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# Clarifications on Larkin Hydraulics Problem

### Making Sense of the Carry Forward Calculations

Firstly, the carry forward rate comes from the 12% cost of equity. This is our practical HURDLE rate. Any investment opportunity available to our company should exceed this rate.
Now let’s move on to the choices one by one:
(a) Hedge in FM
• When the August A/R is received, the Forward contract in settled immediately. Thus, we have cash in hand in August. We want to know what the value of this (2,000,000 * 1.1060) cash amount will be when November A/R is received. Remember, the ultimate goal is to compute the total value of both A/Rs TOGETHER (in November). So, the company will invest the (2,000,000 * 1.1060) amount @ 12% for 3 months (Aug→Nov). Hence (2,000,000 * 1.1060) * (1 + 0.12/4) = 2,278,360.
(b) Hedge in MM
• Unlike the forward market, now we are BORROWING from the Frankfurt branch of our bank. That means, NOW (in May) we have the \$\$\$ ready that we borrowed against our A/Rs. We will now invest these borrowed funds. But invest at what rate? Of course, at our hurdle rate (or above). May→Nov = 6 months. That’s why it’s multiplied by (1+0.12/2).
(c) Hedge in OM
• The same principle as choice (a) applies. In May (NOW), we have committed to buy the option at a premium. That means a cash outflow. If we did not buy this option, we would have retained the cash. Right? That means our purchase of the options creates an opportunity cost. That opportunity cost is computed again @12% for 6 months (May→Nov).
• Again, for the August A/R, if the option is exercised, when will it be exercised? In August. We still have 3 more months to go. That’s why the value of the exercised option (at the strike price of 1.100) will be compounded again @12% for 3 months.
• We do not need to repeat the above process for the November A/R because if the option is exercised, it is already November. Hence, no compounding.
##### Replacement Announcement for Groups 10 and 11

Please be informed that November 7’s Tutorial Sessions for Groups 10 and 11 will not take place.
Replacement will be conducted on October 31 during your regular workshop hours at the workshop venue.

# Slides for Week 13 (Chapter 12)

#### IFM – Tutorial Week 13 (Chapter 12)

Ganado Corporation: Unwinding a Swap Tutorial
1. Transaction Exposure
• Occurs due to changes in cash flows as a result of existing contractual obligations.
2. Translation Exposure
• Change in owner’s equity because of translating foreign currency financial statements.
3. Operating Exposure
• Economic Exposure / Competitive Exposure
• Changes in the present value of the firm because of change in future cash flows (due to unexpected FX volatility)

Pros of Currency Hedging

1. Reducing unpredictability of future cash flows.
2. Helps with long-term planning.
3. Ensures firm’s cash flows remain above financial distress level.
4. Management has better knowledge of the real currency exposure of the firm compared to shareholder.
5. The opportunity to engage in selective hedging to increase firm’s value.

Cons of Currency Hedging

1. Shareholders can diversify away currency risk without help from management.
2. Does not increase the expected cash flow of the firm. Instead, risk management this way can cause cash outflow.
3. Benefits management instead of shareholders (agency problem)
4. Impossible to out-guess or out-predict the market.
5. Often motivated by accounting reasons rather than profitability.
6. Supporters of EMH argue that investors already factored in currency risks of a firm and thus extra hedging activities only add costs.

Problem 10.10 (Mattel Toy)

Option A: Do Nothing

Option B: Sell Euros

Option C: Money Market Hedge

Let us evaluate what happens in each scenario.

Option A

1. Spot doesn’t change → 30,000,000 * 1.4158 = \$42,474,000
2. Spot = Credit Suisse → 30,000,000 * 1.4172 = \$42, 516,000
3. Spot = Barclays → 30,000,000 * 1.4195 = 42,585,000
4. Spot = Expected Rate → 30,000,000 * 1.42 = \$42,600,000

All of the above are risky because we are exposed to market fluctuations. We have not used any derivatives to lock in our positions. Therefore, remaining uncovered means none of A1-A4 are guaranteed.

Thus, as an analyst, you will consider option A as RISKY because the outcomes are uncertain.

Option B

If we go with Credit Suisse, at the end of 90 days we receive 30,000,000 * 1.4172 = \$42,516,000

If we go with Barclays, at the end of 90 days we receive 30,000,000 * 1.4195 = \$42,585,000

Compared to Option A, we are locking in the rates. Therefore, if we engage in 90-day forward with either bank, we are guaranteed to receive these amounts.

Thus, as an analyst, you will consider option B as CERTAIN because the outcomes are sure.

Option C

We expect to receive 30 million Euros in 90 days. Against this amount, we can borrow USD right now.

The borrowing rate is given @ 5%.

Thus, EUR 30,000,000 is equivalent to 30,000,000 (1 + 5%*90/360) = EUR 29,629,629.63

Converting this amount to USD using current spot rate, we get:

29,629,629.63 * 1.4158 = \$41,949,629.63

We can reinvest this amount and make some extra bucks in 90 days while our Account Receivable comes back to us.

What rate can we invest in? Use the WACC carry forward rate of 9.6%.

Thus, we receive in 90 days: \$41,949,629.63 * (1 + 9.6%*90/360) = \$42,956,420.74

This outcome is CERTAIN because we used money market instruments to lock in the position.

Decision

The money market hedge guarantees Mattel the greatest dollar value for the A/R when using the cost of capital as the reinvestment rate (carry-forward rate).

Option A: Do nothing

You should be able to do this part by yourself.

Option B: Forward Market Hedge

The company has an A/P liability of Dirham 6 million in 180 days. They can choose to enter into a forward contract so that in six months they will receive a delivery of 6 million Dirham. But how much would it cost them in USD terms?

6,000,000 Dirham / 10.40 = USD 576,923.08

This option is CERTAIN because the rates are locked in.

———————————————–

Option C: Money Market Hedge

We need to pay back Dirhams in six months. But right now we only have USD. So we can convert our USD into Dirham and invest them for six months. First, we find out the PRESENT VALUE of six million Dirhams today.

6,000,000 Dirham in 6 months → Worth 6,000,000 /( 1+7%*180/360) = Dirham 5,797,101.45 TODAY

Exchanging the above value into USD, we get 5,797,101.45 / 10.00 = \$579,710,145

If we invest the above amount (AGAIN, using the WACC Carry Forward Rate), we receive

\$579,710,145 * (1+14%*180/360) = \$620,289.86

This amount is CERTAIN because we have locked in the rates.

———————————————–

Option D: Hedging via CALL Option

The option principal = 6,000,000

Current Spot Rate = 10.00

Option Premium = 6,000,000 * 2% = \$12,000

If option exercised, dollar cost at strike price of 10.00 dirhams/\$ → \$600,000

Premium Carried Forward = \$12,000 * 1.07 = \$12,840

Total cost = \$612,840

———————————————–

So which one costs the least?

Forward.

##### Sunway University: Aug-19 Semster

Here you will find some supplementary material for tutorial sessions conducted for FIN3034 (International Financial Management) for August 2019 semester at Sunway University Business School.

##### Tutorial 2 (Week 3)

There have been some modifications to the slides due to students’ confusion over Licensing/MC/GFDI/Acquisition. The added materials have been amended in the following updated file.

IFM – Tutorial 2 (Week 3)

##### Tutorial 6 (Week 7)

Unfortunate change of plans: due to the lengthy nature of the problem 8.12 covered in week 7, we could not go over the planned revision of older material. As such, on week 9, we will dedicate the first 25 minutes to the unwinding swap problem from week 7. The remaining 35 minutes will deal with the math-oriented problem for week 9 material.

You are instructed to go over the theoretical portion of week 9’s tutorial content by yourself. If anything is unclear to you, do not hesitate to contact me about it.

Meanwhile, please revise the Firenza Motors problem and practice till you are perfect! The spreadsheet is appended below.

Firenza Motors