MINI TEST 2 (TRI A 2020 SOLUTIONS)

Q. 1
Forward hedge
Given spot rate = $1 NZD = $0.64

Forward rate will be $1NZD = $0.64 x (1-4.5%) =$0.6112

Sell NZ$3,000,000 @ US$0.6112 = US$1,833,600

Money market hedge

All the interest rates are given as annual. We need to convert them to 180 days.
Borrow in NZD @ 7% for one year. So, rate for 180 days is: 7% x180/360 = 3.5%
Invest in USD @ 8% for one year. So, rate for 180 days is: 8% x180/360 = 4%

Borrow the PV of NZ$3,000,000 =NZ$3,000,000/1.035 = NZ$2,898,550

Convert NZ$2,898,550 to US$ (@spot rate)= NZ$2,898,550 x US$0.64 = US$1,855,072
Invest US$1,855,072@ 4% =US$2,981,651 x 1.04 = US$1,929,274

Put option hedge (exercise price = US$0.62; premium = US$0.03) = Net will be $0.59
Amount
Received per
Option Unit (also Total Amount
Possible Spot Premium per accounting for Received for
Rate Unit Exercise premium) NZD$3,000,000 Probability
$0.60 $0.03 Yes $0.59 $1,770,000 20%
$0.61 $0.03 Yes $0.59 $1,770,000 50%
$0.63 $0.03 No $0.60 $1,800,000 30%

The money market hedge is superior to the forward hedge and has a 100% chance of outperforming the
put option hedge. Therefore, the money market hedge is the optimal hedge.

Unhedged Strategy
Total Amount Received for
Possible Spot Rate NZ$3,000,000 Probability
$0.60 $1,800,000 20%
$0.61 $1,830,000 50%
$0.63 $1,890,000 30%

2. A
Exchange dollars for Euro = $2,000,000/$2.8 = Euro 714,286;
exchange Euros for yen = 714,286 x 280 = 200,000,000 yen.
Exchange yen for dollars = 200,000,000 yen / $.022 = $4,400,000.
Yield = {($4,400,000 - $2,000,000)/$2,000,000} =120%

2.B
$2,000,000/$0.60 = SF3,333,333.33 x (1.1) = SF3,666,666 X $.62 = $2,273,333.33
Yield = ($2,273,333.33- $2,000,000)/$2,000,000 = 13.67%
This yield exceeds what is possible domestically.
Opportunity cost in USA = $2,000,000 * 1.12 = $2,240,000

Alternative: Check the interest rate parity:

Interest difference = 2%; Spot and forward rate differentials = F-S/S = 0.62-0.60/0.60 = 3.33%
Therefore no parity
Q. 3

Calculate the exchange rates

Y0 $1 NZD= $0.50
Y1 $1 NZD= $0.50x0.95 = $0.475
Y2 $1 NZD= $0.475X0.95= $0.451250
Y3 $1 NZD= $0.451250X0.95= $0.4287

Yr.0 Yr.1 Yr.2 Yr.3

-
Initial Outlay/ Investment
30,000,000
Revenue 20,000,000 25,500,000 31,500,000
Less:
1,750,000 2,400,000 3,150,000
Total variable costs
Less:
6,000,000 6,000,000 6,000,000
Less: Other cash expenses
Less: Depreciation 3,000,000 3,000,000 3,000,000
Interest expense 1,000,000 1,000,000 1,000,000
EBIT 8,250,000 13,100,000 18,350,000
LESS:

2,475,000 3,930,000 5,505,000

30% Corporate Tax

EAT 5,775,000 9,170,000 12,845,000

Add back: Depreciation 3,000,000 3,000,000 3,000,000
Net cash flow ready for
8,775,000 12,170,000 15,845,000
remittance by subsidiary
Less: Remittance Tax 877,500 1,217,000 1,584,500
Cash flows after Remit. Tax 7,897,500 10,953,000 14,260,500
Plant sale proceeds 0 0 25,000,000
Total Cash Flow 7,897,500 10,953,000 39,260,500
Exchange Rate 0.5 0.475 0.45125 0.4286875
Total -
3,751,313 4,942,541 16,830,486
cash Flow to parent in USD 15,000,000
NPV $3,065,600
Q.4
NPV = $32,630
IRR = 17.9%
Payback = 3.9166 years
Payback = 3 years + $55,000/$60,000 =3.9166 years
Break Even Salvage Value= (initial investment – NPV) (1+i)^n = (145,000 – 32,630)X (1.10)5
= $180,973