Question 1 a An Australian firm needs to borrow 1 million AUD for 1 year. The interest rate in Australia is 8 percent and the interest rate in the US is 5 percent and the spot exchange rate is AUD/USD= .9000. Can the Australian firm achieve lower interest costs by borrowing offshore on a covered basis? (Quantitative and conceptual problem) Question1 b Mattel is a U.S.-based company whose sales are roughly two-thirds in dollars (Asia and the Americas) and one-third in euros (Europe). In September Mattel delivers a large shipment of toys (primarily Barbies and Hot Wheels) to a major distributor in Antwerp. The receivable, 30 million EUR, is due in 90 days, standard terms for the toy industry in Europe. Mattel’s treasury team has collected the following currency and market quotes. The company’s foreign exchange advisors believe the euro will be at about EUR/USD=1.4200 in 90 days. Mattel’s management does not use currency options in currency risk management activities. Advise Mattel on which hedging alternative is probably preferable. (Analysis of business situations) Question 2 a Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures. What are four of the most commonly employed proactive policies? Explain how each of the four policies can offset operating exposure. (Conceptual problem) Question 2 b Hurte-Paroxysm Products, Inc. (HP) of the United States exports computer printers to Brazil, whose currency, the reais (symbol R$) has been trading at R$3.40/US$. Exports to Brazil are currently 50,000 printers per year at the reais equivalent of $200 each. A strong rumor exists that the reais will be devalued to R$4.00/$ within two weeks by the Brazilian government. Should the devaluation take place, the reais is expected to remain unchanged for another decade. Accepting this forecast as given, HP Products faces a pricing decision which must be made before any actual devaluation: HP Products may either (1) maintain the same reais price and in effect sell for fewer dollars, in which case Brazilian volume will not change, or (2) maintain the same dollar price, raise the reais price in Brazil to compensate for the devaluation, and experience a 20% drop in volume. Direct costs in the U.S. are 60% of the U.S. sales price. What would be the short-run (one-year) implication of each pricing strategy? Which do you recommend? (Analysis of business situation) Question 3 a Define the terms covered interest arbitrage and uncovered interest arbitrage. What is the difference between these two transactions? Illustrate your answer with a numerical example. (Conceptual problem) Question 3 b Assume that the export price of a Toyota Corolla from Osaka, Japan is 2,150,000 JPY. The exchange rate is USD/ JPY=87.60. The forecast rate of inflation in the United States is 2.2% per year and is 0.0% per year in Japan. Use this data to answer the following questions on exchange rate pass-through. a. What was the export price for the Corolla at the beginning of the year expressed in U.S. dollars? b. Assuming purchasing power parity holds, what should the exchange rate be at the end of the year? c. Assuming 100% pass-through of exchange rate, what will be the dollar price of a Corolla at the end of the year? d. Assuming 75% pass-through, what will be the dollar price of a Corolla at the end of the year? (Conceptual problem) Question 4 a Deming, Inc., is a large U.S. natural gas pipeline company that wants to raise $120 million to finance expansion. Deming wants a capital structure that is 50% debt and 50% equity. Its corporate combined federal and state income tax rate is 40%. Deming finds that it can finance in the domestic U.S. capital market at the rates listed below. Both debt and equity would have to be sold in multiples of $20 million, and these cost figures show the component costs, each, of debt and equity if raised half by equity and half by debt. A London bank advises Deming that U.S. dollars could be raised in Europe at the following costs, also in multiples of $20 million, while maintaining the 50/50 capital structure. Each increment of cost would be influenced by the total amount of capital raised. That is, if Deming first borrowed $20 million in the European market at 6% and matched this with an additional $20 million of equity, additional debt beyond this amount would cost 12% in the United States and 10% in Europe. The same relationship holds for equity financing. Assumptions Values Combined federal and state tax rate 40% Desired capital structure: Proportion debt 50% Proportion equity 50% Capital to be raised $120,000,000 Costs of Raising Capital in the Market Domestic Domestic European European Equity Debt Equity Debt Up to $40 million of new capital 12% 8% 14% 6% $41 million to $80 million of new capital 18% 12% 16% 10% Above $80 million 22% 16% 24% 18% a. Calculate the lowest average cost of capital for each increment of $40 million of new capital, where Deming raises $20 million in the equity market and an additional $20 in the debt market at the same time. b. If Deming plans an expansion of only $60 million, how should that expansion be financed? What will be the weighted average cost of capital for the expansion? (Analysis of business situation) Question 4 b McDougan Associates, a U.S.-based investment partnership, borrows €80,000,000 at a time when the exchange rate is $1.3460/€. The entire principal is to be repaid in three years, and interest is 6.250% per annum, paid annually in euros. The euro is expected to depreciate vis à vis the dollar at 3% per annum. What is the effective cost of this loan for McDougan? (Quantitative problem) Question 5 a Sallie Schnudel trades currencies for Keystone Funds in Jakarta. She focuses nearly all of her time and attention on the U.S. dollar/Singapore dollar ($/S$) cross-rate. The current spot rate is $0.5500/S$. After considerable study, she has concluded that the Singapore dollar will appreciate versus the U.S. dollar in the coming 90 days, probably to about $0.7500/S$. She has the following options on the Singapore dollar to choose from: Option Strike Price Premium Put on Sing $ $0.6500/S$ $0.00003/S$ Call on Sing $ $0.6500/S$ $0.00046/S$ a. Should Sallie buy a put on Singapore dollars or a call on Singapore dollars? b. What is Sallie's breakeven price on the option purchased in part (a)? c. Using your answer from part (a), what is Sallie's gross profit and net profit (including premium) if the spot rate at the end of 90 days is indeed $0.7000/S$? d. Using your answer from part (a), what is Sallie's gross profit and net profit (including premium) if the spot rate at the end of 90 days is $0.8000/S$? (Analysis of business situation) Question 5 b Botany Bay Corporation of Australia seeks to borrow US$30,000,000 in the Eurodollar market. Funding is needed for two years. Investigation leads to three possibilities. Compare the alternatives and make a recommendation. #1. Botany Bay could borrow the US$30,000,000 for two years at a fixed 5% rate of interest #2. Botany Bay could borrow the US$30,000,000 at LIBOR + 1.5%. LIBOR is currently 3.5%, and the rate would be reset every six months #3. Botany Bay could borrow the US$30,000,000 for one year only at 4.5%. At the end of the first year Botany Bay would have to negotiate for a new one-year (Communicate financial analysis and analyse business situation)