Page 277 - DMGT514_MANAGEMENT_CONTROL_SYSTEMS

Management Control Systems

Notes Changes in exchange rates can affect not only firms that are directly engaged in international
trade but also purely domestic firms.

Example: A US bicycle manufacturer that sources only domestic materials and sells
exclusively in the US market with no foreign currency receivables or payables in its accounting
book, can be subject to foreign exchange exposure if it competes against imports say from a
Taiwanese bicycle manufacturer.

14.6.1 How Distinguished from Business Risk

Doing any type of business is subject to risk. That distinguishes entrepreneur’s willingness to
take risks from other modes of investment. Broadly speaking, business risk can be divided into
two categories – core business risk and environmental risk.
Core business risks are operational risks such as: an unsuccessful new product launch, a new
technology which does not perform up to expectations, interruption in raw material supplies,
labour problems, cyclical demand fluctuations and so forth.

Did u know? Environmental risks arise out of unpredictable fluctuations in financial
variables such as exchange rates, interest rates and stock prices, macroeconomic shocks
such as, a sudden steep rise in prices of important commodities like crude oil, shifts in
government policies. Financial risks are thus, a subset of environmental risks.

While core business risks are peculiar to a particular firm, environmental risks are pervasive
and affect all firms or at least all the firms in a given industry. However, the direction and
magnitude of the impacts do vary from firm to firm. Thus, a depreciation of the exchange rate
might have a beneficial impact on the exporting firm while it hurts an importing firm.

14.6.2 Defining Exposure and Risk

The impact of fluctuation in financial prices can be illustrated by a number of situations:
1. An appreciation of the value of a foreign currency (or equivalent, a depreciation of the
domestic currency) increases the domestic currency value of a firm’s foreign currency
assets and liabilities such as: foreign currency receivables and payables, bank deposits and
loans, etc.
2. It will also change domestic currency cash flows from exports and imports.
3. An increase in interest rates reduces the market value of a portfolio of fixed rate bonds and
may increase the cash outflow on account of interest payments.
4. Acceleration in the rate of inflation may increase the value of sold stocks, the revenues
from future sales as well as the future costs of production.
The above demonstrates that the firm is “exposed” to unforeseen exchange in a number of
variables in its environment. These variables are also called risk factors.

Uncertainties arising out of fluctuations in exchange rates, interest rates and relative prices of
key commodities such as crude oil, copper, etc. create strategic exposure and risk for a firm.
The long-term response of the firm to these risks can involve significant changes in the firm’s
strategic posture. Choice of product-market combinations, souring of inputs, choice of
technology, location of manufacturing activities, strategic alliances and so forth.

272 LOVELY PROFESSIONAL UNIVERSITY