Does the Universal Circuits’ Irish controller have a convincing argument for the weakness of the dollar? Why or why not? How would you interpret the evidence?
The controller of the Irish division does have a valid point when stating that the U.S. dollar is in a vulnerable position due to the fact that its trade deficit is currently in excess of $100 billion and growing. (see Exhibit 1). While Universal Circuits’ chief financial officer, Joe Merrill, is correct when stating that the dollar is in the middle of its twenty-year range, he never mentioned which countries currency he was comparing it to. When compared to the Irish punt, which the controller and the company have a vested interest in it is clear that over the last twenty years the dollar has been decreasing in value. When one analyzes the data given in Exhibit 1, it is quite clear that since 1960 when the Punt/Dollar ratio was 0.36 it has since gone to 0.42 in 1970, to 0.53 in 1980 and finally 1.01 in present day (1984). This data plainly shows that the value of the dollar has been steadily going down relative to that of the Punt.
Another part of Exhibit 1 that indicates that the increasing trade deficit is weakening the dollar, primarily when comparing it to the Irish Punt, is the Relative Industrial Prices section. This section of the exhibit shows how, once again, over the course of the 20 years in the study the price for industrial activities has gone up in Ireland relative to U.S.A. According to relative price theory the cost of a certain good should be equivalent in all currencies. In relative purchasing power parity, the exchange rate between the home and foreign currency should adjust to indicate changes in the price levels of the two countries. In this specific scenario if the theory were to hold true for the ratio to be behaving the way the value of the currency must be acting in an appropriate manner. Therefore as the dollar depreciates and the relative costs incurred to the company increase. It must be mentioned that when determining the real depreciation, one must take into account inflation rates as well. These costs are being paid in Ireland where the plant and the current controller reside. These costs are also being paid in Irish punts but need to be converted from U.S. dollars first. Since the costs are staying the same but the value of the dollar is going to the relative costs in Irish punts is increasing.
Should the controller be worried about its exchange value?
In view of the fact that the dollar is the Irish subsidiary’s “functional currency”, the controller has substantial reason to be worried about the Punt/US$ exchange rate. Changes in exchange rates of foreign currencies can adversely affect the reported profits and the nominal net worth of the Irish subsidiary. The Irish subsidiary incurs a significant amount of Irish punt costs. As stated in the case, “operating and other expenses were incurred virtually entirely in Irish punt.” This being said, due to the fact that there are no sources of revenue in punts to offset these costs, Universal Circuits is exposed to both economic and translation exposure. Universal Circuits has a high degree of economic exposure because if the Irish controller’s estimate of the profit margin being highly vulnerable to any weakening of the dollar is right, then logically more US dollars will be required by the Irish subsidiary to offset its’ punt expenses. What is the nature of the foreign exchange exposure(s) faced by the Irish subsidiary?
The Irish subsidiary is subject to three types of foreign exchange exposures. They are economic risk, transaction risk, and translation risk. From class, economic risk comes when the foreign currency value of a foreign investment reacts systematically to an exchange rate movement. Economic exposure is the risk associated with a change in value of a company as a result of a change in exchange rates. As stated in the case, “price is...
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