Example:
Suppose that a U.S. computer company has a wholly owned British subsidiary, Albion Computer PLC, that manufactures and sells personal computers in the UK market. AC PLC imports microprocessors from Intel, which sells them for $512 per unit. At the current exchange rate of $1.60 per pound, each Intel microprocessor costs £320. AC PLC hires British workers and sources all the other inputs locally. The company faces a 50% income tax in the UK.
Projected operations for AC PLC: Benchmark case ($1.60/£):
Sales (50,000 units at £1,000/units) £ 50,000,000
Variable costs (£650/unit)* 32,500,000
Fixed costs 4,000,000
Depreciation 1,000,000
Net profit before tax 12,500,000
Income tax (at 50%) 6,250,000
Profit after tax 6,250,000
Add back depreciation 1,000,000
Operating cash flow in pounds 7,250,000
Operating cash flow in dollars $11,600,000
Now, consider the possible effect of a depreciation of pound on the projected dollar operating cash flow of AC PLC. Assume that the pound may depreciate from $1.60 to $1.40 per pound.
*: the unit variable cost, £650, comprises £330 for locally sourced input and £320 for the imported input.
Case 1: No variables change, except the price of imported input.
Sales ( units at £ /units) £
Variable costs (£ /unit)
Fixed costs
Depreciation
Net profit before tax
Income tax (at 50%)
Profit after tax
Add back depreciation
Operating cash flow in pounds
Operating cash flow in dollars $
Case 2: the selling price as well as the price of the imported input changes, with no other changes.
Sales ( units at £ /units) £
Variable costs (£ /unit)
Fixed costs
Depreciation
Net profit before tax
Income tax (at 50%)
Profit after tax
Add back depreciation
Operating cash flow in pounds
Operating cash flow in dollars $
Case 3: all the variables change (UK has a inflation rate of 8%).
Sales (40,000 units at £1,080/units) £
Variable costs (£722/unit)
Fixed costs
Depreciation
Net profit before tax
Income tax (at 50%)
Profit after tax
Add back depreciation
Operating cash flow in pounds
Operating cash flow in dollars $
1