Executive Summary for Farmington Industries
The case study reveals the conditions of Farmington Industries Incorporated, which has to face the challenges arising from Mexico currency’s devaluation against US dollars. Farmington Industries Incorporated is a US based manufacturing company which has significant business presence in Mexico. The company currently has four types of Mexican-related business activities. The first one is called Farmington de Mexico, which a 100% is owned Mexican subsidiary that supplied manufactured products to consumers.
This is considered a full Mexican-based business of Farmington Industries Inc because the products are manufactured locally and the targeted consumers are domestic companies also. The second Mexican-related business is the Maquiladora facility. This form of business activity is Farmington’s idea of taking advantage over Mexico’s lower production cost structure compare to the United States business environment. Within this business Farmington assembled components unto final products, and sells it gain to US customers. The third business is called the Farmington (Antilles) NV.
This is an offshore company designed to distribute manufactured products to Mexico and other markets. The products are all manufactured in the United States. The last is called Exportaciones (Farmington) S A, which is a manufacturing business designed to serve the Latin America markets. The facility of this business is located in a Mexican port city called Veracruz, The balancing effect of Mexico’s economic growth during the last several years has considerable negative effects toward the performance of these four businesses.
Due to the Mexican government’s effort of keeping a steady-looking business environment for foreign investors, the country’s deficit budget reached an intolerable point. Furthermore, it is believed that The Mexican economy is using a rather unhealthy trade policy where imports are much larger than its exports. After the president decided to no longer support the currency, the Mexican Peso’s value dropped significantly toward US dollar. The significantly reduced value of Peso brought different effects toward the four Mexican-related businesses of Farmington Industries Inc.
In order to clarify the effects of Peso-value-drop toward each of these businesses, Farmington held a conference call which revealed the following: ? The Peso devaluation will not affect Farmington’s performance significantly in the financial period of 1994 because the occurrence took place very close to year end. ? On the other hand, the Peso devaluation considerably impacted the businesses in the financial year of 1995, and Farmington was changing its short run responses and long term strategy to deal with the situation.
? Most of Farmington’s businesses were using US dollars as a basic currency, thus, the company is naturally hedged toward Peso fluctuation. ? Farmington has a generous credit period which could go as long as 120 days. ? Farmington did not use letters of credit to secure transactions with Mexican customers. Management believes that the use of such a mechanism will send a bad signal that could insult the Mexican customers. Farmington’s management decided to put forth customers’ satisfaction, and sold their products on open accounts. ? Farmington’s management did not make efforts to persuade its Mexican importers to hedge the US Dollar
? The company did not use any export insurance agreement with any bank because management always have good credit experience with its Mexican partners, and because the management did not see a significant risk in performing exports to Mexico at that time. ? Farmington also did not hedge any aspect of their Mexican-based operations and investment, but the company reviews their export payments and existing hedging policies. ? Some transactions in Farmington’s Mexican related businesses were made based on the Peso, thus, some export sales were payable in Pesos
? The company also had Peso receivables but their amount were not significant ? Management of Farmington believed that a quick recovery of the Mexican economy can happen if the government agree to take measures like: limiting inflation; negotiating substantial bailout package with IMF; refuse to impose on exchange controls; realized undiscovered exports potentials, accelerate privatization; reform the labor and tax laws for business and; cooperating with labor unions to perform wage and price control efforts.
? Despite the conditions in the Mexican markets, Farmington decided not to change its investment plan, because management believed that when the bilateral agreement is finalized, Farmington will obtain political risk insurance and direct financing sources that will assist the growth of these investments. ? Farmington used a mixed currency policy, where some activities are translated using Pesos and other using US Dollars. ? The company planned to change those policies and use only US Dollar as the functional currency if the cumulative three-year inflation rate exceeds 100%.
? Management understand that the ‘hot money’ period had arrived in Mexico, where inflation, unemployment, bankruptcies and tight credit would be more common, but management will stay in Mexico until the crisis passes. From the elaboration above, we can make assessments on the effects of Peso devaluation on the four businesses of Farmington. 1. For the Maquiladora Assembly facility, most of the operational cost is denominated in Peso. This means that the Peso devaluation will reduce the operational costs in the short term, and actually beneficial for Farmington.
Nevertheless, due to the small amount of work in process, components and finished goods at had, the benefits gained from the peso devaluation would not be significant. 2. For Farmington (Antilles) NV, most of the credit agreements are made in US Dollars, however, frequent customers can insist using Peso for alternative. In this business, we can assess a significant loss of receivables value because the company still has approximately 4 million Pesos in receivables. 3.
For Farmington de Mexico, the company lost significantly because all payables and receivables are denominated in Pesos. 4. In Exportaciones (Farmington) SA the company did not experience a negative effect because most of the receivables and payables are paid in US Dollars. Suggested answer to question 1: Farmington de Mexico reported an exchange loss while the Exportaciones (Farmington) SA reported an exchange gain because payables and receivables are denominated in US dollars.
Thus, when receivables denominated in Peso are less that payables or debt denominated in Peso, than the result would be an exchange gain, on the other hand if the receivables denominated in Peso are more than payables or debt denominated in Peso, the result would be an exchange loss (Doupnik, 2007). This means Farmington de Mexico has more debt denominated in Peso compare to receivables, and Exportaciones (Farmington) SA has more receivables denominated in Peso compare to payables or debt. Suggested answer to question 6:
Farmington Industries Inc Mexican-related businesses are not well prepared for the Peso devaluation because most of the transactions are not hedged for US dollar. Even tough most of the transactions are naturally hedged because they are denominated in US dollars; other Mexican-based transactions are not protected by hedge transactions and letter of credits. The causes of this lack of preparation are organizational inability to persuade customers and Mexican importers to use letter of credit and the lack of proper currency-risk assessment in Farmington (Hawkins, 2004).
The effect of this lack of preparation is the decreasing value of receivables that were in possession of Farmington’s Mexican-based businesses. Because the receivables are denominated in Peso, the Peso devaluation will produce a significantly smaller number in Farmington parent company’s financial report. Actually, the company can better prepare to face the foreign exchange risks. In order to alleviate the potential negative results from undulating exchange rate, currently several tools can be taken into consideration.
Fortunately, the tools can be taken not only to prevent huge loss but also to gain profit from the currency movement. As research in the financial management continues evolving, fortunately, there are many tools available in recent days with many other sophisticated techniques constantly being added. In this paper, we will discuss four common tools that often used to manage exchange rate risk. The tools are forwards, futures, options, and swaps.
• Forward – Tried and True: A forward rate agreement (FRA) is a contract to buy or sell currency at an agreed upon exchange rate at a specific date in the future (Price 1992). • Future — Exchange-Based Forward: This method is somewhat similar to forwards except that Future is traded on exchanges, which specify settlement dates. Under such circumstances, a company can eliminate exchange risk (“hedge”) by using a futures contract to offset the risk involved in receiving foreign currency as payment for an overseas sale (Price 1992).
By taking a short position (that is, contracting to sell foreign currency on the settlement date), the company like General Motors will make a profit if the value of the currency decline, which will compensate the currency-related loss on their sale. • Options — Financial Insurance: There are two basic types of options, calls and puts. Purchase of a call grants us the right – but not the obligation – to buy a specified asset at a particular price at a specified time in the future.
Meanwhile, a put option is identical, except that it replaces the right to buy with the right to sell. The purchaser of either option pays a premium to the seller, or writer. • Swaps: A swap is an agreement between two parties to exchange certain specified cash flows over the life of a contract (Price 1992). One of the parties is generally a bank. For example, exporters with exchange-rate risk can renegotiate a swap of U. S. dollars for the currency of the country to which they are selling. The exporter will then be indifferent to exchange-rate movements.
The bank or financial institution is willing to do this because it can manage its foreign exchange exposure better than the exporters and use other risk management tools to hedge their risk. Bibliography Doupnik, Timothy. Parera, Hector. 2007. International Accounting. McGraw-Hill. Hawkins, David F. 2004. ‘Farmington Industries Inc: Managing Currency Exposure Risk’. Harvard Business School. 9-104-053 Price, John. 1992. Managing Currency Rate Movement: Weighing the Options. [Online] Available from: http://www. sherlockinvesting. com/articles/currency. htmSample Essay of AssignmentExpert.com