Business application of purchasing power parity

Beacon Lighting is a small Australian business in Perth that produces and sells lamp fixtures. Its costs and revenues have been very stable over time. Its profits have been adequate, but Beacon has been searching for means of increasing profits in the future. It has recently been negotiating with a Chinese company called Alibaba, from which it will purchase some necessary parts. Every three months, Alibaba will send a specified number of parts with the bill invoiced in Chinese yuan. By having the parts produced by Alibaba, Beacon expects to save about 20 per cent on production costs. Alibaba is willing to work out a deal only if it is assured that it will receive a minimum specified number of orders every three months over the next 10 years, for a minimum specified amount. Beacon will be required to use its assets to serve as collateral in case it does not fulfil its obligation.

The price of the parts will change over time in response to the costs of production. Beacon recognises that the cost to Alibaba will increase substantially over time as a result of the very high inflation rate in China. Therefore, the price charged in yuan likely will rise substantially every three months. However, Beacon feels that, because of the concept of purchasing power parity (PPP), its Australian dollar payments to Alibaba will be stable. According to PPP, if Chinese inflation is much higher than Australian inflation, the yuan will weaken against the Australian dollar by that difference. Since Beacon does not have much liquidity, it could experience a severe cash shortage if its expenses are much higher than anticipated.

The demand for Beacon's product has been stable and is expected to continue that way. Since the Australian inflation rate is expected to be very low, Beacon likely will continue pricing its lamps at today's prices (in Australian dollars). It believes that by saving 20 per cent on production costs, it will substantially increase its profits. It is about ready to sign a contract with Alibaba.

• Describe a scenario that could cause Beacon to save even more than 20 per cent on production costs.
• Describe a scenario that could cause Beacon to actually incur higher production costs than if it simply had the parts produced in Australia.
• Do you think that Beacon will experience stable Australian dollar outflow payments to Alibaba over time? Explain. (Assume that the number of parts ordered is constant over time.)
• Do you think that Beacon's risk changes at all as a result of its new relationship with Alibaba? Explain.