General Robotic has received an order from an English firm to produce 10 robots that will perform welding tasks on the customer’s assembly line. General Robotic’s managers estimate that it will take four months to produce and deliver the robots. The total variable costs to produce the robots will be $600,000. The selling price to the customer is £64,000 each. Typically, payment is made at the time of delivery.
Currently, the exchange rate between the British pound and the U.S. dollar is £1 = $1.25. Management is concerned about a potential adverse change in the exchange rate between now and four months from now. Three alternatives for dealing with this potential problem have been proposed: 1. Do nothing and hope for the best.
2. Offer the customer a $10,000 price reduction if the customer will pay one-half of the selling prices now with the remainder due on delivery.
3. Buy a four-month option that gives the firm the right to sell £640,000 for $800,000. The cost of the option would be $30,000.
REQUIRED
A. Write an equation for the pretax profit the company will earn under each option. Use “R” to represent the exchange rate four months from now. (Ignore any interest on the money.)
B. What would the exchange rate need to be four months from now for the company to earn the same pretax profit on options 1 and 2?
C. What would the exchange rate need to be four months from now for the company to earn the same pretax profit on options 2 and 3?
D. What would the exchange rate need to be four months from now for the company to earn the same pretax profit on options 1 and 3?
E. Prepare a schedule that shows the best action for every possible exchange rate that might occur four months from now.
F. Assume that the managers chose option 3 and the actual exchange rate turns out to be £1 =
$1.35 four months from now. How much profit did the company lose by choosing option 3 instead of option 1?
G. Assume the same information as in part (F). Were the managers wrong to choose option 3?
Why or why not?