Analysis of Business Studies - Case Study Example

CASE STUDY The United s economy grew faster than expected in 2005, therefore, in early 2006 interest rates were raised to reduce inflationary pressures. The US dollar also went up in value against the euro. Some European economies were in recession and interest rates remained relatively stable. Although Japan remained in recession, the outlook for the Japanese Economy improved and the yen did not fall in value by as much as forecast (see Appendix 1). Exchange rates: Actual (Forecast) 2004 2005 2006 2007 Exchange rate yen per euro 140 145 148 142 Exchange rate dollars per euro 1.16 1.22 1.18 1.10 Cash flow statement January – April 2006 January February March April (Euros) Receipts Sales 281 000 265 000 275 000 342 000 Loan _______ 105 000 _______ _______ Total receipts 281 000 370 000 275 000 342 000 Payments Interest 7 880 7 880 8 650 8 650 Purchases (materials) 204 000 282 000 284 000 432 000 Purchases (fixed assets) 58 000 54 000 Salaries 38 000 38 000 46 000 46 000 Rent 3 650 3 650 3 650 3 650 Office expenses 2 800 2 750 2 900 3 100 Distribution costs 4 120 4 446 5 230 8 657 Other overheads 3 232 3 454 3 566 6 669 Total payments ? ? ? ? Net cash flow ? ? ? ? Opening balance 88 020 ? ? ? Closing balance ? ? ? ? 1. Explain the potential effects on Gadgets2u.com as interest rates go up. (Total 4 marks) ANSWER: Rising interest rates have various economic effects on gadgets2u.com: 1. Increases the cost of borrowing. Interest payments on credit cards and loans are more expensive. Therefore this discourages people from borrowing and saving. People who already have loans will have less disposable income because they spend more on interest payments. Therefore areas of consumption will fall and sales will decline of gadgets2u.com. Furthermore, any existing loan taken up by the company will be more expensive to tender and any new loans will be more expensive as well. Gadgets2u,com may have to seek other sources of financing like selling shares etc. 2. Increase in mortgage interest payments. Related to the first point is the fact that interest payments on variable mortgages will increase. This will have a big impact on consumer spending. This is because a 0. 5% increase in interest rates can increase the cost of a £100,000 mortgage by £60 per month. This is a significant impact on personal disposable income. People will have less spending power and lesser wallet size and overall sales of the company will decline. 4. Higher interest rates increase the value of £ (due to hot money flows) this makes UK exports less competitive reducing exports and increasing imports. This has the effect of reducing Aggregate demand in the economy. Gadgets2u.com will have to rely mostly on the local market to meet its revenues and sales targets or will have to spend more in research and development to make their products more cost effective. 5. Rising interest rates affect both consumers and firms. Therefore the economy is likely to experience falls in consumption and investment. As less people will be willing to invest, there will be lesser investment available for expansion or support of business function of gadgets2u.com- making it harder to grow or even make it go in a slump. 6. Government debt interest payments increase. The UK currently pays over £23bn a year on its own national debt. Higher interest rates increase the cost of government interest payments. This could lead to higher taxes in the future. Gadgets2u.com may have to be prepared or plan for higher taxes to pay that will lead in higher prices of the products and services it furnishes which then again will lead it to be less competitive for exports. Real Interest Rate. It is worth bearing in mind that what is important is the real interest rate. The real interest rate is nominal interest rates minus inflation. Thus if interest rates rose from 5% to 6% but inflation rose from 2% to 5.5 %. This actually represents a cut in real interest rates from 3% (5-2) to 0.5% (6-5.5) Thus in this circumstance the rise in nominal interest rates actually represents expansionary monetary policy. Word count: 458 [4 marks] 2. Identify the potential effect of changes in the euro to dollar and euro to yen exchange rates on the performance of Gadgets2u.com. As the Dollar gets stronger against the Euro, gadgets2u.com will have to pay more for its purchases from the US and purchases in the Europe will be relatively cheaper, keeping everything else constant. Furthermore, as the Euro gets stronger against the Yen, gadgets2u.com will have to pay more for its purchases in Europe, as compared to Japan- which will be relatively cheaper, keeping everything else constant. Gadgets2u.com will have to either source from Europe or Japan to be competitive. Furthermore, gadgets2u.com can have more profits in selling its products and services in the US and will have to re-consider its pricing for Japan as now the Japanese have a weaker currency and will be paying more yens for the companies products and may prefer local products which would be cheaper. Gadgets2u.com operating form Europe can actually benefit from sales revenues by selling more to the US market with a better exchange rate and selling less to the Japanese market with a lower exchange rate. The effects of which can be reversed by the 2007 forecast of the exchange rates- making the currency position a temporary shift in the markets. (Total 4 marks) CASE STUDY # 2 L’Oreal came to China in 1996 and launched all its principal brands, L’Oreal Paris, Lancôme and Maybelline, scoring some big successes. Maybelline is the brand leader for lipsticks in China’s largest cities and L’Oreal Excellence is the number one hair-colouring product. Sales are increasing rapidly and L’Oreal is expecting a 40% increase in sales this year. L’Oreal – an expert in brand development – is leaving nothing to chance. It spends massively on research and development, some £200 million a year (3% of its annual sales). In the highly competitive world of branded beauty products, L’Oreal has been able to segment the market. New products are launched by Lancôme – the up market brand – and then gradually extended into the mass-market brands. Extensive sales of these cover the costs of investment. The corporate focus is on getting sales at every level by simultaneously pushing three brands. L’Oreal Paris sells French sophistication. Maybelline tries to capture the new generation of young, more affluent Chinese who want a bright American look and image. Lancôme, the top luxury brand, is available only in exclusive department stores. L’Oreal’s targeted female customer spends more than 10% of her pay on cosmetics. The L’Oreal slogan – “I am worth it” – suits this young female generation. Chinese women have short eyelashes – so L’Oreal invented a special mascara brush to help sell its products. Also in China, a suntan is not a status symbol, the desirable woman is pale – so L’Oreal sells skin whiteners under the Lancôme brand. In L’Oreal, it is claimed that everything is open to question. Decisions are based on constant feedback from consumers and retailers. The company reacts very quickly if a product is not doing well. [Source: adapted from an article ‘Long march of L’Oreal sweeps into Shanghai’ by Carl Morlished, The Independent (London), 30 October 1999.] 1. Explain two costs and two benefits for Chinese citizens of a MNC operating in their country. (Total 4 marks) The Balance of Payments MNCs import large amounts of capital in order to pay for their new business investments; factories, offices or whatever. This surplus on the capital account creates a deficit on the current account ie the country is importing more goods and services than it is exporting. This lifts local standards of living until the import of capital stops for whatever reason and then standards fall again. If the new business is for import substitution (ie producing locally what had been imported) then imports fall and the current account improves. If the new business is developing local raw materials for export (eg oil exploration) then the exports of raw material also improve the current account. But, the MNC may need to import large amounts of technical equipment not available locally, and this will worsen the current account. If the MNC re-invests its profits then there is no effect on the Balance of Payments, but if it repatriates its profits, the current account worsens. Further, the exchange market of a small country may not be well-developed, so the attempt by a business to buy or to sell large amounts of foreign exchange will send the price of that currency sharply up or down unless things are managed very carefully Employment Generally, MNCs set up new businesses which need new workers and so employment is improved; jobs are created. However, it depends on the skills match between the new jobs and the local employment market. The business may set up a factory specifically designed to suit the local employment market. But in the Middle East oil states, for example, there are many factories producing for the local consumer markets. Sometimes the jobs are too demanding for the locals, and sometimes the jobs are too demeaning. Either way, the result is huge numbers of expatriate workers from India, Bangladesh, the Philippines and so on and at the same time large local unemployment. But, MNCs can sometimes provide devastating competition for local businesses which may end up closing which creates unemployment. MNCs usually employ fewer workers; that is part of their greater efficiency. The MNC may then relocate again after a period of years. Technology transfer An MNC invariably operates to a higher standard of managerial and technical expertise than the local economy. Local employees can learn about these things and the local economy can benefit from this new expertise. Even the UK can benefit, so we are not simply talking about developing countries where technology transfer is enormously important. This will depend on how willing the MNC is to employ and train local workers. Social responsibility Standards and regulations are another kind of business cost, and MNCs are always looking for lower costs. So there is an advantage to locating in countries with few regulations. Some poor countries are prey to corruption and bribery which means their few regulations are ineffective. India, for example, has excellent environmental protection laws, on paper. In practice, the inspectors are so badly paid it only costs a matter of dollars to get them to look the other way. This opens the way for a slippage of standards below the levels considered acceptable in the MNCs home country. Government control It is quite difficult for some governments to exercise effective control over MNCs because they are so large and powerful. One MNC may be the dominant force in the local economy. Even large and wealthy countries such as the UK can’t always control MNCs effectively. They have a wide repertoire of tricks to minimise government control, especially taxes. One favourite trick (technically illegal) is transfer pricing. MNCs often buy and sell between different national offices of the same business, because each is a separate profit centre. For example, the Paris office makes the product, and the Berlin office sells it. So the Paris office has to sell to the Berlin office. There is then the question of at what price the sale takes place. Officially, the selling price must be the market price on the day, but some markets don’t have prices every day, and governments have a difficulty in proving what is going on. If, for example, German company taxes are higher than French company taxes, then the Berlin office will pay too much for the product and make a loss. The Paris office makes a very large profit and pays tax on this profit at the lower rate. When different governments have completely different tax systems, with thousands of detailed rules of how tax is paid, and deductions for this, and allowances for that, the opportunities for MNCs to employ a few clever tax accountants and ‘cook the books’ are enormous. CASE STUDY # 3 Safepac is a small European engineering company, manufacturing and supplying shops with metal display units. Their present factory has a production capacity of 20 000 display units. Safepac has been approached by one of its major customers to supply an additional 12 000 display units, with a possibility of more orders to follow. The Production Manager presents the following data to the owner of the business: Price per display unit $28.00 Raw material cost $4800 per batch of 1000 metal sheets Direct labour per unit $6.4 Fixed costs $252 000 Present output/sales 18 000 display units N.B. One metal sheet is needed for each display unit. To manufacture the extra output, Safepac will need an extra factory, offering increased production capacity of 15 000 cases, but adding $200 000 to fixed costs. The owner of Safepac has recently discussed transferring manufacture of the finished display units to an Indian subcontractor, which would provide the finished product to Safepac at 840 Indian rupees per display unit. The present exchange rate is 40 Indian rupees for each $changed, although this has fluctuated by 10% over the last year. This would transform Safepac into a wholesaler, rather than a manufacturer, and would reduce its fixed costs to $140 000. Inflation is falling in Europe and the Central Bank is thinking of cutting interest rates below that of most countries, and certainly below that of India. 1. Explain the relationships between interest rates, inflation and exchange rates. (Total 5 marks) ANSWER: 1. Differentials in inflation: A country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates. 2. Differentials in interest rates: Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates - that is, lower interest rates tend to decrease exchange rates. 3. Current-account deficits: The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the countrys exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests. 4. Public debt: Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. A large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future. In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds, increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the countrys debt rating is a crucial determinant of its exchange rate. 5. Terms of trade: A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments. If the price of a countrys exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater demand for the countrys exports. This, in turn, results in rising revenues from exports, which provides increased demand for the countrys currency (and an increase in the currencys value). If the price of exports rises by a smaller rate than that of its imports, the currencys value will decrease in relation to its trading partners. 6. Political stability and economic performance: Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries. Read More