vulnerable to any weakening in US
dollar.
Irish plant is operating at level of 15% profit before tax presently but every 1% decrease
in US dollar price could decrease profit before tax by 0.514%.

Team Members:
Anil Kumar Nayak (CGT19003) | Animesh Kumar Singh (CGT19004)
Ankit Bansal (CGT19005) | Bhavani Shankar (CGT19009)
4|Page GMP – Tata Steel (2019-20)

2. Overvalued US Dollar

Analysis of data given in exhibit 1& 2 shows that US dollar is overvalued in 1984 as
the exchange rate differential is greater than the relative inflation between the USA and
other countries. Thus, if the purchasing power parity comparison between USA and
Ireland holds true then the Irish Plant is right to be concerned regarding their fear of the
US Dollar weakening against the Irish Punt. Moreover, US had 100 Billion US Dollar
trade deficit in the past year which further increases the risk of future devaluation of US
dollar.

3. Different Views of Irish Plant Management & Group CFO

Universal believed heavily in decentralisation and maintained a strong entrepreneurial

mentality at the divisions by granting them full managerial responsibility. At the same
time, the CFO of the company felt that the plants need to focus on operations and sales
divisions need to focus on pricing and sales margins rather than “mess around with
currencies”. At one hand, the Irish plant expressed concern with the potential
devaluation of US dollar because of its impact on plant cost. On the other hand, the
point of the group CFO is that no one really knows in which direction the dollar will go
and therefore speculating on this issue was of no real interest to those in the
manufacturing business.

4. Difficulty in Hedging the Long Run Exposure

Irish plant faces long run exposure to exchange rate risk. Hedging long run exposure is
more difficult than hedging short run exposure as organized forward markets don’t exist
for long term needs. The primary option to hedge long run exposure is to match foreign
currency inflows and outflows. This match isn’t possible in Irish plant’s case as around
51.4% of the sales amount is spent in Irish punts while all the sales to customers are
based on US dollars. Thus, inflow and outflow of Irish punts doesn’t match in Universal
Circuit’s case, making it very difficult to hedge long run exchange rate risk.

Team Members:
Anil Kumar Nayak (CGT19003) | Animesh Kumar Singh (CGT19004)
Ankit Bansal (CGT19005) | Bhavani Shankar (CGT19009)
5|Page GMP – Tata Steel (2019-20)

Analysis

1. Identifying Exchange Rate Risk to Irish Plant

Given Profit & Loss statement of Irish operations (% of sales) is as follows:

Sales 100%
Direct Cost of Sales 48%
Direct Margin 52%
Operating Expenses 34%
Contribution Margin 18%
Other Income/expense 3%
Profit Before Tax 15%

Total outflow in Irish punt

= 30% of direct cost of sales + operating expenses + other expenses
= 0.3*48% + 34% + 3% = 51.4% of total sales of Irish Plant

Observations:
• Irish plant manufactures 25% of total quantity of Universal Circuit’s.
• 51.4% of sales amount of Irish Plant goes as cash outflow in Irish Punts.
• Sales are based on dollar price in US. Thus, fluctuations in Irish punt exchange
rates can’t be passed to customers.
• The exchange rate risk of Irish plant in long term in nature.

Thus, based on above observations, Irish plant has long run exposure to exchange rate
risk and we identify exchange rate risk as significant risk to Universal Circuit.

2. Assessment of Exchange Rate Risk

Exchange Rate (Irish punt / dollar)

1980 0.53
1984 1.01
Percentage fluctuation possible in exchange rate (from current level)
= 1.01 – 0.53 /1.01 = 47.52%

Team Members:
Anil Kumar Nayak (CGT19003) | Animesh Kumar Singh (CGT19004)
Ankit Bansal (CGT19005) | Bhavani Shankar (CGT19009)
6|Page GMP – Tata Steel (2019-20)

Estimates profit & loss statement for Irish Plant based on consolidated statement of
Universal (given in Exhibit 2 & 3) for year 1983 is as below

Irish Plant Estimations Based on Consolidated Statement (of 1983)

Amount ($ Millions) % of Sales
Consolidated Sales (2013) 214
Irish Plant % 0.25
Estimated Sales of Irish Plant 53.5 100%
Direct Cost of Sales 25.7 48%
Direct Margin 27.8 52%
Operating Expenses 18.2 34%
Contribution Margin 9.6 18%
Other Income/expense 1.6 3%
Profit Before Tax 8.0 15%

For the simplicity of our calculation, this statement can be interpreted as below:

Equivalent Calculations
Amount ($ Millions)
Estimated Sales of Irish Plant 53.5
Total Cost/Expense (in US $) 18.0
Total Cost/Expense (in punts) 27.5
Profit Before Tax 8.0

Impact of 47.5% fluctuation in interest rate from current level on profitability &
cashflows of Universals is as below:

Equivalent Calculations Impact of exchange rate fluctuation

Amount ($ Millions) Amount ($ Millions)
Estimated Sales of Irish Plant 53.5 53.5
Total Cost/Expense (in US $) 18.0 18.0
Total Cost/Expense (in punts) 27.5 40.6
Profit Before Tax 8.0 -5.0

Thus, a revert of exchange rates to 4 years back (1980) level can decrease the Irish
plant’s profit before tax by US $ 13 million.
Total net income of Universal Circuit (1983) as given in exhibit 2 is US $ 18.4 million.
Thus, exchange rate risk at Irish plant can hit the net income of universal by almost
70%.

Team Members:
Anil Kumar Nayak (CGT19003) | Animesh Kumar Singh (CGT19004)
Ankit Bansal (CGT19005) | Bhavani Shankar (CGT19009)
7|Page GMP – Tata Steel (2019-20)

3. Mitigation of Exchange Rate Risk

Operational Hedging:
As part of operational hedging efforts, Universal Circuit is already sourcing 70% of
direct cost of sales (raw material & other input supplies) in US currency. Any more
operational hedging from upstream side doesn’t look practical.
Since Irish plant is only 25% of total Universal capacity, it isn’t practical to bill the
customers based on Irish punt rates. So, customers are being charged based on US $
rate and any fluctuations in local currency (sales location) is being passed to customers.
Thus, operational hedging isn’t possible from sales side too.
Although the Irish plant can definitely redesign the wage structure with an objective of
minimizing punt outflow.
Avoidance hedging:
Although Irish plant can work towards efficiency improvement and cost reduction, but
any large avoidance of Irish punt outflow doesn’t seem feasible.
Financial hedging:
Firm can look for following financial hedging options to hedge their exposure to Irish
punt/dollar exchange rate:
• Futures
• Options
• Swaps
• Forwards
• Foreign Debt

Summary and Conclusion

In our analysis, we have found that Irish plant management is right in their concerns
about exchange rate risk to plant profitability. As analysed above, Irish punt/dollar
exchange rate is also a significant risk to Universal Circuit as whole. Thus, appropriate
exchange rate risk management seems necessary.
Though Fisher effect and Purchasing Power Parity theory suggest that inflation and
interest rates balance against exchange rate currency in long term but still firm may
prefer to protect itself by adopting any of the above suggested tools to minimize its risk
by HEDGING.

Team Members:
Anil Kumar Nayak (CGT19003) | Animesh Kumar Singh (CGT19004)
Ankit Bansal (CGT19005) | Bhavani Shankar (CGT19009)