Finance Part III Homework January 1982 Mexican Companies Foreign Firms Operating

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Part III Case Studies

Case III.1 Rolls-Royce Limited

Rolls-Royce Limited, the British aeroengine

manufacturer, suffered a loss of £58 million in

1979 on worldwide sales of £848 million. The

company’s annual report for 1979 (page 4)

blamed the loss on the dramatic revaluation of

the pound sterling against the dollar, from £1

$1.71 in early 1977 to £1 $2.12 by the

end of 1979.

The most important reason for the loss was

the effect of the continued weakness of the

U.S. dollar against sterling. The large civil

engines that Rolls-Royce produces are sup-

plied to American air frames. Because of U.S.

dominance in civil aviation, both as producer

and customer, these engines are usually priced

in U.S. dollars and escalated accordingly to

U.S. indices….

A closer look at Rolls-Royce’s competitive

position in the global market for jet engines

reveals the sources of its dollar exposure. For

the previous several years Rolls-Royce’s export

sales had accounted for a stable 40% of total

sales and had been directed at the U.S. market.

This market is dominated by two U.S. competi-

tors, Pratt and Whitney Aircraft Group (United

Technologies) and General Electric’s aerospace

division. As the clients of its mainstay engine,

the RB 211, were U.S. aircraft manufacturers

(Boeing’s 747SP and 747,00 and Lockheed’s

L1011), Rolls-Royce had little choice in the cur-

rency denomination of its export sales but to

use the dollar.

Indeed, Rolls-Royce won some huge engine

contracts in 1978 and 1979 that were fixed

in dollar terms. Rolls-Royce’s operating costs,

on the other hand, were almost exclusively

incurred in sterling (wages, components, and

debt servicing). These contracts were mostly

pegged to an exchange rate of about $1.80 for

the pound, and Rolls-Royce officials, in fact,

expected the pound to fall further to $1.65.

Hence, they didn’t cover their dollar exposures.

If the officials were correct, and the dollar

strengthened, Rolls-Royce would enjoy windfall

profits. When the dollar weakened instead, the

combined effect of fixed dollar revenues and

sterling costs resulted in foreign exchange losses

in 1979 on its U.S. engine contracts that were

estimated by the Wall Street Journal (March 11,

1980, p. 6) to be equivalent to as much as

$200 million.

Moreover, according to that same Wall Street

Journal article, “the more engines produced and

sold under the previously negotiated contracts,

the greater Rolls-Royce’s losses will be.”

Questions

1. Describe the factors you would need to

know to assess the economic impact on

Rolls-Royce of the change in the dollar:

sterling exchange rate. Does inflation affect

Rolls-Royce’s exposure?

2. Given these factors, how would you calculate

Rolls-Royce’s economic exposure?

3. Suppose Rolls-Royce had hedged its dollar con-

tracts. Would it now be facing any economic

exposure? How about inflation risk?

4. What alternative financial management strate-

gies might Rolls-Royce have followed that

would have reduced or eliminated its economic

exposure on the U.S. engine contracts?

5. What nonfinancial tactics might Rolls-Royce

now initiate to reduce its exposure on

the remaining engines to be supplied under

the contracts? On future business (e.g., diver-

sification of export sales)?

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418 Part III •Case Studies

Case III.2 The Mexican Peso

The basic purpose of this case is to have you

conduct an in-depth analysis of government

macroeconomic policies on firms and banks doing

business with Mexico. The vehicle being used is

the Mexican peso. See Exhibit III 2.1 for statistics

related to exchange rates and price indexes in

the United States and Mexico for the period

1976–1997. Using these data, please address the

following questions.

Questions

1. What are the causes of the continuing devalua-

tion of the peso since August 1976? Analyze

both the immediate causes (e.g., balance-of-

payments deficits) and longer-term, more fun-

damental causes (e.g., inflation, the political

and economic environment). Concentrate espe-

cially on the 1982 and 1994–1995 devalua-

tions of the peso.

2. What role did oil price changes play in Mexico’s

difficulties?

3. What indicators of peso devaluation prior to

1982 and 1994 were there?

4. What were the likely effects of the peso deval-

uation between 1976 and January 1982 on

a. Mexican companies?

b. Foreign firms operating in Mexico?

c. U.S. companies in border towns catering to

Mexicans?

5. Redo question 4, focusing on the effects of

peso devaluation subsequent to February 1982

and prior to December 1994.

6. In August 1982, the Mexican government

devalued the peso, froze all dollar accounts in

Mexican banks, and imposed currency con-

trols. What are the government’s objectives?

How did these actions affect the black market

value of the peso? Why?

7. How did the Mexican government’s expro-

priation of Mexico City real estate, following

the September 1985 earthquake, affect the

value of the peso and why?

8. Consider the trust factor with respect to

Mexican policies. What have been the proba-

ble effects of trust or its lack on investment in

Mexico, Mexican citizens’ investment choices,

and the peso’s value?

9. Are dollar loans to the Mexican government

and Mexican companies exposed to exchange

risk? Explain.

10. How did Mexico’s economic policies contribute

to its debt crisis? How have subsequent gov-

ernment policies affected Mexico’s financial

health?

6. What additional information would you

require to ascertain the validity of the state-

ment that “the more engines produced and

sold under the previously negotiated

contracts, the greater Rolls-Royce’s losses

will be”?

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Case III.2 •The Mexican Peso 419

Exhibit III 2.1 The Mexican Peso’s Key Statistics: 1975 – 1997

Nominal Exchange Rates (period average)

Year:Quarter Peso:Dollar Dollar:Peso CPI Mexico CPI United States

75:1 12.5 $0.08000 100.0 100.0

75:2 12.5 $0.08000 103.2 101.9

75:3 12.5 $0.08000 107.0 104.1

75:4 12.5 $0.08000 110.4 105.8

76:1 12.5 $0.08000 115.2 106.8

79:3 22.8 $0.04390 225.2 141.3

79:4 22.8 $0.04386 235.6 145.4

80:1 22.9 $0.04376 256.8 151.1

80:2 22.9 $0.04361 271.5 156.6

80:3 23.1 $0.04337 289.3 159.4

80:4 23.3 $0.04301 303.9 163.7

81:1 23.8 $0.04209 328.5 168.0

81:2 24.4 $0.04103 348.4 171.9

81:3 25.2 $0.03968 365.9 176.9

81:4 26.3 $0.03804 389.4 179.3

82:1 45.5 $0.02198 435.0 180.9

82:2 48.0 $0.02082 501.5 183.5

82:3 50.0 $0.02000 606.1 187.0

(Continued)

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420 Part III •Case Studies

Nominal Exchange Rates (period average)

Year:Quarter Peso:Dollar Dollar:Peso CPI Mexico CPI United States

86:2 575.4 $0.00174 4,957.8 212.6

86:3 752.0 $0.00133 5,930.4 214.3

86:4 923.5 $0.00108 7,164.7 215.4

89:1 2,369.0 $0.00042 36,943.5 240.5

89:2 2,460.0 $0.00041 38,435.6 244.3

89:3 2,551.0 $0.00039 39,687.9 246.4

89:4 2,641.0 $0.00038 41,501.0 248.7

90:1 2,733.0 $0.00037 45,621.2 253.0

90:2 2,817.0 $0.00035 48,104.5 255.5

90:3 2,890.6 $0.00035 50,789.0 260.0

90:4 2,945.4 $0.00034 53,783.8 264.3

91:1 2,981.0 $0.00034 57,724.0 266.4

91:2 3,018.2 $0.00033 59,806.8 267.9

91:3 3,055.8 $0.00033 61,443.3 270.0

91:4 3,071.0 $0.00033 64,270.0 272.1

92:1 3,083.5 $0.00032 67,741.4 274.0

92:2 3,122.3 $0.00032 69,576.3 276.3

92:3 3,116.3 $0.00032 70,964.8 278.1

92:4 3,115.4 $0.00032 72,750.1 280.1

93:1 3,097.6 $0.00032 75,130.5 282.5

93:2 3,121.2 $0.00032 76,519.0 284.5

93:3 3,117.8 $0.00032 77,758.8 285.3

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