PLC Investment in United States
UK retailer Next PLC admitted that “its November and December 2011 sales were “disappointing” as the company faced dampened consumer confidence”. Next Plc.’s CEO at a meeting with the business intelligence team has directed the team to accelerate the BOD approved strategic plan to grow overseas. Next PLC Investment in United States currently has a very limited overseas trading however 50% (by value) of its supply chain is based in China with rest in the UK. The BOD report had identified the following markets as a high priority:
US, Japan, Australia, Germany, France, Canada, Italy & Switzerland.
ALTERNATIVE MARKET ENTRY OPPORTUNITIES
- A) Green field: Greenfield project includes establishing a new wholly owned subsidiary. In Greenfield investment there is no previous establishments and thus company needs to build everything from the scratch. Advantages of Greenfield projects are that it helps the company in building the reputation in the foreign company because of the jobs that get generated in the country. Other advantage is that companies get some tax benefits on Greenfield projects. Disadvantages associated with Greenfield projects are: It requires huge initial investment which makes this option little less feasible. Due to huge amount of costs involves sometimes the companies have to restrict or limit their expansion only to a fewer geographies or they expand at a very slower rate. This strategy is beneficial in the cases where the competition is very less or skill set required for operations management is not available in foreign country. Since, Next Plc does not have any such competitive advantage so it is not advisable for Next Plc to go for Greenfield projects. (Buckley, Peter J. and Casson, Mark, 1981)
- B) Acquisition of local operator: Acquisition of a local operator is beneficial when company wants to enter the foreign market quickly. Risk in case of acquisition is less compared to Greenfield project because company can estimate the outcome more easily and can decide accordingly weather to enter the new market or not. There are some problems that company might face if they go ahead with the business strategy. Merging two companies of different countries with significant cultural differences can cause problems during the integration of two companies (Ravenscraft, David J. and Scherer, F.M., 1987). Restructuring of the organization is another problem that most of the companies face after acquisition. Since Next Plc is not getting any significant advantage by acquiring a firm in the foreign company, it is not advisable to go ahead with its option (Zejan, Mario C. 1990). Also the amount of investment is high and they source 50% of their supply chain from China, so Next Plc is better off leaving this option as is. (Buckley, Peter J. and Casson, Mark, 1998)
- C) License/ Franchise Option: Franchising is a suitable option for the companies which want to expand in the new markets and already have a established brand name. Companies can leverage upon their brand value and can earn through providing franchise to the local player. Companies can earn through royalties and the profit sharing.
Risk involved is also very less because all the investment and costs are incurred by the franchise and not the parent company. But there is potential harm in franchising that the franchise might not live up to the service or performance level of the parent company which will affect the brand image and thus will affect the future prospects of the company. To avoid this company can add a clause that the franchise will but the products from the parent company only or by any other supplier approved by the parent company. For Next plc this option is a feasible option as the investment is very low, they will earn the royalties irrespective of the performance of the franchise, if the franchise performs well they will also earn a share in the profit. Also the time to enter the new geography is low compared to other two options and it does not face the issues faced by other two options. Moreover since the 50% of the supply chain of the company is from China, they can make some arrangements so that the franchise buys the material from them only.
Of the 3 options available Franchise option is suggested for the next PLC because of the advantages that are listed above. Risk is also less in this case that makes the option most feasible.
1.Foreign Currency Exposure: There is some amount of foreign currency risk that the company will face in case of going ahead with franchising option. Parent company receives money from companies in the form of royalties and also they have a share in the profit. While in case or royalties, company can fix an amount in its local currency that all the franchise needs to pay, there they can avoid the foreign currency risk. But in the case of profit sharing, it is generally a fixed percentage of the profit that the franchise makes. So the amount calculated in case of profit sharing will be some amount in the local currency which company needs to convert back into its local currency. While converting the local currency next plc will face a foreign currency risk due to the fluctuation of the exchange rates.
2.Double Taxation: In case of franchise option the basic source of income for the company is either the royalties or the income through profit sharing. Company will have to pay tax to the local authorities for making an earning in their land. After the profits are taken back to the country of the parent company there they will have to pay the income tax on the income that they show in their income statement. Depending upon the state or the country in which the company has a franchise, they might have to pay a franchise tax.
3.Ability to repatriate local profits: Depending upon the geography of operation, company can repatriate their local profits that they earn as a part of profit sharing with franchise. In some countries there is a restriction on the amount of the profit that can be repatriated. In some cases local authorities demand to reinvest the earned profit in their own country.
4.Corporate Structuring: Corporate structuring is required when the company is acquiring another company or they are expanding their operations through Greenfield or Brownfield project. In case of franchising there is no such need of the corporate restructuring as there in no merger or acquisition.
5.Financing: In case of franchising parent company do not need much of financing themselves. It’s the franchise that needs the financing. Next plc can help the franchise to raise money by using their brand name. Next plc can also set up their own financing arm which will provide financial help to the franchise. For the operations of its financing arm Next plc can raise money through floating more share or taking debt for the market.
- Recruitment and management of personnel from a distance: While doing operations in geography other than your own country it is very important for the company to maintain a proper mix of local and the expatriates. Expatriates are needed who know the operations of the company properly. At the same time company needs people from the local country who understand the market and customer in a better way.
- Management and respect of the cultural difference: While operating in a foreign land it is very important that the company understands and is sensitive towards the cultural difference between the two companies. Companies should understand the local customs of the foreign country and should respect them and provisions should be made to adjust according to the local culture. It is very critical for the success of the company that is sensitive to the local culture. While opening the franchise company should make sure that they are not hurting the sentiments of people living in that geography, they are not doing anything that is considered terribly wrong in that culture.
OVERVIEW OF PROJECT
Starting its operations in 1982 next plc has been expanding its product range to expand its customer service and sales volume. The products now offered range from trendy clothing line to accessories for women. Looking at the recent performance of sales figures of next plc. it is now realized that new foreign markets need to be explored in order to improve the financial conditions through better profitability, which is possible through increased sales. Keeping this in mind, it is decided to open 100 new branches of next plc in US market. Profit for the year 2011, stood at 400.9 million pounds while in the year 2010 it stood at 363 million pounds (next annual reports, 2011). Next has forewarned the public about the plausible problems it might face in the near future owing to the trading and over economic scenario in Europe.
“UK clothing retailer Next plc has reported a 4.1% increase in sales for the 13 week period of 1 May, but remain cautious on the UK trading environment for the remainder of the year” (Just Style, 2011)
In the precarious scenario prevailing the European economy it has become more essential for next plc to explore more opportunities in the foreign markets. If the expansion is to take place in United States according to the financial projections it is estimated that in the first year company is to bear a loss of around $2.5 million which would convert into a profit of $27 million in the next year and from there on increase significantly in the years to come.
The long term objective of the organization is to provide sustained profits to its shareholders whilst improving the quality of its products. The new stores, which are being considered, are in-line with strict financial target, which definitely requires an excellent level of service and sales force performance.
SHOULD THE PROJECT BE UNDERTAKEN
Whether or not the project should be undertaken?
Project should be taken up because the Net Present Value over a period of the project is positive. Theory of Net Present Value says that if the Net Present Value of any project is zero or greater than zero than the company can go ahead with the project.
(It is assumed that company will extend the lease for 2 more years at the same rate)
|Year 0||Year 1||Year 2||Year 3||Year 4||Year 5||Year 6||Year 7|
|Foreign Exchange Rate||1.567||1.567||1.567||1.567||1.567||1.567||1.567||1.567|
|Net Cash flow In Pounds||-159,900,421.295||-168,252,904.379||38,990,871.952||46,187,076.471||54,203,252.879||63,125,412.421||80,931,642.214||91,959,731.102|
|NET PRESENT VALUE||43,006,749.960|
|Income Statement – For opening 100 Shops in USA|
|Per Shop||Year 1||Year 2||Year 3||Year 4||Year 5||Year 6||Year 7|
|Cost of Goods Sold||150,000,000||337,500,000||371,250,000||408,375,000||449,212,500||494,133,750||543,547,125|
|Operating Cost – Inflation covered (Assumed 4 %)||1,000,000||100,000,000||104,000,000||108,160,000||112,486,400||116,985,856||121,665,290||126,531,902|
|Monitoring and Management Costs||2,000,000||2,000,000||2,080,000||2,163,200||2,249,728||2,339,717||2,433,306||2,530,638|
|Depriciation on Fixtures – 20 Percent per annum||200,000||20,000,000||20,000,000||20,000,000||20,000,000||20,000,000||20,000,000||20,000,000|
|Market Research Cost||500,000|
|Projected Net Profit/Loss before tax||-102,500,000||18,920,000||37,176,800||57,513,872||80,149,427||105,323,904||133,302,210|
|Cooperation Tax – 35%||0||6,622,000||13,011,880||20,129,855||28,052,299||36,863,366||46,655,774|
|Witholding Tax – 5%||0||614,900||1,208,246||1,869,201||2,604,856||3,423,027||4,332,322|
|Profit After Tax||-102,500,000||11,683,100||22,956,674||35,514,816||49,492,271||65,037,511||82,314,115|
STRATEGIES OF ON-GOING MANAGEMENT OF FOREX
Strategies for the on-going management of Forex risk which may arise as a result of such expansion should it go ahead.
While expanding the operations globally companies face lot of risks, of which one major risk is the forex risk. This directly affects the revenue of the company and thus affects all the stakeholders that are associated to it. To avoid the risk of exchange rate fluctuations, company can use various hedging strategies.
If the proper hedging strategies are in place, company can go ahead with the project without the fear of losing money.
EVALUATION OF FOREIGN EXCHANGE EXPOSURE
A detailed consideration and evaluation of specific foreign exchange exposure the investment may be faced together with a detailed hedging and management of this potential risk.
There are various hedging strategies which the company can use in order to reduce the impact of foreign exchange risk. Although hedging strategies have some cost but they save the firm from the huge losses due to the unexpected movement of in the exchange rate of the currency. At the same time there are some losses in some of the hedging strategies that the firm cannot take advantage of the favorable movement in currency.
- Company can enter into short forward contract where they can fix upon an exchange rate at the current date which is valid for a future date. By doing that company can ensure that they can sell their foreign currency inflows at the rate that is fixed in the forward contract irrespective of the spot exchange rate at the time of executing the contract. This strategy is useful when the exchange rate movement is unfavorable for the company. But when the exchange rate movement is favorable i.e. the local currency is depreciating with respect to the foreign currency, then also the company has to sell its foreign currency reserves at the agreed upon rate of the forward contract. (Barton, Shenkir, and Walker, 2002)
- Company can enter into swap agreements through a investment banker. Company can decide upon a fixed amount to enter the agreement by predicting the cash flows of the coming. They can enter into swap with some minimum fixed amount and any amount they earn above the swap amount they can exchange it on the exchange rate.( Bodnar, Gebhardt, 1998)
- Company can take put options of the foreign currency, by doing this they can ensure that if the exchange rate foes down below the expected level they can still sell it at the strike price of the put contract. In buying the put option they have to pay a premium for buying the option. But in buying the put option they do not necessarily have to exercise it. If the exchange rate (POUND/USD) is above the strike price of the put contract, company will let their put contract to expire and will change the currency at the spot rate in the market. If the spot exchange rate is below the strike price of the put contract, company will exercise its right to sell (put option) and will sell their dollars at the strike price of the put option irrespective of how much lower the spot rate is below strike price. (Hakala, J., and U. Wystup, 2002)
ORGANIZATIONAL STRUCTURE AND FINANCING ARRANGEMENTS
Advice on the organizational structure and financing arrangements which the company should adopt if it were to undertake such a project.
Company has various financing options available to them. They have to invest $500 million in opening 100 new stores in US in two years time.
- Next plc can borrow locally: Borrowing the amount locally and accordingly divide the payback according to expected cash flow projections. In doing this they will face a problem of exchange rate fluctuations. The money company earns in US, they will have to remit back to UK and the prevailing exchange rates (if no hedging option is in place) and then they have to pay back the local back in pounds.
- Long term debt from foreign bank: This option is a preferable option since the company can avoid its exchange rate risk. But borrowing from the foreign bank they will get the money in the foreign currency and the revenues that they are earning are also in foreign currency. So when they pay back the principal and the interest on the borrowed money, it will be pain in the foreign currency, thus reducing the risk due to exchange rate movement.
- Company can use their previously retained earnings. By doing this they can avoid paying the higher interest rates that they would end up paying if they borrow money from market. This option might be hazardous for the company if the market conditions are not good and the company is not doing well. Company should maintain sufficient cash to manage their operations and at least meet their current liabilities.
- Floating more shares in the market. By floating more shares in the market, value of the company’s share will reduce and moreover the control/ ownership of the company will be diluted. It depends on the logistics management of the company to decide how much control they want on the company. By floating shares they do not have to pay the borrowers every month and the management can decide how much dividend to be paid to the shareowners and what should be the frequency of paying the dividends.
Borrowing from the foreign bank seems to be the most feasible option , because they will avoid the exchange rate risk to some extent and they will get the tax benefit on the interest that they will pay on the borrowed money.
Next PLC has identified few of the potential markets for their overseas expansion of which one identified market is US market. Size of US market is very large compared to all other potential market; this makes US market one of the favorable markets to start the expansion. One problem with US market is that it has so many competitors with international operations. There players not only operate internationally but they also have a stronghold in the local market. Next plc can leverage upon its brand image that will help the company grow in US market. According to the market research company is expected to earn revenue of $5m from each of its stores. Having decided to expand operations in US, company has to make 2 critical decisions, one of them is to decide the source of financing and the other critical decision is about how to manage the exchange rate risk arising due to increased exposure in foreign currency.
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It is advisable for the company to finance its expansion through a local financial institution. In doing this company would negate the risk of exchange rate fluctuation as they would be borrowing and paying back the borrowed funds in the same currency. Company needs to do some corporate restructuring as well, they will have to move few local employees to US to support in operations. As the financial projections show that the net present value of the project is positive so there is no harm in going ahead with the project. Company’s income statement will show a negative income for the first year (and year 0 i.e start of the project, as well) because of the cash outflow due to the investing activities. Company’s income statement will show a positive figure for income from year 1 onwards.
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