Question

Burton Co., based in the U.S., considers a project in which it has an initial outlay of $2 million and expects to receive 6 million Swiss francs (SF) in one year. The spot rate of the franc is $.90. Burton Co. decides to purchase put options on Swiss francs with an exercise price of $.88 and a premium of $.02 per unit to hedge its receivables. It has a required rate of return of 18 percent.

a. Determine the net present value of this project for Burton Co. based on the forecast that the Swiss franc will be valued at $.80 at the end of one year. (4 Points)

b. Assume the same information in part (a), but with the following adjustment. While Burton expected to receive 6 million Swiss francs, assume that there were unexpected weak economic conditions in Switzerland after Burton initiated the project. Consequently, Burton received only 4 million Swiss francs at the end of the year. Also assume that the spot rate of the franc at the end of the year was $.89. Determine the net present value of this project for Burton Co. if these conditions occur. (4 Points)

Answer 1

Part-A:

As at the end of year, the option’s exercise price ($0.88) is greater than the market price ($0.80), so the Burton Co. will exercise its put option. Burton’s cash flow would be;

Cash Outlay = $2 million

Put Option Premium = (6 million SF * $0.02) = $0.12 million

Cash Inflow = (6 million SF * $0.88) = $5.28 million

NPV = PV of Cash Inflows – PV of Cash Outflows

                = ($2 million + $0.12 million) – ($5.28 million * PVF @ 18% for 1 years)

                = 2,120,000 – ($5,280,000 * 0.84745)

              = S2,354,536

Part-2:

As at the end of year, the option’s exercise price ($0.88) is less than market price ($0.89), so Burton will not exercise its put instead convert the inflow at market rate;

Cash Inflow= (4 million SF * $0.89) = $3.56 million

Initial Cash Outlay and Put premium will remain same as circumstances changed after initiation of project.

NPV = ($2 million + $0.12 million) + ($3.56 million * 0.84745)

         = $2,120,000 - $3,016,922

         = $896,922