8/18/2019 Part 3 Case Study Exchange Rate Risk Management

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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. Itis 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 accountant’s 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 toGermany.

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.

8/18/2019 Part 3 Case Study Exchange Rate Risk Management

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Answer –  guidance notes

a)  The accountant’s calculations are: 

1.2 0.91Exchange

rate 1.2euro:£1 0.91 euro:£1total volumechange

volume 100 110 100 1.075

£m  Home Foreign total Home Foreign total

Sales 30 10 40 33 13 46

Cost ofsales 10 10 20 11 14 25

Gross profit 20 21

Fixed costs 10 6 16 10 8 18

Net profit 4 3

 b)  Production only in Germany1.2 0.91

Exchangerate 1.2euro:£1 0.91 euro:£1

total volumechange

volume 100 110 100 1.075

£m  Home Foreign total Home Foreign total

Sales 30 10 40 33 13 46

Cost ofsales 0 20 20 0 28 28

Grossprofit 20 18

Fixedcosts 0 16 16 0 21 21

Net profit 4 -3

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