Rolls$-$Royce Limited, the British aero engine manufacturer, suffered a loss of $58$ million in $1979$ on worldwide sales of $848$ million. The company's annual report for $1979$ blamed the loss on the dramatic revaluation of the pound sterling against the dollar, from $1=$ $$1\mathrm{.}71$ in early $1977$ to $1=$ $$2\mathrm{.}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$\text{'}$s $747$SP and $747,00$ and Lockheed's L$1011),$ 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 $$1\mathrm{.}80$ for the pound, and Rolls$-$Royce officials, in fact, expected the pound to fall further to $$1\mathrm{.}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$"?$