Question

DeKalb, Inc. is a U.S. company that sells apparel in the U.S. and in New Zealand. It is due to receive NZ$10,000,000 in 3 months time from its New Zealand distributor. It also needs to pay NZ$5,000,000 in 3 months to its New Zealand wool supplier.

a. If there’s a 60% chance that NZ$1 will be equal $0.55 in 3 months, and a 40% chance that NZ$1 will be equal $0.45 in 3 months, then what is the range within which DeKalb cash flow will be, given the two possible exchange rate scenarios? What is the expected value of DeKalb’s net cash flow? Please explain your answer with appropriate calculations.
b. What type of exposure (transactional, economic, or translation) does the situation from part a describe best? Please explain your answer.
c. Suppose DeKalb sets up a wholly-owned subsidiary that will make the all clothing that DeKalb plans to sell in New Zealand, and will obtain all the inputs locally. How will that affect DeKalb’s transaction, economic, and translation exposure? Specify, if each type of exposure would increase or decrease, compared to when DeKalb didn’t have a New Zealand subsidiary, and why you think so.

Answer 1

DeKalb, Inc.'s net cash flow range is $2,250,000 to $2,750,000 with an expected value of $2,550,000. The company faces transaction exposure, which could be reduced by operating a local subsidiary, potentially affecting economic and translation exposure as well.

Step-by-step explanation:

When dealing with the potential cash flow for DeKalb, Inc., we need to calculate the expected cash flows under both exchange rate scenarios and then compute the expected value. For the scenario where NZ$1 equals $0.55, DeKalb's cash flow would be (NZ$10,000,000 - NZ$5,000,000) * $0.55, resulting in a $2,750,000 cash inflow. Conversely, if NZ$1 equals $0.45, the cash flow would be (NZ$10,000,000 - NZ$5,000,000) * $0.45, giving us a $2,250,000 cash inflow. The range would be $2,250,000 to $2,750,000.

The expected value of DeKalb's net cash flow would be calculated as follows:

0.60 (probability of $0.55 rate) * $2,750,000 = $1,650,000

0.40 (probability of $0.45 rate) * $2,250,000 = $900,000

Expected value = $1,650,000 + $900,000 = $2,550,000

Thus, the expected value of DeKalb's net cash flow is $2,550,000.

In part b, the exposure best described here is transaction exposure because it deals with the uncertainty in cash flows resulting from future commercial transactions that will be executed at uncertain future exchange rates.

Finally, in part c, if DeKalb sets up a subsidiary in New Zealand, its transaction exposure would decrease as the cash flows will be in local currency, reducing the risk of currency fluctuation between NZD and USD. The economic exposure could decrease as well, as operations would be more closely aligned with the local economic environment. The translation exposure, related to consolidating financial statements, could increase as the subsidiary's financials would need to be converted to USD for reporting purposes.