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7239AFE Financial Risk Management

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Question:

You have been hired as an analyst for Ant Bank and your team is working on an independent assessment of the Fresh Vegies Ltd (FV). FV is a firm that specializes in the production of fresh farm products and especially fruit, vegies and eggs.  Your assistant has provided you with the following data for FV Ltd and their industry.

 

Ratio

 

2017

 

2016

 

2015

Industry Average 2017

Inventory Turnover

62.65

42.42

32.25

53.25

Accounts Receivable Period

33.08

25.55

23.40

36.25

Debt to Equity

0.75

0.85

0.90

0.88

Payables Turnover

12.08

10.90

8.90

11.00

Profit Margin

0.082

0.07

0.06

0.075

Quick Ratio

1.028

1.03

1.029

1.031

Current Ratio

1.33

1.21

1.15

1.25

In the annual report to the shareholders, the CFO of FV wrote, “2017 was a good year for the firm with respect to our ability to meet our short-term obligations. We had higher liquidity largely due to an increase in highly liquid current (marketable) assets.” Is the CFO correct?  Explain and use only relevant information in your analysis.
  1. What can you say about the working capital management of FV? Be as complete as possible given the above information, but do not use any irrelevant information. 

Problem

You have been employed as a consultant of Wazup Ltd, a company which tunes expensive cars.  You find out that

  • Wazup pays interest (coupons) of $ 125,000 once every year on its bonds with face value of $ 2,500,000. The bonds mature in exactly 10 years. The current market interest rate (yield) on similar bonds is 5.5%.
  • The company’s tax rate is 25%.
  • Risk-free rate is 3.5 %.
  • In total, there are 2,000,000 ordinary shares issued. Current trading price per share is $ 3.34.
  • There are 200,000 non-redeemable preference shares which pay 10% annually (last payment just occurred).
  • The preference shares have an original value (face value) of $ 2 each.
  • Current market price of a preference share is $ 2.73.
  • The market risk premium is 5 %.
  • The company’s beta is 2.1.

Based on this information:

  1. Calculate the company’s cost of equity.
  2. Calculate the cost of preference shares.
  3. Calculate the current market value of the company’s debt.
  4. Calculate the company’s weighted average cost of capital in a world without taxes.
  5. Calculate the company’s after-tax weighted average cost of capital.
  6. A manager of Wazup who is not familiar with the Capital Asset Pricing Model would like to know more about the beta factor of 2.1 which you have used for your calculations. Please provide an explanation of the difference between systematic and unsystematic risk. What does it mean that the company’s beta is 2.1?

Problem 3

The Kalkbrenner Ltd is considering whether to make an investment in a new machine with initial outlay of $ 100,000, economic life of four years and no salvage value. This machine will generate annual cash inflows of $ 40,000 per year. Assume that this amount represents also the net accounting profit (before depreciation), the machine is depreciated on a straight-line basis and there are no taxes.  The Kalkbrenner Ltd uses a minimum benchmark ARR of 15% and a benchmark payback period of 2 years. The company’s cost of capital is 16%.

  1. Evaluate the project with the ARR, payback period, NPV and IRR methods of capital budgeting and provide an investment decision according to each of these criteria. Please use the approximation method for calculating the IRR.
  2. The Kalkbrenner Ltd has as a second alternative a project with initial outlay of $ 120,000, economic life of 3 years and annual inflows of $ 55,000 per year. Both projects are mutually exclusive.
    1. What is the NPV of the second project?
    2. Which project should be chosen based on the constant chain of replacement assumption? Hint: Calculate the equivalent annual annuity (EAA). 

Problem 4

Assume it is the 20th of August 2017. An Australian-based company with functional currency AUD exports sport equipment to the US. The negotiated contract price for the company’s sales in six months (20th of February 2018) is USD 10 million. The company has costs of AUD 8.8 million. The company is concerned about its foreign exchange rate risk because the AUD/USD exchange rate has been historically quite volatile and has hired you as a risk management advisor.

You obtain following additional information:

  • The AUD/USD spot rate on the 20th of August is 0.9200.
  • The US six-month interest rate is 3.0%.
  • The Australian six-month interest rate is 2.4%.
  • An AUD/USD foreign exchange futures contract with the size of AUD 2 million expiring on the 30th of January 2018 is available with futures rate AUD/USD 0.9223.
  • The company’s target (ideal) profit margin (profit as percentage of revenue) is 20%.
  • The minimum acceptable profit margin below which the company will have difficulties servicing its debt is 14%.
  • Following foreign exchange option contracts expiring on the 20th of February 2018 are available:

Option type

Strike rate
AUD/USD

Premium

AUD Call

0.97

15 points

AUD Put

0.75

5 points

AUD Call

0.88

200 points

AUD Put

0.85

100 points

  1. What would be the profit margin of the company if the current spot rate is used? What is the critical AUD/USD currency rate for the company? What is the AUD/USD currency rate at which the company achieves exactly its target (ideal) rate?
  2. What steps would you undertake to analyse the need of this company for hedging? Give two examples of situations in which the company may not need to hedge its FX risks with derivatives.
  3. What risks is the company exposed to if it decides to use the available futures contract for hedging? Please explain.
  4. You consider following strategies:
    1. Hedge 100 % of the revenues with a forward contract.
    2. Hedge 50 % of the revenues with a forward contract and leave the other 50 % unhedged.
  • Meet the target rate and have protection against unfavourable exchange rate movements but fully benefit from favourable exchange rate movements.
  1. Worst-case protection.
  2. No hedge at all.

If a strategy includes options, state clearly which option contract should be used. Comment on the advantages and disadvantages of each strategy and calculate the profit margin of the company if the AUD/USD spot exchange rate on the 20th of February 2018 is

  1. a) 1.05,
  2. b) 0.85.

What is the effective exchange rate in each case?

If a strategy uses options, take the option premium into account in the way we did this in the lecture. Disregard the time value of money. Assume that there are 180 days in a period of six months.

  1. Give two examples of low-cost hedging strategies employing financial derivatives, different than the strategies you already discussed. These strategies do not need to be based on the option contracts listed in the table above. You don’t need to do any calculations for these examples.
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