Question

The directors of Ribs Co, a listed company, are reviewing the company's current strategic position. The firm makes high quality garden tools which it sells in its domestic market but not abroad.

Over the last few years, the share price has risen significantly as the firm has expanded organically within its domestic market. Unfortunately, in the last 12 months, the influx of cheaper, foreign tools has adversely impacted the firm's profitability. Consequently, the share price has dropped sharply in recent weeks and the shareholders expressed their displeasure at the recent AGM.

The directors are evaluating two alternative investment projects which they hope will arrest the decline in profitability.

Project 1: This would involve closing the firm's domestic factory and switching production to a foreign country where labour rates are a quarter of those in the domestic market. Sales would continue to be targeted exclusively at the domestic market.

Project 2: This would involve a new investment in machinery at the domestic factory to allow production to be increased by 50%. The extra tools would be exported and sold as high-quality tools in foreign marketplaces.

Both projects have a positive Net Present Value (NPV) when discounted at the firm's current cost of capital.

Required:

Discuss the strategic and financial issues that this case presents.

Answer 1

The strategic and Financial issues for both the projects are discussed below;

1. Project 1: This is equivalent to opening a subsidiary with full production capacity in the foreign country and closing the domestic unit. This project bears a strategic risk from the fact that the domestic unit will be closed and the total dependence will be on the foreign factory. The economic policy of the foreign country regarding foreign investment, the labour availability , labor skills available, the labor union situation etc will have to be reviewed carefully. As the product is of high quality , maintaining the high quality in foreign country will need extensive labor training and presence of the current experienced managers and technicians in the foreign country for overall supervision may be needed. The overall legal and procedural aspects for setting up new units. the ease of doing business and the work culture of the foreign country will be important factors to consider. In case the foreign production fails to become Sustainable, there is an additional risk of loss of operation and the need to relocating back to domestic country incurring huge additional cost.

From Financial angle, the economic condition like the cost of capital , the inflation rate and the GDP growth rate of the country are important aspects determining the cost of production. As the product has to be imported into the domestic country, the exchange rate between the two countries is very important determining the cost of import in domestic country and sales revenue in foreign country. The Income tax rate in the foreign country and the existence of double taxation avoidance agreement is to be reviewed as that will determine whether the venture is profitable from taxation angle. All these factors and the projections regarding these factors are critical for decision making.

Project 2:

This is an investment in domestic market with additional market in foreign countries. The strategic aspects will be the market potential in the foreign market and the retention of domestic market in the face of stiff competition from cheap foreign imports. As the domestic company will have higher labor cost as compared to imported items, the company needs to position as differentiated high quality niche product having special value proposition. That is an important aspect to be considered. Availability of labor pool and the labor laws in the country will also impact the labor cost part .

The financial aspects that will affect the project is the exchange rate of the country. If the domestic exchange rate weakens against major foreign rates, the export of goods will be more profitable and import will be costly, both the situations will be favorable to the company. The reverse will happen if the exchange rate strengthens in future. The prevailing inflation rate and GDP growth will impact the cost of capital and cost of production.

The NPV of both the projects are positive , but the above strategic and financial factors may be critically reviewed and the risk of the projects can be adjusted accordingly to get a better decision regarding the expected NPV and the choice of the correct project.