Merrill Lynch IB Institute August 2006 International Finance Sessions Professor Gordon Bodnar
Instructions for HBS Case: Jaguar plc 1984
NOTE: A spreadsheet template is on the website. You may also find data from previous problems sets useful. Use assumptions in this instruction sheet if they differ from those given in the case
In July 1984, the British government was preparing toprivatize Jaguar plc. Having a significant portion of its sales in the U.S. and all of its production in Britain, Jaguar’s cash flows appeared sensitive to exchange rate movements. In mid 1984 the dollar was rather strong against sterling with respect to PPP and many people believe that the dollar must weaken over the medium term, despite the fact that U.S. inflation was expected to be lower than U.K.inflation over the near future. Others argued that the U.S. need for foreign capital would keep U.S. real interest rates high and thus lead to a continued strong dollar. Your job is amid all this uncertainty to determine a value that should be placed on Jaguar and to determine the exchange rate sensitivity of the investment. Q1: a. Generate forecasts of exchange rate using i) IRP based upon LTinterest rates, ii) Relative PPP based upon expected inflation, and iii) linear reversion to an Absolute PPP level by 1989. b. For each set of XR forecasts, determine an estimate for how much Jaguar is worth in GBP as of the beginning of 1984 based upon the PV of its future expected cash flows. To determine how much Jaguar is worth, consider the company’s 1983 cash flows as presented in the case. Ifthese flows are projected into the future then a value for Jaguar can be determined. To do this you must estimate future expected free cash flow (FCF) and discount them back to the present to obtain a present value (beginning of 1984) that will represents the value of the firm at that time. To do this, use the sample spreadsheet on the webpage and construct estimates of these expected free cash flows(as the end of each year) from 1984 to 1989 based upon the 1983 values and forecasts for market growth and inflation. To finish the valuation you must also estimate the expected future cash flows beyond 1989. Calculate a terminal value for the investment based upon the assumption that the inflation-adjusted value of sterling cash flows for 1990 and beyond will be the same as in 1989. In otherwords, the 1989 cash flow will be the basis for a perpetuity growing at the GBP inflation rate for 1990 onwards. The value you generate will be dependent upon estimates of future exchange rates. With over 53% of sales in the U.S. market, the USD/GBP rate will be crucial for valuing Jaguar. While currencies of other foreign competitors may also be important, we will focus on the USD/GBP rate. Forsimplicity use mid year rates in our analysis (mid year 1984 is already given as USD1.35/GBP. Produce forecasts for 1985 – 1989 using each of the three forecasting approaches mentioned above. This will result in three different value scenarios for Jaguar. Thought must be given to how exchange rates will affect the pricing of Jaguar cars in the U.S. While in reality this would be a complicatedcalculation based upon demand elasticities and competitor reactions, as a simplifying assumption for this analysis assume that Jaguar sets its pass-through at 0. Thus, the USD price Jaguar charges only changes over time in line with the U.S. inflation rate and does not change with exchange rate movements. In order to help you focus on important variables the following assumptions may be made about: R&D isassumed to be GBP18.0 million in 1984 and rises at the growth rate of total sales (in £). Fixed Costs Distribution expenses rise with sales growth from their 1983 figure GBP13.3. Administrative expenses (assumed to be a fixed cost) rise at the inflation rate from their 1983 figure of GBP22.0m. Fixed assets are GBP112m at beginning of 1984, depreciation expense will be assumed to be 10% of the...
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