Reference no: EM132175668

Assignment Brief -

SoulnD is a manufacturer of stereos located in Australia. The main parts used in its production line are imported from the United States (US), and due to the depreciation of the Australian dollar (AUD) against the US dollar (USD), the company has faced an increase of 10% in its production costs. Increased competition from foreign companies that have recently entered the Australian market, has further aggravated the situation of SoulnD forcing a mark down in prices that led to a decrease in its revenue of 13%. These events have made SoulnD's annual return on investment (ROI) decrease to 5%, with no concomitant changes in the risk attached to the business (i.e. 6% annual standard deviation of the ROI).

Based on this scenario, the company is on the lookout for options that could either reduce its production costs or improve its revenues. Two investment opportunities were recently identified:

Option A: Songs4All is a local producer of stereos that enjoys a monopoly position in country A. Country A is characterised by low income and cheap labour costs, with the performance of its economy relying heavily on the global price of commodities since the country is a major exporter of oil. The central bank of country A has been keeping interest rates at a high level (15%) as a way of curbing inflation (i.e. 8% last year), with no changes of monetary policy expected in the short-term. By way of acquiring Songs4All and moving its assembly line to country A, SoulnD would have access to a market that has yielded an average annual ROI of 8% in the last 5 years, at a relatively low risk (i.e. 5% standard deviation). Moreover, through a reduction in its operation costs, SoulnD's ROI is estimated to increase by 10%. Since they are in the same industry, the correlation of Songs4All's business to that of SoulnD is roughly 90%.

Option B: Listen&Play is a European producer of gaming headsets, in a market characterised by fierce competition that, nonetheless, offered an average annual ROI of 20% in the last 3 years (Listen&Play only sells in Europe). The demand for gaming headsets is mainly determined by the popularity of online multi-player games, developed by technology companies mostly in the United Kingdom (UK). Game developers have proliferated through cheap access to capital resulting from the Bank of England's conduct of monetary policy (i.e. 1% interest rate), which will likely be reverted as soon as the political turmoil in Europe subdues and inflation goes beyond the current 0.5% level. Listen&Play's business has attached to it a relatively high risk (i.e. 12% standard deviation), with a correlation of 20% to SoulnD's revenues. By investing in Listen&Play, SoulnD would have access to a new technology that could potentially enhance and differentiate its stereos, allowing it to charge higher prices in Australia and becoming less dependent on components imported from the US; the estimated increase in SoulnD's ROI would be 6%.

Required - Imagine you are hired as a consultant and asked to recommend one of the two investment options above to SoulnD. Assume that both require the same initial investment, and that either way the company decides to go, the new venture will have 60% of its total capital allocated to SoulnD's current business, and the remaining 40% to either Songs4All or Listen&Play. Write a report addressing the following:

A. Provide a diversification analysis of international projects based on the estimated ROI and risk that an investment of SoulnD in either Songs4All or Listen&Play would entail.

B. Elaborate on how changes in inflation, interest rates and exchange rates, would affect the viability of an investment in Songs4All and Listen&Play.

C. Create two scenarios (i.e. optimist and pessimist) that contain an outlook for inflation, interest rates and exchange rates relevant to both companies that SoulnD is considering to invest in, explaining how Songs4All and Listen&Play would perform in each of these scenarios. Be mindful of the impact of oil prices, political uncertainty, and labour cost on your variables when designing the scenarios.

D. Identify the main risks that SoulnD would be exposed to by expanding its operations according to options A and B, and elaborate on a strategy using financial derivatives that could be used as a hedge against those risks.

E. Based on your previous analysis, provide a recommendation to SoulnD.