timer Asked: Apr 30th, 2020

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On questions #4, that is ok to use separate Excel spread sheet for the calculation.

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1. Caterpillar, Inc., a US corporation, has sold some heavy machinery to an Italian company for 10,000,000 euros, with the payment to be received in six months. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, as the Lead Risk Analyst in Caterpillar’s heavy machinery division, you need to make a recommendation to the Treasurer regarding how Caterpillar should hedge the risk arising from this transaction exposure. You have gathered the following information. • • • • • • • • The spot exchange rate is $1.1000/€ (i.e., 1 euro = 1.1000 US dollars) The six month forward rate is $1.1050/€ Caterpillar’s cost of capital is 10% per annum. The euro 6-month borrowing rate is 4% per year (or 2% for 6 months) The euro 6-month lending rate is 2% per year (or 1% for 6 months) The US dollar 6-month borrowing rate is 5% per year (or 2.5% for 6 months) The US dollar 6-month lending rate is 3% per year (or 1.5% for 6 months) The premium on 6 month put options on the euro with strike rate $1.10 is 2.5%. You need to compare the hedging alternatives in order to make a recommendation. To that end, you are required to compute the net receipts in dollars of each hedging alternative. The phrase “net receipts in dollars” refers to the (actual or deemed) net cash inflow in dollars in six months time. a) Suppose that Caterpillar chooses to hedge its transaction exposure using a forward contract. Will Caterpillar sell or buy euros forward? What will be the net receipts in dollars? In other words, what is the amount Caterpillar will receive in dollars in six months time? (2 points) b) Suppose Caterpillar chooses a money market hedge. What are the transactions that the firm will need to undertake to implement this hedge, and what will be the net receipts in dollars using this hedge? (3 points) c) Suppose Caterpillar decides to hedge using a put option. (i) Suppose that the spot rate in 6 months is $1.15 per euro. Will the option be exercised? What will be the net receipts in dollars? (2 points) (ii) Suppose that spot rate in 6 months is $1.05 per euro. Will the option be exercised? What will be the net receipts in dollars? (2 points) d) Suppose that you strongly expect the euro to depreciate. In that case, which of the hedging alternatives would you recommend? Briefly justify your recommendation e) Suppose that you strongly expect the euro to appreciate. In that case, which of the hedging alternatives would you recommend? Briefly justify your recommendation f) By how much does the euro need to appreciate to make the put option at least as good an alternative (in retrospect) as the forward contract? In other words, by how much does the euro need to go up in value against the dollar in order for the net cash inflow from the put option to equal the cash inflow from the forward contract? Support your answer with calculations. 2. Do MNEs (Multinational Enterprises) have a lower or higher cost of capital than domestic firms? Discuss. 3. Suppose that a certain country is facing a widening current account deficit and rising inflation. As a result, its currency is starting to face downward pressure in the foreign exchange market. Explain what is meant by currency market intervention and the three main methods of intervention the country could use to try to protect the value of its currency. 4. Apex Tool Group, a US-based firm, is setting up a tool manufacturing firm in Honduras named Empresa. This will require an upfront investment of 400 million Honduran lempiras (Lp). Apex estimates that Empresa will generate a free cash flow of 200 million lempiras next year, and that this cash flow will grow at a constant rate of 10.0% per annum indefinitely. Empresa will pay the entire amount of its free cash flow as dividends to its parent company. In addition to dividends, Empresa will also pay 10 million lempiras each year as management fees to its parent company. The firm has a tax deal with the Honduran government according to which no taxes will be payable in Honduras for the foreseeable future. However, US federal income tax will be levied on all income received by Apex at a tax rate of 20%. Further, Apex is planning on selling off the subsidiary to a Honduran business family at the end of year 5 for ten times the free cash flow in that year. Assume that no taxes will be payable on these proceeds. The current spot exchange rate is Lp25.00/$. Inflation is expected to be 5% a year in Honduras and 2% a year in the US. Use relative PPP to project future exchange rates. You need to carry out an analysis of this project from the viewpoint of the parent company, Apex Tool Group. Please compute project cash flows and the NPV of the project in US dollars taking the cost of capital to be 25%. ...
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