On May 1, Larkin Hydraulics, a wholly owned subsidiary of Caterpillar (U.S.), sold a 12-megawatt compression...

On May 1, Larkin Hydraulics, a wholly owned subsidiary of Caterpillar (U.S.), sold a 12-megawatt compression turbine to Rebecke-Terwilleger Company of the Netherlands for €4,000,000 payable on August 1. Larkin determined the €4,000,000 price tag on April 1 when the spot rate was $1.0800/€. By the time the order was received and booked on May 1, the euro strengthened to $1.100/€. Nevertheless, Larkin’s Director of Finance now wonders if the firm should hedge against a reversal of the recent trend of the euro and proposes the following options:

OPTION 1: Hedge in the forward market – The 3-month forward exchange quote is $1.1060/€.

OPTION 2: Hedge in the money market – Larkin could borrow euros from the Frankfurt branch of its U.S. Bank at 8% per annum.

OPTION 3: Do nothing – Larkin could wait until the sales proceeds are received in August, hope the recent strengthening of the euro would continue, and sell the euros received for dollars in the spot market.

If Larkin’s cost of capital is 12%, what should Larkin do? At what cost of capital would Larkin be indifferent between Options 1 and 2?

Expert Solution

Particular	Amount	Amount
Option 1
Hedge Using Forward Contract
Receivable	€ 4,000,000
Forward Rate	$1.1060/€
Cash Flow in Forward Contract		$ 4,424,000.00

Option 2
Money Market Hedge
Receivable	€ 4,000,000
Borrow € equivelent to €4,000,000 after 3-months at a rate of 8% p.a.
€ Borrow	€ 3,921,568.63
Convert it into $ at spot rate
Spot rate	$1.100/€
$ received	$ 4,313,725.49
Cost of capital 12% so saving in cost or interest earn at the rate of 12%
Interest Earn	$ 129,411.76
Cash Flow in Money Market Hedge		$ 4,443,137.26

Option 3
Do Nothing
Receivable	€ 4,000,000
Spot Rate as on August 1	$1.100/€ *
Cash Flow in Forward Contract		$ 4,400,000.00

*hope the recent strengthening of the euro would continue, and sell the euros received for dollars in the spot market so $1.100 taken.

Option 2 is better cash flow for company.

Larkin be indifferent between Options 1 and 2 when cash flow in both option is equal.

Option 1 Cash flow = $4,424,000

Option 2 $ received after borrow and convert at spot rate so cash flow in dollor today = $4,313,725.49

So Cost saving / Interest earn = $4,424,000 - $4,313,725.49 = $110,274.51

So Rate = $110,274.51/ $4,313,725.49 = 2.5564% for 3-Months so Annual = 2.5564% x 12/3 = 10.2255% or say 10.23%

At 10.23% cost of capital would Larkin be indifferent between Options 1 and 2.

(Spot rate taken $1.100 because transaction taken place as on May 1 (Order received and book date)

jeff jeffy answered 2 years ago

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