Period: USA Inflation UK Inflation Estimated Exchange Rate 1 2. 4% 3. 2% X1 2 2. 8% 3. 6% X2 3 3. 5% 4. 2% X3 4 3. 2% 2. 5% X4 What is the expected future spot exchange rate in period 4? A. US$ 1. 5722/ UK? B. US$ 1. 5482/ UK? C. US$ 1. 5569/ UK? D. US$ 1. 5158/ UK? 10. Which of the following statements best describes an ADR: I. refers to certificates traded in the United States and denominated in US$. ADR’s are sold, registered and transferred in the United States in same manner as any share of the stock – with each ADR representing a particular multiple of the underlying foreign share. II. efers to certificates traded in the global markets and denominated in US$. ADR’s are sold, registered and transferred in a major world market such as London in same manner as any share of the stock – with each receipt instrument representing a particular multiple of the underlying foreign share. III. refers to certificates traded in a overseas market that are representative of a multiple of underlying shares listed and traded in a foreign domestic market. IV. refer to “baskets” or portfolios of shares of a foreign company listed and traded in US and denominated in US$. A. I only B. II only C. III only D. IV only
Part B: Calculation question You should attempt both questions Each question carries 20 marks 1. You are CFO of Darwin Mineral Exploration, a small Australian mining conglomerate based in Australia. An opportunity to expand operations has arisen with two potential venues under consideration: Perth, Western Australia or Papua New Guinea, a neighbouring country with significant mineral reserves. Each venue has an initial “sunk” cost or capital investment (outlay) and projected cash flows in table below. The current spot exchange rate between Australian Dollar (Aus$) and Papua New Guinean Kina (PGK) is PGK 2. 3106/ Aus$ and we make the assumption that as both currencies are major world currencies that the market for these is efficient and relative purchasing power parity relation holds to a reasonable approximation. As such the forecast annual inflation rates are also displayed in below table for each year. Assume the financing of both potential venues is undertaken in the domestic Australian market. The Australian one year yield rate is 4. 37% while the expected return on the Australian ASX-All Share market portfolio is 14% and the beta between Darwin Mineral Exploration listed equity and the market portfolio is 0. 780. The Australian corporate tax rate is 30% and the default premium on the firms listed debt is 11. 50%. The firm is entirely financed by debt and equity with the latter accounting for 40% of the financial structure. Australia Initial Investment Year 1 2 3 4 Papua New Guinea Australia Aus$ 30,000,000 Forecast Inflation Rate 3. 20% 3. 60% 3. 00% 3. 20% Forecast Inflation Rate 6. 10% 6. 25% 6. 60% 7. 20% Papua New Guinea PGK 250,000,000 Operating Cash Flows Aus$ 10,000,000 Aus$ 20,000,000 Aus$ 15,000,000 Aus$ 12,000,000 PGK 80,000,000 PGK 120,000,000 PGK 126,000,000 PGK 200,000,000
What is the cost of debt for the firm? a) What is the cost of equity for the firm? b) What is the WACC for the firm? c) Estimate the spot exchange rate for each year and use this to recalibrate the Papua New Guinean cash flows into their Aus$ equivalent d) Calculate which of the two venues Perth, Western Australia or Papua New Guinea is likely to be most economically viable and profitable using this Net Present Value formula [Hint: use the cost of capital to discount each individual cash flow] Answer: a) What is the cost of debt for the firm?
Given the firm is financed with respect to domestic Australian market this is the Australian risk free rate plus the firm’s default risk premium on top of this i. e. Pre-tax cost of debt = Risk Free Rate + Default Risk Premium = 4. 37% + 11. 50% = 15. 87% b) What is the cost of equity for the firm? Recall the CAPM formula for the expected returns (otherwise known as cost of equity) for a stock or portfolio: Costof Equity ? Rstock ? RRiskFree ? ? ( RMarket ? RRiskFree ) So Cost of Equity = 4. 37% + 0. 9780*(14% – 4. 37%) = 13. 788% c) What is the WACC for the firm?
We are told that the firm is entirely financed by equity and debt. We are also told that equity accounts for 40% of financial structure. Also don’t forget the importance of corporate tax rate at 28% WACC ? E D * K equity ? (1 ? ? ) * K debt * V V WACC ? (0. 40) *13. 788% ? (1 ? 0. 30) *15. 87% * (0. 60) ? 12. 181% So the WACC = 12. 18% d) Estimate the spot exchange rate for each year and use this to recalibrate the Papua New Guinea cash flows into their Aus $ equivalent We are given the current spot exchange rate between Papua New Guinean Kina and Aus $ i. e. PGK 2. 13106/ Aus$.
For the projected 4 year future span of the project in each venue we are given the inflation rates. So the estimated spot exchange rate for each year (given relative PPP holds) is: Estimated Ex Rate Year 1: 1 ? ? PGK 1 ? (6. 10 / 100) SYear1 ? Scurrent(Year0 ) * ? PGK 2. 13106 / Aus$ * Aus$ 1? ? 1 ? (3. 20 / 100) ? PGK 2. 19094 / Aus$ Estimated Ex Rate Year 2: 1 ? ? PGK 1 ? (6. 25 / 100) SYear2 ? SYear1 * ? PGK 2. 19094 / Aus$ * Aus$ 1? ? 1 ? (3. 60 / 100) ? PGK 2. 24699 / Aus$ Estimated Ex Rate Year 3: 1 ? ? PGK 1 ? (6. 60 / 100) ? PGK 2. 24699 / Aus$ * 1 ? ? Aus$ 1 ? (3. 00 / 100) ? PGK 2. 32552 / Aus$ SYear3 ?
SYear2 * Estimated Ex Rate Year 4: 1 ? ? PGK 1 ? (7. 20 / 100) SYear4 ? SYear3 * ? PGK 2. 32552 / Aus$ * 1 ? ? Aus$ 1 ? (3. 20 / 100) ? PGK 2. 41566 / Aus$ So we have an estimated series of spot exchange rates, namely: Year 1: PGK 2. 19094/ Aus $ Year 2: PGK 2. 24699/ Aus $ Year 3: PGK 2. 32552/ Aus $ Year 4: PGK 2. 41566/ Aus $ e) Calculate which of the two venues A or B is likely to be most economically viable and profitable using this Net Present Value formula [Hint: use the cost of capital to discount each individual cash flow] Perth, Western Australia CF0 = -30,000,000 Discounting of cash flows:
Year 1: 10,000,000 ? 8,914,192. 84 ? 1 ? 0. 1218? 1 20,000,000 ? 15,892,566. 78 ? 1 ? 0. 1218? 2 Year 2: Year 3: 15,000,000 ? 10,625,205. 37 ? 1 ? 0. 1218? 3 Year 4: 12,000,000 ? 7,577,210. 37 ? 1 ? 0. 1218? 4 Overall NPV = -30,000,000+ Sum (Discounted Cash Flows) = Aus $ 13,009,175. 36 Papua New Guinea CF0 = – PGK 250,000,000 = (250,000,000 / PGK 2. 13106/ Aus $) = Aus $ 117,312,511. 14 Discounting of cash flows: Year 1: ? 80,000,000 ? ? PGK 2. 19094/ Aus $ ? ? ? ? 32,549,224. 64 1 ? 1 ? 0. 1218? Year 2: ?120,000,000 ? ? PGK 2. 24699/ Aus $ ? ? ? ? 42,437,007. 17 2 ? 1 ? 0. 1218? Year 3: ?126,000,000 ? PGK 2. 32552/ Aus $ ? ? ? ? 38,379,215. 38 3 ? 1 ? 0. 1218? Year 4: ? 200,000,000 ? ? PGK 2. 41566/ Aus $ ? ? ? ? 52,278,423. 07 4 ? 1 ? 0. 1218? Overall NPV = – Aus $ 13,009,175. 36 + Sum (Discounted Cash Flows) = Aus $ 48,331,359. 11 Choice of venue is: Papua New Guinea (highest positive NPV) 2. A German based firm, has a foreign currency denominated receivable to a Peruvian trading partner due in 270 days of Peruvian Neuvo Sol 35,000,000. As CFO and given the information in the table below you have to evaluate and distinguish between four hedging strategies and decide which is preferable.
Spot exchange rate Nine month forward rate Firm’s best estimate of spot rate in nine months Firm’s WACC (weighted average cost of capital) Nine month Peruvian borrowing interest rate (per annum) Nine month Peruvian lending interest rate (per annum) Nine month German borrowing interest rate (per annum) Nine month German lending interest rate (per annum) Put option near-at-the-money strike price Put option premium (payable at time option contract is written) Number of days in a year Number of days in a month Peru N-Sol 3. 4573/Euro Peru N-Sol 3. 500/Euro Peru N-Sol 3. 3500/Euro 7. 5% 4% per annum 3% per annum 6% per annum 8% per annum Peru N-Sol 3. 4500/Euro 1. 5% 360 30 i) What is the most likely value in nine months if position if left un-hedged? ii) What is the value is a forward contract is used as a hedge? iii) What is the value if a Money market hedge is used? iv) What is the terminal value if a Call option hedge is used? v) As CFO which of these hedging techniques would you recommend and why? Answers i) What is the most likely value in three months if position if left un-hedged?
Leaving the position unhedged will result in the account receivable, namely Peru Neuvo Sol 35,000,000 divided by spot exchange rate in 9 months (270 days): i. e. Un-hedged value = Peru Neuvo Sol 35,000,000 / Peru N-Sol 3. 3500/Euro = Euro 10,447,761. 19 ii) What is the value is a forward contract is used as a hedge? A “forward hedge” involves a forward contract and a source of funds to fulfill that contract. The forward contract is entered into at the time the exposure is created i. e. at the current time (t=0) when the sale of good to Peruvian company was entered on account ledger statement as an account receivable.
In order to “cover” the exposure risk of adverse movements in the foreign exchange rate in 9 months from now affecting the value of the moneys due in the account receivable. So given the firm expects to receive Peruvian Neuvo Sol 35,000,000 in 9 months’ time (270 days) it needs to “sell forward” an equivalent amount (i. e. Peruvian Neuvo Sol 35,000,000) but at a pre-specified forward rate (implicit and stated within the forward contract). This forward rate (given in table above) is: Peru N-Sol 3. 2500/Euro As such the firm agrees to sell Peruvian Neuvo Sol 35,000,000 in 9 months’ time (i. . to *buy* Euros in nine months’ time) at a guaranteed forward rate of Peru N-Sol 3. 2500/Euro – thereby locking in a forward exchange rate from which to be able to receive the expected account receivable of Peruvian Neuvo Sol 35,000,000 and translate this using this forward rate into EUR. So funds (in EUR) to be received using forward exchange rate in nine months’ time = = Peruvian Neuvo Sol 35,000,000/ Peru N-Sol 3. 2500/Euro = EUR 10,769,230. 77 However the account receivable is logged in firm’s balance sheet at current spot rate i. e. Peru N-Sol 3. 573/Euro so the difference between this and the value obtained by using forward rate (forward contract) is = Peruvian Neuvo Sol 35,000,000/ Peru N-Sol 3. 3500/Euro = EUR 10,123,506. 78 The difference i. e. EUR 645,723. 99 is attributed by the firm to foreign exchange risk iii) What is the value if a Money market hedge is used? The first step in setting up a money market hedge for the Peruvian Neuvo Sol 35,000,000 account receivable is to take out a loan in this currency for this amount less interest proceeds i. e. Peruvian Neuvo Sol 35,000,000 loan discounted by Peruvian Neuvo Sol borrowing interest rate (nine months) =
PeruSol35,000,000 ? PeruSol33,980,582. 52 ? 270 ? ? ? ?1 ? ? 0. 04 * ?? ? 360 ? ? ? ? ? As such in borrowing Peru Neuvo Sol 33,980,582. 52 now it will be necessary in 9 months’ time to repay this principal value plus the interest proceeds of Peru Neuvo Sol 1,019,417. 48 – i. e. in 9 months’ time the amount of Peruvian Neuvo Sol 35,000,000 (the amount of the account receivable) will be repaid in full. So in borrowing the loan principal amount of Peruvian Neuvo Sol 33,980,582. 52 and converting this using the current spot exchange rate of Peru N-Sol 3. 4573/Euro (from table in question above) you would receive EUR 9,828,647. 6 today Now if this EUR 9,828,647. 36 is invested today for 9 months into 3 different investment opportunities it will accumulate value as follows: Treasury Bill Start: EUR 9,828,647. 36 End: EUR9,828,647. 36 * (1 ? 0. 06 * 270 ) ? EUR10,270,936. 49 360 A Euro-denominated loan Start: EUR 9,828,647. 36 End: EUR9,828,647. 36 * (1 ? 0. 08 * 270 ) ? EUR10,418,366. 20 360 Back into the Firm at the firm’s WACC Start: EUR 9,828,647. 36 End: EUR9,828,647. 36 * (1 ? 0. 08 * 270 ) ? EUR10,381,508. 78 360 So in contrast to the using the Forward rate (Peru N-Sol 3. 2500/Euro) where the expected proceeds are EUR 10,769,230. 7 – – which of the three above options leads to a value in excess than that of proceeds obtained from using the forward rate? The answer is none – as in the Money Market hedge does not compare favourably against the Forward hedging instrument iv) What is the terminal value if a Call option hedge is used? The option hedge possibility involves the purchase of a put option. The cost of this option would be the following: Size of Option * premium / current spot rate = cost of option (Peruvian Neuvo Sol 35,000,000)*(0. 015)/(Peru N-Sol 3. 4573/Euro) = EUR 151,852. 60
Next carry this value forward at the firms time value for money (or opportunity cost of capital/ WACC) for 9 months: EUR 151,852. 60 * (1+(0. 075*(270/360)) = EUR 160,394. 31 The upside potential from this option is unlimited and is the same as the un-hedged alternative. However the downside risk is limited with this option and the option can be exercised at the excise price or exchange rate of Peru N-Sol 3. 4500/Euro So minimum net proceeds: Peru-N-Sol 35,000,000/ Peru N-Sol 3. 4500/Euro = EUR 10,144,927. 54 However deduct from this value the cost of the option i. e. EUR 160,394. 31
And total minimum value of option is EUR 10,144,927. 54 – EUR 160,394. 31 = EUR 9,984,533. 23 v) As CFO which of these hedging techniques would you recommend and why? Overall the single hedging instrument that is attributable to largest account receivable value is the Forward hedge Section C: short answer essay questions Answer two questions from three Each question carries 20 marks 1. Describe how the recent global financial crisis affected international firms financing 2. Describe and critically assess the assumptions of the Net Present Value (NPV) model and critically appraise its use to evaluate international nvestment opportunities 3. Detail and outline risks involved in the various types of MNE operations [Hint: recall operations can be classified as Green Field, Brown Field, and various Joint Venture] Generally for essay-style answers it would be expected that students write up to 2 or 3 short paragraphs and use the structure introduced in the coursework assignment i. e. Introduction – Main Body/Discussion – Conclusions. Answers should involve carefully constructed arguments which are critically appraised and contrasted