Decision in the USA Supercars - Assignment Example

DECISION IN USA SUPERCARS By Presented to Contents Executive Summary 2 Introduction 3 Analysis 3 Legal Risk 7 Credit Risk 7 Transit Risk 8 Buyer Acceptance Risk 8 Conclusion 10 References 11 Executive Summary USA Super Cars has several foreign and one domestic customer, with each customer intending to purchase a number of cars from the firm. However, the Super Cars’ management is approached by HSBC bank’s management, and is offered the opportunity to transfer the transaction to the bank, in exchange for a smaller revenue amount than would be realized if it went on to complete the sale itself. HSBC intends to entice Super Cars into accepting the deal, hoping the car seller is cognizant of the various risks the deal will shield it from. In exchange, the bank expects to earn a profit for entering the deal. The bank presents different offers to Super Cars; the option to receive payment after three months of entering the deal, or receiving the payment after one year. By unleashing these contrasting offers, the bank wants to also shield itself from the effects of uncertainties in the international market, thereby offering Super Cars minimum cushioning from the same. The Super Cars’ resolve to opt for the three-month payment duration presents better value for the firm, and subsequently affirms greater exposure to risk for HSBC. Finally, HSBC evaluates two options with the foreign currency it acquires: to either convert the currency to dollars immediately or after one year. This is done through examining strategies to mitigate effects of currency value fluctuations that the bank could use. Introduction The USA Super Cars sells luxury sports cars to buyers in different destinations around the world. Over the next one year, the firm will be expected to supply the UK, Japanese, Canadian, South African and the local US markets with sports cars. In order to determine the expected prices of the products at the time they will be shipped to requested destinations (the cars will be required exactly one year from now), the firm has taken forecasted estimates of the dollar’s exchange rates against the foreign currencies in the target markets. This way, it is possible to fairly estimate the amount of revenue expected from the sales, considering both the lower and upper bounds for the same. This report examines the value of the offer presented by HSBC to USA Super Cars, its ability to cushion the latter from expected risks and the ability to generate a profit for HSBC. Analysis Date of birth used: 2nd May, 1994. The figure 94 has been used for the year to avoid exaggerated deflation of prices where applicable. Using these dates of birth, the completed table is obtained as follows: Table 1. Exact figures determined using birth details. Worldwide Orders Exchange Rate to USD Customer Quantity Selling Price Mean Std. Deviation UK 12 £57,500 $0.28/£ $0.041/£ Japan 1 5 ¥8,400,000 $0.0045/¥ $0.00045/¥ Japan 2 3 9,000,000 $0.0045/¥ $0.00045/¥ Canada 1 1 CAD 97,000 $0.0088/CAD $0.0342/CAD Canada 2 3 CAD 100,000 $0.0088/CAD $0.0342/CAD South Africa 2 R4,100,000 $0.0211/R 0.00083/R USA 1 $100,000 From the figures in the table we work out the necessary calculations as follows: 1) The distribution and mean/ standard deviation of total revenue is obtained by working the total expected revenues for the total vehicles ordered. Table 2. Extended calculations on the prices of component orders. Customer Quantity Selling Price Mean Std. Deviation Price (in USD) Total (USD) UK 12 £57,500 $0.28/£ $0.041/£ 205,357.143 2464285.72 Japan 1 5 ¥8,400,000 $0.0045/¥ $0.00045/¥ 37,800 189,000 Japan 2 3 9,000,000 $0.0045/¥ $0.00045/¥ 40,500 121,500 Canada 1 1 CAD 97,000 $0.0088/CAD $0.0342/CAD 853.6 853.6 Canada 2 3 CAD 100,000 $0.0088/CAD $0.0342/CAD 880.0 2,640 South Africa 2 R4,100,000 $0.0211/R 0.00083/R 86,510 173,020 USA 1 $100,000 100,000 100,000 Total 27 3,051,299.32 The overall mean is 113,011.1 and the standard deviation is 85,692. The distribution of the total payments is obtained from the standard error of the total revenue expected, using the formula: = 85692/ √27 = 16,491.4 Note: s is the standard deviation of the selling prices; n is the number of cars ordered by buyers. Therefore, the distribution of the total revenue is 3,051,299.32 ± 16,491.40 = [3,034,807.9, 3,067,790.72]. Note: In these calculations, the totals are subsequently divided by n = 27 (the number of cars that have been ordered by the domestic and foreign buyers) in order to work with the formula for z-scores. 2) (a) The probability that the revenue will exceed 2,200,000 is determined using the formula = (81,481.48 – 113,011.1) / 16,491.40 = -1.912, equivalent to the probability 0.027946. The probability that the total revenue exceeds the stated benchmark is (1 – 0.028) = 0.972. This is the probability that the total revenue collected exceeds $2,200,000. Note: z is the standard score of individual average sales’ revenues, x is the particular sales value for which a standard score we are seeking, µ is the calculated average revenue from the sales, and σ is the standard deviation of the prices about the mean. (b) Next, we calculate the probability that the revenue will exceed the 2,225,000 benchmark. Using a similar procedure as above, we obtain: z = (82,407.41 - 113,011.1) / 16,491.40 = -1.8557, with the probability 0.031748. Therefore, the probability that the proceeds of the sales exceed $2,225,000 is (1 – 0.032) = 0.968. 3) (a) The probability that the revenue will be less than $2,160,000 is determined as demonstrated below. Using the formula: again, we have (80000 - 113,011.1) / 16,491.40 = -2.0017. The actual probability from this z-score is 0.022659. Therefore, the probability that the revenue collected from the sales is 0.022. (b) We now work out the probability that the revenue will be less than 2,130,000. Again, this is obtained from the z-score. (78888.9 - 113,011.1) / 16,491.40 = -2.07. The z-score has a corresponding probability 0.019226, implying that the probability that the likelihood of getting revenues below $2,130,000 is 0.019. 4) HSBC has offered to deposit with US Super Cars a sum of $2,150,000 in exchange for the total revenues due to the company. There are several factors to consider in determining the viability of this estimate; whether it is bound to save US Super Cars more troubles in terms of uncertainty in the market. In order to determine whether the offer by HSBC is productive for the firm, we need to establish whether the figure falls within allowable margins for probabilities of the total revenue we US Super Cars expects. We use the same formula: to determine the probability that the revenues would be less than the offered amount. z = (79629.6 - 113,011.1) / 16,491.40 = -2.024. This z-score corresponds to the probability value 0.021485. There is only a 2.15% chance that the revenues earned from the sale of the cars will be less than $2,150,000. This probability is quite small. The company would rather consider much higher risks, such as from 30% and above. For that reason, the figure 2,150,000 falls within extremely conservative margins for US Super Cars, and is, therefore, not totally considerate of the fact that the firm could still generate revenues higher than this with a 97.85% likelihood. The offer is not good for the company. 5) Risk aversion is the tendency of individuals to accept a bargain that has lesser payoff but which poses lesser risk, than one that poses greater risk with a higher payoff clause (MathWorks 2014). In the case of US Super Cars, the sales manager appears content with the rather smaller but guaranteed offer of $2,150,000 from HSBC. However, the CEO has a different opinion, holding that the company should sell the cars and collect the proceeds itself. The consideration made by the company’s sales manager befits the definition of risk aversion stated above. Therefore, the sales manager is more risk averse than the CEO. 6) HSBC is taking several risks in attempting to guarantee US Super Cars the amount in exchange for the rights to sell the vehicles on behalf of the company. The more obvious is the risk of fluctuations in exchange rates between the foreign currencies and the US dollar. Other risks include legal risk, interest rate risk, credit risk, transit risk and buyer acceptance risk. Each of these risks has its basis as discussed below. Legal Risk This is the risk arising form litigations initiated by interested parties, including the destination country’s government, recipient’s shareholders and management, and shareholders of the company that allows another to transact on its behalf (in this case US Super Cars’ shareholders). These parties may raise queries in case the process used to hand over the transacting rights to HSBC are flouted or breached. It may arise from improper instructions from the company’s legal representatives, changes in the constitution of the benefactor, unearthing improper conduct such as coercion in securing the deal, or changes in the foreign exchange control policy of the destined market for the goods. The company has several ways of mitigating the effects of such proceedings (and, by extension, their potential harm on the balance sheet) by comprehensively studying the contract documents and any governing laws in the home and foreign market. Luckily, the cars cannot be classified in a category that earns interest rates. As such, this risk is not borne by the bank when taking over the transaction from US Super Cars. Credit Risk In the current setup, the bank has offered to advance cash to the US Super Cars and bear any oncoming costs after the transaction is sealed. In this way, the bank appears to be advancing credit to the car seller. By extension, the bank will incur any costs associated with faulty cars transported to the foreign markets. Furthermore, the intended buyers may fail to deposit the agreed amounts into the seller’s bank account, creating a credit-risk situation. Transit Risk These are the risks associated with transporting the cars from the source to the intended markets. If the cars are delayed, the companies may initiate a chargeback on the bank. This may be extremely expensive. Other uncertainties along the transit route include piracy (which may lead to theft of the goods) and loss of goods. Buyer Acceptance Risk The buyers may fail to accept the goods sent to them for many reasons. They may feel that the products grossly misrepresent what they were made to believe, or the goods may have been involved in accidents, which make them lose their default value. In this case, the bank would bear the risk for such inconveniences based on the opinion of the buyers. 7) The two firms are faced with a payment situation in which to make a choice between payments in three or twelve months. In order for each firm to decide on which method is more preferable to it, it must consider the risks associated with their decisions, and the value they get for the choice. If the bank were to decide to pay US Super Cars within three months, then it will be left with lesser chances for initiating recourse in case the cars transferred to it are faulty, or the buyers recede on their initial commitment. However, a similar arrangement would be to the benefit of US Super Cars. For them, the risks associated with uncooperative buyers, legal undertakings, credit transfer and transportation would be avoided by signing into such a deal. Again, the agreement would offer the requisite value for transferring their rights to HSBC. Twelve months from the moment, the cars will be transported to the ordering entities. In the event that an agreement is made for the bank to remit the agreed amount to the car seller’s bank account after twelve months, the bank will have effectively avoided any risks associated with unpredictable buyers, transit, legal and credit transfer. These costs will then be borne by the car seller. Such an arrangement does not provide the US Super Cars with enough reasons to transfer their rights to the bank. The arrangement has no additional value to US Super Cars, and the car seller is more likely to refuse to sign into the deal. 8) With USA Super Cars having accepted to sign into the deal to allow HSBC to continue with the transaction on in its place, the bank effectively bears all the aforementioned risks; legal risk, currency exchange risk, credit risk, transit risk and buyer acceptance risk. While no figures currently exist to help us determine what the values of the other risks would be, it is possible to calculate the risk associated with currency exchange fluctuations. Assuming that the bank sells the cars at the prevailing exchange rates, the probability that the bank will likely incur a loss can be determined using the amount it transferred to US Super Cars in order to gain the rights. The cost is 2,150,000, and the probability of selling the cars at a price below this amount is 0.0215 (or 2.15%) as determined in section four above. 9) The statement indicates that the bank considers the value within the bottom 5% to be at risk. This way, we need to know the value representing the 5%. The situation indicates that the probability (p) determined by the unknown z-score equals 0.05. Using the z-tables we obtain a z-value of -1.64485 to correspond to this probability. Now, we extend this value to the formula: , with x being the unknown value. This gives us: -1.64485 = (x - 113,011.1) / 16,491.40. x = $85885.22 × 27 (since there are 27 cars to sell at this value) = 2,318,901. Having offered a price of $2,150,000 to USA Super Cars, the VAR for HSBC is (2,318,901 – 2,150,000) = $168,901. Maintaining a constant exchange rate, the expected profit for the bank is (3,051,299.32 – 2,150,000) = $901,299.32. 10) If the bank decides not to convert all or part of the currency obtained through the transaction within twelve months, it may consider options that will ensure that it does not lose in value eventually. One such approach is through hedging. Apparently, the bank has no control over whether fluctuations occur in the currency markets, and the amounts of fluctuations experienced. For that reason, it is wise to engage in fund hedging as a means of mitigating the impacts of such fluctuations. Alternatively, the firm may decide to purchase commodities in markets within countries whose currency it holds. This will enable the company to acquire goods at relatively constant prices, since domestic markets are rarely influenced by currency fluctuations, especially when the local market is not entirely or substantially reliant on imports (Trapani 2013). Conclusion USA Super Cars has been presented with a great opportunity to cushion it from the risks presented by trading with international partners. Some of the risks that company is exposed to include legal risk, interest rate risk, credit risk, transit risk and buyer acceptance risk. Through engaging HSBC bank to proceed with the transaction in exchange of forfeiture for some of the expected revenues, the bank takes up the risks and gets the opportunity to make a profit in the transaction. By examining the probabilities of both selling below or above certain benchmarks, the two firms are able to plan for the impending transaction in light of their own targets for revenues and profits. That way, they are able to decide whether engaging in the transaction is worth their time and money or not. Effectively, the deal by HSBC to pay $2,150,000 to Super Cars is validly valuable for both firms. References MathWorks. 2014. Financial Toolbox: Portfolio selection and risk aversion. [Online]. http://www.mathworks.com/help/finance/portfolio-selection-and-risk-aversion.html. (Accessed 23rd November 2014). Trapani, L. 2013. Trade risk management: A global approach. World Customs Journal. 6(2): 101–106. Read More