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What Advice Would You Give Regarding Hedging Investment Summary

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Hedging and Risk
What advice would you give regarding hedging investment?
The company is building a manufacturing plant, and as such will be subject to a number of risks associated with
doing business aboard. The company will face foreign exchange risk.
When hedging depends on the nature of the assets it is hedging:
Real assets in the foreign country, such as the plant, machinery and real estate need not be hedged since they
will rise in value along with local assets.
Financial assets, such as the cash flow from the operations, if it is being brought back to it’s the mother Co., do
need to be hedged. There is a risk that cash flows that are due out of foreign Co. may be worth less than
expected if the exchange rate weakens against the Domestic Currency. If the company had borrowed to make this
investment, there is a danger that the translated cash flows may not be sufficient to service the debt, if the Foreign
Currency were to weaken. So the financial assets need to be hedged, to protect their value.
The company can use:
Forward Rate Agreements (FRA)
Futures contracts
Swaps
Options.
The first three are similar, but options are quite different.
FRAs involve the company setting the price now for delivery at some point in the future of an amount of
currency. There is no cash flow to set the contract up, only a cash flow at expiry when the contract will be
closed out at the agreed rate. If the currency moves up or down, the company is protected as they have
fixed the exchange rate for that date in the future. Any potential gains are sacrificed, but the company is
covered against losses.
Futures are similar in that they fix a rate that you are willing to exchange at in the future. With futures,
however, there may be intervening cash flows, as the contracts are exchange traded (FRAs are over-the-
counter instruments) and a margin may have to be paid in to cover losses.
Currency swaps are like long term forward contracts. These allow the company to effectively lock in long
term exchange rates over the life of the project.
Each of these products are contractual obligations, the contracts must be fulfilled.
Options are different; they involve the payment of a premium up front (which is like an insurance
payment). They will protect the holder against an adverse movement. If there is an adverse movement in
the option, it does not need to be fulfilled and the holder can walk away from the contract. The purchaser
of the option contract will only lose as much as they pay for it at inception. This is not the case with
futures and FRAs. Options are much more expensive than the first set of products, so it is likely that the
company would favors futures, forwards or swaps. If the exchange rate was particularly volatile,
The advantages of hedging are that there is certainty over future cash flows. It could be said that by not hedging,
the company is actually speculating because the final exchange rate or interest rate is uncertain.
Bondholders will be more pleased that the company is hedging, because it makes financial distress less likely.
Shareholders would like the company to hedge when it prevents losses, but they prefer the company not to
hedge when prices are moving in the company’s favors.

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There is also the problem of hedging when the underlying price has been favorable to the company and rivals
haven’t hedged, which would allow them to reduce prices and put pressure on the company that had hedged.
Capital Budgeting
How are the following treated in cash flow analysis?
Replacement decisions for machines with different lives
Investment inter-relatedness
Company overheads
Creditors
Replacement decisions for machines with different lives: use an equivalent annual cost calculation to
compare the cost of machines on a comparable basis.
Investment interrelatedness: If investments are independent, they can be considered on their own. If there is
interrelatedness, a list of all possible combinations is made, the combinations must be mutually exclusive. The
NPV of each combination is calculated and the one with the highest NPV is chosen.
Company overheads: Only overheads that are specific to a project can be considered. General company
overheads should be ignored for project cash flow analysis. This is an accounting term and is applied on the basis
of arbitrary rules that may have little to do with the actual cash flows.
Creditors: This will be captured in changes NWC. An increase in creditors will mean that working capital is
increasing over the period. Creditors on their own will snot appear as a cash flow, only as part of the working
capital adjustment.
In capital budgeting, describe how the following items are treated in the project appraisal:
Product cannibalisation refers to the situation where a company launches a new product or service and that
affects the existing range of products and services. This can steal sales away from the existing
offering thus lowering cash flows. This has to be taken into account when estimating the cash flows
when evaluating the project. A cash flow loss would have to be built in to reflect the loss in sales. This would be
the case unless the company was involved in a very competitive sector where they would have lost sales whether
they introduced a new product or not, as in, for example, the mobile phone market and the personal music player
market. If you don’t launch a new product, you will lose sales to the new product from the other company.
Depreciation is not a cash flow, but it does have an impact. The company will benefit through the depreciation
tax shield, so they will pay lower taxes as a result, When the company buys new machinery, the cash is gone at the
start. Depreciation recognises this over a longer time frame. Depreciation can be straight line or accelerated. If
accelerated, the company benefits because they will receive a greater time value benefit.
Interest charges are ignored in the cash flows; they are built into the discount rate that is applied to the project.
The after tax cost of debt is used. The interest tax shields are excluded from the analysis.
How does capital rationing affect a company and how can capital budgeting techniques help resolve the
problem?
Capital rationing can be internal or external. External capital rationing should not exist. This is the capital markets
effectively not supplying the company with capital. If the company has identified good projects (positive NPV) to
invest in, the market will provide the company with capital, but the company might not like the price the markets
are charging for the capital. The market might decide the company is too high a risk and charge a substantial
premium for debt or equity capital.

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Hedging and Risk What advice would you give regarding hedging investment? The company is building a manufacturing plant, and as such will be subject to a number of risks associated with doing business aboard. The company will face foreign exchange risk. When hedging depends on the nature of the assets it is hedging: Real assets in the foreign country, such as the plant, machinery and real estate need not be hedged since they will rise in value along with local assets. Financial assets, such as the cash flow from the operations, if it is being brought back to it’s the mother Co., do need to be hedged. There is a risk that cash flows that are due out of foreign Co. may be worth less than expected if the exchange rate weakens against the Domestic Currency. If the company had borrowed to make this investment, there is a danger that the translated cash flows may not be sufficient to service the debt, if the Foreign Currency were to weaken. So the financial assets need to be hedged, to protect their value. The company can use: • Forward Rate Agreements (FRA) • Futures contracts • Swaps • Options. The first three are similar, but options are quite different. • • • FRAs involve the company setting the price now for delivery at some point in the future of an amount of currency. There is no cash flow to set the contract up, only a cash flow at expiry when the contract will be closed out at the agreed rate. If the currency moves up or down, the company is protected as ...
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