Recitation, 22.12.2016

Problems

1.You plan to visit Geneva, Switzerland, in three months to attend a business conference. You expect to incur a total cost of SF5000 for lodging, meals and transportation during your stay. As of today, the spot exchange rate is $0.60/SF and the three-month forward rate is $0.63/SF. You can buy the three-month call option on SF with an exercise price of $0.64/SF for the premium of $0.05 per SF. Assume that your expected future spot exchange rate is the same as the forward rate. The three-month interest rate is 6 percent per annum in the US and 4 percent per annum in Switzerland.

a) Calculate your expected dollar cost of buying SF 5000, if you choose to hedge by a call option on SF.

b) Calculate the future dollar cost of meeting this SF obligation if you decide to hedge using a forward contract.

c) At what future spot exchange rate will you be indifferent between the forward and option market hedges?

d) Illustrate the future dollar cost of meeting SF payable against the future spot exchange rate under both the options and forward market hedges.

2. Here below is the balance sheet of a Spanish Affiliate of a US parent firm, Centralia Corp. The functional currency of the Spanish affiliate is euro, the reporting currency of the parent company is USD. The initial exchange rate is €1.10/$. Assume that on Jan 2, 2017 the euro depreciated to €1.1896/$ level. Translate the balance sheet into dollar terms and calculate the cumulative translation adjustment account in both the current and the temporal method. We are also given information that the fixed assets and common stock were retained when the exchange rate was €1,00/$ and the inventories were purchased when the exchange rate was €1,08/4$.

Spanish Affiliate Dec 31, 2016
Assets
Cash / €825
Accounts Receivable / 1045
Inventory / 1650
Net Fixed Assets / 4400
Total Assets / 7920
Liabilities and Net Worth
Accounts Payable / €1364
Notes Payable / 1210
Long-Term Debt / 3520
Common Stock / 1320
Retained Earnings / 506
Total Liabilities and Net Worth / 7920
Current Rate Method / Before Depreciation / After Depreciation
Spanish Affiliate Dec 31, 2016 / Spanish Affiliate Jan 2, 2017
Assets
Cash
Accounts Receivable
Inventory
Net Fixed Assets
Total Assets
Liabilities and Net Worth
Accounts Payable
Notes Payable
Long-Term Debt
Common Stock
Retained Earnings
CTA
Total Liabilities and Net Worth
Temporal Method / Before Depreciation / After Depreciation
Spanish Affiliate Dec 31, 2016 / Spanish Affiliate Jan 2, 2017
Assets
Cash
Accounts Receivable
Inventory
Net Fixed Assets
Total Assets
Liabilities and Net Worth
Accounts Payable
Notes Payable
Long-Term Debt
Common Stock
Retained Earnings
CTA
Total Liabilities and Net Worth

3. A US computer company has a wholly owned British subsidiary Albion Computers that manufactures and sells personal computers in the UK market. Albion imports microprocessors from Intel which sells them for $512 per unit. Albion hires British workers and sources all the other inputs locally. The applicable tax rate is 50% in UK. Current exchange rate is $1.60 per pound. Assume that the pound may depreciate to $1.40 per pound, calculate the results of the possible scenarios presented below.

Base Case / Case 1 / Case 2 / Case 3
Sales Volume / 50,000 units / 50,000 units / 50,000 units / 40,000 units
Sales Price / £1,000 / £1,000 / £1,143 / £1,080
Variable Costs per unit / £650 (comprises £330 for the local inputs, £320 for the imported input ($512/$1,60/£) / £330 for the local inputs, $512 for the imported input / £330 for the local inputs, $512 for the imported input / £330 for the local inputs, $512 for the imported input
Fixed Overhead Costs / 4,000,000 / 4,000,000 / 4,000,000 / 4,000,000
Depreciation / 1,000,000 / 1,000,000 / 1,000,000 / 1,000,000
Benchmark Case / Case 1 / Case 2 / Case 3
Sales
Variable Costs
Fixed Overhead Costs
Depreciation
Net Profit Before Tax
Income Tax
Profit After Tax
Add back depreciation
Operating cash flow in pounds
Operating cash flow in dollars