Consider the following scenario. A company has decided to expand its operations

Question

Consider the following scenario. A company has decided to expand its operations globally. The pricing department has concluded that the company will save two million dollars annually by purchasing raw materials from Japan. The yen, Japan's national currency is currently stronger than the U.S. dollar which makes importing goods cost effective. Both the U.S. Dollar and the Yen have fluctuated in strength the last ten years. If the yen weakens against the U.S. Dollar, this new purchasing agreement will not be profitable for the company. Please discuss the following:

1. What can the organization do to mitigate this risk?

2. Describe the implications of failing to effectively manage this risk.

a. Describe how these factors will affect the company's profitability metrics.

3. Please include examples of companies that failed to manage this risk and describe how it impacted them.

Explanation / Answer

A company has opted to expand the operations by purchasing Raw material from Japan.

Currently 1 USD = 111.98 Japanese Yen.

During August 1998 1 USD = 146.21 Japanese Yen and than Japanese Yen strangthened against USD and during August 2011 1 USD = 76.54 Japanese Yen. So Let us assume we are in 2011.

1) Here company is already saving 2 Million Dollar by purchasing raw material from Japan. But to mitigate the risk of weakening Yen against Dollar they can enter into future contract to buy Japanese Yen at a predifined price of USD in future when the company has to pay in Japanese Yen.

2)If the company fails to effectively manage this risk than it may have to pay huge losses due to currency exchange rate fluctuations. Like after 2011 the Japanese Yen weakened against USD and in August 2015 it reached to 124.21 Japanese Yen = 1 USD so company might have lost approx. 48 Japanese Yen against the 1 dollar of raw material puchased from Japan.

a) The Company will report this kind of losses as extraordinary losses. and this will affect directly the Profit after taxes and extraordinary items.

3) There was a company named Aracruz Celulose in Brazil, a manufacturer of Pulp & Paper. During 2008 financial crisis company faced  the financial losses of U$2.1 billion due to currency derivatives trading in the third quarter of 2008. And after huge losses it got murged with the Fibria (formerly known as VCP) company during 2009.

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