QUESTION

The Ruritanian Project

Your company, which is headquartered in the United Kingdom, is considering setting up a new manufacturing facility in Ruritania. Ruritania is a politically stable, economically developing Eastern European country.

Although, last year, the annual growth rate was only 0.7%, the annual growth rate has averaged around 6% per annum over the last five years.  The rate of price inflation has been stable, averaging 5.2% per annum over the last five years.

Although Ruritania does not have a long tradition of democracy, Governments have been democratically elected for the last twenty years and new elections are due in Ruritania in approximately nine months’ time. There are two major political parties in Ruritania and recent opinion polls suggest that the present Government currently enjoys a 7% lead over the other major party. This opinion poll lead has remained reasonably stable for the last eight months. The other major party is also committed to democratic principles and a market based economy although, if elected, it is likely that they would increase both corporate and personal taxation to provide additional funding for their proposed social expenditure.

The Crown (the currency of Ruritania) traditionally had a centrally managed exchange rate, but the Ruritanian Government allowed the Crown to float freely about twelve years ago. This, initially, resulted in a fairly large drop in the value of the Crown, but the Crown has enjoyed reasonable stability against major international currencies during the past three or four years. There has been persistent press speculation that the present Government will peg the Crown against a major international currency within the next few months.  This would be a preparatory step prior to applying for inclusion in ERM 2 and, eventually, adopting the Euro as a full member of the Eurozone.

Ruritania is currently negotiating for membership of the European Union and hopes to join in about 2014.

The total investment is expected to be, approximately, GBP 55 million.  The total Market Capitalisation of your Company is around GBP 600 million.

The reasons for this proposal are to benefit from the low labour cost currently experienced in Ruritania and to establish a presence in the region, partly in order to deny these markets to your company’s global competitors. Foreign investment of this nature represents a new venture for your company. In the past, all manufacturing has been done in the United Kingdom, as the Board of Directors has considered foreign investment to be more risky than home investment.

Question:

As the company’s Treasurer, you have been asked to draft a report, outlining the financial issues that you believe are important to this decision. Other members of the company’s management team are reporting on non-financial issues such as marketing and competition, operations management and human resource management and you can disregard these issues, except where they impinge on financial issues.

The report should make use of theory and appropriate indicative calculations where these help to expand or explain your discussion. The use of graphs, diagrams and other means to assist with the development of your discussion is encouraged.
You should include appropriate conclusions. These conclusions should be based on the discussion in the body of the text.

SOLUTION

1. Introduction

The company head quartered in the United Kingdom is considering Investment in the Ruirtania in Eastern Europe, Ruirtana is a developing country in Eastern Europe. Ruirtania can also be described as a transition economy just like other eastern European economies like Poland and Hungary. The company is considering setting up a new manufacturing facility in the country, for this purpose it has undertaken the analysis of the potential risks and profits that pose for the firm. The organization has considered foreign investment as more risky and therefore has never under taken the proposition. The purpose of the analysis is to understand the potential risks and returns that exist for the firm.

The paper understands and highlights the pros and cons of the investment being considered in Ruirtana. A critical analysis of the environment has been undertaken for the purpose in the discussion below.

2. Environment Analysis

To understand the macroeconomic environment the critical analysis is the most suitable. The analysis would enable to develop some clarity on the actual position of the environment and determine the suitability for investment.

2.1 Economic Policy of the Government

Foreign Direct Investment is a forward looking activity for the investors and therefore the examination of the political stability is a key factor in ensuring investor confidence in the capabilities of the host country. The political instability is likely to have an impact on the currency value of the country, thus eventually reducing the value of assets in the country affecting profitability. There are two main risks that can be associated with political conditions determinant of the economic policy of the country.

I.          Firstly, the war or conflict reduce the neighbouring countries reduce the profitability of operations in the country. This kind of instability does not only impact the manufacturing but also has an impact on the growth of sales and exports of the country thus reducing the profitability of the country.

II.          Secondly, the political instability is an indicator of the economically inefficient policies. The direct implication of the political instability is no attention been given to the economic growth and the policies undertaken by governments. There is growing literature which indicates that the political stability has a direct impact on the economic performance of the country.

(Brada et al, 2005)

In the case of Ruirtana the country under consideration for investment has had relatively stable political conditions with the governments being democratically elected. The impact of the political stability is evident on the growth of the economy as over the last 5 years the economy has registered the growth of 6%. With elections due in 9 months in the country and the indications given by the political parties on the change in the economic policy that could adversely impact the profitability of the investment is an indicator of the potential risk to the investment.

Therefore, it is advisable to the corporation to consider the investment once there is clarity on the economic policy being undertaken by the government after the elections.

2.2 Inflation and Growth Rates

2.2.1 Inflation

Like Poland and Hungary Ruirtana is also an example of a transition economy. As the transition economy are increasingly focussing on de regulating their economic structure the impact inflation the growth rates of the economy cannot be ignored(Gillman and Harris,2009). According to Akinboade, Siebrits and Roussot low inflation is an indicator of the economic stability of a country. On the other hand a high inflation reflects the inability of the government to maintain a balance between budget and central banks monitory policy position. Therefore most analysts and researchers believe inflation to be an indicator of the economic and political stability of the economy.

(Kiat,2007)

Considering the above case of the inflation rate in the Ruirtian economy has been maintained at a steady rate of 5 %. While in comparison the country of current operation i.e. the United Kingdom has experienced fluctuating rates of inflation.

Figure 1: UK Inflation Rates 2008-2012 (Source – Trading Economics.com , accessed on 7/5/2012)

Figure 2 : Inflation Rate of Ruirtian economy 2008-2012(Source : Case Study accessed on 7/5/2012)

The fluctuation in the inflation rate is clearly evident, it should be noted that the inflation rate in the British economy is on a decline and has declined from the peak of over 5.2% to 3.5% in 2012. On the other hand the Ruirtian economy has experienced a steady rate of inflation over the past 5 years. The high rates of inflation in the British economy were the consequent results of the economy’s poor performance owning to the financial crisis. On the other hand the Ruirtian economy which is a developing economy in the Eastern Europe has registered a high growth rate of 6% over the past 5 years and maintained a steady inflation rate as well. Therefore the investment opportunity should be further evaluated taking in account the other factors as well.

2.2.2 Growth Rate

The Ruirtian economy which is a developing economy in the Eastern Europe has registered a high growth rate of 6% over the past 5 years whereas in comparison the British economic growth rate has been very sluggish as Britain has been adversely affected by the financial crisis. The Economic growth can be defined as the measure of productivity of the country , the economic growth is dependent upon the efficient allocation of resources like labour forces , stock of capital and technology. This growth and increase in the productivity has been reflected by the Ruirtian economy in the past 4 years but has experienced a major decline last year when the economy grew only at the rate of 0.7%. Thus an examination into the reason for the poor growth should be accounted by the corporation before undertaking the investment.

Figure 3 : Growth Rate of the UK Economy 2008-2012(Source- Tradingeconomics.com – accessed on 7/5/2012)

The British economy appears clearly in crisis with the consistent negative growth performance from 2007 onwards. From 2007 onwards there seems to be a minor improvement in 2010 but 2012 is also reflecting the same negative growth performance. The negative growth performance is a clear indicator of the low productivity of the British economy. The sector which has suffered the most because of the low productivity is the manufacturing sector whose growth rate has declined from 21% in 1996 to 12 % in 2008 , Thus the manufacturing sector reflects inefficiency and therefore the manufacturing companies have to look for more efficient sources of production for this purpose the investment in the developing economy seems ideal(postrecession.files.wordpress.com(2009) – accessed on 7/5/2012)

2.2 Net Present Value Analysis and Internal Rate Analysis

The NPV and the IRR produce the same results if the investments are independent of each other. An independent investment implies that the cash flows from one project do not affect the cash flows of the other project or investment. Thus in such a case when the investments are independent of each other the cash flow remains the same they can be discounted eventually producing the same results or both NPV and IRR. Therefore, after determining the nature of the investment and the potential cash flows that the investment is bound to generate the NPV as well as the IRR are suitable analysis to determine the undertaking of the investment. As in the case of most capital budgeting decisions the NPV is a better measure to evaluate the present value of the investment as it accounts both time value of money and takes cares of long term goals and profitability considerations.

(Bringham et al, 2009)

In the above case is a case of a long term capital budgeting decision being undertaken by the firm with the total investment estimated at GBP 55 million and the market capitalization expected at GBP 600 million. The investment is highly levered therefore an NPV analysis is very important to account for the potential risk associated with the decision. The NPV would determine the current value of the investment as well as determine the payback period of the project which would give a clear picture of the investment circumstances and enable sound decision making by the firm.

The NPV analysis gives has the following advantages and therefore is a better determinant of the value of the investment undertaken by the corporation.

I.          Firstly, the Net present value would clearly indicate if the investment would increase the value of the firm in the future or not.

II.          Secondly, The net present values accounts for all the cash flows therefore is a true representation of the value of the firm in dollar terms

III.          Thirdly, it accounts for the time value of money and discounts it at the current rate; this enables comparison of the current value and the future value of the investment.

IV.          Fourthly, the NPV considers the cost of capital and then accounts for the results.

The capital budgeting decisions under take by the firm are crucial decisions as they determine the long term profitability and efficiency of the firm. Therefore the capital budgeting decision should be taken after a careful evaluation of the investment proposals. The investment proposals are evaluated using  the NPV .The case of most capital budgeting decisions the NPV is a better measure to evaluate the present value of the investment as it accounts both time value of money and takes cares of long term goals and profitability considerations.

2.3 Currency

In the past there has been widespread debate of the exchange rate stability and its impact on the FDI. Today the economists globally have determined the existence of an interdependent between the two. Most argue that when the currency of a country de values it is the opportunity for the corporation to procure assets lower prices. This is especially true when the FDI firms have predetermined targets for the host countries and have clear investment targets. Then the devaluation gives them an opportunity to attain their target assets at a subsequently lower price (Kiat , 2007)

In the case of the Reutarian economy , the crown which is the currency of the country has maintained the Crown has experienced a recent drop in the value after maintaining stability in the past two or three years with the world currencies. The devaluation of the Crown makes the Reutarian economy an attractive investment prospect at it gives opportunity to the firm to acquire assets at a relatively lower price, which would prove to be profitable for the organization.

However the speculation in the market proves to be potential risk for the market where the Crown is being considered being pegged to another currency, this would introduce greater risk for the corporation and thus may drive the value of the currency upward where by the corporation would lose the advantage of acquiring assets at the potential lower prices.

Moreover the government’s decision to apply for Euro Zone membership is a step in the positive direction by the government. As the members of the Euro Zone enjoy certain investment advantages provided to them by the Eurozone pact. Moreover it also offers attractive investment deals to the British corporations for investment in the zone. This procedure is however long and would only be accomplished by 2014. Thus the firm has to determine if it has to undertake the investment now or after the conversion of the economy into EURO ZONE. The EURO ZONE is a more resilient exchange rate mechanism and is not likely to be affected by the major fluctuations in the exchange rate systems.  The European central bank has focused more on the economic conditions of the community and therefore has had less volatile interest rates in comparison to Britain. The single currency would give the Retuarian economy the status of other developing economies in the zone like Poland and Hungary thus making a powerful player in the global economy along with the other developing countries.

(historylearningsite.co.uk – accessed on 7/5/2012)

Therefore the potential risks and the strengths of the investment in the Retuarian economy have been appropriately highlighted in the analysis. The firm should understand and identify each of the potential risk and undertake a sound decision which would increase the profitability of the corporation on the long run.

3. Conclusion

The investment under consideration is a long term capital budgeting decision under discussion moreover so because the corporation has never undertaken such a decision in the past. The corporation has refrained from FDI as it has identified it as a high risk proposition. The FDI may be risky investment but the potential high returns from the investment cannot be ignored especially in the current decision making.

With British manufacturing sector struggling and the Reutaria offering a low cost high profitability proposition the investment can be undertaken. The corporation should undertake all factors of exchange rate volatility, political stability as well as the inflation and growth rates into account before arriving at the decisions. The impact on the current financial crisis also cannot be ignored as the British economy is struggling and Europe is struggling with the Greek Debt crisis. Therefore the decision to invest should be based on appropriate knowledge of all the economic factors and political factor. Based on an effective risk return analysis the decision of the investment should be undertaken.

4. References

• Brada, Joseph, Ali Kutan, and Taner Yigit. “The Effects of Transition and Political Instability on Foreign Direct Investment in ECE Emerging Markets *.” UNECE. 1.1 (2005): 1-37. Print.
• Gillman, Max, and Mark N Harris. “The Effect of Inflation on Growth: Evidence from a Panel of Transition Countries.” NSTITUTE OF ECONOMICS, HUNGARIAN ACADEMY OF SCIENCES 12.1 (2009): 1-27. Print.
• TradingEconomics.com, and UK Statistics. ”           United Kingdom GDP Growth Rate.” TradingEconomics.com – Economic Data for 196 Countries. N.p., n.d. Web. 7 May 2012. <http://www.tradingeconomics.com/united-kingdom/gdp-growth>.
• Word, Press. “UK economy after the recession.” http://postrecession.files.wordpress.com 1.1 (2012): 1-12. .wordpress.com. Web. 7 May 2012.
• Kiat, Jason. “The effect of exchange rate and inflation on foreign direct investment and its relationship with economic growth in South Africa.” Gordon Institute of Business Science, University of Pretoria. 1.1 (2007): 1-115. Print
• Drake, Pamela P. “Advantages and Disadvantages of Different Capital Budgeting Techniques.” http://educ.jmu.edu. N.p., n.d. Web. 7 May 2012. <http://educ.jmu.edu/~drakepp/principles
• Brigham, Eugene F., and Phillip R. Daves. Study guide: intermediate financial management, 9th ed.. Mason: Thomson Higher Education, 2007. Print.
• “What are the arguments for and against joining the Euro.” History Learning Site. N.p., n.d. Web. 7 May 2012. <http://www.historylearningsite.co.uk/eur

KI66

Please  Click on the  below links to Chat Now  or fill the Order Form !