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Mini-Case: Honey well and Pakistan International Airways This case analysis is one of the authors' favorites. It combines exchange rate risk, the...

Exhibit 1 Is Julie's spreadsheet analysis of what she considers relevant choices using these, what would you recommend as a financing package?

■ Mini-Case: Honey well and Pakistan International Airways This case analysis is one of the authors’ favorites. It combines exchange rate risk, the timing associated with cash flows (and commensurate currency risk), emerging market financial management practices, corporate performance goals for working capital management, pricing and invoicing decisions, and the most difficult of all— managerial judgement. 1. Estimate what cash flows in which currencies the proposal would probably yield What is the Expected U.S. dollar value that would, in the end, be received? Answer : The spreadsheet analysis on the following page is helpful in understanding the complexity of the proposed transaction. Original Agreement: The original proposal which Honeywell had thought it had negotiated was for all payments to be made in U.S. dollars. The original contract price of $23,700,000 would be paid in two installments, 20% on contract signing ($4,740,000), and the remaining balance would be invoiced at the end of one year upon completion of the cockpit retrofits ($18,960,000). (It is a bit unclear as to whether the original contract under negotiation had included any type of up-front payment; it was evidently smaller than the 20% now on the negotiating table.) The second payment invoice would be due in 180 days. All payments would be in U.S. dollars, and Honeywell’s Pakistani agent, Makran, would broker the transaction for the standard 5% fee. Pakistani Rupee Invoicing: The Pakistan Airways counterproposal, for all invoicing and payments to be made in Pakistani rupee, constituted serious issues and risks for Honeywell. ∙ First, it was against corporate policy to receive payment in any other currency than U.S. dollars (not unusual in the global airline industry). This specific transaction was already considered a troubled one internally within Honeywell, as it did not meet corporate goals on return on sales and had been continually postponed. Unfortunately, the division within Honeywell had already included it in their prospective sales goals for the period, so the pressures were numerous. ∙ Secondly, the rupee appeared to be a currency subject to near-term devaluation. It had experienced a relatively recent devaluation of 7.86% which by traditional exchange rate standards was a small—and possibly incomplete—
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devaluation. Most devaluation was 15% to 25% in recent history, and the rumors of further devaluation were strong. The black market rate of Rp50.00/$ represented a devaluation from the current rate of Rp40.4795/$ of about 23.5%.International Financial Management. If Honeywell were to accept payment in rupee, it would be incurring substantial currency risk. If the payments were to occur on schedule, 20% advance payment upon contract signing and the 80% balance settled 180 days following invoice for completed work in 360 days (180 + 360 = 540 days from the present, contract signing), and no currency devaluation were to take place, the present value of the sale was estimated at $18,662,397. If, however, the rupee suffered a 20% devaluation after the advance payment but before balance settlement, the sale has a present value of only $16,262,997. This will sure not meet corporate margin on sales goals! ∙ If Honeywell were to use Makran to both facilitate the transaction (mandatory) and provide currency conversion services, the exchange rate risk would be eliminated for a 5% fee, and the 80% balance would be settled in 360 + 30 days (390 days total), rather than 540 days. 2. Do you think the services that Makran is offering are worth the costs? Answer : Yes. If Honeywell were to use Makran for currency services, it would eliminate the currency exposure and accelerate the remaining payment. This would provide a present value of $18,283,032, only $379,365 less than originally envisioned. This is far superior to incurring the currency risk, and waiting possibly 540 days or longer to receive rupees which would be worth who knows what in U.S. dollars at that time. And the Makran solution also aids in reducing the days sales outstanding of the division, another divisional goal. This does not assume, however, that the sale is a good one from Honeywell’s perspective. It would still be up to Honeywell to decide whether the sale is sufficiently profitable and important from a corporate perspective. 3. What would you do if you were heading the Honeywell SAC group negotiating the deal?
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