a. 

i.

Under the terms of the arrangement, James, as the company with the largest debt, will pay David $5.22m, as the company with the smallest amount owed. Then James will pay Strongspace $6.35m and Giffen will pay Strongspace $3.01m.

(8 marks)

 ii. 

The Strongspace Group may have problems if any of the governments of the countries where the subsidiaries are located object to multilateral netting. However, this may be unlikely here.

The new system may not be popular with the management of the subsidiaries because of the length of time before settlement (up to six months). Not only might this cause cash flow issues for the subsidiaries, but also the length of time may mean that some of the subsidiaries face significant foreign exchange risks. The system may possibly have to allow for immediate settlement in certain circumstances, for example, if transactions are above a certain size or if a subsidiary will have significant cash problems if amounts are not settled immediately.

(Max 3 marks)

b. Need to hedge against a fall in interest rate, therefore buy call options. Require 50 contracts (25,000,000/1,000,000) u 6/3.

As James is looking to invest on 30 November, December contracts are needed.

Basis

Futures price – current price (1 September) = basis

95.76 – (100 – 3.6) = –0.64

Unexpired basis = ¼ u 0.64 = –0.16

Option

Amount received will be (LIBOR – 0.4%) u 25,000,000 u 6/12

If interest rates increase by 0.5% to 4.1%

Expected futures price = (100 – 4.1) – 0.16 = 95.74

Alternative solution:

If interest rates fall by 0.5% to 3.1%

Expected futures price = (100 – 3.1) – 0.16 = 96.74

Alternative solution:

Using a collar

Buy December call at 97.00 for 0.032 and sell December put at 96.50 for 0.123. Net premium received = 0.091.

If interest rates increase to 4.1%

Alternative solution:

If interest rates fall to 3.1%

Alternative solution:

Summary

The collar gives a significantly worse result than either of the options if interest rates rise, because James cannot take full advantage of the increase. It is marginally the better choice if interest rates fall.

The recommendation would be to choose the option with the 97.00 exercise price, which has a cheaper premium, unless interest rates are virtually certain to fall.

Gross amounts of interest receivable from Ratus Bank based on Year 1 spot rate and Years 2–4 forward rates.

Year 1 = 0.025 × $320m = $8m

Year 2 = 0.037 × $320m = $11.84m

Year 3 = 0.043 × $320m = $13.76m

Year 4 = 0.047 × $320m = $15.04m

Fixed gross amount of interest payable to Ratus Bank in each of the Years 1–4

3.7625% × $320m = $12.04m

Therefore, the expected receipts/(payments) are:

Year 1 = $8.00m – $12.04m = ($4.04m)

Year 2 = $11.84m – $12.04m = ($0.20m)

Year 3 = $13.76m – $12.04m = $1.72m

Year 4 = $15.04m – $12.04m = $3.00m

The equivalent fixed rate of 3.7625% is less than the 3.8% 4-year yield curve rate because the 3.8% represents a zero-coupon bond with one payment in the fourth year. The relevant bond here pays coupons at different time periods when the yield curve rates are lower, hence the fixed rate is lower.

i.

The receipt and payment based on the yield curve remove the fluctuating element, leaving the 60 basis points borrowing charge, the 20-basis points fee and the fixed payment rate: 0.6% + 3.7625% + 0.2% = 4.5625%

(5 marks)

ii.

MetCon Co is using the swap to manage its interest rate risk and is protecting against a rise in interest rates. This has been done without changing the initial debt of $320 million, which is already in issue.

The interest rate payments are fixed, which means that it is much easier for MetCon Co to forecast its future cash flows and also helps to budget accurately.

The cost to MetCon Co is relatively small, especially when compared to potential losses if interest rates are to rise. Other derivatives, such as options, are typically more expensive.

The swap will be relatively straightforward, with the bank undertaking all the relevant administration and organisation. Other derivatives would be more time consuming to arrange. The main disadvantage is that MetCon Co will be unable to take advantage of a favourable movement in interest rates.

There is no counterparty risk involved as the bank is guaranteeing the swap and will make good any default.

(max 5 marks)

Issuing equity and using the proceeds to reduce the amount of debt will change the capital structure of MetCon Co and there are a number of implications of this which need to be considered.

As the proportion of debt compared to equity increases, financial distress also increases and associated costs along with it. Companies with high levels of financial distress may find that suppliers demand more onerous credit terms, and that they may have to give longer credit terms to attract customers and pay higher wages to attract employees. Also, providers of equity may demand a higher level of return because financial risk has increased. In addition, there may be restrictive covenants that make it more difficult to raise funds (either debt or equity). On the other hand, there will be greater levels of tax relief from the higher interest payments. However, this is only available while the company is making taxable profits or tax exhaustion will set in. MetCon Co is assumed to have judged the relative benefits of high and low levels of financial gearing in making its original decision on debt and equity levels.

The proposed equity issue will change the existing balance and therefore the value of MetCon Co may not be maximised. However, a lower debt level would result in a higher credit rating for the company as well as reduce the scale of restrictive covenants. Increasing the level of equity would also increase the debt capacity of the company, which would help to raise finance for future projects more easily. Reduced financial distress may make it easier to deal with stakeholders such as suppliers and customers.

Changing the financial structure of a company can be expensive. There are likely to be costs for the early redemption of debt which can be found in the contractual clauses of the debt to be repaid. A new issue of equity may also be expensive, especially if shares are offered to new shareholders as there will be marketing costs and underwriting costs as well. Although a rights issue may be less expensive, the costs may still be significant.

If a rights issue is undertaken, MetCon Co will need to decide on whether the current shareholders will be able to take up the rights and the level of discount to the current market price that should be offered to ensure a full take-up of rights. The impact of the rights issue on the current price should be considered as well. Studies have shown that typically markets view rights issues positively and the share price does not reduce to the theoretical ex-rights price. However, this is because the funds are usually spent on profitable projects and the reaction may not be so positive if the funds are to be used to repay debt.

The move will need to be justified to the market and so MetCon Co will need to provide information to existing and any new shareholders which shows that one group will not be favoured at the expense of another. Sufficient information is required to prevent issues with information asymmetry, but if too much information is produced it may reduce the competitive position of MetCon Co.

Using forward rate agreements (FRAs)

FRA rate 4.82% (3–7), since the investment will take place in three months’ time for a period of four months.

If interest rates increase by 0.9% to 4.99%

If interest rates decrease by 0.9% to 3.19%

Using futures

Need to hedge against a fall in interest rates, therefore go long in the futures market. Standard Co needs March contracts as the investment will be made on 1 February.

No. of contracts needed = $48,000,000/$2,000,000 × 4 months/3 months = 32 contracts.

Basis

Current price (on 1/11) – futures price = total basis

(100 – 4.09) – 94.76 = 1.15

Unexpired basis = 2/5 × 1.15 = 0.46

If interest rates increase by 0.9% to 4.99%

If interest rates decrease by 0.9% to 3.19%

Using options on futures

Need to hedge against a fall in interest rates, therefore buy call options. As before, Standard Co needs 32 March call option contracts

($48,000,000/$2,000,000 × 4 months/3 months).

If interest rates increase by 0.9% to 4.99%

If interest rates decrease by 0.9% to 3.19%

(14 marks)

Discussion

The FRA offer from Sage Bank gives a slightly higher return compared to the futures market; however, Standard Co faces a credit risk with over-the-counter products like the FRA, where Sage Bank may default on any money owing to Standard Co if interest rates should fall. The March call option at the exercise price of 94.50 seems to fix the rate of return at 4.41%, which is lower than the return on the futures market and should therefore be rejected. The March call option at the exercise price of 95.00 gives a higher return compared to the FRA and the futures if interest rates increase, but does not perform as well if the interest rates fall. If Standard Co takes the view that it is more important to be protected against a likely fall in interest rates, then that option should also be rejected. The choice between the FRA and the futures depends on Standard Co’s attitude to risk and return, the FRA gives a small, higher return, but carries a credit risk. If the view is that the credit risk is small and it is unlikely that Sage Bank will default on its obligation, then the FRA should be chosen as the hedge instrument.

(5-6 marks)

(Max 19 marks)

The delta value measures the extent to which the value of a derivative instrument, such as an option, changes as the value of its underlying asset changes. For example, a delta of 0.8 would mean that a company would need to purchase 1.25 option contracts (1/0.8) to hedge against a rise in price of an underlying asset of that contract size, known as the hedge ratio. This is because the delta indicates that when the underlying asset increases in value by $1, the value of the equivalent option contract will increase by only $0.80.

The option delta is equal to N(d₁) from the Black-Scholes Option Pricing (BSOP) formula. This means that the delta is constantly changing when the volatility or time to expiry change. Therefore, even when the delta and hedge ratio are used to determine the number of option contracts needed, this number needs to be updated periodically to reflect the new delta.

An interest rate collar involves the purchase of a put option and the simultaneous selling of a call option at different exercise prices. The main advantage is that it is cheaper than just purchasing the put option. This is because the premium received from selling the call option reduces the higher premium payable for the put option.

The main disadvantage is that the benefit from any upside movement in interest rates is capped by the sale of the call option. With just the put option, the full upside benefit would be realised.

Futures

As Alex is looking to protect against a rise in interest rates it needs to sell futures. As the borrowing is required on 1 May, June contracts are needed.

No of contracts needed = €22,000,000/€1,000,000 × 5/3 months = 36.67

Need 37 contracts

Basis

Current price (1 Jan) – futures price = basis

100 – 3.3 – 96.16 = 0.54

Unexpired basis = 2/6 × 0.54 = 0.18

The difference in interest rates comes from the rounding of the contracts.

Using options on futures

As Alex is looking to protect against a rise in interest rates it needs to buy June put options. As before 37 contracts are needed.

In each case the cost in euros can be calculated as interest rate x 5/12 x size of loan e.g., 0.0476 x 5/12 x 22m = 436,333 euros.

Using a collar

Buy June put at 96.00 for 0.163 and sell June call at 96.50 for 0.090. Net premium payable = 0.073. As before 37 contracts are required.

If interest rates increase to 3.8%

If interest rates decrease to 2.8%

The cost in euros can be calculated as interest rate x 5/12 x size of loan i.e., 0.0419 x 5/12 x 22m = 384,083 euros.

If the interest rate futures market is used, the interest cost will be fixed at 4.47%, but if options on futures or an interest rate collar is used the cost will change. If interest rates were to fall then the options hedge gives the more favourable rates. However, if interest rates rise, then the futures hedge gives the lowest interest cost and the options hedge has the highest cost. If Alex wants to fix its interest rate irrespective of the circumstances, then the futures hedge should be selected.

This recommendation does not include margin payments or other transaction costs, which should be considered in full before a final decision is made.

Basis risk arises from the fact the price of a futures contract may not move as expected in relation to the value of the instrument being hedged. Basis changes do occur and thus represent potential profits/losses to investors. Basis risk is the difference between the spot and futures prices and so there is no basis risk where a futures contract is held until maturity. In this case, however, the June contracts are closed two months before expiry and there is no guarantee that the price of the futures contract will be the same as the predicted price calculated by basis at that date. It is assumed that the unexpired basis above is 0.18 but it could be either more or less.

This creates a problem in that the futures contract, which in theory gives a fixed interest cost, may vary and therefore the amount of interest is not fixed or predictable. Typically, this risk is much smaller than the risk of remaining unhedged and therefore the impact of this risk is smaller and preferable to not hedging at all.

Options

Buy put options as need to hedge against a rise in interest rates.

Number of contracts required: $84,000,000/$2,000,000 × 6/3 = 84

Total basis = current price (1 May) – futures price = (100 – 4.50) – 95.05 = 0.45

Unexpired basis on 1 September = 0.45 × 1/5 = 0.09

Expected futures price = 100 – 5.1 – 0.09 = 94.81

Swaps

Dexter Co has an advantage in borrowing at both fixed and floating rates, but the floating rate advantage is larger.

Gain % for Dexter Co = 50% (1 – 0.5 – 0.2) = 0.15

(12 marks)

Comments

The swap gives a result which is marginally worse than the forward rate agreement and the futures. The options give a worse result than the other choices.

Risks which might be considered include counterparty risk for the forward rate agreement and swap. Using Carnell Bank should mean that this risk is low for forward rate agreements, and also for swaps, assuming that the bank bears the risk of the counterparty defaulting.

Basis risk should be considered for the traded futures. Here, because the differences between the instruments are small, a failure to estimate basis accurately may mean that futures are chosen when they do not offer the lowest borrowing cost. For the swaps, if Dexter Co swaps into fixed rate debt, it faces the market risk of an unexpected fall in interest rates.

Other factors to consider include the possibility that rates will increase rather less than forecast, meaning that the option would not be exercised and at some point, would be the lowest cost choice. The length of time of the swap also needs to be considered. Although it commits Dexter Co to the fixed rate, if the borrowing turns out to be longer than the six months, the swap may provide a better time match than the other hedging opportunities.

(3-4 marks)

Advantages of swaps

Transaction costs are generally relatively low. If Dexter Co arranged the swap itself, the costs would be limited to legal fees. The transaction costs may also be lower than the costs of terminating one loan and arranging another.

Dexter Co can, as here, swap a commitment to pay a variable rate of interest which is uncertain with a guaranteed fixed rate of interest. This allows Dexter Co to forecast finance costs on the loan with certainty.

Swaps are over-the-counter arrangements. They can be arranged in any size and for whatever time period is required, unlike traded derivatives. The period available for the swap may be longer than is offered for other interest rate derivatives.

Swaps make use of the principle of comparative advantage. Dexter Co can borrow in the market where the best deal is available to it, and then use the swap to access the loan finance it actually wants at an overall cheaper cost.

Disadvantages of swaps

Swaps are subject to counterparty risk, the risk that the other party to the arrangement may default on the arrangement. This would apply in particular if Dexter Co arranged the swap itself. If it is arranged through a bank, the bank can provide a guarantee that the swap will be honoured.

If Dexter Co swaps into a fixed rate commitment, it cannot then change that commitment. This means it cannot take advantage of favourable interest rate changes as it could if it used options. This may be a particular problem if the swap period is more than a few months and interest rates are expected to be volatile.

As swaps are over-the-counter instruments, they cannot be easily traded or allowed to lapse if they are not needed or become no longer advantageous. It is possible that a bank may allow a re-swapping arrangement to reverse a swap which is not required, but this will incur further costs.

The chief executive appears to underestimate the degree of knowledge required for day-to-day work. Less experienced staff may be able to arrange borrowing if the lender has already been chosen or, for example, arrange forward rate agreements to be used if they are prescribed.

However, if judgement is required as to, for example, which lender or hedging instrument to use, using less experienced staff may mean that a sub-optimal decision is taken. Poor decisions may result in opportunity costs, for example, not using the lender who gives the best deal or being committed to a fixed forward rate agreement when an option would have allowed the business to take advantage of favourable rate movements. These opportunity costs may not be as clear as the salary costs of experienced staff.

As the business operates internationally, the treasury department will need to monitor financial market conditions and exchange rates, and other issues which may be significant such as political developments. Because of their previous experiences, longer-serving staff are more likely to appreciate the implications of developments and whether treasury policies and decisions need to change in response to changes in risk. Senior staff are also needed to manage the work of less experienced staff to prevent or mitigate the effect of mistakes which may be costly.

Experienced staff are also needed to establish overall guidelines and policies for treasury activities. Their judgement will be required to establish principles which will mean that actions taken by staff are in line with the risk appetite of the business and are sufficiently prudent from the viewpoint of risk management. Experienced staff will also have greater knowledge of law, accounting standards and tax regulations, which can help the business avoid penalties and perhaps structure its dealings so that it can, for example, minimise the level of tax paid.

The chief executive has plans for a major expansion of the business, involving significant investment and financing decisions. Advice from experienced treasury staff will be invaluable in supporting the decisions required. If Dexter Co is planning a major acquisition, the treasury function can provide advice on the structure of consideration and financing implications. If, as here, a major investment is being contemplated, experienced staff can advise on translating views on risk into a relevant cost of capital, which will help ensure that the financial appraisal of the investment is realistic.

Options

Meridian needs to hedge against a rise in interest rates, therefore it needs to buy put options.

Meridian Co needs 42 March put option contracts ($18,000,000/$1,000,000 u 7 months/3 months).

Basis

Current March futures price – spot price = total basis = 44 basis points as at 1 December

Unexpired basis as at 1 February = 22 or 0.22% (given in the question)

If 95.50 options (i.e., 4.5%) are used:

Alternative solution:

Expected futures price on 1 February if interest rates increase by 0.5%

= 100 – (3. + 0.5) – 0.22 = 95.48

Expected futures price on 1 February if interest rates decrease by 0.5%

= 100 – (3.8 – 0.5) – 0.22 = 96.48

If interest rates increase by 0.5% to 4.3%

If interest rates decrease by 0.5% to 3.3%

Using swaps

Meridian will want to swap into fixed rate finance in order to hedge the risk of interest rates rising.

With this type of swap the outcome will be as follows:

(12 marks)

Discussion and recommendation

Under each choice the interest rate cost to Meridian Co will be as follows:

Borrowing at the floating rate and undertaking a swap effectively fixes the rate of interest at 5.04% for the loan, which is significantly lower than the market fixed rate of 5.5%.

On the other hand, doing nothing and borrowing at the floating rate minimises the interest rate at 4.7%, against the next best choice which is the swap at 5.04% if interest rates increase by 0.5%. And, should interest rates decrease by 0.5%, then doing nothing and borrowing at a floating rate of 3.7% minimises cost, compared to the next best choice which is the 95.50 option.

On the face of it, doing nothing and borrowing at a floating rate seems to be the better choice if interest rates increase or decrease by a small amount, but if interest rates increase substantially then this choice will no longer result in the lowest cost.

The swap minimises the variability of the borrowing rates, while doing nothing and borrowing at a floating rate maximises the variability. If Meridian Co wants to eliminate the risk of interest rate fluctuations completely, then it should borrow at the floating rate and swap it into a fixed rate.

(3-4 marks)

A centralised treasury department should be able to evaluate the financing requirements of Meridian Co’s group as a whole and it may be able to negotiate better rates when borrowing in bulk. The department could operate as an internal bank and undertake matching of funds. Therefore, it could transfer funds from subsidiaries which have spare cash resources to ones which need them, and thus avoid going into the costly external market to raise funds.

The department may be able to undertake multilateral internal netting and thereby reduce costs related to hedging activity. Experts and resources within one location could reduce duplication costs. The concentration of experts and resources within one central department may result in a more effective decision-making environment and higher quality risk monitoring and control. Further, having access to the Meridian Co group’s entire cash funds may give the company access to larger and more diverse investment markets.

Decentralising Meridian Co’s treasury function to its subsidiary companies may be beneficial in several ways. Each subsidiary company may be better placed to take local regulations and customs into consideration. An example is the case of Susan Co’s need to use Salam contracts instead of conventional derivative products which the centralised treasury department may use as a matter of course.

Giving subsidiary companies more autonomy over how they undertake their own fund management may result in increased motivation and effort from the subsidiary’s senior management and thereby increase future income. Subsidiary companies which have access to their own funds may be able to respond to opportunities quicker and establish competitive advantage more effectively.

Islamic principles stipulate the need to avoid uncertainty and speculation. In the case of Salam contracts, payment for the commodity is made at the start of the contract. The buyer and seller of the commodity know the price, the quality and the quantity of the commodity and the date of future delivery with certainty. Therefore, uncertainty and speculation are avoided.

On the other hand, futures contracts are marked to market daily and this could lead to uncertainty in the amounts received and paid every day. Furthermore, standardised futures contracts have fixed expiry dates and predetermined contract sizes.

This may mean that the underlying position is not hedged or covered completely, leading to limited speculative positions even where the futures contracts are used entirely for hedging purposes. Finally, only a few commodity futures contracts are offered to cover a range of different quality grades for a commodity, and therefore price movement of the futures market may not be completely in line with the price movement in the underlying asset.

(Note. Credit will be given for alternative, relevant discussion for parts (b) and (c).)

Hedging strategy

Forward contract

The company will be receiving US$ therefore we use US$1.3623 as the rate.

Receipt in € = US$20m/1.3623 = €14,681,054

The hedge fixes the rate at €1 = US$1.3623. This rate is legally binding.

Futures contract

A two-month contract is too short for the required hedge period therefore we must use a five-month contract. The contract will be closed out in four months’ time.

Number of contracts = €14,624,159/€125,000 = 117 contracts

Comments

The futures rate is worse than the forward rate. Futures contracts are marked to market on a daily basis and require margin payments as a result. As with forward contracts, futures contracts fix the rates and are legally binding.

Options

With options the holder has the right but not the obligation to exercise the option (that is, the option will be exercised if it is beneficial to the holder). However, there is a premium to be paid for this flexibility, making options more expensive than futures and forward contracts.

To protect itself against a weakening US$, Camomile will purchase euro call options.

Exercise price = $1.36

Receipts = $20m/1.36 = €14,705,882

Number of contracts = €14,705,882/€125,000 = 117.6 contracts (117 contracts)

With 117 contracts, receipts = €125,000 × 117 = €14,625,000

Premium payable = $0.0280 × 117 × 125,000 = $409,500 (or $409,500/1.3585 = €301,435)

Amount not hedged = US$20m – (117 × €125,000 × 1.36) = US$110,000

This amount can be hedged using a 4-month forward contract as follows:

US$110,000/1.3623 = €80,746

Total receipts = €14,625,000 – €301,435 + €80,746 = €14,404,311

Exercise price = $1.38

Receipts = $20m/1.38 = €14,492,754

Number of contracts = €14,492,754/€125,000 = 115.9 contracts (purchase 115 contracts)

With 115 contracts, receipts = €125,000 × 115 = €14,375,000

Premium payable = $0.0223 × 115 × 125,000 = US$320,563 (or $320,563/1.3585 = €235,968) Amount not hedged = US$20m – (115 × €125,000 × 1.38) = US$162,500

This amount can be hedged using a 4-month forward contract as follows:

US$162,500/1.3623 = €119,284

Total receipts = €14,375,000 – €235,968 + €119,284 = €14,258,316

The receipts from either of the options are considerably lower than those from either the futures contract or the forward contract. This is primarily due to the premiums payable to secure the flexibility that options offer. The US$ would have to move significantly against the € to allow Camomile to cover the cost of the premiums.

Conclusion

Based on the calculations above, it is recommended that Camomile uses forward contracts to hedge against the US$ depreciating against the € in order to maximise receipts. The company should be aware that once the contract is agreed, the price is fixed and is legally binding. In addition, there is no formal exchange for forward contracts, thus giving rise to default risk.

(Max 15 marks)

Project NPV

Expected forward rates (using interest rate parity)

F₀= S₀ x

NPV calculation (note that Year 1 actually means 1.5 years from now as project starts in 6 months’ time)

Total present value = €23.17m

Expected spot rate (MShs) in 12 months’ time (using purchasing power parity):

S₁= S₀ x

S1 = 116 × (1 + 0.097)/ (1 + 0.012) = 125.74

In 6 months’, time expected spot rate = 116 + (125.74 – 116)/2 = 120.9

Total investment required in € = MShs2.64 billion/120.9 = €21.84m

NPV = €1.33m

Will the swap be beneficial for Camomile?

Forward rates based on interest rate parity show that MShs is depreciating against the € as interest rates are much higher in Mazabia (10.8%) than in the European country (2.2%). However, even with a depreciating MShs the project is still worthwhile (positive NPV).

When forward rates are estimated using purchasing power parity, it is assumed that forward rates will change according to differences between the two countries’ inflation rates. If Mazabia’s inflation rate is greater than the European country’s rate, the MShs will depreciate against the €.

We are told that Mazabia’s inflation rate could vary between 5% and 15% over the next few years therefore a swap would appear to be advantageous (as it would fix the future exchange rates). Without the swap there will be uncertainty over the NPV of the project.

Default risk should also be taken into consideration and Camomile may ask the Government of Mazabia to act as a guarantor in order to reduce the risk.

The grant funding will be provided directly to the Mazabian Government in MShs. It may be worthwhile for Camomile to explore the possibility of receiving the grant directly in € as this would reduce currency exposure.

Forward rate agreement FRA 5.02% (4–9) since the investment will take place in four months’ time for a period of five months.

Futures

Go long in the futures market, as the hedge is against a fall in interest rates. Use March contracts, as investment will be made on 31 January.

Number of contracts = D27,000,000/D500,000 × 5 months/3 months = 90 contracts

Basis

Current price (1 October) – futures price = basis (100 – 4.20) – 94.78 = 1.02

Unexpired basis on 31 January = 2/6 × 1.02 = 0.34

Options on futures

Buy call options as need to hedge against a fall in interest rates. As above, 90 contracts required.

Discussion

The forward rate agreement gives the highest guaranteed return. If Whale Co wishes to have a certain cash flow and is primarily concerned with protecting itself against a fall in interest rates, it will most likely choose the forward rate agreement. The 95.25 option gives a better rate if interest rates rise, but a significantly lower rate if interest rates fall, so if Whale Co is at all risk averse, it will choose the forward rate agreement.

This assumes that the bank which Whale Co deals with is reliable and there is no risk of default. If Whale Co believes that the current economic uncertainty may result in a risk that the bank will default, the choice will be between the futures and the options, as these are guaranteed by the exchange. Again the 95.25 option may be ruled out because it gives a much worse result if interest rates fall to 3.6%. The futures give a marginally better result than the 94.25 option in both scenarios but the difference is small. If Whale Co feels there is a possibility that interest rates will be higher than 5.41%, the point at which the 94.25 option would not be exercised, it may choose this option rather than the future.

Regional functions compared with national functions

Organising treasury activities on a regional basis would be consistent with what is happening in the group overall. Other functions will be organised regionally. A regional treasury function may be able to achieve synergies with them and also benefit from information flows being organised based on the regional structure.

If, as part of a reorganisation, some treasury activities were to be devolved outside to a bank or other third party, it would be simpler to arrange for a single provider on a regional basis than arrange for separate providers in each country.

A regional function will avoid duplication of responsibilities over all the countries within a region. A regional function will have more work to do, with maybe a greater range of activities, whereas staff based nationally may be more likely to be under-employed. There may be enough complex work on a regional basis to justify employing specialists in particular treasury areas which will enhance the performance of the function. It may be easier to recruit these specialists if recruitment is done regionally rather than in each country.

Regional centres can carry out some activities on a regional basis which will simplify how funds are managed and mean less cost than managing funds on a national basis. These include pooling cash, borrowing and investing in bulk, and netting of foreign currency income and expenditure.

Regional centres could in theory be located anywhere in the region, rather than having one treasury function based in each country. This means that they could be located in the most important financial centres in each region or in countries which offered significant tax advantages.

From the point of view of Whale Co’s directors and senior managers, it will be easier to enforce common standards and risk management policies on a few regional functions than on many national functions with differing cultures in individual countries.

Regional functions compared with global function

Whale Co is being reorganised on a regional basis because of the demands of its global expansion. As discussed above, reorganising treasury functions regionally will be consistent with the way other functions are organised. Reorganising the treasury function regionally will be one way of dealing with the problem of having a single, overstretched, global function.

A regional function could employ experts with knowledge of the regulations, practices and culture of the major countries within the region. It may be more difficult for a global function to recruit staff with local expertise.

There may be practical issues why individual countries prefer to deal with regional functions rather than a global function, for example, a regional function will be based in the same, or similar, time zone as the countries in its region.

A regional function may have better ideas of local finance and investment opportunities. There may, for example, be better alternatives for investment of the surplus funds than the centralised function has been able to identify.

The company is worried about a fall in interest rates during the next five months. It will need a long futures hedge, with December futures purchased at 96.60. If interest rates fall, the futures price will rise and the contracts may be closed out at a higher price to partially offset the cash market interest rate fall. For a risk of £7.1 million to protect a four-month period the company will need to buy:

x = 18.93, or 19 contracts, a slight over hedge.

Basis is (100 – LIBOR) – futures price,

= (100 – 4.00) – 96.60

= -0.60%.

The time to expiry of the December futures contract is seven months. Remaining time at the close-out date (five months’ time) is two months.

The expected basis for two months is –0.60% ×  = –0.171%

The expected LIBOR lock-in rate is

=100 – (current futures price + unexpired basis)

= 100 – (96.60 – 0.171)

= 3.571%

The company will invest in commercial paper at LIBOR + 0.60%. The overall expected lock-in rate is 4.171%.

The relevant FRA rate is 5 v 9. The company would sell the FRA to a bank to fix the interest rate at 3.45%. This is a lower rate than the expected futures LIBOR lock-in rate of 3.571%.

Cash market:

Expected receipts from the investment on 1 November:

£ 7.1m × 4.1% × = £97,033 (4.1% is LIBOR of 3.5% + 0.6%)

Futures market:

1 June: Buy 19 December contracts at 96.60

1 November: Sell 19 December contracts at 96.671 ((100 – 3.50) + 0.171 unexpired basis)

Profit from futures is 7.1 basis points × £12.50 × 19 = £1,686

Overall receipts are £97,033 + £1,686 = £98,719

(NB😡 = 4.171%, the expected lock-in rate).

FRA:

The FRA fixed rate is 3.45%. Actual LIBOR is 3.5%. The company will therefore have to make a payment to the bank.

This will be: £7.1m (3.50% – 3.45%) x x  or £1,169.65

This will be deducted from the actual receipts of £97,033 (estimated above) to give a net £95,863, a return of 4.05%. (NB: This is the FRA rate of 3.45 plus the 0.6% over LIBOR from the commercial paper.)

The futures market outcome might differ because:

i. The hedge is not exact; 19 contracts is a slight over hedge.

Basis risk might exist. The basis at the futures close-out date might differ from the expected basis of 0.171.

Commercial paper interest rates might not move exactly with LIBOR rates.

ii. Any gains or losses on futures contracts would be taken/payable daily when the futures contracts are marked to market. The interest effect of such receipts or payments is ignored in the calculations.

iii. The above analysis ignores transactions costs.

A swap is the exchange of one stream of future cash flows for another stream of future cash flows with different characteristics.

Interest rate and currency swaps offer many potential benefits to companies including:

1. The ability to obtain finance cheaper than would be possible by borrowing directly in the relevant market.
2. As companies with different credit ratings can borrow at different cost differentials in for example the fixed and floating rate markets, a company that borrows in the market where it has a comparative advantage (or least disadvantage) can, through swaps, reduce its borrowing costs. For example a highly rated company might be able to borrow funds 1.5% cheaper in the fixed rate market than a lower rated company, and 0.80% cheaper in the floating rate market. By using swaps an arbitrage gain of 0.70% (1.5% – 0.80%) can be made and split between the participants in the swap.

Foreign exchange exposures

With case one, Brook Co faces a possible exposure due to the receipt it is expecting in four months in a foreign currency, and the possibility that the exchange rates may move against it between now and in four months’ time. This is known as transactions exposure.

With case two, the exposure is in the form of translation exposure, where a subsidiary’s assets are being translated from the subsidiary’s local currency into Euro. The local currency is facing an imminent depreciation of 20%.

Finally in the third case, the present value of future sales of a locally produced and sold good is being eroded because of overseas products being sold for a relatively cheaper price. The case seems to indicate that because the US$ has depreciated against the Euro, it is possible to sell the goods at the same dollar price but at a lower Euro price. This is known as economic exposure.

(1 mark per exposure explained)

b. Case One

Workings:

Using forward rate

Forward rate = 142 × (1 + (0.085 + 0.0025)/3)/ (1 + (0.022 – 0.0030)/3) = 145.23

Income in Euro fixed at ZP145.23 = ZP140,000,000/145.23 = €963,988

Using OTC options

Purchase call options to cover for the ZP rate depreciating

Gross income from option = ZP140,000,000/142 = €985,915

Cost

€985,915 × ZP7 = ZP6,901,405

In € = ZP6,901,405/142 = €48,601

€48,601 × (1 + 0.037/3) = €49,200

(Use borrowing rate on the assumption that extra funds to pay costs need to borrowed initially; investing rate can be used if that is the stated preference)

Net income = €985,915 – €49,200 = €936,715

Hedging strategies

Transactions exposure, as faced by Brook Co in situation one, lasts for a short while and is easier to manage by means of derivative products or more conventional means. Here Brook Co has access to two derivative products: an OTC forward rate and OTC option. Using the forward rate gives a higher return of €963,988, compared to options where the return is €936,715 (see workings. However, with the forward rate, Brook Co is locked into a fixed rate (ZP145.23 per €1) whether the foreign exchange rates move in its favour or against it. With the options, the company has a choice and if the rate moves in its favour, that is if the Zupesos appreciates against the Euro, then the option can be allowed to lapse. Brook Co needs to decide whether it is happy receiving €963,988, no matter what happens to the exchange rate over the four months or whether it is happy to receive at least €936,715 if the ZP weakens against the €, but with a possibility of higher gains if the Zupesos strengthens.

Brook Co should also explore alternative strategies to derivative hedging. For example, money markets, leading and lagging, and maintaining a Zupesos account may be possibilities. If information on the investment rate in Zupesos could be obtained, then a money market hedge could be considered. Maintaining a Zupesos account may enable Brook Co to offset any natural hedges and only convert currency periodically to minimise transaction costs.

c. Case Two

Workings: Financial impact of the devaluation of the Giffen Ringit

MR devalued rate = MR35 × 1.20 = MR42 per €1

Translation loss = €6,108,000 – €5,090,000 = €1,018,000

Hedging strategies

Hedging translation risk may not be necessary if the stock market in which Brook Co’s shares are traded is efficient. Translation of currency is an accounting entry where subsidiary accounts are incorporated into the group accounts. No physical cash flows in or out of the company. In such cases, spending money to hedge such risk means that the group loses money overall, reducing the cash flows attributable to shareholders. However, translation losses may be viewed negatively by the equity holders and may impact some analytical trends and ratios negatively. In these circumstances, Brook Co may decide to hedge the risk.

The most efficient way to hedge translation exposure is to match the assets and liabilities. In Selen Co’s case the assets are more exposed to the Giffen Ringit compared to the liabilities, hence the weakening of the Giffen Ringit from MR35 per €1 to MR42 per €1 would make the assets lose more (accounting) value than the liabilities by €1,018,000 (see workings). If the exposure for the assets and liabilities were matched more closely, for example by converting non-current liabilities from loans in Euro to loans in MR, translation exposure would be reduced.

d. Case Three

Economic exposure, which is not part of transactions exposure, is long-term in nature and therefore more difficult to manage. There are for example, few derivatives which are offered over a long period, with the possible exception of swaps. A further issue is that economic exposure may cause a substantial negative impact to a company’s cash flows and value over the long period of time.

In this situation, if the US$ continues to remain weak against the Euro, then Brook Co will find it difficult to maintain a sustained advantage against its American competitor. A strategic, long-term viewpoint needs to be undertaken to manage risk of this nature, such as locating production in countries with favourable exchange rates and cheaper raw material and labour inputs or setting up a subsidiary company in the USA to create a natural hedge for the majority of the US$ cash flows.

Lingam Co may want to invest in overseas projects for a number of reasons which result in competitive advantage for it, for example:

Investing overseas may give Lingam Co access to new markets and/or enable it to develop a market for its products in locations where none existed before. Being involved in marketing and selling products in overseas markets may also help it gain an understanding of the needs of customers, which it may not have had if it merely exported its products.

Investing overseas may give Lingam Co easier and cheaper access to raw materials it needs. It would therefore make good strategic sense for it to undertake the overseas investment.

Investing in projects internationally may give Lingam Co access to cheaper labour resources and/or access to expertise which may not be readily available in Japan. This could therefore lead to reduction in costs and give Lingam Co an edge against its competitors.

Closer proximity to markets, raw materials and labour resources may enable Lingam Co to reduce its costs. For example, transportation and other costs related to logistics may be reduced if products are manufactured close to the markets where they are sold.

Risk, such as economic risk resulting from long-term currency fluctuations, may be reduced where costs and revenues are matched and therefore naturally hedged.

Lingam Co may increase its reputation because it is based in the country within which it trades leading to a competitive edge against its rivals. International investments might reduce both the unsystematic and systematic risks for Lingam Co if its shareholders only hold well diversified portfolios in domestic markets, but not internationally.

Tutorial note: The marking scheme here allowed for credit to be given for any alternative but relevant discussion.

Advantages

Exchange traded options are readily available on the financial markets, their price and contract details are transparent, and there is no need to negotiate these. Greater transparency and tight regulations can make exchange traded options less risky. For these reasons, exchange traded options’ transaction costs can be lower.

The option buyer can sell (close) the options before expiry. American style options can be exercised any time before expiry and most traded options are American style options, whereas over-the-counter options tend to be European style options.

Disadvantages

The maturity date and contract sizes for exchange traded options are fixed, whereas over-the-counter options can be tailored to the needs of parties buying and selling the options.

Exchange traded options tend to be of shorter terms, so if longer term options are needed, then they would probably need to be over-the-counter.

A wider range of products (for example, a greater choice of currencies) is normally available in over-the-counter options markets.

Report to the board of directors (BoD), Lingam Co

Introduction

This report evaluates whether or not Lingam Co should invest in the Airone project and the amount of debt finance required of JPY 3,408.6 million (appendix 1) to fund the project. The evaluation considers both the financial and the non-financial factors.

Evaluation of the preferred hedge choice and debt finance required

The income from the sale of the European subsidiary is maximised when futures contracts are used. Therefore, these are chosen as Lingam Co will borrow the least amount of debt finance as a result. However, compared to the forward contract, futures are marked-to-market daily and require a margin to be placed with the broker. This could affect Lingam Co’s liquidity position. The assumption has been made that basis reduces proportionally as the futures contracts approach expiry, but there is no guarantee that this will be the case. Therefore, basis risk still exists with futures contracts. Although forward contracts give a smaller return, there is no basis risk and margin requirements. However, they do contain a higher risk of default as they are not market traded. Options give the lowest return but would give Lingam Co the flexibility of not exercising the option should the Euro strengthen against the Yen.

Although the EUR 80 million receipt from the sale of the subsidiary has been agreed, there may be a risk that the sale may fall through and/or the funds or some proportion of the funds are not received. Lingam Co may need to assess and factor in this risk, however small it may be.

The amount of interest on deposit is based on the current short-dated Japanese treasury bills and the estimate of the borrowing requirement is computed from the predicted exchange rate between ARD and JPY in a year’s time, based on the purchasing power parity. Both these estimates could be inaccurate if changes occur over the coming months. Although insufficient information is provided for a financial assessment, Lingam Co should explore the possibility of converting the EUR into ARD immediately on receipt and keeping it in an ARD bank account until needed, instead of first converting EUR into JPY and then into ARD.

Using debt finance to make up any shortfall in the funding requirement may be appropriate for Lingam Co given that it is an unlisted company and therefore access to other sources of funding may be limited. Nevertheless, Lingam Co should assess how the extra borrowing would affect any restrictive covenants placed on it and the impact on its cost of capital. Since the amount seems to be small in the context of the project as a whole, this may not be a major problem.

Lingam Co should also explore whether or not investing in the Airone project restricts its ability to fund other projects or affects its ability to continue normal business activity, especially if Lingam Co is facing the possibility of hard capital rationing.

Evaluation of the Airone project

The net present value of the Airone project is estimated to be JPY (457) million (appendix 2). Given the negative net present value, the initial recommendation would be to reject the project. However, given that the result is marginal, Lingam Co should consider the following factors before rejecting the project.

At present, Lingam Co does not have a significant presence in the part of the world where Airone is located. Taking on the project may make good strategic sense and provide a platform for Lingam Co to establish its presence in that part of the world.

Furthermore, once Lingam Co has established itself in Airone, it may be able to develop further opportunities and new projects. The value of these follow-on options has not been incorporated into the financial assessment. Lingam Co should explore the possibility of such opportunities and their possible value.

The financial assessment ends abruptly at the end of the four years. No indication is given on what would happen to the project thereafter. It may be sold as a going concern or, if closed, its land and assets may be sold. The cash flows from these possible courses of action need to be incorporated into the assessment, and these could make the project worthwhile.

A number of assumptions and estimates would have been made in the financial assessment. For example, the rate of inflation used for future figures is the current rate and the tax rate used is the current rate, these may well change in the coming years. Therefore, it is best to undertake sensitivity analysis and produce a number of financial assessments before making any firm commitment to proceed with the project or deciding to reject it.

Conclusion and recommendation

The income from the sale of the European subsidiary is maximised when futures contracts are used, but Lingam Co should weigh this against the benefits and drawbacks of all hedging instruments before making a final decision.

Although the project is currently giving a negative net present value, rejecting it at the outset is premature. A number of factors, discussed above, need to be considered and assessed before a final decision is made. Sensitivity analysis would be very helpful in this respect.

Finally, Lingam Co should consider alternative uses for the funding which will be dedicated to the project. These alternative uses for the finance need to be considered before any decision is made, especially if Lingam Co is facing the possibility of hard capital rationing.

(Max 8 marks)

Report compiled by: XXX

Date XX/XX/XX

APPENDICES:

Appendix 1 (Part (c) (i)): Japanese Yen receivable from sale of European subsidiary under each hedging choice and the additional debt finance needed to fund the Airone project

Forward rate

Since it is a EUR receipt, the lock-in rate of JPY125.3 per EUR will be used. Expected receipt from sale: EUR 80m x 125.3 = JPY 10,024m

Futures contracts

The futures contracts need to show a gain when the Euro depreciates against the Yen, therefore a short position is needed, using the seven-month contracts. It is assumed that basis will depreciate proportionally to the time expired.

Predicted futures rate

125.2 + 1/3 × (126.9 – 125.2) = 125.8

[Or: 125.2 + 1/7 × (129.2 – 125.2) = 125.8]

Number of contacts sold = EUR 80,000,000/EUR 125,000 = 640 contracts Expected receipt from sale: EUR 125,000 × 640 × 125.8 = JPY 10,064m

Options contracts

640 seven-month put options contracts will be purchased to protect against a depreciation of Euro.

If options are exercised:

EUR 125,000 x 640 x 126 = JPY 10,080m

Premium payable = JPY 3.8 × 125,000 × 640 = JPY 304m Net income = JPY 10,080m – JPY 304m = JPY 9,776m

Conclusion

Futures contracts give the highest receipt and will, therefore, be used to hedge the expected Euro receipt.

Receipt invested

Invested for further six months till needed for the Airone project. JPY 10,064m × (1 + (0.012/2)) = JPY 10,124.4m

Spot cross rates: 0.70 – 0.74 ARD per JPY 1

[92.7/132.4 = 0.70 and 95.6/129.2 = 0.74]

Expected ARD/JPY conversion spot rate in 12 months = 0.70 x 1.09/1.015 = 0.75

Additional debt finance needed to fund Airone project

Investment amount required = ARD 10,150m/0.75 = JPY 13,533m

Debt finance required = JPY 13,533m – JPY 10,124.4m = JPY 3,408.6m

(Max 12 marks)

Appendix 2 (Part (c) (ii): Airone project net present value

Expected net present value is JPY (457) m

(Max 9 marks)

Workings:

(W1) Predicted future exchange rate (ARD/JPY)

(W2) Components contribution

(W3) Additional tax payable

(Professional marks: 4 marks)

It is difficult to conclude definitively whether a centralised treasury department is beneficial or not in all circumstances and for all companies. It depends on each company itself and the circumstances it faces. Lingam Co should take this into account before making a final decision.

Benefits of a centralised treasury department

Having a centralised treasury management function avoids the need to have many bank accounts and may therefore reduce transactions costs and high bank charges.

Large cash deposits may give Lingam Co access to a larger, diverse range of investment opportunities and it may be able to earn interest on a short-term basis, to which smaller cash deposits do not have access. On the other hand, if bulk borrowings are required, it may be possible for Lingam Co to negotiate lower interest rates, which it would not be able to do on smaller borrowings.

A centralised treasury function can offer the opportunity for Lingam Co to match income and expenditure and reduce the need for excessive risk management, and thereby reduce costs related to this.

A centralised treasury management department could hire experts, which smaller, diverse treasury management departments may not have access to.

A centralised treasury function may be better able to access what is beneficial for Lingam Co as a whole, whereas local treasury functions may lead to dysfunctional behaviour.

Benefits of separate (decentralised) treasury departments

It could be argued that decentralised treasury departments are better able to match and judge the funding required with the need for asset purchases for investment purposes on a local level. Therefore, they may be able to respond quicker when opportunities arise and so could be more effective and efficient.

Individual departments within a subsidiary may have better relationships with the treasury departments of that subsidiary and are therefore able to present their case without lengthy bureaucratic delays.

Ultimately, the benefits may be implicit rather than explicit. Having decentralised treasury departments may make the subsidiary companies’ senior management and directors more empowered and have greater autonomy. This in turn may increase their levels of motivation, as they are more in control of their own future, resulting in better decisions being made.

Adjusted present values (APVs) separate out a project’s cash flows and allocate a specific discount rate to each type of cash flow, dependent on the risk attributable to that particular type of cash flow. Net present value (NPV) discounts all cash flows by the average discount rate attributable to the average risk of a project.

One reason why APV may be preferable to NPV is because by separating out different types of cash flows, the company’s managers will be able to see which part of the project generates what proportion of the project’s value. Furthermore, allocating a specific discount rate to a cash flow part helps determine the value added or destroyed. In this example, Grape Co is able to determine how much value is being created by the investment and how much by the debt financing. For complex projects, investment related cash flows could be further distinguished by their constituent risk factors, where applicable.

Report to the board of directors (BoD), Grape Co

Introduction

This report evaluates, and provides a justification and decision, on whether Grape Co should pursue Project Wan or Project Lan, based on the important factors identified by the company, namely the returns generated by the projects, the projects’ risks and non-financial aspects.

Evaluation

Financing

Using forward markets to hedge the expected receipt in six months’ time results in the higher receipt equalling Y$25,462,000 approximately. If the money markets hedge is used the receipt is Y$25,234,936 (appendix 1).

Using forward markets to hedge the expected receipt would therefore minimise the amount of debt borrowing. However, the amount receivable from the money markets hedge is based on the annual bank investment rate available to Grape Co of 2.4%. Grape Co may be able to use the funds borrowed to generate a higher return than the bank investment and therefore using money markets to undertake the hedge may be financially advisable. Grape Co should investigate any opportunities for higher income, but based on the current results, the forward market hedge is recommended to minimise the amount of debt finance needed.

Minimum amount of debt borrowing required is Y$24,538,000 approximately.

Project returns and risk

Project Wan’s and Project Lan’s base case NPVs and APVs are similar to each other, with Project Wan expected to yield a small amount in excess to the yield expected from Project Lan. However, Project Lan’s project duration is significantly lower. This is because a higher proportion of Project Lan’s cash flows come earlier in the project’s life, compared to Project Wan. There is more certainty to earlier cash flows and this is reflected in the lower duration for Project Lan. Project Lan’s risk is lower than Project Wan.

In estimating the base case NPV and APV for Project Wan, it is assumed that the cash flows are known with reasonable certainty and the inflation rates will not change during the life of the project. It is also assumed that the future exchange rate between the Y$ and the £ will change in accordance with the purchasing power parity differential. Furthermore, it is assumed that the prices and costs related to Project Wan will increase in line with inflation during the six months before the project starts. For Project Wan, it is assumed that the initial working capital requirement is funded by the company and not from the funds raised from the subsidised loan, similar to the assumption made for Project Lan. However, for both projects, Grape Co needs to consider, and take account of, the opportunity costs related to this.

In terms of the Project Wan’s discount rate, it is assumed that the given discount rate accurately reflects the business risk of the project.

Whilst this level of detail is not provided for Project Lan, it is assumed that similar assumptions will have been made for Project Lan as well. In the case of both projects, Grape Co should assess the accuracy or reasonableness of the assumptions, and if necessary, conduct sensitivity analysis to observe how much the projects’ values change if input variables are altered.

Notwithstanding the assumptions and caveats made above, it would appear that Project Lan would be preferable to Project Wan, given that it has a similar APV but a significantly lower risk.

Nevertheless, there may be good strategic reasons why Grape Co may select Project Wan over Project Lan. For example, these reasons may include providing access to new markets, enabling Grape Co to erect barriers to entry against competitors or looking at follow-on opportunities as possible real options.

Justification

Due to the substantially lower risk (as measured by the project duration) and similar APV, it is recommended that Project Lan be selected by Grape Co. It is also recommended that forward markets are used to hedge the income expected in six months’ time to part fund the project. This would minimise the debt borrowing needed.

However, this decision is predicated on the fact that the implications of the assumptions and the wider strategic reasons discussed above have been carefully considered by Grape Co.

Report compiled by:

Date

(Note: Credit will be given for alternative and valid evaluative comments)

(Max 8 marks)

(Maximum 7 marks if no considered justification given)

Appendices:

Appendix 1 (Part (b) (i)):

Expected receipt in six months’ time, using forward markets

€10,000,000 × 2.5462 = Y$25,462,000

Expected receipt in six months’ time, using money markets

€10,000,000/ (1 + 0.022/2) = €9,891,197

€9,891,197 × 2.5210 = Y$24,935,708

Y$24,935,708 × (1 + 0.024/2) = Y$25,234,936

Minimum amount of debt borrowing Grape Co would require

Y$50,000,000 – Y$25,462,000 = Y$24,538,000

(4 marks)

Appendix 2a (Part (b) (ii)): Projects Wan and Lan, base case net present value, in six months’ time

Base case net present value before considering financing side effects. All figures are in Y$000s.

Approximate, base case net present value (NPV) of Project Wan = Y$5,272,000.

Base case net present value (NPV) of Project Lan

= Y$(8,450,000 + 19,360,000 + 22,340,000 + 4,950,000) – Y$50,000,000 = Y$ 5,100,000

Workings:

Working 1 (w1): Sales revenue

Working 2 (w2): Production costs

Component costs are not inflated, but future exchange rates are based on purchasing power parity (PPP).

Working 3 (w3): Component cost

Working 4 (w4): Tax

(12 marks)

Appendix 2b (Part (b) (ii)): Projects Wan and Lan, adjusted present value (APV), in six months’ time

Issue costs = 3/97 × Y$24,538,000 = Y$758,907

Annual tax shield = 2.1% × Y$24,538,000 × 20% = Y$103,060

Annual interest saved on subsidised loan = 2.9% × Y$24,538,000 × 80% = Y$569,282

Annuity factor, years 1 to 4 at 5% interest = 3.546

Present value of the tax shield and loan subsidy benefit = (Y$103,060 + Y$569,282) × 3.546 = Y$2,384,125

(6 marks)

Appendix 2c (Part (b) (ii)): Project Wan’s duration based on its base case present values of cash flows

Project Wan

Total PVs × time = 173,254,000 approximately

Total PVs = 57,005,000 approximately

Project Wan duration = 173,254,000/57,005,000 = 3.04 years

(2 marks)

(Professional marks for part (b) 4 marks)

Explanation of why the subsidiary company may be exposed to economic risk and how it may be managed

Companies face economic exposure when their competitive position is affected due to macroeconomic factors such as changes in currency rates, political stability, or changes in the regulatory environment. Long-term economic exposure or economic shocks can cause a permanent shift in the purchasing power and other parity conditions. Normally, companies face economic exposure when they trade internationally. However, even companies which do not trade internationally nor rely on inputs sourced internationally may still face economic exposure.

In the case of Grape Co’s subsidiary company, economic risk may have occurred because interest rates have been kept at a high level, causing the original parity conditions to break down. High interest rates will be attractive to international investors, as they can get higher returns and may lead to the Y$ becoming stronger relative to other currencies. This in turn would allow international competitors to produce goods more cheaply than the subsidiary company and thereby enhance their competitive position relative to the subsidiary company.

Managing economic exposure is difficult due to its long-lasting nature and because it can be difficult to identify. Financial instruments, such as derivatives, and money markets cannot normally be used to manage such risks. Grape Co’s subsidiary company can try tactics such as borrowing in international or eurocurrency markets, sourcing input products from overseas suppliers and ultimately shifting production facilities overseas. None of these are easy or cheap, and can expose the company to new types of risks. Grape Co would also need to assess that any action it takes to manage economic risk fits into its overall risk management strategy.

How each category or risk may be managed

Risks which fall into the severe and frequent category need immediate attention, as they could threaten the company’s survival or derail its long-term strategy. The aim here would be to reduce the severity of the risks and the frequency with which they occur quickly. It may mean avoiding certain actions or abandoning certain projects, even if they could be profitable in the long term. Where a company has a real option, and does not need to take action which will result in high frequency and high severity of risk, it may prefer to wait and see what happens.

Where the frequency of risks occurring is high but their impact is not severe, action needs to be taken so that such risks do not become severe in the future. For example, the company could put systems into place to detect these risks early and plans to deal with them if they do occur. Where the same kind of risks occur often, the company may decide to have set processes for dealing with them. For example, where there is a loss of relatively unskilled staff, the company may decide to replace staff quickly with casual workers, but also have appropriate training facilities in place.

If there are risks which are severe but only happen occasionally or infrequently, the company should try to insure against these. Contingency plans could also be put into place to mitigate the severity. For example, if the consequences of IT failure are high when a business decides to move to a new system, it could put appropriate contingencies into place. These may include secondary backup IT systems or initially trialling the new system on a few business units before undertaking a complete role out.

Risks which are neither severe, nor frequent, should be monitored and kept under review, but no significant action should be taken. It is possible that any significant action would incur costs which would likely be higher than the benefits derived from eliminating such risks. Monitoring such risks will ensure that should they move out of this category into the more severe/frequent categories, the company can start to take appropriate action.

(Note: Credit will be given for alternative and valid explanatory and discussion comments)