Project #56711 - Assignment 4 Risk Managment Application

Assignment 4— (100 points) Risk Management Applications

While there are many factors that lead to an organization's success or failure, it is important to identify the risk associated with the endeavor—financial or nonfinancial. Once the risks have been identified, management has a responsibility to develop measures to mitigate those risks.

Tasks:

Use the publicly-traded company (Walmart you used in Assignment 2) and imagine it has made a strategic decision to start doing business in China. Using the discussion on page 192 of your textbook as a template, do the following:

  1. Develop a brief country risk assessment.
  2. Determine the political, economic, social, and capital risks associated with doing business in China. What are the most important factors to consider? Why?
  3. After years of keeping the Yuan pegged to the US dollar, the Chinese have recently allowed it to float freely in international currency exchange rate markets. Many economists believe that keeping the Yuan pegged to the US dollar has caused it to be undervalued by 30 to 50 percent. Discuss what impact a revaluation of the Yuan might have on US multinationals doing business there, on China’s exports, and on Chinese citizens’ standard of living. What impact would a revaluation have on Chinese inflation and on purchasing power parity? Explain.

    Your paper should be about 2,500 words.

Page 192 Discussion as reference

Currency Exchange Rates: A Case in China with Country Risk

  • Dad: Let's look at an investment from a business point of view.Consider the following case: A multinational corporation needs to invest in many countries and for periods of many years. We will look at an investment in China. There is a long history, but we will look only at relatively recent background. I'll pick a period with interesting times. Let's assume that the initial investment was made on October 23, 1995.China has been a special case because the government has taken steps to keep its currency stable compared to the U.S. dollar.

China is a manufacturing superpower. Assume that you are CFO of a small engine manufacturer, Small Co., looking to build a $100 million plant in China. Let's assume that your company requires a return of 10% on its investments in the United States and 16% on its investments in China. We will discuss the reasons for the 16% required return later in this section.

 

Before you invest, your (simplified) balance sheet might look like Exhibit 7.7.

We pick a date of October 23, 1995, for the investment, and your balance sheet looks like Exhibit 7.8 at the end of October:

192 193

Exhibit 7.7 Small Co. balance sheet, September 30, 1995 (in millions).

Exhibit 7.8 Small Co. balance sheet, October 31, 1995 (in millions).

Actually, the value of the investment will be in Chinese yuan renminbi (CNY), the currency of China. The accountants will convert that investment to dollars at the prevailing exchange rate at the end of each accounting period. If the $100 million were invested in China on October 31, 1995, it would buy CNY 831.490 million, and that would become the value of the plant. The exchange rate was CNY 8.31490 to one U.S. dollar on October 31, 1995. The balance sheet is important because public companies will report any gains or losses on investments on their income statements. So both the balance sheet and the income statement will change as a result of exchange rate movements. Of course, the major reason for this investment is to obtain goods for sale in the United States and in other countries at lower prices. Unlike Rodney's investment in England, the government of China had a policy to hold the exchange rate constant with the dollar. This effectively created one currency for China and the United States for 10 years. This was a huge advantage to companies doing business with China.

 

clear search

Look at the exchange rate of the yuan to the dollar in Exhibit 7.9.

As you can see, there has been a 10-year period of very stable exchange rates. Let's value your $100 million plant on December 31, 2004. Recall that the plant was actually valued at CNY 831.490 million on October 31, 1995. Assume no depreciation and no plant additions to allow us to see what happened because of exchange rates. We see that CNY 831.490 million divided by the December 31, 2004, exchange rate of 8.28650 converts to $100.34 million (Exhibit 7.10).

The change since 1995 is so small as to be insignificant. I'm sure Rodney wishes that his investment in England had had this stability. However, from 2005 onward, the yuan has strengthened against the dollar. The effect from a change in the rate from 8.3 to 6.9 has been to raise prices of Chinese goods by 20%, assuming that all else is equal. By now you should be able to tell what happened to the value of the investment. Since the yuan increased in value, the investment translated to dollars increased in value. Now let's convert the value of CNY 831.490 million as of December 31, 2008. The dollar amount becomes $121 million (Exhibit 7.11). Now we are seeing significant change, although it is helpful to the accounting statements.

193 194

Exhibit 7.9 Exchange rate: Number of Chinese yuan renminbi per U.S. dollar.

Exhibit 7.10 Small Co. balance sheet, December 31, 2004 (in millions).

 
 

Exhibit 7.11 Small Co. balance sheet, December 31, 2008 (in millions).

The negative side is that this same movement increased the cost of the engines that Small Co. was exporting from China and importing into the United States. Just as the assets rose in value by 21%, the cost of the engines also rose by this same 21%. If we look at a five-year history in January 2001 at OANDA.com, we would see the summary shown in Exhibit 7.12.

This table shows the success of the government of China in keeping the exchange rate stable. Of course, history can be a guide but not a guarantee of future events.

194 195

Exhibit 7.12 Summary of exchange rates: Chinese yuan per dollar.

We could do a time line of cash flows if we had more information. For now let's make some points that do not require us to make a time line.

If Small Co. were importing the engines into the United States and buying them for $25 each, they would have been free of exchange rate risk for 10 of the past 13 years. The price of manufacturing the engines would still be subject to inflation in China. The cost of raw materials, parts, and labor might have risen, but there was no cost escalation from the exchange rate until relatively recently. By 2008, the price would have increased to $30 each even if there was zero inflation in China.

 
 
 

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Due By (Pacific Time) 02/11/2015 01:00 pm
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