Situation: A small Canadian company has contracted to purchase 100,000 toys for
ID: 430631 • Letter: S
Question
Situation:
A small Canadian company has contracted to purchase 100,000 toys for £ 3.50 each from a British toy manufacturer. The Canadians have agreed to pay in pounds sterling. The Canadians have also agreed to sell the toys to a US company for $5.50 US per toy. The Canadian company has agreed to accept US dollars but plans to convert these revenues to Canadian dollars. The Canadian company estimates its marginal costs for warehousing, distribution, etc. is C$.75 per toy.
Question 4: a) What impact would a devaluation of the US dollar relative to the British pound have on the Canadian company's profits? b) What impact would a revaluation upward have?
Question 6: What could the Canadian company do to minimize its exposure to exchange rate losses?
Explanation / Answer
It must be noted that expenditure incurred by Canadian company are in :
Revenue earned by Canadian company is in :
Whereas , the books of accounts and therefore profitability will be calculated in terms of Canadian Dollars.
It thus can be seen that there is a great mismatch amongst currencies in which the company earns and spends making it very difficult to forecast its profit in Canadian Dollar due to uncertainty in exchange rate fluctuations amongst US Dollars, Pound Sterling and British Pounds. Devaluation or revaluation ( i.e. appreciation ) of one currency against any other( s) will affect the profitability in Canadian Dollar.
Devaluation of US Dollars against British Pound will result in reduction in value of sales compared to the purchase price since purchase price in terms of US Dollars will go up and thus reducing profitability of the company.
Similarly upward revision of US Dollar against British Pound will result reduction in purchase price in Dollar terms and thus will increase profitability of the company
What needs to be done by the company is to hedge its currencies i.e. British Pounds to Canadian Dollar as well as US dollars to Canadian Dollar forward so that there is certainty in terms of value of sales and value of purchase expressed in Canadian Dollars and thus resulting in certainty on its profitability.There are standard “forward covers” available in financial market for Canadian Dollar vs GBP as well as Canadian Dollar vs USD which company must avail . This action will minimize its exposure to exchange rate losses .