Textron free essay sample

Anna Amphlett, a financial analyst at Textron Corporation, has been asked by the controller to benchmark the company’s recent financial performance against competitors in the aerospace and defense industry. Top management plans to assess the performance of the company’s supply chain and its future working capital requirements. Textron experienced impressive stock price growth in the last five years, but top management is particularly interested in understanding the company’s sizeable investments in net working capital over the same period. In benchmarking Textron’s performance, Amphlett must also consider what to do about accounting method differences across companies in the aerospace and defense industry, since they may have a significant effect on the interpretation of differences in reported performance. EXECUTIVE SUMMARY Textrons Board of Directors had launched a new initiative to assess the companys supply chain and the companys working capital needs. First step was to benchmark the companys recent financial performance against other aerospace and defense firms to determine the areas in which the companys performance could be improved. Top management was particularly interested in understanding the companys sizeable investments in net working capital. COMPANY PROFILE Company History Textron started as a small textile company in 1923, when 27-year-old Royal Little founded the Special Yarns Corporation in Boston, Massachusetts. Revenues that first year were just $75,000. Today that company has grown into a highly successful multi-industry enterprise recognized for our network of powerful brands, world-class processes and talented people. The Tex was derived from textiles and the tron came from synthetics such as Lustron. The theme of the advertising reflected Littles vision: From yarn to you, its Textron all the way. Birth of a Conglomerate,Products and Business Segments In 1952, facing yet another decline in the demand for textiles, Little approached the Textron Board of Directors for approval to diversify by acquiring businesses in unrelated industries. He planned to maintain textile operations as an earnings base while acquiring non-textile businesses. Textron purchased its first non-textiles business Burkart Manufacturing Co. of St. Louis, Missouri who supplied cushioning materials to the automotive market in 1953. Littles success building a diversified company prompted other businesses to follow his model. The pace of acquisitions was great and among the more important businesses added in the early 1950s Textron Inc. is a Global Multi-Industry Company. It is a pioneer of the diversified business model. It grown into a network of businesses with total revenues of $12. 2 billion, and approximately 40,000 employees with facilities and presence in 32 countries, serving a diverse and global customer base. Headquartered in Providence, Rhode Island, U. S. A. ,Textron is ranked as 190th from 216th in 2005 on the Fortune 500 list of largest U. S. companies. Organizationally, Textron consists of numerous subsidiaries and operating divisions and segments, which are responsible for the day-to-day operation of their business namely:(1) The Cessna segment manufactures business jets, single-engine utility turboprops, and single-engine piston aircraft, as well as parts, maintenance, inspection, and repair services. (2) The Bell segment manufactures and supplies military and commercial helicopters, tiltrotor aircraft, and related spare parts and services. (3) The Textron Systems designs, develops, installs, and provides maintenance of advanced full flight simulators; and supports aviation training products and related services. (4) The Industrial segment offers blow-molded plastic fuel systems, windshield and headlamp washer systems, engine camshafts, catalytic reduction systems, and other parts, as well as plastic bottles and containers; golf cars and professional turf-maintenance equipment, (5) The Finance segment provides commercial loans and leases for aircraft and helicopters. Textron’s Strategy Textrons Board of Directors provides strategic and management oversight as well asglobal business perspective, while upholding rigorous governing principles on behalf of the companys shareholders. Senior leaders from directors to the corporate officers share an unrelenting focus on Textrons vision to become the premier multi-industry company in the world, recognized for the network of powerful brands, world class enterprise and talented people through enterprise and portfolio management. Textron’s stock price performance Textron’s recent stock price performance was impressive with overall increase from $22 in 2001 to more than $55 in 2007 much better than SP 500. According to Cowan the estimated EPS in 2007 and 2008 of $6. 25 and $7. 30 respectively. $51. 50 is the target price per share set by Prudential. STATEMENT OF THE PROBLEM Over the last 10 years of unimpressive growth of Textron’s sales, net income and cash flow, Anna Amphlett (financial analyst) has come up to the following problems: 1. What is Textron’s current standing in the Aerospace and Defense industry? 2. Is Textron making more money than its competitors? Is Textron’s management strategy more effective than others? 3. What might be some of the areas Textron need to improve? 4. How do different accounting methods used by companies of the same industry affect her analysis? OBJECTIVES To make a benchmark performance between the Textron and its best and immediate competitor(s) within the same industry segment (mostly Aerospace and Defense firms) by using financial ratios for the fiscal 2005 and 2006 and to compare with Textron’s. ANALYSIS Financial Ratio Benchmarking Benchmarking can be done in many ways, and ratio analysis is only one of these. One benefit of ratio analysis as a component of benchmarking is that many financial ratios are well-established calculations derived from verified data. In benchmarking as a whole, benchmarking can be done on a variety of processes, meaning that definitions may change over time within the same organization due to changes in leadership and priorities. The most useful comparisons can be made when metrics definitions are common and consistent between compared units and over time. Benchmarking using ratio analysis can be useful to various audiences. From an investor perspective, benchmarking can involve comparing a company to peer companies that can be considered alternative investment opportunities from the perspective of an investor. In this process, the investor may compare the focus company to others in the peer group (leaders, averages) on certain financial ratios relevant to those companies and the investor’s investment style. From a management perspective, benchmarking using ratio analysis may be a way for a manager to compare their company to peers using externally recognizable, quantitative data. Industry competitors General Dynamics is a market leader in business aviation; land and expeditionary combat vehicles and systems, armaments, and munitions; shipbuilding and marine systems; and mission-critical information systems and technology. Honeywell International, Inc is an American multinational conglomerate company that produces a variety of commercial and consumer products, engineering services, and aerospace systems for a wide variety of customers, from private consumers to major corporations and governments. Lockheed Martin global aerospace, defense, security, and advanced technology company with worldwide interests. It was formed by the merger of Lockheed Corporation with Martin Marietta in March 1995. It is headquartered in Bethesda, Maryland, in the Washington Metropolitan Area. Lockheed Martin employs 116,000 people worldwide Northrop Grumman Aerospace Systems, one of four sectors within Northrop Grumman Corporation, is a premier developer, integrator, and producer of manned and unmanned aircraft, space systems and advanced technologies critical to our nation’s security. From sea, air, land or space, Aerospace Systems provides solutions that advance technology and discovery while meeting customer needs with high impact, best value aerospace products and systems. The Raytheon Company is a major American defense contractor and industrial corporation with core manufacturing concentrations in weapons and military and commercial electronics. It was previously involved in corporate and special-mission aircraft until early 2007. Raytheon is the worlds largest producer of guided missiles. Rockwell Collins, Inc. is a large United States-based international company headquartered in Cedar Rapids, Iowa, primarily providing avionics and information technology systems and services to governmental agencies and aircraft manufacturers. Financial Ratio Analysis In analyzing the Textron Corporation and its industry which is the aerospace and defense, we opt to performed financial benchmarking since financial ratios and as dictated by our objectives. With that we could compare and analysis financial data to assess our company’s overall competitiveness and productivity. First we identify the subject of which we need to improve or the weaknesses we choose to benchmark. The company’s unimpressive growth on sales, net income/operating margin and cash flows over ten years was what we had identified. We compared financial ratios of profitability, solvency, liquidity and activity from 2005-2006 of Textron Corporation against the industry competitors namely General Dynamics Corp. , Honeywell Int’l Inc. , Lockheed Martin Corp. , Northrop Grumman Corp. , Raytheon Co. , and Rockwell Collins Inc. against Textron Corporation. These were the result of the analysis: On the basis of gross margin and return on sales left after of cost of goods sold and operating expenses. General Dynamics Corporation had the top percentage of a 100%. Next-to-leading was Rockwell Collins Inc. followed by Textron Corporation(GMR) while Rockwell hit the top with regard to Return on sale of 12. 35%. Rockwell Collins also top the most outstanding and effective management as measured by ROE and ROA, Textron and Raytheon had the lowest percentage on ROS and ROA however Textron got the third rank next to Lockheed on accomplished ROE. In terms of liquidity Rockwell Collins had a strong level of current and quick assets while General Dynamics and Northrop is at the least. Textron also had a good s Ranking the financial leverage ratios Textron’s assets were mostly finance by long-term debt compare to other company. Notice that Rockwell Collins had the most conservative policy with regards to borrowing funds from long-term accounts. The company also had a good standing in meeting interest obligations. Textron’s can collect receivables more often than others, approximately 12 times while Raytheon can create and sold inventories 36 times in one operating period. Such companies hit the top ratio of activity measurement. On the other hand Rockwell had a rare receivable collection policy and longest times inventories were created and sold. After we had conduct comparison on the overall Aerospace and Defense Industry and determine significant areas which may affect our benchmarking analysis, we now conclude that ROCKWELL COLLINS INC. will be our basis for best practice and standard for the remaining analysis. Since Rockwell Collins profitability and management effectiveness were constant we also assume its attainment for our company. We considered to aim the highest possible stand Rockwell had currently so that if ever we failed to meet our goal or if won’t be on top we still be falling at least near to the industry’s best practice. So on the next reporting period we can define our strategies and be better that what the industry has for today. With these, we now take a closer look on the analysis between TEXTRON CORPORATION and ROCKWELL COLLINS INC. to know on more of the areas we want to improve and learn from them on how they achieve their success. BENCHMARKING: TEXTRON CORPORATION VS ROCKWELL COLLINS As pictured in the graph Rockwell had an excellent performance in terms of profitability than Textron. Rockwell’s GMR, ROS and ROA’s ratio were assumed to be the result of effective management and strategies to increase sales at maximum in the minimum cost. Although Textron gross margin ratios were closely to Rockwell’s the return on sale (ROS) bent down to 5%. This was to assume that Textron’s fixed administrative and selling expenses were higher that Rockwell. However Textron boost its return on equity (ROE) because of debts. Obtaining higher debt automatically generates an increase in the equity return. Return on asset (ROA) simply implicates how much earnings we had for every dollar sales and obviously Rockwell had a higher return on assets for it maximize the capacity of its fixed assets for a higher a sales volume. Textron showed a reliance borrowing funds from others than its shareholders in financing its operation and therefore its assets was mostly finance by creditors rather than owner. Times interest earned by Rockwell hits the highest times its earnings available could meet interest obligations against it interest obligations. These graph simply showed that Textron was under a financial leverage and such contributes a financial risk on part of Textron On the analysis liquidity analysis we look at the change in Textron’s acid test ratio and current ratio. The graph pictured out that how the company’s management strategies in handling quick asset were quite aggressive Textron’s operating cycle takes 119 days while payment period takes 114 days this means that Textron should be aware on conserving its investment on current assets. There was a delay of 5 days in paying creditors after maturity. Definitely Rockwell Inc. has the same scenario since their ratios were similarly closer to one another. In asset management analysis, day’s receivable of Textron compare to Rockwell Collins Inc. is stricter in this could be one the reason of decrease of Textron’s growth in its revenue, net sales and cash flows. We assume that Textron’s collection policy stricter than Rockwell. Rockwell’s asset was more utilized at maximum compare to Textron. However, Textron’s number of days inventory was created before sold was shorter than Rockwell which was favorable for Textron. Disclosure Incorporated with the Analysis In order to make an â€Å"apples-to-apples† comparison between the companies, appropriate adjustments to inventory and cost of sales data must be adjusted. Inventory accounting method has a direct impact on financial ratio analysis results on the reported financial measures. We do not adjust these accounts considering the other ratios may be affected and for reasons that the financial statements of competitors are not given. We wish to do common-size analysis and inventory adjustments as well if only these data limitations associated with the case would not exist. Being on the same industry Textron and Rockwell both have products of spare parts it just so happen that most of Rockwell’s revenues are coming from the sale of parts and other related services rather aircrafts which is contrary to Textron. Inventory Ratio analysis compared between Textron and Rockwell would not be adopted since Textron’s inventory days are better than Rockwell’s instead we recommend of ways on how to improve it and lower the number of days on the creation and sale of goods waiting time. In effect this would contribute to a more efficient operating cash cycle. CONCLUSION After the benchmarking performance analysis on the Aerospace and Defense Industry we could conclude that Textron Corporation’s stand on the industry was on average because Textron was not on top but it had strong positions that were better than the most among the industry. The different accounting policies that exist among different companies will not affect our benchmarking analysis as long as it conforms to the GAAP. We do not adjust the inventory and cost of sales account for it would affect the other ratio analysis since we only have limited financial information about the other company in the industry. On the other hand, proper disclosure of the effect of the differences would be appropriate as remedy for be believe that the methods use by the companies are base on the management strategies of what is better for their organizations. RECOMMENDATIONS There are areas in which Textron needs to improve like its receivable collection policy, days to sell inventories, asset utilization, conservation on current assets and debt/capital structure. With these Textron would be able to strengthen it unimpressive growth on sales, net income and cash flows. We recommend Textron to offer cash discounts for example a period of 10 days and maintain their strict credit policy collection to commercial products like spare parts, repairs and maintenance etc. Establish good creditor-debtor relationship. We are expecting that this strategy will increase sales and reduce receivable balance. Days to sell inventory should be shorten to avoid excess cost on handling inventories cost. Solvency on part of Textron must also be observed due their increasing long term debts. We also advise them to minimize borrowing of funds because this could help a business in the long run. Wise decision on borrowing long-term debts must be first considered. A heavy debt burden couples with a sudden economic downturn could put a company out of business rather quickly. Textron conservatism on current ratio be observe so that it could improve their operating cycle. Assessing the company’s overhead cost and see if there are opportunities to decrease them. Lowering overhead has a direct impact on profitability. Overhead expenses including administrative, selling, labor etc. that Textron was incur to operate the business out of direct materials and direct labors. Review the profitability on the company’s various product and services. Assess where prices can be increase on a regular basis to maintain and increase profitability. As costs increase and market change, prices may lead to be adjusted as well.

History Seminar Beethoven Piano Sonatas free essay sample

After the completion of the Hammerless, Beethovens passion for the piano sonata refused to dissipate. The next three piano sonatas, written over the span of three years, have consecutive opus numbers: Pop. 109 in E major, Pop. 110 in A flat Major, and Pop. 11 In C minor. Beethoven clearly approached his last three Plano sonatas as a single project.In the letters to Doll Schlesinger dated 30 April 1820 and 20 September 1820, Beethoven mentioned that: l am also very willing to sell you some new sonatas, but at no other price than 40 florins each, thus perhaps a lot of three mantas for 120 florins. Everything will go more quickly in the case of the three sonatas- the first is quite ready save for correcting the copy and I am working uninterruptedly at the other two. Among the three last piano sonatas, Pop. 111 may have the most interesting history.For example, the primary theme of the first movement appeared in Beethovens sketchbook in 1 801 . We will write a custom essay sample on History Seminar: Beethoven Piano Sonatas or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page According to a nineteenth-century German editor, Gustavo Notebook, this theme may have been intended for the finale of one of the Pop. 30 violin sonatas. On 3 July 1822, Beethovens publisher of Pop. 11, Adopt Schlesinger wrote to Beethoven regarding his concern for the two-movement layout, asking if a third movement had been left behind by the copyists. According to Anton Schneider, Beethoven answered casually that he had not had time to write a third movement, and had therefore simply expanded the second. However, two-movement piano sonatas were not unheard of in Beethovens oeuvre. Works such as the Piano Sonata Pop. 54, Pop. 78. And Pop. 90 consist of two movements of a much shorter length and lighter weight. In my opinion, the reason that Pop. 111 is two-movements, besides the extraordinary weight and length of the second movement, is its extra-musical Implication composed of a two-movement scheme which will be discussed In a later paragraph. Pop. 111 was written between 1821 and 1822 and dedicated to Archduke Rudolf of Austria.Critics of the time found it difficult to understand it when it was published in 1823; Journalists began to use Beethovens deafness as a convenient explanation for Its level of technical experimentation and its Intensely personal nature. In 1823. A review in The Harmonic of London states that: The Sonata, Pop. 111 consists of two events. The first betrays a violent effort to produce something in the shape of novelty. In It are visible some of those dissonances the harshness of which may have escaped the observation of the composer.The second movement is an Irritate We have devoted a full hour to this enigma, and cannot solve. Composed In the fateful key of C minor, Pop. 111 shares similar characteristics with works written in the same key, such as Piano trio Pop. L No. 3, String Trio Pop. 9 No. 3, Violin Sonata Pop. 30 No. 2, Plano Sonata Pop. 10 No. L and Pop. 13, Piano concerto Pop. 37 No. , Symphony Pop. 67 No. 5, and Corcoran Overture Pop. 62. Chopin was known to have greatly admired Pop. 11, and such association between C minor and the fateful character can be found in his second piano sonata and the Revolutionary Etude in respectively. Besides the fateful character, its implied musical meaning has been Model recognized. As Alfred Breeder states, Pop. 111 leaves a dual impression- it is the final testimony of his sonatas as well as a prelude to silence. Different writers have suggested that the significance of this last sonata goes far beyond the fact that he sonata simply finalizes Beethovens piano sonata composition. William Zimmerman describes the philosophical meaning of Pop. 111: Beethovens last piano sonata is a monument to his conviction that solutions to the problems facing humanity lie ever Nothing our grasp if they can be recognized for what they are and be confronted by models of human transformation. The heart of such recognition of philosophical meaning in pop. 111 is the aesthetic of the two-movement sonata design, which incorporates and implies dualism of two antithetic ideas. In other words, Pop. 1 lays the platform for the extra-musical battles between two opposite forces occurring not only within a movement, and between the first and the second theme, but also among the movements. Beethoven pits the following against one another: the impulsive Allegros con brio De passionate and the serene Adagio molt simple e cantabile; chromatic harmony of the thematic development and transitions and the diatonic harmony of the theme; C minor and C major; common time with duple subdivision and compound meter Ninth triple subdivision; frequent interruption of harmony and tempo and one tempoNinth no interruption; and linear style with fugal passages and great variety of keyboard writing. In addition, the first movement is structured in a combination of sonata form and fugue, which demonstrates the composers original and bold aspects. The integration of two formal elements emancipates the fugue from being confined to the development section of the sonata. The second movement, on the other hand, is cast in the theme and variation. In spite of its expansiveness, the music follows the traditional variation scheme with one basic tempo maintained throughout the movement.

Purchasing Power Parity Theory

Introduction As a result of various economic pressures it is a known fact that currency exchange rates vary over time. For example, in 1970 one US Dollar could be used to buy 627 Italian Lira or 3.65 German Marks. In 1998 both Italy and Germany were making preparations to make the Euro their common currency.Advertising We will write a custom research paper sample on Purchasing Power Parity Theory specifically for you for only $16.05 $11/page Learn More In this period one US Dollar could purchase 1,737 Italian Lira or 1.76 German Marks (Mankiw 2008, p. 707). From this data alone it is possible to grasp that the Dollar value dropped by over half when compared to the Mark while it increased almost twice when compared to the Lira. Economists often make models that attempt to explain these large and opposite changes. To understand these changes it is crucial to provide in depth information that indicates how the various economic forces work to cause the fluct uations. The Purchasing Power Parity (PPP) theory is one of the simplest theories used in explaining this behavior in exchange rates. This theory states that one unit of a given currency should be able to purchase the same quantity of goods in any part of the world. It has been suggested by several economists that the theory provides a description of the forces that affect exchange rates over a long duration (Mankiw 2008, p. 707). The PPP theory is founded on a principle known as the law of one price. This law states a good must sell at a single price in all locations. If this is not the case then the market leaves opportunities for profit unexploited (Mankiw 2008, p. 707). For example if coffee costs $4 in one location and $5 in another location people will begin to do business between the locations making $1 profit from each sale. This process of taking advantage of price difference of a product in different market is known as arbitrage (Mankiw 2008, p. 707). Based on this example the trade would increase demand in the source location and increase supply in the destination location. The forces of supply and demand would then act upon the price at the source and destination causing the price to be equal. There are two popular applications of the PPP theory each with its implications. The first application is the Absolute form of PPP based on the notion that in the absence of international barriers the consumers are expected to shift their demand to where the lowest prices are offered.Advertising Looking for research paper on business economics? Let's see if we can help you! Get your first paper with 15% OFF Learn More This suggests the rice of a particular category of gods should be the same in different countries when compared using a common currency unit (Madura 2008, p. 214). Any shift in prices will cause a shift in demand based on the law of one price thus causing convergence of prices. However, the effect of tariffs, transport costs and s uch associated costs do not allow absolute PPP theory to be applicable. The second application is the relative form of the PPP theory which considers the role of market imperfections such as tariffs, transport, etc. This suggests that prices for the same category of products may not necessarily be the same in different regions. However, the theory suggests that the rate of change in price should exhibit similarity when market imperfections are considered and a common currency is used for measurement (Madura 2008, p. 215). Based on this estimation a specific product category price can be used to estimate exchange rates. Taking the example of the Big Mac Index, in July 2007 a Big Mac cost $3.41 in the US and 280 Yen in Japan. Based on this the expected exchange rate is 82 Yen to the Dollar whereas the actual rate was 122 Yen/Dollar (Mankiw 2008, p. 711). This example illustrates that the PPP theory is not always accurate for measuring the exchange rate though it can be used for estima tion. Empirical Literature on PPP In a period of over twenty years after the Bretton Woods system of exchange there are still debates over whether real rates of exchange are mean reverting (Caner and Kilian 2000, p. 12). It is also reported that most economists agree on some form of PPP and recognize its essence in construction various macro economic models. The statistical tests on the PP theory f mean reversion have to date produced conflicting results. As earlier stated the theory operates based on the law of one price. This law suggests that in time forces of supply and demand will always work to make a product price stabilize (Mankiw 2008, p. 707). This position has made this a case of interest that may be worth testing using the null hypothesis that real exchange rates are mean reverting. Though a failure to reject this null hypothesis is inadequate to convince skeptics of the existence of long run PPP such attest would provide compelling evidence against long run PPP (Caner a nd Kilian 2000, p. 12).Advertising We will write a custom research paper sample on Purchasing Power Parity Theory specifically for you for only $16.05 $11/page Learn More Tests to determine the stationarity of the PPP theory have failed to be proven and as such suggest that PPP theory can not accurately determine the exchange rate. This is because results mainly show many contradictions and spurious acceptance. The intuitive appeal of PPP notwithstanding it has been found that there is inconclusive evidence in support of the theory. This has been based on an analysis in countries with relatively low inflation rates in the post Bretton Woods era (Ender and Dibooglu 2004, p. 1). This has been observed in numerous co integration tests known as stage three tests that indicate exchange rates exhibit major fluctuations with a very slow rate of decay towards a long run average. This point is especially unfortunate since stage three tests appear very suitable f or the task. The stage three tests typically require no assumptions with regard to exogeneity. In addition to that these tests are based on a sensible implication and dynamic between price levels and exchange rates (Ender and Dibooglu 2004, p. 1). After conclusive testing using fur pairs of countries, it is reported that this theory is inadequate for calculation of exchange rates in industrialized countries. It has been suggested that the move by central banks to influence exchange rate movements may be the cause of the poor results (Ender and Dibooglu 2004, p. 16). In addition to this it has been observed that national prices levels are prone to increase more readily than to decrease. As a result prices and exchange rates show different adjustment patterns for positive deviations from PPP as opposed to the adjustment patterns for negative deviations (Ender and Dibooglu 2004, p. 16). The source of such behavior as stated before may be due to the role of central banks. Following the collapse of the Bretton Woods institutions the exchange rates are calculated using data from a relatively short span of time. The result has seen the use of the floating exchange rate and has caused much controversy on the use of the PPP theory (Pedroni 2001, p. 727). This is especially true since PPP theory is accurate over longer periods of time using much more data.Advertising Looking for research paper on business economics? Let's see if we can help you! Get your first paper with 15% OFF Learn More The use of co integrated tests is based on the realization that PPP is affected by several factors such as transportation, production costs, etc. which vary from one region to another. It is assumed that since there is a variation in these factors there is varying significance to these in different regions. This is what gives rise to the null hypothesis test to confirm relevance of the co integrated relationships (Pedroni 2001, p. 727). Despite the fact that these tests prove a relationship between these factors it is not adequate to give strength to the PPP theory. It is reported that in the period of two decades that has seen the use of the random walk in predicting foreign exchange rates, research has failed to produce models that can provide accurate predictions. The conclusion of many economists is that the standard models for estimation are inadequate. Others go further to say that the system is sound despite its poor implementation as a liner statistical model (Kilian and Tay lor 2001, p. 1). However some researchers argue that PPP test when carried out with respect to national prices and allowance for exchange rate shocks remains valid (Coakley, Flood, Fuertes and Taylor 2005, p. 273). This is because the exchange rate is influenced by the movement relative prices between two countries. Thus the changes in currency exchange are offset by price changes in the currencies of the countries. For this evaluation to be successful the data set should include heterogeneous countries. The relationship between the countries is crucial especially with regard to stock and growth rates (Head and Shi 2003, p. 1556). Any change in money stocks or growth rates is likely to lead to error in the results generated. There have been many tests that have applied co integration to PPP but the results provided are still inadequate to provide the theory required plausibility (Froot and Rogoff 1994, p. 23). Some researchers argue that the data produced is misleading due to sample bias in the studies. There has been resurgence in studies on PPP and it is promising to note that on the long term there appears to be a convergence to PPP values (Froot and Rogoff 1994, p. 39). However, it is crucial to note that in most studies where such convergence is evident rely on some fixed data. This has been accompanied by several studies on government expenditure and real exchange rate shocks. It is hoped that in time this data when applied with econometric techniques will allow researchers to determine how long it takes for convergence with PPP values to be realized (Froot and Rogoff 1994, p. 40). This is crucial given that PPP appears to play a central role in the calculation of exchange rates. With this in mind a clear understanding of the role of various shocks may prove fruitful in providing a solid method of estimating exchange rates. Testing PPP Theory US UK Base Year 2000 2000 Base Year Annual CPI Average 88.7 88.15 Target Year 2009 2009 Target Year A nnual CPI Average 111.3 109.875 Inflation 0.797 0.802 Percentage of Inflation 79.7 80.2 Devaluation 20.3 19.8 Target Year Expected CPI x 100 125.5 126.5 Target Year Actual CPI 112.9 110.7 (IMF 2010) In this example the null hypothesis being tested was whether the PPP theory can be used to accurately estimate the customer price index for two given countries. In such a test either the (PPI) Producer Price Index or (CPI) Consumer Price Index may be used. In this case the statistics offered data for the CPI and hence the CPI was used for the countries USA and UK. The CPI is an established average price for a given set/basket of goods within a give country (Ignatiuk 2007, p. 8). To calculate the inflation rate of the country the test required the selection of a base year and a target year. For this case the base selected was 2000 and the target was 2009. Using the average CPI for the base year and target year inflation is calculated. The result is multiplied by a hundred to get a percentage. The difference between this sum and 100 is the inflation that has been experienced during the range of years selected (Ignatiuk 2007, p. 8). Possible Reasons for the Results As stated above the rejection of the PPP null hypothesis is inadequate to reject the theory entirely. The problem is that PPP requires a very long term for mean convergence to be achieved and deviations in results and the PPP estimates is too persistent (Parsley and Wei 2004, p. 1). For the reason that exchange rates are prone to several short term factors it would appear that PPP is better suited for making long term foreign exchange predictions. There are several factors that are likely to influence the exchange rate and thus the PPP. Among these factors is the growth or the slump in the Gross Domestic Product (GDP). In addition to this are any potential interventions by the central bank in the economy (Dun and Bradstreet 2007, p. 21). In summary the behavior of a currency is similar to commo dity behavior in a market and is influenced by forces of supply and demand. An increase in demand for a specific currency due to trade increases leads to increases in the exchange price for that particular currency. Any increase in supply of the same currency also leads to decline in the exchange price for that currency (Dun and Bradstreet 2007, p. 21). Justification for the Estimation Method The theory of PPP is known to be based on the rule of one price (Mankiw 2008, p. 707). For this reason an accurate estimation of prices in various countries would require a product with a price that can be used as a standard price. IN this case the study selected the USD Big Mac Index. The selection of the Big Mac Index was considered favorable because for an accurate estimation of the PPP a basket of goods is necessary. In our case the Big Mac is a widely accepted product and is well suited as a basket of goods. The Big Mac produced by the McDonald’s franchise is made from known ingredi ents that can also help in assessment of a specific basket of goods (Parsley and Wei 2004, p. 3). Another crucial factor to consider in the application of PPP theory is the inflation rate of the countries being compared. Thus to perform an accurate PPP analysis countries that bear similar economic traits should be considered Head and Shi 2003, p. 1556. Inflation which is mainly the increase in cost of goods is influenced by many external and internal factors (Brigham and Houston 2009, p. 609). The rate of inflation will therefore affect the Consumer price index which is used in calculation of the PPP. With such changes accounted the PPP may be less inaccurate (Adams 2003, p. 98). According to the theory of PPP the increases in prices of goods is reflects the inflation rates in a country. The last point that justifies the use of the CPI to study PPP and exchange rates is due to the fact that baskets across different countries are not identical. This is because new products are added over time and quality of the ingredients varies from one region to the next (Parsley and Wei 2004, p. 2). The CPI is calculated based on a given set of goods that are available in all countries. Results In this test the CPI has been used to test the validity of the PPP theory with regards to accurate estimation of CPI data. The results of this test indicate that the CPI calculated using the PPP theory indicate some similarities but are significantly inaccurate based on the data in the CPI index (Parsley and Wei 2004, p. 23). This indicates that the PPP theory is inappropriate to estimate the CPI probably due to exclusion of variables in the calculation. In the course of the study some interesting facts are established. In similar studies that used the Big Mac Index it is established that a significant percentage of Big Mac Prices are attributable to non tradable components. In addition to that there is a more significant dispersion with regard to the price of the non traded componen t as opposed to the traded components (Parsley and Wei 2004, p. 23). This suggests that for greater accuracy of the PPP theory in calculation of CPI such factors must be considered. In addition to this it was also revealed that there was greater convergence for non traded inputs across the country as opposed to traded inputs (Parsley and Wei 2004, p. 23). It is hoped that through the study of PPP using non standard indexes such as the Big Mac Index, the evasive answers concerning the slow convergence rate may be unveiled. This is because the theory (PPP) has long been in use though its accuracy in short term situations has been found wanting. Conclusion In this report the discussion presented has provided some information on the Purchasing Power Parity theory. The theory states that the change in price levels in two countries determines the change in exchange rates (Ignatiuk 2007, p. 4). This is based on the principle of one price and argues that exchange rates can adjust with ease when there is movement of goods from one country to another (Neave 2002, p. 247). According to the theory when the prices of goods vary in regions there are opportunities created for arbitrage. This involves transfer of goods from the region with the lower price to the region with a higher price (Wu 2003, p. 252). It is assumed that through forces of demand and supply the prices should come to a mean value. Based on its efficiency in providing accurate estimates of foreign exchange rates some practitioners have argued that the theory presents a good means of estimating exchange rates. It has been observed that despite the fact that the theory does over a long period of time result in convergence of prices. It is unsuitable for estimation on a short term which would require more accurate analysis of econometric shocks that affect currencies. In addition to this the theory assumes similar goods packages which may not be readily available in all countries (Wessels 2006, p. 285) In this report a test was carried out to confirm whether the theory is accurate for estimation of exchange rates. To simplify the process the CPI was selected due to ready availability of long term data and reliability. The results from calculations to estimate the CPI it was found that the PPP theory was inaccurate. However, it should be noted that the rejection of this null hypothesis is inadequate in disapproving the PPP theory. The results merely indicate the inadequacy in exchange rate estimation. 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Peng, M 2008, Global Business, Mason, OH, South Western Cengage Learning. The Economist 2009, ‘Big Mac Index’, The Economist, February 2009, retrieved from https://www.economist.com/economic-and-financial-indicators/2009/02/04/big-mac-index Wessels, W 2006, Economics, US, Baron’s Educational Series. Wu, C 2003, Outline of International Price Theories, London Routeledge. Appendix Figure 1: Big Mac Index 2009 This research paper on Purchasing Power Parity Theory was written and submitted by user Axel Allison to help you with your own studies. You are free to use it for research and reference purposes in order to write your own paper; however, you must cite it accordingly. You can donate your paper here.