finance for decision making Explain the impact of currency fluctuations on a mul
ID: 2632670 • Letter: F
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finance for decision making
Explain the impact of currency fluctuations on a multinational corporation. Explain how a company can use forward market hedging to protect itself against wide currency fluctuations. An Australian airline company has just entered into a contract to purchase a new fleet of airplanes for US$2 billion and the current exchange rate is A$/US$0.91(i.e. 1A$ = 0.91US$). The company has to pay for the fleet in six months' time. The airline company considers hedging its exposure to foreign exchange risk by using an option; currently an option on US$ that expires in 6 months has an exercise price of A$/US$0.89 and a premium of A$0.01. What type of option should the company use? Why? If the actual exchange rate in six months' time is A$/US$0.85/ explain how the hedge has protected the company from its exposure to exchange rate fluctuation. If the actual exchange rate in six months' time is A$/US$0.93, explain how the hedge has protected the company from its exposure to exchange rate fluctuation. Wombat Ltd is considering the acquisition of Koala Ltd at a cash price of $200,000. Wombat would immediately sell some of Koala's assets for $20,000 if it makes the acquisition. Koala has a cash balance of $2,000 at the time of the acquisition. Wombat believes it can generate after-tax inflows of $3 per year for the next seven years from the Koala acquisition. Wombat has a cost of capital of 10 per cent. Would you recommend Wombat make the cash acquisition? Explain your answer. ABC Limited is considering two projects. Each requires an immediate cash outlay: $10,000 for project A and $9,000 for project B. Project A has a life of four years, and project B has a life of five years; neither will have any salvage value at the end of its life. For tax purposes, each would be depreciated by the prime cost method (i.e. depreciate by a percentage of the prime cost each year), project A at 25% and project B at 20%. The company's tax rate is 30%, and its required rate of return after tax is 11%. Net cash flows before taxes have been projected as follows: Calculate the net cash flows after tax for each project. Calculate the payback period for each project. Calculate the net present value for each project. If the two projects are mutually exclusive, should ABC Limited adopt project A, or project B? Why?Explanation / Answer
Question 5
a)It depends on the maturity of the company and the ratio of company's profit due to executing their underlying business plan versus currency impact. For growing companies that are early in their industry/business development lifecycle, currency management should be a low-level concern. Building out the infrastructure and powering growth are the two of the top concerns while currency management will be considered a back-office function. As a company and/or its industry matures and management becomes focused on "optimization" issues, then currency management will rise in importance as a business factor, especially for public companies.
But even under these circumstances, most institutional investors don't want companies managing currency effects too aggressively as they want to control exposure to currency themselves (i.e. "Let your results be unhedged and I'll make my own decisions regarding my exposure to that currency by making my own hedging decisions.").
This is a potential "agency problem" in that a company may want to control currency hedging in order to bring predictability to their earnings so that they can reliably forecast to the investment markets. However, investors will want financial results provided in an unhedged manner so that they can gauge true underlying business performance that isn't masked by currency hedging operations. These divergent interests are a source of substantial discussion between companies with significant foreign operations and their investors.
b)
Forward Currency Exchange Contracts for the Small Importer
Big businesses have access to exotic systems for managing currency exchange risk, among which is a financial product called the forward currency exchange contract. As a small importer, it is possible in certain situations for you to use this method to manage currency risk, too
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