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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Answer 11 STAFER PLC

(a)

Xendia and Germany are examples of segmented and integrated markets respectively. Where a segmented market exists, the capital asset pricing model should focus upon local factors when assessing the required return from an investment. The relevant risk free rate and market return will be the local rates in Xendia, and the beta that best reflects the risk of the investment is, in theory, the Xendian beta for the sector.

Cost of equity in Xendia:

Ke = Rf + (Rm – Rf) beta = 7% + (14% – 7%) 1·4 = 16·8%

WACC = ke E +ED + kd (1 – t) E D+ D

WACC in Xendia is estimated to be:

16·8% × 0·65 + 9%(1 – 0·35) × 0·35 = 12·96%

Cost of equity in Germany:

As there are no restrictions on the movement of capital or foreign exchange the German market may be regarded as part of an integrated “world” market, and the relevant data when assessing the required return will be the world data.

Ke = Rf + (Rm – Rf) beta = 4·5% + (10% – 4·5%) 0·95 = 9·725%

WACC in Germany is estimated to be:

9·725% × 0·65 + 5·5% (1 – 0·28) × 0·35 = 7·7%

As debt is borrowed in Germany, the German cost of debt and corporate tax rate have been used, but it might be argued that the world rates are a valid alternative.

Adjusted present value is an alternative method that might be used to appraise overseas investments. This would require an estimate of the base case NPV for each project, using an estimate of the ungeared equity beta, and discounting any financing side effects by a discount rate that reflects the risk of each individual financing side effect.

(b)Possible errors include:

The markets are unlikely to be either perfectly segmented or perfectly integrated. Most markets fall between these extremes. A margin of error will exist in these estimates.

The International capital asset pricing model assumes that investors are well diversified internationally. In reality many are not, and there is a tendency for investors to hold a higher than expected proportion of their assets in their own domestic capital market.

The betas provided are average equity betas for the relevant sector. Such betas will reflect the average gearing of the relevant sector. If the gearing of Stafer differs from the relevant average gearing, it is necessary to degear the sector beta and then regear for Stafer’s gearing in order to reflect the financial risk of Stafer.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Unless the dollar is expected to strengthen significantly the participating option looks the better alternative.

However, the company might also consider an option collar whereby a call option was purchased and a put option sold in order to reduce the net premium payable. Possibilities include buy June 1·65 calls at 1·1 cents and sell June 1·55 puts at 0·9 cents resulting in a net premium of 0·2 cents. This would result in a worst case (ignoring inexact contract sizes) position of $1·652/£ and a best case position of $1·552/£. However, this still involves significant exchange rate risk. A better collar would be to buy 1·60 calls at 5·3 cents and sell 1·60 puts at 4·0 cents, resulting in a net premium of 1·3 cents. This would lock-in the exchange rate at $1·613/£ including premium cost, which is almost identical to the current spot rate exchange rate of $1·61/£.

Answer 13 PONDHILLS INC

(a)

Translation exposure exists because of the need for multinational companies to periodically consolidate the financial statements of overseas subsidiaries with those of the parent company in order to present the financial details and to assess the performance of the entire group. In order to achieve consolidation the subsidiaries’ accounts need to be translated from a foreign currency basis into the currency of the parent company. Translation is not a physical exchange of currencies; it is the change in the monetary expression of the subsidiaries’ activities from one currency to another.

There are several methodologies for translating financial statements. Governments or professional accounting standards bodies will normally specify the preferred or required method(s). Depending on the method used the resulting foreign exchange gain or loss on translation will significantly differ. Translation exposure does not directly measure the cash flow implications of exchange rate changes, or the effect of such changes on the value of a multinational. Because of this many multinational companies do not hedge against translation exposure. However, if the exposure is expected to result in a significant reported loss, which the company believes might, in an inefficient market, have a detrimental effect on share price, some hedging might be undertaken.

Economic exposure results from the fact that a company’s economic value will change as a result of changes in foreign exchange rates. It is often split into two forms:

Transaction exposure, which focuses on the short-term impact on cash flow, for example through foreign trade activities. Many multinationals hedge against the potential cash flow loss of transaction exposure through forward markets, currency options etc.

Real operating exposure, which considers the longer term effects on cash flow and NPV after the effect of inflation has been removed.

Economic exposure refers to unexpected changes in exchange rates. As economic exposure has a direct effect on the value of the firm it is important for multinationals to try to manage such exposure. However, as the size and nature of the exposure is unknown it is difficult to hedge against. International diversification of sales, production, raw material sources and financing is suggested as this will provide more flexibility to respond to adverse unexpected change in exchange rates.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

(b)(i)

Analysis is required of the possible foreign exchange exposure of Pondhills Inc the parent company from the operations of its African subsidiary.

The current/closing rate method translates all EXPOSED assets and liabilities at the exchange rate prevailing at the year end. However, from the viewpoint of Pondhills Inc, not all of Ponda SA’s assets and liabilities are exposed, as sales are denominated in US dollars, and some liabilities are payable in sterling. As no change is expected between the dollar and sterling exchange rates, the exposure to Pondhills Inc is only from assets and liabilities that are denominated in dinars.

Current exchange rate is 246·3 dinars/$US. If a 15% devaluation occurs this will move to 246·3 × 1·15 = 283·2 dinars/$US.

The balance sheet exposure is (510 + 86 + 380) – (148 + 500) or 328 million dinars

The expected loss on translation exposure is 328 × $US/dinar change in exchange rate = 328 (0·004060 – 0·003531) = 0·1735 million dollars, which is the change in shareholders’ equity shown in the table above, $US2·396m – 2·222m = 0·174 million dollars.

(ii)

Economic exposure measures the cash flow effects of a change in exchange rates. The data below shows the change over a full year with a 15% devaluation of the dinar.

There is an initial annualised gain in cash flow for Pondhills Inc of $US 543,000.

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

(c)

Unlike the translation exposure estimate where a loss was forecast, the expected impact on economic exposure results in an exposure gain. Translation exposure does not measure the effect of exchange changes on cash flows. Unless a reported translation loss is expected to have a detrimental effect on Pondhills Inc’s share price, (which it should not if the market is efficient), no hedging against translation exposure is recommended.

In the light of the expected economic exposure gain there is no need to hedge against the possible devaluation, although it might be advisable to pay any hard currency liabilities to third parties (e.g. sterling liabilities) and to reduce dinar cash levels before any devaluation occurred.

(d)

Although the initial economic effects of the devaluation appear to be favourable to Pondhills Inc, the longer term effects are less clear. A devaluation in the African country means that inflation levels in that country are likely to be significantly higher than in the US. This will affect local wage rates and raw material costs, and will increase the local COGS and expenses, reducing the economic benefits to Pondhills.

However, a devaluation with an expected economic gain provides the opportunity for Ponda SA to reconsider its pricing strategy. Ponda might reduce its price levels in order to attract more demand. Whether or not this would produce additional cash flow to Pondhills Inc depends upon the price elasticity of demand for Ponda’s products, and the relative dollar cost of the lower prices compared to the dollar benefits of additional cash flow.

As prices are in dollars the devaluation could adversely affect any sales by Ponda in its domestic market, as the local price would effectively increase by 15%. The effect on dollar cash flows of differential pricing in domestic and export markets might be investigated.

Answer 14 FOREIGN TRADE RISK

The management of risk associated with foreign trade will depend upon the nature of the risk:

Commercial risk is risk that the client will not pay or will only pay after the due date. It may be managed by:

Credit screening prior to the contract being signed. This might include formal credit evaluation through a credit agency, use of information from trade associations, government databases (e.g. the DTI in the UK), bank references or trade references.

The terms of sale. Some terms of sale involve much less risk than others. Most secure (but not common) is cash in advance. Others, in order of increasing risk include cash on delivery, documentary letters of credit, bills of exchange and open account.

The method of payment. The quicker and more secure the method of payment, the lower the risk. Extremes range from secure electronic funds transfer to sending a cheque in the post.

Insurance against non-payment or late payment. In many countries this is offered through government agencies. In the UK short-term insurance providers include NCM and Trade Indemnity.

Physical risk, the risk of damage or theft in transit is best managed through insurance cover.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Political risk is risk of non-payment or late payment as a result of the actions of a foreign government, e.g. through the introduction of exchange controls, tariffs or quotas. Political risk protection is often offered by the same insurers as commercial risk. Political risk might also be avoided by using different forms of international activity, e.g. tariffs and quotas might be avoided by direct investment in the country concerned, exchange controls might be avoided by engaging in counter trade rather than cash trade.

Cultural risk is risk associated with different cultures, ways of doing business, attitude to religion, colours, gender, food and drink etc. In order to reduce such risk thorough research of the local market, culture, and business practices should be undertaken prior to trading.

Answer 15 KYT

(a)

KYT needs to purchase yen on the spot market in two months time. To protect against the risk of the yen strengthening against the $US, KYT should buy yen futures contracts, hoping to sell them at a higher price if the yen strengthens. This is intended to offset any loss relative to the current spot rate when the yen are purchased in the spot market in two months time.

The most suitable contract will be the contract that matures at the nearest date after 1 September, the September contract. To protect 140 million yen, 11 contracts will need to be bought. This will leave 2·5 million yen unhedged.

(b)

Basis is the difference between the current spot price and the futures price, in this case Y128·15 – Y125·23 or 2.92 yen. (September futures in terms of yen/$ = 1/0.007985 = 125.23)

(c)

Basis will be zero at the maturity date of the futures contract, 30 September. If it reduces in a

The expected futures price is 0·973 yen below the spot price of 120 yen/$, Y119·027/$ or $0·008401/yen

Expected result of the hedge:

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REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Hedge efficiency is 5774,,197200 = 77%

This result may not occur as basis is unlikely to decrease in a linear manner. Depending on the movement in basis the hedge efficiency might be higher or lower than 77%.

Answer 16 NTC PLC

(a)

Centralised treasury management is normally recommended for multinational companies because:

It allows centralised knowledge of the financial dealings of the entire group, better judgement of risk and exposure management, and the netting of inter-group currency requirements.

A central treasury can ensure that financial actions are taken that are in line with the objectives of the group as a whole, rather than individual subsidiaries.

It may perform a watchdog function to ensure that there are no problems in subsidiaries with the use of derivatives.

It allows greater control over inter-company receipts.

A central treasury function may reduce the cost of borrowing for subsidiaries by lending necessary funds at rates lower than could be obtained by the subsidiaries in local markets. Such funds might be surplus funds from other subsidiaries, which would be offered favourable interest on the surplus, effectively eliminating the interest spread of banks.

A centralised treasury may have access to international markets, such as the Euromarkets, which are not directly accessible by individual subsidiaries. Such markets may offer more favourable interest rates. Combining the needs of various subsidiaries means that larger amounts will be invested and borrowed, which again may give access to more favourable rates.

It will be cheaper to develop treasury management and hedging expertise in one central function rather than in each subsidiary.

The main disadvantages of centralised treasury management are:

It potentially removes decision-making and responsibility from the subsidiaries, and may affect motivation and initiative within subsidiaries.

It relies heavily on the timely provision of information.

Performance evaluation of staff in subsidiaries may be distorted if actions are taken centrally that are detrimental to the subsidiaries, although in the long-term interest of the group as a whole.

The volume of treasury decisions within a multinational may be too large to handle in one central function.

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

(b)

(i)Receipts and payments in sterling at spot mid-rates:

As a result of multilateral netting the number of transactions may be reduced from nine to three, with the UK parent, the Spanish and Hong Kong subsidiaries each making one payment to the US subsidiary.

(ii)Forward contracts, money market hedging and currency options will be illustrated.

In order to minimise transaction costs, netting of trade will be used where possible. As the Hong Kong dollar is pegged against the US dollar, the exposure risk of the Hong Kong dollar will be hedged using US dollars. This involves a slight risk, as the Hong Kong dollar might discontinue its pegged position. As interest rates are less than 1% different between the US and Hong Kong, the economic pressure for the Hong Kong dollar to devalue is not likely to be strong at present.

UK parent net exposures:

Only two exposures need to be hedged.

Forward markets:

Euro 210,0001·6166 = £129,902 receipt

$278,970 = £195,289 payment 1·4285

Money markets:

Euro hedge:

Borrow Euro at 5·3% for 3 months, 1·01325210,000

or 207,254 to repay Euro 210,000 in 3 months time Convert Euro 207,254 at spot of E1·6292/£ to give £127,212

Invest £127,212 for 3 months at 6·0% to yield £127,212 × 1·015 = £129,120

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ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

The required spot rates for the option to be the preferred hedge are rates where the dollar is weaker than:

1·42 $1·4529/£ 1·43 $1·4629/£ 1·44 $1·4757/£

Conclusion:

A forward market hedge is recommended for the Euro transaction.

For the $US payment a money market hedge, or alternatively a currency option hedge with an exercise price of 1·42 is recommended. The 1·42 exercise price is chosen as this has a similar cost to the 1·43 option if it is exercised, but requires the dollar to depreciate less before the option hedge is the preferred alternative to the money market hedge.

(c)

As the Russian currency is not convertible, if NTC wishes to export to Russia payment through counter-trade may be the only way in which the deal may be arranged. There may also be restrictions in Russia in the use of convertible foreign currency reserves for the purchase of imports, and limited access to bank credits. Without counter-trade there may be no trade in these circumstances.

Problems of counter-trade include:

It requires considerable time and effort to organise, and often has high administrative costs.

It may be difficult and expensive to establish a fair exchange ratio for goods to be counter traded.

The price for wheat that NTC will receive may be unknown, although a futures market exists in wheat.

The quality of the wheat is not known with certainty.

One party has to bear transportation costs of the wheat.

Bank guarantees and other forms of security that exist in foreign trade through documentary letters of credit, bills of exchange etc. are unlikely to exist, possibly increasing the risk of trade for NTC.

Advantages of counter-trade include:

Allowing NTC to become known in the Russian market, which may generate future business.

Eliminating the risks concerned with foreign exchange rate movements.

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