In early 1980, U.S. Semiconductor, a large specialized semiconductor manufacturer headquartered in Santa Clara, California, decided to make a strategic move into the U.K. market. Until this time the company had a small sales office in London that serviced clients in that country. The product, semiconductors, were shipped by air freight from warehouses in Silicon Valley to London's Heathrow Airport, and distributed to various customers.
Due to increased competition from other American firms, the company decided to establish a distribution center and technical support facility in the United Kingdom. A location was found approximately 50 miles west of Heathrow Airport near the small town of Swindon. A business plan was established that provided for the construction of a special, climate controlled, warehouse to protect the chips, the acquisition of a number of small yellow trucks to move them around, and some storage and inventory control equipment.
The legal/tax department advised that all these assets should be "housed" under a corporate umbrella called U.S. Semiconductor Ltd., a wholly-owned subsidiary of the parent company incorporated in Delaware. By the same token, the entity should be capitalized with minimal equity investment. The remainder of the assets, including the high-value inventories, should be funded with debt.
It was at this point that U.S. Semiconductor's Finance Department got involved. This group had responsibility not only for the funding operations at home and abroad but was also in charge of risk management, particularly exchange risk management. The Assistant Treasurer, Marcel Godfrey, began to work with a number of commercial banks headquartered both in the United States as well as the United Kingdom with whom U.S. Semiconductor had previously established relationships. He solicited them for financing proposals. The company decided to go for "plain vanilla" debt financing rather than a legally complex leasing arrangement.
When everything was said and done and the analysts at U.S. Semiconductor had sorted out the numbers, it came down to two financing alternatives; both incorporated the usual, standard documentation with a strong comfort letter from the parent. When all front- and side- and back-end fees were included, the choice was between two five-year fixed rate term facilities in either U.S. dollars at 8 percent per annum or pound sterling at 12 percent per annum. The spot rate for STG was quoted at approximately USD 2.40; long dated forward cover for five years was available at roughly USD 1.97.
This was where the difficulties began. Local management supported by the Group Vice President for European Operations insisted on pound sterling funding because they did not want to have any exchange risk. They argued that there was no other choice anyway, because the Chief Executive Officer, Andrew Godfornough, an immigrant Soviet physicist, had long ago laid down the policy that financial risks should be minimized in view of the big gambles that the company took in its business which was extremely cyclical and characterized by dynamic changes in technology. Thus, the guiding principle was "hedge everything."
Some staffers at headquarters, however, were inclined to argue differently on the same principle: since the semiconductor business worldwide was a "dollar driven" business it would be prudent to use dollar denominated debt. In addition, they argued, it was obviously cheaper!
The Director of Foreign Exchange, who had recently been hired away from the foreign exchange trading operations of a major U.S. West Coast bank, insisted that the company should borrow in sterling since that currency would be weak as oil prices would drop over the coming years. "This is a chance for Treasury finally to make some money and become a profit center rather than a constant drain on the company resources by paying out interest and fees to the bankers," he wrote in a memo to Marcel Godfrey.
Others on the finance staff argued that a compromise was appropriate: the subsidiary should simply fund its debt half in dollars and half in sterling since nobody could really tell which way exchange rates would go. However, all shipments from the warehouse in Santa Clara to the facility in Swindon should be hedged by selling U.S. dollars forward against pounds by way of three-month contracts.
At this point, the controller's group put its two cents worth of advice forth in a special memorandum. They argued that maybe they could persuade the outside accountants to treat all these assets of U.S. Semiconductor Ltd. as de facto dollar assets on the basis that the dollar would be the "functional" currency of that business in the United Kingdom. The new accounting standard 52 provided for just such a contingency.
By now, the new V.P. Finance decided that what was needed was a weekend meeting at a small hotel in Monterey to bring all the issues on the table and to reach an agreement that could be sold to the Finance Committee of the Board at the next meeting. He invited some of the company's bankers and a consultant to advise the company on its international funding and risk management strategy.
The facts of the case have been sufficiently disguised to protect the innocent. Any similarity with real persons, institutions, and situations is purely accidental. The case serves as a basis for discussion only; it is not designed to present an illustration of effective or ineffective decision making. Developed from publicly available information by G. Dufey, The University of Michigan, 1989. Revised copyright G. Dufey, 1994.