Suppose a U.S. computer company has a wholly-owned British subsidiary, Albion Computers PLC, which manufactures and sells personal computers in the U.K. market. Albion Computers imports microprocessors from Intel, which sells them for $512 per unit. At the current exchange rate of $1.60 per pound, each Intel microprocessor costs £320. Albion Computers hires British workers and sources all the other inputs locally. Albion faces a 50 percent income tax rate in the U.K.
The exhibit below summarizes projected operations for Albion Computers, assuming that the exchange rate will remain unchanged at $1.60 per pound. The company expects to sell 50,000 units of personal computers per year at a selling price of £1,000 per unit. The unit variable cost is £650, which comprises £320 for the imported input and £330 for the locally sourced inputs. Needless to say, the pound price of the imported input will change as the exchange rate changes, which, in turn, can affect the selling price in the U.K. market. Each year, Albion incurs fixed overhead costs of £4 million for rents, property taxes, and the like, regardless of output level. As the exhibit shows, the projected operating cash flow is £7,250,000 per year, which is equivalent to $11,600,000 at the current exchange rate of $1.60.
BenchmarkSales (50,000 units at £1,000/unit) £50,000,000
Variable costs (50,000 units at £650/unit) 32,500,000
Fixed overhead costs 4,000,000
Depreciation allowances 1,000,000
Net profit before tax £12,500,000
Income tax (50%) 6,250,000
Profit after tax 6,250,000
Add back depreciation 1,000,000
Operating cash flow in pounds £7,250,000
Operating cash flow in dollars $11,600,000
1. Now consider the possible effect of an appreciation of the pound on the projected dollar operating cash flow of Albion Computers. Assume that the pound may appreciate from $1.60 to $1.90 per pound.
(a) Suppose Albion decides to maintain its selling price of its personal computers in the U.S. market at US$1,600 per unit. Compute the projected cash flow in pounds as well as in dollars following the pound appreciation.
(b) Assuming that the pound appreciation would affect CFs for 4 years, and assuming a discount rate of 15%, calculate the PV of the CFs over 4 years. Using the benchmark case for comparison, calculate Albion's Gain/Loss in operating CFs from the change in the pound.
2. Consider Case 3 of Albion Computers PLC discussed in the chapter. Now, assume that the pound is expected to depreciate to $1.50 from the current level of $1.60 per pound. This implies that the pound cost of the imported part, i.e., Intel's microprocessors, is £341 (=$512/$1.50). Other variables, such as the unit sales volume and the U.K. inflation rate of 8 percent, remain the same as in Case 3. Also, because of facing an elastic demand for its products, sales volume declines to 40,000 units per year after the price increase.
(a) Compute the projected annual cash flow in pounds as well as in dollars.
(b) Assuming that the pound depreciation would affect CFs for 4 years, and assuming a discount rate of 15%, computethe PV of the CFs over 4 years. Using the benchmark case for comparison, calculate Albion's projected operating gains/losses over the four-year horizon due to the pound depreciation.