BFF2341 Mini Test 2

Date: 18th May 2020

PART A: Financial Problems. All Questions are compulsory unless specified.

1. Hedging Techniques

Excel Inc is based in USA and currently has a future receivables of $3,000,000 NZD (New
Zealand Dollars) in 180 days time. Due to some forecasted recession, the forward rate of
NZD is expected to depreciate by 4.5% in next 180 days time. Excel would like to hedge
itself due to the uncertainty and must decide whether to use forward, money market or
options to hedge this position.

(a) Use the following information to analyze Excel’s position and make the hedging
decision. (7.5 Marks)

Spot rate of $1 NZD = $0.64

Call option: Exercise price = $0.60; premium = $0.07
Put option: Exercise price = $0.62; premium = $0.03

USA New Zealand

One-year deposit rate 8% 5%
One-year borrowing rate 10% 7%

Rate Probability
Forecasted spot rate of NZ$ $0.60 20%
$0.61 50%
$0.63 30%

(b) Do you think, Excel will be better off without any hedging? Yes or no? Show
calculations about your standing. (2.5 Marks)

2. Answer ONE of the following: (Triangular/Covered Interest Arbitrage) (5 Marks)

(a) Assume the following exchange rate information:

Exchange rate of Japanese yen in USD = $0.022

Exchange rate of euro in USD = $2.80
Exchange rate of euro in Japanese yen = 280 yen

What will be the yield for an investor who has $2,000,000 available to conduct
triangular arbitrage? (That is: show the triangular arbitrage calculations and the yield
generated from the arbitrage)

(b) Assume the following information:

U.S. investors have $2,000,000 to invest:

1-year deposit rate offered by U.S. banks = 12%
1-year deposit rate offered on Swiss francs = 10%
1-year forward rate of Swiss francs = $0.62
Spot rate of Swiss franc = $0.60

Does interest rate parity exist? Do the US investors have any arbitrage opportunity?
Show your calculations to justify answers.
3. Multinational Capital Budgeting (15 Marks)

Atlas Corp. currently has no existing business in New Zealand but is considering
establishing a subsidiary there. The following information has been gathered to assess this
project:

The initial investment required is $30 million in New Zealand dollars (NZ$). Given the
existing spot rate of $0.50 per New Zealand dollar, the initial investment in U.S. dollars is
$15 million. In addition to the NZ$30 million initial investment for plant and equipment,
NZ$10 million is needed for working capital and will be borrowed by the subsidiary from
a New Zealand bank. The New Zealand subsidiary will pay interest only on the loan each
year, at an interest rate of 10 percent. The loan principal is to be paid in 10 years. Interest
expenses are tax deductible.

The project will be terminated at the end of Year 3, when the subsidiary will be sold.

The price, demand, and variable cost of the product in New Zealand are as follows:

Year Price Demand Variable Cost

1 NZ$400 50,000 units NZ$35
2 NZ$425 60,000 units NZ$40
3 NZ$450 70,000 units NZ$45

The fixed costs, such as overhead expenses, are estimated to be NZ$6 million per year.

The exchange rate of the New Zealand dollar is expected to depreciate each year by 5%.

The New Zealand government will impose an income tax of 30 percent on income. In
addition, it will impose a withholding tax of 10 percent on earnings remitted by the
subsidiary. The U.S. government will allow a tax credit on the remitted earnings and will
not impose any additional taxes.

All cash flows received by the subsidiary are to be sent to the parent at the end of each
year. The subsidiary will use its working capital to support ongoing operations.

The plant and equipment are depreciated over 10 years using the straight-line depreciation
method. Since the plant and equipment are initially valued at NZ$30 million.

In three years, the subsidiary is to be sold. Atlas plans to pass on the existing New Zealand
loan on to the new acquiring firm. Atlas expects to receive NZ$25 million net in cash when
it sells the subsidiary after 3 years. Assume that this amount is not subject to a withholding
tax.

Atlas requires a 15% percent rate of return on this project.

Determine the net present value of this project. Should Atlas accept this project?
 4. Investment Decision (5 Marks)

XYZ Corporation is attempting to evaluate the feasibility of investing $145,000 in a

project with five years life. The firm has required rate of return 10 percent. Calculate The
firm has estimated the associated cash inflows as following:

$50,000 $70,000 -$30,000 $60,000 $90,000

Using the above information, answer ONE of the following:

(a) Calculate NPV, IRR and Payback Period of the project.

(b) Calculate the break-even salvage value

PART B: Theoretical Concepts

Answer any two of the following: (5 x 2 =10 marks)

(a) Should MNCs avoid FDI in “Countries with Liberal Child Labor Laws”? Do you support
the view? Or not? Explain why or why not.
(b) Define “Interest Rate Parity”. Explain its relationship with covered interest arbitrage
with an example.
(c) What is “Net Transaction Exposure”? Show an example.
(d) Explain “True Cost of Hedging”. Provide an example.