How Increased Level of Cost of Depreciation on Firms Tangible Assets Reduces Return on Investment - Case Study Example

Archers Organic Foods Plc Here of Table of Contents Table of Contents……………………………………………………………………........2 1.0 Abstract …........................................................................................................3 2.0 Introduction …..................................................................................................3 3.0 Discussion……………………………………………………..................................4 4.0 Conclusion ……………………………………………......….................................9 5.0 Recommendations............................................................................................9 References………………………………………………………………………….……..10 Appendices ………………………………………………………………………….....….10 Abstract Without a doubt, the issue of foreign exchange exposures through loss of economic value leads to high losses in firms’ value as the management seeks to maximize the profitability, net cash flow and market value of the firm. More significantly, foreign exchange rates get exposures to translation, transaction, and economic exposures depending on the market prevalent exchange rates in the foreign exchange market. With the existence of increased exchange exposure risks among companies that operate globally, different current and uprising fluctuations in the foreign exchange rates influence its growth (Allayannis and Ofek, 2001). As a result, most companies’ analysts undertake a thorough analysis of the foreign exchange markets, which reflects the increased significance of monitoring the effects of the fluctuating exchange rate as it affects individual firms’ profitability levels. Considerably, the management of Archer’s Organic Foods plc should ensure that they undertake measures against increased influence of foreign exchange risk and interest rate risk as it remains paramount for the sustainable survival of the entire business entity in the highly volatile foreign markets. Introduction The Archers Organic Foods plc management is interested in undertaking investment decisions that will increase its profitability levels, thus avoiding any losses that might arise from its expansion to France due to increased risks of foreign exchange exposures. Considering the market sensitivity to exchange rate exposures, it is radical to undertake a decision based on foreign exchange exposures that are more likely to occur in terms of a regression of asset value on the exchange rate. As a company considering undertaking investment projects that will increase their profitability levels, the management of Archer’s Organic Foods plc should consider the increased possibility of accounting, operation and strategic exposures that could arise from increased foreign exchange rate fluctuations. More significantly, the possibility of increased volatility of the financial markets as Archer’s Organic Foods plc seeks to undertake increased expansion growth allows for unexpected movements in exchange rates and interest rates within the different foreign markets (Elliott, Huffman and Makar, 2003). More importantly, the increased free movements of cash flows and profits generated from trading with France increases the likelihood of foreign exchange exposures. With the growing global competition, the increased likelihood of foreign exchange exposures through increased unanticipated movements with the foreign currency trading can cause very large gains or losses if the risks remain largely uncontrolled. As a result, the company’s management should seek to undertake increased measures through increased use of foreign currency derivatives and other hedging instruments that are more likely to mitigate the risk of foreign exchange losses affecting the firm’s asset value. Foreign Exchange Rate Exposures More often than not, foreign exchange rate exposures have been measured as the sensitivity of the market value of the firm to increased unanticipated fluctuations of foreign exchange trading. As a result, the increasing likelihood of loss by one point two percent in the exchange of Euro for Sterling, even as the management intends to increase its dominance in extending its production facility, is more likely anticipated as a risky expansion venture. Nonetheless, as the management considers the effects of the foreign exposures, it is necessary to consider the influences of cost exposure, operating revenue and operating cash flow margin on the general outcome of the company’s profitability levels. More significantly, the decision to undertake expansion to other countries using different currencies should be geared towards boosting the cash flow position of the prevalent state (Simi and Mozumdar, 2003). In most cases, the increased use of foreign currency hedging as a way of reducing currency exchange exposures depends on the firm’s increased responsiveness to the exchange rates movements on the company’s market value. In addition, the level of foreign currency exchange loss will be influenced by the amount of foreign revenues and costs that are more likely to be affected by the increased exchange rates movement (Elliott, Huffman and Makar, 2003). As a result, Archer’s management should consider the setting up of the production facility for the organic foods at a location likely to increase the profitability levels of the company. More often than not, foreign exchange exposures occur through transaction exposure as one of the most apparent and easily identified form of exposure. This is because all business entities run transactions daily, thus transactional exposure remains highly related to the flows of funds that can be easily traced at the process of pricing, order placement and eventually payments that are made to the current accounts (Shapiro, 2010). As a regular service industry dealing with production of organic foods, the management of Archer’s should be ready to face increased transaction exposures as it trades with different currencies. On the other hand, economic exposure remains a long-term effect measure as it measures changes on the currency exchange rates on a long-term basis as it extends its effects on the cash flows revenues and cost not realised through influences of future sales volumes, prices and input cost. More importantly, economic exposures can be aligned using natural hedging, as it relates to future operative earning and future operative costs. On the other hand, translation exposure relates to transactions of funds that are non-cash based on the assets and liabilities shown in the balance sheet to be cleared (Elliott, Huffman and Makar, 2003). As a result, translation exposure is referred to as net balance position exposed to trading risks based on the currency exchange rates. In most cases, the hedging measure undertaken depends on the cause of the risk through either transactional, economical or translation exposures that highly differ depending on the volatility levels of the exchange rate. Importantly, hedging strategies depend on increased transactional costs that are highly affected by the transactional cost of the firm expanding because of large volumes affected by increased exchange rates deviations. Nonetheless, Archer’s management should not only focus on the prevalent exchange rates but also on the costs to be incurred during the payments for products exported or imported from other countries that require foreign currency conversion. It is essential to understand that foreign currency hedging as an exposure management practise is more practicable when the company can gain a competitive advantage using the varied currency denomination over a specified period. In most cases, firms with lower volumes in the exchanging country undertake the full risk of foreign exchange exposure because it will reduce a specified firm’s volatility as compared to others. However, in most instances companies can undertake short term hedging through the stock market as it remains viable when they are faced with market inefficiencies in their transactional costs (Simi and Mozumdar, 2003). As a company located in the European market where its market is not closed, Archer’s Organic Foods plc should be more ready to face both positive and negative exposures that have an increased effect on the irrelevance of undertaking hedging because it does not affect the investor’s portfolio levels. However, it is necessary for the Archer’s Organic Foods plc management to use hedging in cases where it increases the firm’s value especially through currency derivatives. More significantly, the increased use of borrowed facility prevailing at the current exchange rates of six percent would lead to increased availability of transactional exposures. The use of currency derivatives in trading affects the cost of capital especially when used together with other operational and economical factors that affect the firm’s value. As a result, hedging remains one of the efficient tools supported by shareholders to control foreign exchange exposures, as it reduces the level of cash flow volatility and does not prevent companies from undertaking growth opportunities. In addition, companies that show economies of scale in hedging costs have a competitive advantage, thus allowing investors to make an accurate prediction when valuing cash flow because of its negative volatility. As a way of controlling influences of increased foreign exchange exposures, it remains essential for the management of the Archer group of companies to take into consideration the principles of hedging. An estimate of future transaction exposures over specified periods through the expected plan of exposures will also lead to an increased expansion process. As a result, the estimate of the net exposure can be hedged through increased local borrowing through spot exchange or forward contracts. In case the management of Archer intends to undertake long term foreign investments in France, there is a need for them to implement operational hedging strategies in managing the increased likelihood of long-term foreign exchange exposures (Shapiro, 2010). On the other hand, the financial hedging strategies remain as the viable option of mitigating sales and production operations as it hedges foreign exchange risks in the short run. As Archer’s management’s resolution is geared to increasing the profitability rates for the shareholders value, the effects of increased foreign exchange exposures based on the fluctuations in the exchange rates influence results in shorter distances between individual entities. In addition, it remains essential for proper prediction of the effect of the changes in the shareholders value because of increased expansion globally. In most cases, borrowing capital from available sources of income in international companies has become more relevant as the organizations expand through the globalization of markets as it undertakes the increasingly changing dynamics of increased expansion. Archer’s management has to focus more on the increased gain from its foreign trade as it emphasises the success of organizations by mitigating the likelihood of foreign exchange losses through forecasting on increasing the shareholders wealth. Even though Organique is a company that has increased opportunities of investment, it remains critical for Archer’s management to undertake increased expansions of its dominance in France. Conclusion Organique as a company with an increased level of its cost of depreciation on its tangible assets reduces the revenue of its shareholders return on investment. As a result, the unexpected influences of foreign exchange exposures are not likely to meet the required high returns expected by the directors of a hundred percent premium (Moles and Bradley, 2002). Taking into consideration the increasing size of firms that have a well-diversified company with lower volumes in the exchanging country, Archer will have to undertake the full risk of foreign exchange exposure after it acquires Organique because it will reduce its specified firm’s volatility as compared to others. Recommendations It is advisable for Archer to undertake its investments based on mitigating risk levels using short term hedging through the stock market, as it remains viable when they are faced with market inefficiencies in their transactional costs. It is necessary for the Archer’s Organic Foods plc management to use hedging in cases where its investment in a new foreign entity increases firm’s value especially through currency derivatives. The use of currency derivatives in trading affects the cost of capital especially when used together with other operational and economical factors that affect the firm’s value. Hedging remains one of the efficient tools to control foreign exchange exposures, as it reduces the level of cash flow volatility and does not prevent any company from undertaking growth opportunities (Allayannis and Ofek, 2001). In addition, companies that show economies of scale in hedging costs have a competitive advantage, thus allowing investors to make an accurate prediction when valuing cash flow because of its negative volatility. As a way of controlling influences of increased foreign exchange exposures, it remains essential for the management of the Archer group of companies to undertake mitigation measures to control losses from foreign exchange exposures. More significantly, an estimate of future transaction exposures over specified periods before undertaking the expansion process remains relevant as the estimate of the net exposure can be hedged through increased local borrowing through spot exchange or forward contracts. References Allayannis, G. and Ofek, E., 2001. Exchange rate exposure, hedging, and the use of foreign currency derivatives, Journal of International Money and Finance, 20, pp. 273-296. Elliott, B., Huffman, S. and Makar, D., 2003. Foreign-denominated debt and foreign currency derivatives: complements or substitutes in hedging currency risk? Journal of Multinational Financial Management, 13, pp. 123-139. Moles, P. and Bradley, K., 2002. The nature and determinants of economic currency exposure of non financial UK firms, Managerial Finance, 28 (11), pp. 1-15. Shapiro, A., 2010. Multinational financial management. 9th Edition. New York: Wiley. Simi, K.and Mozumdar, A., 2003. Foreign currency-denominated debt: an empirical examination. Journal of Business, 76, pp. 521-546. Appendix 1 Risk Free return= Risk free rate + Beta (Market rate – Risk free rate) Rf = 0.04 + 1.7 (0.05- 0.04) Rf= 0.04 + 0.017 = 0.057*100 =5.7% Ratio analysis based on Abridged Company financial statements Ratio Formula 2012 2011 Gross profit margin Gross Profit / Net Income 1410/646 =2.183 1284/472 = 2.720 Net profit margin Net income / Sales 646/ 7884 =0.0819 472/6780 =0.0696 Cash Flow Margin Cash flow/ Net Sales 140/451 = 0.310 136/290=0.469 Return on Assets Ratio Net income/ total average asset 646/ 2178 = 0.2967 472/ 1843 = 0.2561 Return on Equity Ratio Net income/ average stockholders’ equity 646 / 700 = 0.9229 472/ 1400 =0.3371 Read More