Partial Increases in Prices, Costs, and Volume. In the most realistic situation, all variables will adjust somewhat. It is assumed here that the sales price at home rises by 10% to SKr 22 and the export price rises to SKr 24—still providing a competitive advantage in dollar terms over foreign products. The result is a 20% increase in domestic sales and a 15% increase in export sales.
Local input prices are assumed to go up, but the dollar price of imported material stays at its predevaluation level. As a result of the change in relative cost, some substitutions are made between domestic and imported goods. The result is an increase in SKr unit cost of approximately 17%. Overhead expenses rise by only 10% because some components of this account, such as rent and local taxes, are fixed in value. The net result of all these adjustments is an operating cash flow of $1,010,800, which is a gain of $110,800 over the predevaluation level of $900,000. The calculations are shown in Exhibit 11.10.
Exhibit 11.9 Summary of Projected Operations for Spectrum Manufacturing AB: Scenario 2
Exhibit 11.10 Summary of Projected Operations for Spectrum Manufacturing AB: Scenario 3
Over the next three years, cash flows and the firm’s economic value will change as follows:
Year
Postdevaluation Cash Flow (1)
—
Predevaluation Cash Flow (2)
=
Change in Cash Flow (3)
X
15% Present Value Factor (4)
=
Present Value (5)
1
$1,010,800
$900,000
$110,800
0.870
$ 96,396
2
1,010,800
900,000
110,800
0.756
83,765
3
1,160,800*
900,000
260,800
0.658
171,606
Net Gain
$351,767
*Includes a gain of $150,000 on loan repayment.
Thus, under this scenario, the economic value of the firm will increase by $351,767. This gain reflects the increase in operating cash flow combined with the gain on loan repayment.
Case Analysis.
The three preceding scenarios demonstrate the sensitivity of a firm’s economic exposure to assumptions concerning its price elasticity of demand, its ability to adjust its mix of inputs as relative costs change, its pricing flexibility, subsequent local inflation, and its use of local currency financing. Perhaps most important of all, this example makes clear the lack of any necessary relationship between accounting-derived measures of exchange gains or losses and the true impact of currency changes on a firm’s economic value. The economic effects of this devaluation under the three alternative scenarios are summarized in Exhibit 11.11.
4 No Swedish taxes will be owed on this gain because SKr 3 million were borrowed and SKr 3 million were repaid.