Universal Circuits Inc PDF

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Case background Universal circuits Inc., is a leading supplier of components for the measurement and control industry. Its products have application in medical instruments such as blood analysers and CAT scanners, industrial automation systems, process controls, environmental controls, pollution control, cancer research, oil exploration, radar systems for missile detection, aircraft navigation systems, and fire control systems. The products are widely sold by extensive field sales force. Universal Circuits foreign sales account for 40% of total sales, where it wholly owned the sales subsidiaries in eleven countries. Also, the company is represented by independent sales representatives in seventeen other countries. Universal Circuits faced challenges from competitors as well where its relative strength lies in the technical innovation, quality and reliability, product availability, technical service and support, and range of products. The price is the most important competitive factor when all other considerations are same but customers can pay for higher price as well. Most of the suppliers for Universal Circuits are from US and Europe, though it is expanding. 25% of Universal Circuit’s manufacturing is done in Ireland, UK, Philippines and Japan. The targeted return on capital is 19% and the growth is largely self-financed. Universal Circuits sales has tripled to $214 million in fiscal 1983, net income quadrupled to $18.4 million and share prices have increased tenfold, which made an equity issue of $37 million successful at a price of $35.5/share. In 1976, Universal Circuits started business in Ireland due to the attractive schemes given by the Irish Development Authority in the form of attractive tax inducements. To facilitate intercompany funds transfers, Irish operation was established as branch of Dutch Holding Company, UCNV Netherlands. The Irish branch was a fully integrated research and manufacturing operation, responsible for design, development and manufacturing of all computer measurement and control system products. Labor and locally sourced supplies accounted for 30% of direct cost of sales. Approximately 10-20% of foreign sales are made on long term contracts at a fixed currency rate. Another 10-20% of the quotes are in US dollars but 60% to 90% of foreign sales is exposed to the currency fluctuation risks. Collection period in various countries varies from 28 days to 100 days. Some members of the senior management felt that the responsibility for exchange rate exposure should be centralised. In terms of profit and loss exposure, the company takes one month horizon, estimate the exposure and then decide whether to hedge based on trends in the market for the currency and current market inputs. After receiving a telex from the controller of Irish plant, a tough decision for hedging against the depreciation of US Dollar, the manager of international finance of Universal circuit’s organization is concerned about the exposure of the firm to change in exchange rates.

Financial Problems 1. Till date the strong US dollar has contributed significantly to the profitability of the company but now there a threat to US Dollar to get weaken due to trade deficit of excess of $100 Bn. The weakness of US dollar would have negative impact on the company’s business performance.

2. Company is not confident about the future trend of US dollar (increasing or decreasing) so decision of whether to hedge against the depreciation of US dollar or not becomes critical. 3. Exchange rate exposure is not centralised which may lead to mess around the currencies.

Analysis (i) (ii) (iii)

Risk Identification: Is there a threat to US Dollar to get weaken further? What nature of currency exchange exposure does the Irish subsidiary face? Risk Measurement: How do they measure risk against foreign currency? Risk Management: How do they manage risk against foreign currency? Should the Punt be bought forward?

Particulars Sales Net Income Net Income % of Sales Earnings Per Share(EPS) Dividend Per Share Share Price High Share Price - Low Book Value Per Share Shares Outstanding Equity Book Value Long Term Debt Capital Equity Capital Equity Value Debt Value Enterprise Value

UOM USD Mn USD Mn %

1978 66 4.5 6.8%

1979 100 7.0 7.1%

1980 136 9.3 7.0%

1981 156 4.6 2.9%

1982 174 9.9 5.7%

1983 214 18.4 8.6%

USD / share USD / share USD

0.32

0.47

0.59

0.27

0.55

0.97

0

0

0

0

0

0

4.5

8.5

16.5

15.375

19.75

41.75

USD USD / share Nos. Mn

2.25 1.72

3.25 2.23

6.5 3.05

8.375 4.02

8.75 4.69

17.5 7.79

13.2

15

15.8

17.2

18

19

USD Mn

22.70

33.45

48.19

69.14

84.42

148.01

%

38%

45%

51%

42%

37%

15%

% USD Mn USD Mn USD Mn

62% 22.70 13.92 36.62

55% 33.45 27.37 60.82

49% 48.19 50.16 98.35

58% 63% 85% 69.14 84.42 148.01 50.07 49.58 26.12 119.21 134.00 174.13

Particulars (Y-oY) Sales

1979

1980

1981

1982

1983

51.52% 55.56%

14.71 % 50.54

11.54%

Net Income

36.00 % 32.86 %

22.99 % 85.86 %

115.22 %

Net Income % of Sales

4.41%

1.41%

Earnings Per Share(EPS)

46.88%

25.53 %

Dividend Per Share Book Value Per Share Shares Outstanding Equity Book Value Long Term Debt Capital

0%

0%

% 58.57 % 54.24 % 0%

29.65%

36.77 % 5.33% 44.07 % 13.33 %

13.64% 47.33% 18.42%

Equity Capital

-11.29%

Equity Value

47.33%

Debt Value

96.68%

Enterprise Value

66.08%

96.55%

50.88 %

103.70 %

76.36 %

0%

0%

31.80 % 8.86%

16.67%

66.10 % 5.56%

43.48 % 17.65 % 18.37 %

22.09%

4.65%

-11.90%

10.91 % 44.07 % 83.27 %

8.62%

43.48 % 0.17%

22.09%

61.71 %

21.22 %

12.40%

-0.98%

75.33 % 59.46 % 34.92 % 75.33 % 47.32 % 29.95 %

Risk Identification: The strong US Dollar had contributed to excellent profitability but the same could be a problem on tomorrow. A telex had been received from the controller pointing out the severity of risk and urging to be allowed to buy punt forward to protect his 1985 budgeted profits. The American trade deficits of excess of $100 Bn Dollars implies that the imports are more than the exports. This will lead to excess demand of foreign currency against US dollar which will weaken the US dollar. The same is also evident from movement of Punt and other currencies against Dollar.

Exchange Rates

1960

1970

1980

1984

Range 1960 - 1980

Irish Punt / USD French Franc/USD Japanese

0.36 4.9

0.42 5.52

0.53 4.52

1.01 8.5

.36 - .53 4.02 - 5.56

360

358

203

238

195 - 362

Yen/USD British Pound/USD Deutsche mark/USD

0.36

0.42

0.3

0.74

.36 - .59

4.17

3.65

1.96

2.85

1.73- 4.17

Foreign Currency/USD 14 12 10 8 6 4 2 0 1960

1970 Irish Punt / USD British Pound/USD

1980

1984

French Franc/USD Deutsche mark/USD

It is clear from the trend that Irish Punt is continuously strengthening against dollar. So, the American trade deficits can lead to severe risk against foreign exchange. This in turn can affect Cash flows and income statement and can result in currency loss severely. From 1980 to 1984 the dollar appreciated around 50% against the punt and interest rate averaged 12.6% during the same period. Irish controller’s main worry was that the dollar will be likely to further depreciate. Over the last 2 years inflation has fallen to 5%, much lower than the 10% rate in 1981. A lower inflation rate could result in the US government lowering interest rates, which could cause decline of US dollar. Increasing trading deficit, lower inflation, and lower interest rate signals a possible weakening of dollar. US trade deficit is currently in excess of $100 billion and it is growing year on year. 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. 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.

Risk Measurement: Factors affecting decision to hedge foreign exchange risk:    

Firm size can be proxy for the cost of hedging. Firm with high leverage have better incentive to engage in hedging. Firms with high profitability have lesser incentive to engage in hedging Sales growth Opportunity could be another measure, which is 25% - 35% approx.

As mentioned in the case, labour and locally sourced supplies account for 30% of direct cost of sales and that operating and other expenses are incurred virtually in in

Irish punt. Taking it into consideration, it is possible to calculate from exhibit 5 that the costs incurred in Irish punt contributes 51.4% (i.e.: 30% of cost of sales of 48% = 14.4% + operating expenses of 34% = 48.4% + other expenses of 3% = 51.4%) of total costs. Risk Management: Though few theories like 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 minimize its risk by HEDGING. Hedging is based on the limits a firm set for itself to manage exposure, there can be the following hedging strategies: 









FORWARDS: This is a made-to-measure agreement between two parties either to buy or sell a specified amount of currency at specified rate on a particular day in future. The depreciation is protected by selling a currency forward. Its main advantage is that it can be tailored as per the specific needs of the firm. FUTURES: This contract is similar to forward contract but is more liquid because it is traded in an organized exchange, i.e. the futures market. Again, depreciation of a currency can be hedged by selling futures. OPTIONS: This is a contract giving the right but not the obligation, to buy/sell a specific quantity of one foreign currency in exchange for another at a fixed price, called the strike price or exercise price. SWAP: A swap is a foreign currency contract whereby the buyer as well as seller exchanges equal initial principal amounts of two different currencies at the spot rate. FOREIGN DEBT: It can be used to hedge foreign exchange exposure by taking advantage of the International Fischer Effect relationship. The exporter stands to lose if the domestic currency appreciates against that currency in the meanwhile, so to hedge this, the company can take a loan in the foreign currency for same duration and convert the same into domestic currency at the current exchange rate.

Conclusion: 1. Currency risk will be minimized having a bare minimum account receivable which coupled with an agreement of alteration of price at the time of payment would provide additional safeguard. Universal 2. Circuits might also include hedging tools such as futures, swaps or Options in its transaction exposure management. Control and Limitations should be put in place and clearly communicated. 3. Overall since customers pay in dollars and if dollar weakens, Universal Circuits will become more competitive inside Europe. Economic exposure can only be managed through long term strategies initiatives, such as marketing or production. In terms of market selection, it is advisable to stay in Europe and maintain flexible production facilities to diversify risk: whenever the dollar is weak, primary inputs should be purchased in US, and abroad when the dollar is strong.

4. Buying the punt forward would be optimal, as it would reduce the possible loss due to weakening of the dollar. In case of dollar weakening, buying the punt forward is a feasible option to protect the firm’s profit. In case of dollar remaining stable or appreciating further, the firm will not be able to realize any upside potential, a hedge option will be better than no hedge option here. 5. In long term, controller should also adjust his funds flows, since the short-term outcome of the dollar weakening is unclear; it makes sense to begin with a forward. Go for forward rate of exchange of Irish Punt to mitigate the Forex risk the firm faces....