Question

Question B3:
Alcoa Chemical, a US company, has sold £2 million chemicals to CPL Co. Payment is due in 180 days.
Spot rate: $1.60/£
180-day forward rate $1.56/£
180-day U.S. dollar interest rate (annualized) 3%
180-day Pound interest rate (annualized) 4%
180-day call option on pound at $1.57/£ premium $0.06 per pound
180-day put option on pound at $1.57/£ premium $0.05 per pound
(a) What is the hedged value of Alcoa's receivable using the forward market hedge?
(b) What is the hedged value of Alcoa's receivable using the money market hedge?
(c) Which of the hedging alternatives analyzed in parts (a) and (b) would you recommend to Alcoa? Why?

(d) What alternative is available to Alcoa to use currency options to hedge its receivable? What is the
hedged value of Alcoa's receivable using the option hedge?
(e) Discuss and compare the costs of hedging by forward contracts and option contracts.

(Numbers should be rounded to at least 3 decimal places. Please include currency symbols $, £ in
your answer)


Question B4:
Mill Company is evaluating the proposed acquisition of a new milling machine. The machine's base price is
$150,000, and has a terminal value of $20,000. The company's cost of capital is 8%. The project has a
life-time of 3 years. The operating cash flows are as follows:
Year 1 Year 2 Year 3
1. After-tax savings $35,000 $35,000 $35,000
2. Depreciation tax savings $22,500 $25,000 $8,000
Net cash flow $57,500 $55,000 $43,000
(a) Find the net present value of this project (NPV). Should it be accepted?
Suppose Mill Company wishes to expand its operations in the UK. The exchange rate at the time of
investment is £1= $1.60.
(b) Use the PPP to find the exchange rate 1 year from now, 2 years from now and 3 years from now. The
inflation rate in the U.S. (?$) is 3 percent and in the UK 5 percent (?£)
(c) Find the NPV in pounds. Should Mill Company invest in the UK?
(Numbers should be rounded to at least 3 decimal places. Please include currency symbols $, £ in
your answer)

Answer 1

Answer to Question B3
	Answer to Part a,
	It is given that 180-day forward rate $1.56/£
	Alcoa Chemical, a US company, has sold £2 million chemicals to CPL Co. Payment is due in 180
	the hedged value of Alcoa's receivable using the forward market hedge = £2 million X $1.56/£
	the hedged value=	$31,20,000.00
	Answer to Part b,
	In money market hedge, first Convert the Present value of £2 million into US4 today and
	invest at $ interest rate for 180 days.		Spot rate= $1.60/£
	It is given that 180-day Pound interest rate (annualized) 4%, so for 180days rate = 2%
	180-day U.S. dollar interest rate (annualized) 3%, so for 180 days = 1.5%
	So PV of £2 million = £2 million / 1.02 =		$19,60,784.3137254900
	Convert these pounds to $ today =£1,960,784.31372549 X $1.60 =			$31,37,254.9019607800
	The maurity value of this $3,137,254.90196078 after 180 days at 1.5% =			$31,84,313.7254901900
	Answer to Part c,
	The hedging alternatives analyzed in parts (a) and (b) would you recommend to Alcoa
	I would recommend to go for money market hedge, because it gives $64,313.72549019 more-
	than forward hedge
	Answer to Part d,
	the relevant option will be put option, because Alcoa Chemical will get Pounds, they has to
	sell to get their operating currency od US$s
	strike price = $1.57/£, and premium = $0.05/£
	So total premium = £2,000,000 X $0.05 =		$1,00,000.00
	The Strike price of $1.57 will get only after 180 days, but premium has to pay now,
	So these premiums are compounded for 180 days at US$ interest rate
	So Future value of premium = 1.05 X 1000,000 = 105,000
	the realisation after 180 days = $1.57X£2,000,000 = $3,140,000
	Net realisation = $3,140,000 -$105,000 = $3,035,000
	hedged value of Alcoa's receivable using the option hedge =$3,035,000
	Answer to Part e,
	comparing the costs of hedging by forward contracts and option contracts,
	Value under forward contract =		$31,20,000.00
	Value under Option contract =		$30,35,000.00
	It is better to go with Forward hedge, Because it gives better cash inflow than option contracts,
	but there is a scope of taking the advantage if the Exchange rate $/£ moves upward

Answer to Question B4, Part (a),
	Year1	Year2	Year3
After tax savings	35,000.00	35,000.00	35,000.00
Depreciation tax savings	22,500.00	25,000.00	8,000.00
Net cash flow	57,500.00	60,000.00	43,000.00
Terminal cash flow	-	-	20,000.00
Net Annual Cash inflow	57,500.00	60,000.00	63,000.00
Discount Factor @ 8%	0.92592592593	0.85733882030	0.79383224102
Present value	53,240.7407407	51,440.3292181	50,011.4311843
Total Present Value of Cash inflow		1,54,692.5011431
Initial investment		1,50,000.0000000
	NPV	4,692.50
Resent value of cash inflow = Annual cash inflow X PV Factor
PVFactor = 1/(1+i)n, i= 8% or 0.08, n = corresponding number of the year
Answer to Question B4, Part (b),
Forward exchange rates under ppp theory =
Spot rate X (1+Inflation in foreign country) / (1+Inflation in foreign country)
at the end of year1 = $1.60 X 1.05/1.03 =			$1.63106796117
at the end of year2 = $1.63106796116505 X 1.05/1.03 =			$1.66273918371
at the end of year3 = $1.63106796116505 X 1.05/1.03 =			$1.69502538145
Assumed that the above Amount of cash flows are in UK pounds and
Cash flow inUS $ after converting the above cash flows
It is given that $/£ rates are given,
To convert the cash flow into £, devide the $ cash flows
	Year1	Year2	Year3
After tax savings	£21,458.33333333	£21,049.60317460	£20,648.65835223
Depreciation tax savings	£13,794.64285714	£15,035.43083900	£4,719.69333765
Net cash flow	£35,252.97619048	£36,085.03401361	£25,368.35168988
Terminal cash flow	-	-	£11,799.23334413
Net Annual Cash inflow	£35,252.97619048	£36,085.03401361	£37,167.58503401
Discount Factor @ 8%	£0.92592593	£0.85733882	£0.79383224
Present value	£32,641.64462081	£30,937.10049177	£29,504.82732086
Total Present Value of Cash inflow		£93,083.57243344
Initial investment		£93,750.00000000
	NPV	-£666.42756656

Since the NPV in  £ is negative, if the company raising fund from UK, It will not be Accepted.

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