Rolls-Royce Limited

Rolls-Royce Limited, the British aeroengine manufacturer, suffered a loss of £58 million in 1979 on worldwide sales of £848 million. The company’s annual report for 1979 (page 4) blamed the loss on the dramatic revaluation of the pound sterling against the dollar, from £1 = $1.71 in early 1977 to £1 = $2.12 by the end of 1979.

The most important reason for the loss was the effect of the continued weakness of the U.S. dollar against sterling. The large civil engines that Rolls-Royce produces are supplied to American air frames. Because of U.S. dominance in civil aviation, both as producer and customer, these engines are usually priced in U.S. dollars and escalated accordingly to U.S. indices. . . .

A closer look at Rolls-Royce’s competitive position in the global market for jet engines reveals the sources of its dollar exposure. For the previous several years Rolls-Royce’s export sales had accounted for a stable 40% of total sales and had been directed at the U.S. market. This market is dominated by two U.S. competitors, Pratt and Whitney Aircraft Group (United Technologies) and General Electric’s aerospace division. As the clients of its mainstay engine, the RB 211, were U.S. aircraft manufacturers (Boeing’s 747SP and 747,00 and Lockheed’s L1011), Rolls-Royce had little choice in the currency denomination of its export sales but to use the dollar.

Indeed, Rolls-Royce won some huge engine contracts in 1978 and 1979 that were fixed in dollar terms. Rolls-Royce’s operating costs, on the other hand, were almost exclusively incurred in sterling (wages, components, and debt servicing). These contracts were mostly pegged to an exchange rate of about $1.80 for the pound, and Rolls-Royce officials, in fact, expected the pound to fall further to $1.65. Hence, they didn’t cover their dollar exposures. If the officials were correct, and the dollar strengthened, Rolls-Royce would enjoy windfall profits. When the dollar weakened instead, the combined effect of fixed dollar revenues and sterling costs resulted in foreign exchange losses in 1979 on its U.S. engine contracts that were estimated by the Wall Street Journal (March 11, 1980, p. 6) to be equivalent to as much as $200 million.

Moreover, according to that same Wall Street Journal article, “the more engines produced and sold under the previously negotiated contracts, the greater Rolls-Royce’s losses will be.”

Questions

1. Describe the factors you would need to know to assess the economic impact on Rolls-Royce of the change in the dollar: sterling exchange rate. Does inflation affect Rolls-Royce’s exposure?

2. Given these factors, how would you calculate Rolls-Royce’s economic exposure?

3. Suppose Rolls-Royce had hedged its dollar contracts. Would it now be facing any economic exposure? How about inflation risk?

4. What alternative financial management strategies might Rolls-Royce have followed that would have reduced or eliminated its economic exposure on the U.S. engine contracts?

5. What nonfinancial tactics might Rolls-Royce now initiate to reduce its exposure on the remaining engines to be supplied under the contracts? On future business (e.g., diversification of export sales)?

6. What additional information would you require to ascertain the validity of the statement that “the more engines produced and sold under the previously negotiated contracts, the greater Rolls-Royce’s losses will be”?