Question

Read and answer the 4 questions

Lillichno. FLAME FIXTURES INC. Business Application of Purchasing Power Parity Flame Fixtures ine is a small US business Antons that produces and so lamp fixtures. Its costs and its revenues have been very stable over time. Its profits have been adequate, but Flame has been searching for means of Increasing profits in the future. It has recently been negotiating with a Mexican firm called Coron Company, from which it would purchase some of the necessary parts. Every three months Coron Company would send a specified number of parts with the bill invoiced in Mexican pesos. By having the parts produced by Coron, the company is expected to save about 20 percent on production costs. Coron' is only willing to work out a deal it it is assured that it will receive a minimum specified amount of orders every three months over the next ten years, for a minimum specified amount Flame will be required to use its assets to serve as collateral in case it does not fulfill its obligation. The price of the parts will change over time in response to the costs of production. Flame recognizes that the cost to Coron' will increase substantially over time, as a result of the very high inflation rate in Mexico. Therefore, the price charged in pesos will likely rise substantially every three months. However, Flame feels that because of the concept of purchasing power party (PPP), its dollar payments to Coron' will be very stable. According to PPP, if Mexican inflation is much higher than U.S. inflation, the peso will weaken against the dollar by that difference. Since Flame does not have much liquidity. it could experience a severe cash shortage if its expenses were much higher than anticipated The demand for Flame's product has been very stable, and is expected to continue that way. Since the U.S. inflation rate is expected to be very low. Flame will likely continue pricing its lamps at today's prices (in dollars). It believes that by saving 20 percent on production costs, it will substantially increase its profits. It is about ready to sign a contract with Coron Co a) Describe a scenario that could cause Flame to save even more than 20 percent on production costs. b) Describe a scenario that could cause Flame to actually incur higher production costs than if it simply had the parts produced in the U.S. c) Do you think that Flame will experience stabie dollar outflow payments to Coron' over time? Explain. Assume that the number of parts ordered is constant over time). d) Do you think that Flame's risk changes at all as a result of its new relationship with Coron' Company? Explain.

Answer 1

Ans 1 (a) : Under the following conditions Flame fixture Inc will save more than 20 % on the production cost :-

• Price of Pesso falls or the rate of US dollar increase against Pesso.
• Price of the raw material gets reduced by more than 20 %.
• USA Government announces reduce in tariff and taxes from the imports of Mexico country to boost its international trade.
• Reduction in forex exchange rate and commission rate.

Ans 1(b) : Under the following conditions Flame Fixture Inc may incur higher production cost :-

• Price of Pesso increase as compare to dollar or the dollar price gets reduced against Pesso.
• Price of raw material increase as there is a inflation in the Mexico market which will cause a price hike in the future of the raw material in future
• USA Government increase the trade tariff and taxes between Mexico and USA will increase the cost of production.
• As we are providing a Lien against our assets to Coron as a guarantee for the future order and in turn will increase the cost for the firm to raise the funds domestically.
• Increase in forex exchange rate and commission rate.

Ans 1( C) : No , As in the given case it has been clearly indicated that mexico is having a high inflation rate in turn it will make the products produced in it more expensive and on the other hand due to inflation the rate of interest will increase which will attract the investor for investment to get a higher returns causing a higher demand for pesos making it more expensive against US dollar which will make the payment to coron more expensive in US dollars.

Ans 1(d) : Yes , The risk of Flames Fixture inc will increase because of the following conditions :-

• He needs to pay in Pesso.
• He is providing a guarantee against its assets creating a lien over the same.
• International Trade risk of change in tariff and taxes by both the countries.
• There is a high inflation risk prevailing in Mexico making the future uncertain for the future price .