This case explores the operating exposure of Jaguar PLC in 1984, just as the government is about to relinquish control and take the company public via an IPO. The primary concern of the CFO is that Jaguar sells over 50% of its cars in the US, while its production costs and factories are U.K.-based. This currency mismatch creates operating exposure for the firm that needs to be hedged.
While the current trend in the USD has been higher, the markets are expecting a pullback in the currency. With labor accounting for a significant portion of the cost base for luxury car industry, it is unlikely that the expense will decline in the near future. Again this creates a potential liability in the matching pf the cash inflows and outflows. Given Jaguar’s primary competitors have operating expenses in DEM, the CFO should also be concerned with the competitive advantages that are associated with favorable exchanges rate when compared to the competition.
Thus, there also exists the issue of the GBP/DEM exchange rate. The overarching themes and underlying issues that must be addressed in order to address Jaguar’s currency exposure are: Valuation of the risks associated with firms with multiple currency exposure Risks associated with revenue streams and expenses in different currencies Valuation and assessment of highly competitive niche luxury car markets Supply chain effectiveness and labor trends in the automotive industry Strategic positioning of operations for a multinational firm
After thoroughly weighing the issues from a qualitative and quantitative perspective, we believe that there are several strategies that Jaguar Management can undertake in order to maximize the profitability of and mitigate the exchange rate exposure for the revenue that is generated in the US. In particular, we would recommend:
Management should locate a proportionate level of its manufacturing facilities in the US to foster a reduction in operating exposure since revenues and costs would be denominated in the same currency. Jaguar Treasury should engage in Forward/Swap Contracts to Sell US$ and hedge against currency fluctuations. Jaguar Treasury could also Buy Call Options on GBP to hedge its operating exposure is to use option.
By paying an option premium, Jaguar could reserve the right but not bear the obligation to exercise the option based on favorable or unfavorable currency levels. Jaguar Treasury could create Money Market Hedges by borrowing USD, converting the proceeds into GBP using spot rate, and using the revenues generated in US market to pay back the USD principle and interests in the future. This would provide a “natural” hedge against Jaguar’s dollar revenue stream.
May 10, 2005
Jaguar and the Luxury Automotive BusinessJaguar was founded in 1922 as Swallow Chairs and originally operated as a sidecar and car trimmings company. In 1945 it officially became Jaguar Cars Ltd and had initial production of 1,132 cars. In the mid 1960’s it merged with other British motor companies to become British Leyland. After significant losses, the government found that BL was in serious financial trouble and acquired nearly all of their equity. During the next 20 years the government was able to turn the company around.
The standards were increased and reputation for quality production was developed. Revenue growth grew 40% annually from 1980 to 1983 and employee morale and overall image improved with international races. In 1980, exports accounted for 60% of sales and by 1983 exports totaled 75% of sales. By 1984, Jaguar has come to be regarded as a leading manufacturer of luxury high-priced automobiles. However, the company needs to assess its economic exposure to exchange rates.
Recent developments in the international markets indicate that the US Dollar is set to begin to decline against other currencies. Jaguar’s CFO agrees that the sustained real appreciation of the U.S. dollar has in fact begun to run out of steam, and the currency value is about to reverse its course. Jaguar has performed extremely well in the U.S. market, thanks in large part to the substantial real appreciation of the U.S. dollar against all European currencies.
Previously, the strong dollar gave Jaguar the opportunity to cut its prices, however, given the fact that luxury cars are not price sensitive it had not done so (nor had its competition). If Jaguar were to increase prices of cars in the US (to keep profit margins constant at the pre-U.S. dollar depreciation level), demand would drop and they would sell fewer cars. If they keep prices the same (in US$), profit margins would be squeezed, and hence possibly the company’s share price as well.
Sources of Exchange Rate ExposureGiven the nature of its business, Jaguar is faced with three types of exchange rate exposure (1) Transaction, (2) Translation and (3) Economic.
Transaction exposures arise whenever the firm commits (or is contractually obligated) to make or receive a payment at a future date denominated in a foreign currency. Translation exposures arise from accounting based changes in consolidated financial statements caused by a change in exchange rates. In this case we primarily focus on the Economic exposure -also known as Operating exposure or Competitive exposure- of Jaguar.
Economic exposure is the change in expected cash flows arising because of an unexpected change in exchange rates. Aside from existing obligations of the firm which will be settled in foreign currencies at future dates (transaction exposure) and the imbalances resulting from consolidation practices (translation exposure), the firm’s present valuefirm valuewill change as the value of expected future cash flows (and costs of capital) change as a result of unexpected exchange rate changes.
Thus, Economic exposure to exchange rates occurs when unanticipated real (as opposed to nominal) exchange rate changes have a non-zero effect on its expected future cash flows.
With 55% of its sales occurring in the US and producing US$ revenue, Jaguar is also faced with mismatching exposure since its costs structure is denominated in GBP Sterling. Given the mismatch between the two, the $/£ exchange rate is a crucial (and direct) determinant of firm’s economic exposure. Any real appreciation of the UK£ (and thus a real depreciation of the US$) will have the immediate effect of lowering the firm’s revenues in Sterling terms (or increasing costs in US$ terms).
The Competitive Landscape and the Impact of Currency Exchange Rates Jaguar also needs to focus on the indirect, competitive exposure to the DEM, since that is the currency of denomination of costs for their major competitor, Daimler Benz.
In addition, Daimler Benz’s ability to price its products in the U.S. (and hence create competitive pressure for Jaguar sales in the U.S.) will depend on what happens to the $/DM exchange rate, and since that, in turn, will automatically imply an exchange rate between the GBP and the DEM, Jaguar must closely monitor developments in the GBP/DEM exchange rate as well.
Jaguar Valuation in 1984We use free cash flow (FCF) method to evaluate Jaguar’s equity. The key components of FCF we have taken into consideration include revenue growth rate, expense growth rate, depreciation, tax rate, and capital expenditure. (See Exhibit A for assumptions) Owing to limited information provided by the case, we simply assume that Jaguar’s cost of equity is 12% and later on perform sensitivity analysis over different levels of equity cost. In our base case where no foreign exchange fluctuation happens, Jaguar’s equity is valued for 1,743.62 million pounds.
To future understand the impact from foreign exchange risk, we estimate Jaguar’s equity under four scenarios: no change in foreign exchange, 25% drop in the US dollar, 10% rise in the US dollar, and under purchasing power parity (PPP). Since Jaguar would have a competitive advantage when the dollar is appreciating against the British pound, we assume that Jaguar’s market share will increase and as a result, have its revenue growth rate rising up to 15% per annual. Jaguar’s revenue would also benefit from lower rate of USD/GBP and exchange for more pounds.
In the situation where the dollar is depreciating against pounds, Jaguar will be influenced not only by the higher exchange rate that provides smaller revenue base but also lose its market share to other European competitors.
The equity analysis under the four scenarios and different levels of cost of equity indicates that foreign exchange has a significant impact on Jaguar’s equity value. In the case when the dollar drops 25%, Jaguar’s total revenue cannot even cover its expenses, which turns its equity into negative value.
On the other hand where the dollar rises 10%, Jaguar would achieve the highest equity value at cost of equity of 12%. (See Exhibit B) Overall we feel the sensitivity and scenario analysis provides justice evaluation for Jaguar’s equity. We believe Jaguar’s equity should be valued in a range between 966 to 1,467 million pounds under the PPP scenario due to the fact that inflation rate is a good predictor for exchange rate.
Recommended Hedging Strategies with Associated Benefits and Costs There are several strategies that Jaguar Management can undertake in order to maximize the profitability of and mitigate the exchange rate exposure for the revenue that is generated in the US. Below we outline several of the strategies and identify the associated benefits and costs of each.
Locate Manufacturing Facilities in the US – In the long run, Jaguar could move parts of its production line into US, since US accounted for 55% of its total units sold. Operating exposure would be reduced with revenues and costs in the same currency. However, there would be additional risks associated with moving the facilities oversea. For example, Jaguar might need to covert GBP into USD to final large scale upfront investments and ongoing operating expenses in the first several years until the facilities could generate enough revenue to cover its expenses.
Engage in Forward/Swap Contract to Sell US$ – Jaguar could use forward contracts to hedges against currency fluctuation. However, this method would obligate Jaguar to sell predetermined Dollar amounts regardless of actual sales and currency movements, and therefore might result in problems like over hedge or under hedge.
Buy Call Option on GBP – Another alternative for Jaguar to hedge its operating exposure is to use option. By paying certain amounts of option premium, Jaguar could reserve the right but not bear the obligation to exercise the option, therefore, if the exchange rate changes in favor of Jaguar (i.e., USD appreciate), Jaguar could let the option expired worthless; on the other hand, if USD depreciate, Jaguar could exercise the option and gain revenues. However, Option is relatively expensive since it requires an upfront investment.
Money Market Hedge – Jaguar could borrow USD, convert the proceeds into GBP using spot rate, and use the revenues generated in US market to pay back the USD principle and interests in the future. Borrowing in US dollars would provide a “natural” hedge against Jaguar’s dollar revenue stream. However, Jaguar might not get a favorable interest rate in its USD loans, which might inflate the costs of the money market hedge. What’s more, unpredictable fluctuation of Jaguar’s revenue streams in US might hurt its ability to pay back debts and therefore become a potential threat to Jaguar’s financial situation.