THE IMPLICATION OF FOREIGN EXCHANGE ON PROFITABILITY OF FIRMS

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CHAPTER ONE

INTRODUCTION

1.1       Background of study

Foreign exchanges’ importance will be difficult to overstate in respect to the world economy. Profitability can be affected positively or negatively by foreign exchange. The risk and returns of various assets affect international capital flows. The major focus for the policymakers, the public and certainly the media is the rate of exchange. Nigeria today as a nation is faced with the very big challenge of minimizing import dependence and maximizing an export led-growth policy.

Globally the day to day turnover of foreign exchange transactions in all currencies increased from about USD600 BILLION IN 1998 to about USD1.4 trillion (1,400 billion) in 1998 and later decreased to about USD1.2 trillion in 2001. The reason for the decline primarily was for the forex market involving consolidation of players. Unlike globally, Effects of exchange rate fluctuation in developing countries like Nigeria has received considerable attention and generated much debate. The debate concentrates on the degree of changes in the exchange rate had generated internal and external impact that is sudden in Nigerian Economy. Exchange rate of a country per-takes in an important role in international economic transactions due to the fact that no nation can remain in self-sufficiency due to varying factor gift.

Onotaniyohuwo & Oladipupo (2011) States that movements in the exchange rate have ripple effects on other economic variables such as interest rate, inflation rate, unemployment, money supply, etc. These facts underscore the importance of exchange rate to the economic well-being of every country that opens its doors to international trade in goods and services. The importance of exchange rate derives from the fact that it connects the price systems of two different countries making it possible for international trade to make straight comparison of traded goods. In other words, it links local prices with international prices. (Opaluwa, 2010) Opines that following the changes of the naira in 1986, a policy induced by the structural adjustment programme (SAP), the subject of exchange rate changing has become a topical issue in Nigeria

Nestle plc is a multinational manufacturing company, focused on the manufacturing, marketing and distribution of cereals, beverages, confectionery and table water. Nestle plc is a well-regarded and trustworthy nutrition, health and wellness company famous world-wide for its high quality products.

Exchange rate experience has in many ways differed from what was anticipated in 1973 when the countries that are majorly industrialized abandoned the struggle to keep the values of their currencies fixed. There is an elaborate feeling that exchange rate is currently more volatile than what it is expected to be, than they should be and perhaps what they need to be (Frankel 1995).  The exchange vitality creates a unique problem for business activities performed internationally (exporting and importing) because it brings about a type of risk (foreign exchange risk).  When business deals are organised for future, they are complicated by the changes in the high risk of exchange rate (Evans, Taylor, & Holzman, 1985).This exchange rate changes is definitely going to have an impact negatively or positively on the profitability and performance of companies.

The attached importance to the issue of exchange rate is no doubt due to current trends in the business environment where domestic companies, regardless of size segment could no longer mind their businesses due to globalization. That is, exchange rate is a major technical instrument upon which businesses can survive and make profit. Copeland (2005), “the increased importance joined to exchange rate is to an extent a result of the internationalization of business, the continuing growth in the world trade relative to national economies, the trend towards economic integration and the swift pace of change in the technology of money transfer. It is also a large consequence of the truth that exchange rate is not only variable, but highly volatile.

1.2      STATEMENT OF PROBLEM

Foreign exchange rate basically may affect profitability either negatively or positively.

A number of studies by examining internal factors within the control of the firms have taken a micro approach. However, the current context of globalization has raised competitiveness concerns and necessitates an in-depth examination of the macro variables hence.

This movements in exchange rates became of major concern to corporate establishments and policy makers in Nigeria in the wake of the 2007-2008 global financial crises. In periods of noticeable depreciation of local currency it appears almost as if the whole economy is affected, the question is what is the impact of these exchange rate on the profitability of a firm? even for firms that bring about the bulk of their revenue within the economy, does the rate of foreign exchange have any effect on the profitability of a firm perhaps through the return on asset and return on equity which are major element of profit especially when some factors of production are imported, can the connection between exchange rate and profitability be captured? If the return on asset and return on equity of Nestle Plc. were to be monitored for a period and the variations in profits compared to the variations in foreign exchange rate, could a substantial relationship between foreign exchange rate and profitability be established.

Above are a few of the resultant issues that a firm or company might face as a result of increasing level of debts, in order to fully grasp the effect of these problems they have constitute the primary objectives of this study which would be highlighted in the next section of this chapter.

1.3       OBJECTIVE OF THE STUDY

The primary objective of this study is to gain knowledge on the effects of exchange rate and profitability on a firm, using a control variable of interest rate and two key performance variables, return on asset and return on equity of the dependent variable profitability. The specific objectives are as follows:

1. To determine the effect of foreign exchange rate on return on asset.
2. To determine the effect of foreign exchange rate and interest rate on return on asset.
3. To investigate how foreign exchange rate affects return on equity
4. To investigate how foreign exchange rate and interest rate affects return on equity.

1.4       RESEARCH QUESTIONS

Deduced from the objectives stated are the basic research questions for which this study aims to proffer an answer to the under listed questions:

1. To what extent does foreign exchange rate affect return on asset?
2. To what extent does foreign exchange rate and interest rate affect return on asset?
3. What impact does foreign exchange rate have return on equity?
4. What impact does foreign exchange rate and interest rate have on return on equity?

1.5       RESEARCH HYPOTHESIS

Two propositions would be tested in this research and they are:

Hypothesis I:

H₀: foreign exchange rate has no effect on return on asset of Nestle Plc.

H₁: foreign exchange rate has an effect on return on asset of Nestle Plc.

Hypothesis II:

H₀: foreign exchange rate and interest rate has no effect on return on asset of Nestle Plc.

H₁: foreign exchange rate and interest rate has an effect on return on asset of Nestle Plc.

Hypothesis III:

H₀: foreign exchange rate has no effect on return on equity of Nestle Plc.

H₁: foreign exchange rate has an effect on return on equity of Nestle Plc.

Hypothesis IV:

H₀: foreign exchange rate and interest rate has no effect on return on equity of Nestle Plc.

H₁: foreign exchange rate and interest rate has an effect on return on equity of Nestle Plc.

1.6       SIGNIFICANCE OF THE STUDY

The following are the benefits of this study:

1. To identify and address the various risks associated with the increase and decrease in foreign exchange rate.
2. To Identify and address some possible challenges faced with foreign exchange rate.

III.         To provide various means at which manufacturing companies can reduce the importation

1. To provide a ground for further research and a resourceful material to other researchers
2. To provide knowledge as to how profitability can be maintained as well as increased.

 1.7       SCOPE OF THE STUDY

The focus of this study is to identify the implication of foreign exchange on profitability of firms with regards to the return on asset and return on equity.  The case study of this research is Nestle Nigeria and Switzerland, within a time frame of 30years (1986-2015)

The dependent variable in this study is profitability while the independent variable is foreign exchange and the control variable is interest rate. The proxy for the dependent variable would be nestles return on asset and return on equity from year1986 to 2015, whereas the independent variable would be measured using the prevailing exchange rate of the individual years in view.

1.8       Operationalization of variables

variables could be operationalized as follows:

Y= f(X)

Where;

Y= profitability (PT)

X = Foreign Exchange Rate (FER)

x₁= Foreign Exchange Rate (FER)

x₂=  Interest Rate (INR)

Y= (y₁,y₂) and X = (x₁, x₂)

Y₁= Return on Asset (ROA)

Y₂= Return on equity (ROE)

ROA = f (FER)

ROA = f (FER, INR)

ROE = f (FER)

ROE = f (FER, INR)

1.9       DEFINITION OF KEY TERMS

So as to promote proper understanding of this project work, certain terms would have to be defined to enable the user of this work make complete meaning of it.

RETURN ON EQUITY: shareholders’ profitability expressed as a percentage of the firm’s net worth.

INTEREST RATE: the percentage of an amount of money charged for its use often a year

RETURN ON ASSET: this is the operating income expressed as a percentage of operating asset

FOREIGN EXCHANGE RATE: this is the rate at which one currency can be converted together

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