■ 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 ($18,960,000). (It is a bit unclear as to
whether the original contract under negotiation had included any type of up-front
payment; it was evidently smaller than the 20% now on the negotiating table.) The
second payment invoice would be due in 180 days. All payments would be in U.S.
dollars, and Honeywell’s Pakistani agent, Makran, would broker the transaction for the
standard 5% fee. Pakistani Rupee Invoicing: The Pakistan Airways counterproposal, for
all invoicing and payments to be made in Pakistani rupee, constituted serious issues and
risks for Honeywell. ∙ First, it was against corporate policy to receive payment in any
other currency than U.S. dollars (not unusual in the global airline industry). This specific
transaction was already considered a troubled one internally within Honeywell, as it did
not meet corporate goals on return on sales and had been continually postponed.
Unfortunately, the division within Honeywell had already included it in their prospective
sales goals for the period, so the pressures were numerous. ∙ Secondly, the rupee appeared
to be a currency subject to near-term devaluation. It had experienced a relatively recent
devaluation of 7.86% which by traditional exchange rate standards was a small—and
possibly incomplete—devaluation. Most devaluation was 15% to 25% in recent history,
and the rumors of further devaluation were strong. The black market rate of Rp50.00/$
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?

Answer: The spreadsheet analysis is helpful in understanding a variety of the negotiating

alternatives. If the 20% advance payment is indeed a pivotal point, this could be reduced
against either price or timing alternatives. A number of options could be explored here,
including reducing the 20% to 10% in exchange for accelerated payment of the balance
(guaranteed?). If Honeywell wishes to pursue the Makran currency management
alternative, it may wish to tradeoff when Makran itself receives payment against the
currency charge. (A reduction of the currency charge on both payments from 5% to 4%
results in a present value of total payments of $18,498,127.)