NEW YORK UNIVERSITY Stern School of Business - Graduate Division B40.3388 Richard Levich International Financial Management ____________________________________________________________ Jaguar plc, 1984: Suggested Answers In order to attempt to answer the quantitative questions in this case, it is almost essential to use spreadsheet software. The cash flow projections for Jaguar under the "base case" scenario should be entered in the spreadsheet using the stated assumptions for growth rates, depreciation rates, inflation rates, etc. so that these assumptions can be changed easily, and new profit and valuation figures can be calculated easily. You should recognize that the "base case" is itself built upon a set of assumptions that attempt to formalize the economic situation facing Jaguar. Some figures and relationships had to be assumed in order to generate a numerical result. This is fairly realistic. Note that the value of the firm is £515,410,000 (rather than £502,055,000) when the terminal value is adjusted by (1+g) to correct the spreadsheet error.

1.

Consider Jaguar's exchange rate exposures.

a.

To what currencies is Jaguar exposed? Jaguar is exposed to the US$ as it has sales in the United States that generate US$. Jaguar is also exposed to the DM, as it is in competition with Mercedes-Benz and Porsche. Some might answer that there is also ¥ exposure, as Jaguar may compete with higher priced Japanese cars (e.g. Lexus, Infinity, Acura) introduced in the mid-1980s, although there is no mention of this in the case.

b.

What are the sources of these exposures? The US$ exposure comes by virtue of Jaguar's export sales to the United States that are priced in US$. Since Jaguar production is in the United Kingdom, there are no major US$ expenditures. It could be argued that some percentage of production costs are for materials (e.g. steel, rubber) and energy costs that are US$ based. But basically, Jaguar has a net asset position in US$ by virtue of its US sales and US$ cash flows. The DM exposure comes by virtue of competition from two German luxury car makers -- MercedesBenz and Porsche. A weak DM (strong $) could permit the German car makers to lower their US$ prices (and gain market share and profits) while keeping their DM profit margins intact. This assumes that the $/£ rate remains constant so that Jaguar cannot play the same pricing game in the United States. In other words, Jaguar's US market is at risk from German competition when DM/£ ↑.

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2.

Valuation of Jaguar according to alternative scenarios.

a.

How would a permanent 25% depreciation in the real value of the $ in 1985 effect the valuation of Jaguar? Assume that the "Base Case" assumptions on U.S. prices and volumes remain as before. A 25% depreciation of the real $ pushes the $/£ rate (in Line 1 of the spreadsheet) up by 25% leaving commodity prices constant. Thus the $/£ rate in 1985 jumps to $1.654 and then resumes its decay at 2% per year. The impact on the valuation of Jaguar is substantial, dropping the present value of free cash flows by over 75% to £127,486,000 (£124,738,000 if you left off the 1+g factor).

b.

How would a permanent 25% depreciation in the real value of the $ in 1985 effect the valuation of Jaguar? Assume that Jaguar raises U.S. prices by an extra 10% in 1985 and that U.S. sales grow at only 2% in 1985 and 1986. Keep all other assumptions as in the base case. This scenario assumes that Jaguar passes along some of the exchange rate change into a sticker price change. The 1985 US sales price (Line 5) of $29,040 is 10% higher than in the base case. Demand is price inelastic as the 10% price change causes only a slight reduction in volume growth (Line 2) to 2% in 1985 and 1986. With these changes, the impact on the valuation of Jaguar is still substantial, dropping the present value of free cash flows by nearly 50% to £265,820,000 (£259,324,000 if you left off the 1+g factor).

c.

How would a permanent 10% appreciation in the real value of the $ in 1985 effect the valuation of Jaguar? Return to the assumptions on U.S. prices and volumes as in the "Base Case." This scenario is traced out by letting the US$ appreciate by 10% in 1985 (to $1.215/£) and then letting the exchange rate be governed by the inflation differential as in the base case. This amounts to a permanent 10% appreciation of the US$. We can see that if Jaguar continues to sell as many cars at the same prices as before, having revenues in a strong currency is highly beneficial to them. The present value of free cash flows rises by one-third to £709,022,000 (£670,274,000 if you left off the 1+g factor).

3.

Quantify Jaguar's exposure to the real $/£ exchange rate.

a.

How large (in millions of £) is the impact of a permanent 1% increase or decrease in the real $/£ exchange rate on the present value of Jaguar's cash flows? How large is this amount in US$? In order to make this calculation, you must adopt a single scenario and then perturb the exchange rate by +1% and -1% in 1985. You must pick a single scenario because currency exposure is measured in the context of an economic scenario. If you do not know which scenario will play out in real life, then you have another uncertainty to face. Recognize that this is a different kind of uncertainty. It is not exchange rate uncertainty, but rather a "strategic" or "competitive" uncertainty. I chose to take scenario #2b as my reference point for a realistic valuation of Jaguar's assets. [You could have chosen another scenario or base case as your reference point.] In my calculations, Change in $/£ rate +1% depreciation of $ (1.6544 to 1.6710) -1% appreciation of $ (1.6544 to 1.6379)

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Change in Jaguar Valuation -£15,993,000 +£16,315,000

b.

Given the above calculation, what is your estimate of Jaguar's US$ exposure? The average of these valuation changes is £16,154,000 which at $1.35/£ is $21,807,900. This is the gain or loss to Jaguar from an extra 1% change in the real exchange rate beginning in 1985. Therefore the US$ exposure is £16,154,000/0.007407£/$, or $2.18 billion. Note that exposure to US$ risk is measured in terms of US$. The calculation implies that Jaguar has a $2.18 billion asset exposure, so a permanent unanticipated 1% depreciation in the US$/£ rate causes a loss of roughly 1% of $2.18 billion, or $21.8 million or £16.2 million at current exchange rates. Note that as a UK company, the final figure in £ is most relevant to Jaguar.

c.

Is their US$ exposure a large number in comparison to their sales, assets or equity value? To quote the author of this case, $2.18 billion is a "startlingly large number. It overestimates exposure but its shock value if useful." At $1.35/£, $2.18 billion is about £1.61 billion -- more than five times the market value of the firm and about three times annual sales. It is important to understand both why this number is so large and why it is probably an overestimate of Jaguar's true exposure. To a rough approximation, Jaguar's exposure is equal to its US$ cash flows, i.e. its US$ revenues as opposed to its US$ profits or US$ assets. Moreover, our calculation assumes an unexpected rate change and a permanent rate change. Thus exposure captures the impact on the present value of all expected future US$ revenues. The exposure figure is probably an overestimate because: (1) The analysis is ceteris paribus. In reality, Jaguar may be able to "pass-through" some of the exchange rate change (i.e. raise prices). Even if this means a decline in volume (case #2b) there will be a benefit to Jaguar. (2) The analysis assumes that the exchange rate change is permanent. In reality, the exchange rate will be volatile in the short run, and to the extent that there is overshooting of the real exchange rate, there is likely to be mean reversion over the longer run. (3) We take the exchange rate change as fully unanticipated. In reality, some exchange rate changes may be anticipated and thus already factored into present market values. Thus, when the exchange rate changes, it is seen as a deviation from PPP, but not unexpected.

4.

Implications of exposure for hedging.

a.

Should Jaguar attempt to hedge its US$ exposure? Why or why not? The answer based on the case materials is not obvious. There are strong theoretical arguments against hedging -- the main one being that investors can hedge on their own if they choose. There are practical arguments as well that a corporate hedging program may be expensive to implement, difficult to control, set up potentially perverse incentives for managers, confuse stock market analysts about managers objectives, and therefore be ineffective. The strongest arguments in favor of hedging rely on the idea that reducing the volatility of the firm's value creates value. If hedging can produce a higher debt rating, higher debt capacity, relaxation of onerous bank lending covenants, and so forth, then hedging can add to value. The presumption is that the firm has profit-making investments planned for this extra investing capacity. Then the question becomes, "How much does the firm need to hedge to capture these advantages, and do the gains justify the economic costs of hedging?"

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b.

What general methods are available to Jaguar for hedging their US$ exposure? What are the costs and benefits of each? As we discussed in class, there are two general methods for hedging: financial and operational techniques. Financial hedges are easy, simple, and inexpensive to implement when compared to operational hedges. On the other hand, financial hedges have the disadvantage of being nominal hedges, and so they work only when nominal exchange rate changes and real exchange rate changes are highly correlated -- which has been the case in the short-run in the 1980s, but not in the long-run. Another disadvantage is that financial hedges are typically short-term, except for the case of long-term US$ debt. To offset much of Jaguar's long US$ exposure would require a huge US$ borrowing. This might have a significant impact on the firm's reported accounting statements depending upon the rules for showing exchange rate gains and losses, which in turn could "distort" the value of the firm to financial analysts. Operational hedges would require changes in Jaguar's sourcing policies, manufacturing locations, selling locations, or in the nature of the product itself. These would certainly be costly to implement, especially given the relatively small production runs of Jaguar automobiles. Top management felt that the most important market for Jaguar would continue to be the United States, and establishing production outside of England would jeopardize the firm's efforts at quality control, cooperation with suppliers, and other aspects of the firm's competitive strategy. A substantial use of real hedges thus seemed at odds with the firm's newly successful business strategy.

EPILOGUE (from the case teaching note) At the end of July 1984, BLMC offered 177.88 million Jaguar shares (of a total 180 million shares) to the public at a price of 165 pence per share. This implied a market capitalization of £297 million. The offer was oversubscribed, and the shares traded up about 7% upon being first listed on August 10. Jaguar's executives and bankers felt the company's exposures to the dollar and the mark were quite substantial and made unusual disclosures to that effect in the offering prospectus. In a special section entitled "Sensitivity to Exchange Rates," the following table presented an illustration of what 1983 operating revenues might have been had different US$/£ rates prevailed: Average Exchange Rate US$/£ $ 2.00 1.80 1.60 1.52* 1.40 1.20

Operating Profit (Loss) (£ millions) -£5 + 15 + 38 + 51 + 70 + 112

* The average US$/£ exchange rate in 1983. Prior to the offering, BL had a policy of not hedging currency exposures, either for Jaguar or its other divisions. Immediately upon being privatized, Jaguar's top management reversed this policy and embarked on a hedging program. John Edwards, the CFO, conducted an exhaustive investigation of the possibilities. In conjunction with John Egan and other top officers, he decided that most [hedging possibilities] would not work. In the end, the company adopted a policy of selling forward 50-75% of the next twelve months' anticipated dollar receipts in the interbank forward market. This rolling twelve month hedge was adopted

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with the idea that it would not nearly hedge all of Jaguar's exposure, but would give the company's managers some time to respond to dramatic currency swings. The dollar continued to rise for a short time after the share offering, reaching $1.159/£ at the end of 1984; it did not peak until the first quarter of 1985. This enabled the company to record better-than-expected results for 1984. Jaguar sold nearly 33,000 vehicles world wide in 1984, with slightly more than 18,000 sold in the US. Revenues were £634 million and operating profits were £86.7. Operating results for the period 1983-88 are shown in the attached exhibit. The dollar began to fall in February 1985. In the spring of 1985, Jaguar executives felt that forward rates were attractive and pushed their rolling hedge out 24 months instead of twelve, effectively locking in sterling rates through 1987. This proved to be quite prescient, as the dollar's slide accelerated, until by the end of 1987 it reached $1.871/£. Jaguar's hedge was common knowledge in the financial community and management was roundly praised. Meanwhile, the DM/£ rate was fairly stable. Jaguar's volume continued to rise, topping 50,000 units in 1987, but growth in North America slowed markedly, and US unit volume has dropped every year since 1986. It was in 1986 that Honda entered the US market with its Acura nameplate. Toyota and Nissan followed in 1989. During 1985-88, Jaguar increased its retail dollar prices in the United States by about 10% per year on average, although part of this rise may be accounted for by increases in standard equipment and by the introduction of a new model XJ40 in the United States in 1987. The company steadfastly avoided dealer incentives and rebates, although in 1989 it introduced a stripped-down, less expensive version of its XJ-6 sedan in an effort to increase North American volume. Sterling profits were greatly effected by the fall of the dollar; operating profits peaked in 1985 at £107.8 million and fell steadily with the dollar thereafter. Operating profit in 1988 was £39.4 million compared to £51.1 in 1983, even though unit volume had increased by 78% to over 50,000 vehicles in 1988. In 1989, the company was expected to barely turn a profit for the year. Jaguar's share price peaked in the first quarter of 1987, reaching 585 pence before being nearly halved in the October 1987 market crash. Jaguar's executives considered their hedging program a qualified success. It achieved their primary aims, which were never terribly ambitious. However, it also has some side effects. Jaguar's executives felt that the investment community never understood the company's exposure very well, and hence did not properly evaluate the hedging program. In 1985-87, the City appeared (to Jaguar management) to overestimate the effectiveness of the hedge, and became disenchanted as Jaguar's rolling forward contracts were renewed on inevitably less favorable terms. In 1988-89, management was actually criticized because some of the forward contracts lost money as the dollar recovered. Similarly, many employees were thought to have had too sanguine a view of the future, believing the company to be hedged against a falling dollar. This made labor negotiations more difficult. In short, top management felt at times that Jaguar's position was considerably more tenuous than was generally realized. Unable to hedge its exposure effectively, Jaguar decided to remain competitive through improvements in its dealer network and production efficiencies. Capital expenditures were tripled from 1983 to 1987, with much of this going to modernize manufacturing capacity and lower costs. Expenditures were cut in 1988 as earnings continued to deteriorate and as industry observers began to speculate about a takeover of the company once the golden share expired at the end of 1990. As it happened the government surrendered its golden share fifteen months ahead of time as General Motors and Ford jockeyed for position to acquire all of part of Jaguar. Ford succeeded at the end of October 1989 in buying the entire company for £1.6 billion (about $2.5 billion) which seemed to many a staggering sum, given Jaguar's recent difficulties. For a summary of these events, see the page 1 stories in the Wall Street Journal and the Financial Times on November 1 and 2 respectively, 1989.

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