Case study Part III Exchange rate risk management

Bovey plc produces specialized mouldings used for a range of products. Budgeted
sales for the next year are estimated to be 40m. A quarter of the sales are in euros
being sales in France to established customers. Production is made up of goods
produced partly in Germany and finished in the UK. The total cost of sales is 20m. It
is expected that half of this cost will be from Germany and half from the UK. Fixed
costs total 10m from the UK and 6m from Germany.
The exchange rate used in the budget was 1.2euros: 1 but management are
worried about the effect of a fall in the value of the . They ask the accountant to
prepare a profit and loss statement for an exchange rate of 0.90:1 euro. Management
estimate that UK sales would increase by 10%, but foreign sales that are denominated
in euros would be unchanged. The accountant works out that profits would fall to
about 3 from 4m.
a) Confirm the accountants calculations
b) The directors are considering increasing their investment in Germany and
closing their UK factory. Consider the immediate risk impact of such a
decision.
c) Outline the other economic and political implications of the proposed move to
Germany.
d) Identify and evaluate non market means of managing the exchange rate risk.
e) Bovey is thinking of raising further funds to finance a proposed future
investment. An attractive rate of 1% has been offered for a euro loan. Outline
the effect of raising the funds in euros rather than s.

note: When converting a variable cost convert to the currency of the transaction, then apply the
quantity effect then convert back to the reporting currency.

Answer guidance notes

a) The accountants calculations are:
1.2
Exchange
rate
volume
m

0.91

1.2euro:1
100
Foreign
total

Home

110
Home

total volume
change

0.91 euro:1
100
Foreign
total

1.075

Sales

30

10

40

33

13

46

Cost of
sales

10

10

20

11

14

25

Gross profit

20

Fixed costs

10

21

16

Net profit

10

18
3

b) Production only in Germany

1.2

0.91

Exchange
rate
volume
m

Home

Sales

30

10

40

33

13

46

Cost of
sales

20

20

28

28

1.2euro:1
100
Foreign
total

Gross
profit
Fixed
costs
Net profit

110
Home

0.91 euro:1
100
Foreign
total

20

16

16
4

total volume
change
1.075

18

21

21
-3

c) Answer should centre around possible trade restrictions if the UK were to

leave the EU this is a political implication. Economic factors could include a
range of possibilities including the problem of being distant from the market
as in producing in the UK and selling in France.
d) Leading and lagging, matching revenues with costs in the same currency,
money market hedges, are the main techniques discussion of these issues in
the context of the case study required.
e) It will increase foreign currency outgoings and decrease risk in the part (a)
scenario and increase risk in the part (b) scenario.