7239AFE Financial Risk Management

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.

The statement made by the CFO is not correct, as the organisations current ratio and quick ratio is lower than the industry average, which depicts the low accumulation of current assets to support their financial obligations. The reduction in the accumulation of quick assets and increment in current assets directly indicates the increase in inventory position of the company which are not considered highly liquid assets (Heikal, Khaddafi & Ummah, 2014).

Therefore, the statement provided by the CFO is not true, as the company’s overall liquid position declined in comparisons to its industry average. The inventory accumulation of the company has increased drastically from the level of 32.35 in 2015 to 62.65 in 2017, while the values in 2017 I higher than the industry average of 53.25.

2. Identifying about the working capital management of FV:

            The working capital management is mainly calculated by subtracting the current assets with current liabilities. Hence, with the accumulation of the current asset is appropriate, as the current liabilities are less than the accumulated assets. This mainly depicts that the organisation maintains adequate current assets for supporting their operations. The current ratio formula directly indicates that current assets of the company is higher than the current liabilities (Aktas, Croci & Petmezas, 2015). This relevantly indicates the positive attributes of the working capital management of the company. Moreover, values of the working capital have mainly increased from 2015 to 2017, which can be identified from the rising values of current ratio.

1. Calculating the company’s cost of equity:

Particular	Values
Market risk premium	5.00%
Company beta	2.10
Risk free rate	3.50%
Cost of equity	6.65%

2. Calculating the cost of preference shares:

Particular	Values
Dividend	40,000
Net Proceeds	400,000
Cost of preference shares	10.00%

Calculating the current market value of the company’s debt:

Particular	Values
Interest on bonds	125,000
Face Value bond	2,500,000
Yield rate	5.50%
Time	10
Market Value of bond	2,405,780

Calculating company’s weighted average cost of capital in a world without taxes:

Particular	Values
Ordinary Share price value	6,680,000
Non-redeemable preference shares	546,000
Market Value of bond	2,405,780
Total value	9,631,780
Cost of equity	6.65%
Cost of preference shares	10.00%
Interest rate of bond	5.00%
Weighted Average Cost of Capital	6.43%

5. Calculating the company’s after tax weighted average cost of capital:

Particular	Values
Ordinary Share price value	6,680,000
Non-redeemable preference shares	546,000
Market Value of bond	2,405,780
Total value	9,631,780
Cost of equity	6.65%
Cost of preference shares	10.00%
Interest rate of bond	5.00%
Tax	25.00%
Weighted Average Cost of Capital	6.12%

Providing the difference between the systematic and unsystematic risk, while depicting about the company’s beta of 2.1:

            There are different types of risk, such as systematic and unsystematic risk, which is directly allows the investor for reducing the risk from investment, while increases the level of returns from investment. Systematic risk is the relevant variations, which arise from macroeconomics factors such as interest risk, inflation risk and market risk. These identified risks are directly affecting the return generation capability of the organisation. However, the risk is mainly controllable, where investors can be use different level of theories and measures for curbing the risk from investment. On the contrary, the unsystematic risk is mainly based on the business risk and financial risk of an organisation, which is uncontrollable, as it effects the internal operations of the company.

            Therefore, the beta of 2.1 directly indicates the high level of risk, which is affecting profit generation capability of the organisation. The high-risk attribute indicates the volatility in prices change, which will be witnessed when index price changes. The risk attributes of market are at the levels of 1, while the risk of the organisation is 2.1, which indicates that higher return needs to be provided by the company in comparison to the market return. The use of Capital Asset Pricing Model directly helps in depicting the level of returns, which needs to be provided by the stock with certain level of beta or risk. Marshall (2015) stated that with the help of CAPM model investors are able to detect the level of minimum returns, which needs to be provided by the stock.

1. Evaluating the project with ARR, payback period, NPV and IRR methods of capital budgeting, while providing an investment decision according to each of these criteria’s:

Year	Cash flow	Dis-rate	Dis-cash flow	Cum-cash
0	(100,000)	1.00	(100,000)	(100,000)
1	40,000	0.86	34,483	(60,000)
2	40,000	0.74	29,727	(20,000)
3	40,000	0.64	25,626	20,000
4	40,000	0.55	22,092	60,000
	NPV		11,927
	ARR		60.00%
	IRR		22%
	Payback period		2.5	Years

2.a Identifying the NPV of the second project:

Year	Cash flow	Dis-rate	Dis-cash flow	Cum-cash
0	(120,000)	1.00	(120,000)	(120,000)
1	55,000	0.86	47,414	(65,000)
2	55,000	0.74	40,874	(10,000)
3	55,000	0.64	35,236	45,000
	NPV		3,524
	ARR		37.50%
	IRR		18%
	Payback period		2.2	Years

2.b Calculating the equivalent annual annuity for choosing the adequate project:

Particulars	Project 1	Project 2
Year	4	3
Cost of capital	16%	16%
NPV	11,927	3,524
Equivalent Annual Annuity	$4,262.49	$1,569.06

From the evaluation of above calculation financial viability of the projects can be identified. In addition, with the calculation of equivalent annual annuity it could be identified that selecting project 1 can be used by the organisation for improving the level of returns from investment. The project selected for the calculation is relevantly helpful and generates the highest revenue from investment. moreover, the NPV, IRR, and ARR of project 1 is higher than project 2, which directly indicates the profits and returns that can be generated from investment (Baum & Crosby, 2014).

1. Identifying the profit margin of the company if the current spot rate is used, while depicting the critical AUD/USD currency rate and portraying the AUD/USD currency rate at which the company achieves exactly its target rate:

Particulars	Value
AUD/USD Spot rate 20-08-2017	1.086956522
Payment in USD	AUD       10,869,565
Cost in AUD	AUD         8,800,000
Profit in USD	AUD         2,069,565
Return on USD	19.04%

Particulars	Value
Minimum acceptable profit margin	14.00%
Cost in AUD	AUD    8,800,000.00
Sales	AUD 10,232,558.14
Payment in USD	$             10,000,000
Critical AUD/USD	0.9773

 

Particulars	Value
Target profit (Ideal)	20.00%
Cost in AUD	AUD         8,800,000
Sales	AUD       11,000,000
Payment in USD	$             10,000,000
Ideal Profit AUD/USD	0.9091

2. Steps for undertaking the hedging measure taken by the company, while giving two examples in which the company may not need the hedge process:

            The changes in valuation of the AUD/USD would directly affect the level of hedging measure, which needs to be maintained by the organisation for reducing the risk from investment. However, the continuous decline in the current currency conversion rate would eventually help in reducing the risk involved in investment. There are two different situations under which no hedging process will be required by the organisation.

The first situation under which the hedging process will not be required is the decline in current AUD/USD value. This will eventually increase the level of income from the transactions that will be generated from currency conversion. However, from the evaluation it is also detected that use of fixed forward rate contract from banks would also help in fixing the level of currency values, which will be used for the conversion. Under this situation there is no need for the hedging process, as the conversion rate of fixed (Mensi, Hammoudeh & Yoon, 2015).

3. Identifying the risk involved for investments in future contract by the organisation:

            There is significant risk involved in using the future contract, as the contract will expire in 30-01-2018, while the payment will be received on 20-02-2018, which relevantly increase the gap for 20 days. This difference in transactions period is 20 days, which will directly increase the level of risk from hedging (Dong, Kouvelis & Su, 2014). The hedging process will not be conducted for the duration of 20 days, which will directly increase the level of risk involved in investment. However, values of the future contract are relevantly high, which will negatively affect the level of income that will be converted during 20-02-2018.

4. Considering different hedging strategies that can be used by the organisation:

I. Hedging 100% of the revenue from forward contract:

Particulars	Value
Payment in USD	$             10,000,000
Hedge 100%	100%
Buying AUD Put	0.850
Premium	0.010
Spot rate 20-08-2017 (0.92)	9,300,000
Spot rate 20-02-2018 (1.05)	10,500,000
Loss from hedge	(1,200,000)
Profit from transaction	1,300,000
Total value in currency transaction	100,000

 

Particulars	Value
Payment in USD	$        10,000,000
Hedge 100%	100%
Buying AUD Put	0.850
Premium	0.010
Spot rate 20-08-2017 (0.92)	9,300,000
Spot rate 20-02-2018 (0.85)	8,500,000
Profit from hedge	800,000
Loss from transaction	(700,000)
Total value in currency transaction	100,000

II. hedging 50% of the profit:

Particulars	Value
Payment in USD	$             10,000,000
Hedge 100%	50%
Buying AUD Put	0.850
Premium	0.010
Spot rate 20-08-2017 (0.92)	4,650,000
Spot rate 20-02-2018 (1.05)	5,250,000
Loss from hedge	(600,000)
Profit from transaction	1,300,000
Total value in currency transaction	700,000

 

Particulars	Value
Payment in USD	$        10,000,000
Hedge 100%	50%
Buying AUD Put	0.850
Premium	0.010
Spot rate 20-08-2017 (0.92)	4,650,000
Profit from transaction	4,250,000
Profit from hedge	400,000
Loss from transaction	(700,000)
Total value in currency transaction	(300,000)

III. Taking protection against unfavourable effect and increasing return from favourable effect:

Particulars	Value
Payment in USD	$             10,000,000
Buying [email protected]	0.751
Buying [email protected]	0.900
Total income from hedging	0.150
Total profit from hedge	$               1,495,000

IV. Worst-Case Protection:

Particulars	Value
Payment in USD	$        10,000,000
Hedge 100%	100%
Buying AUD Call	0.970
Premium	0.002
Spot rate 20-08-2017 (0.92)	9,215,000
Spot rate 20-02-2018 (1.05)	10,500,000
Profit from hedge	1,285,000
Loss from transaction	(1,300,000)
Total loss in currency transaction	$              (15,000)

 

Particulars	Value
Payment in USD	$        10,000,000
Hedge 100%	100%
Buying AUD Call	0.97
Premium	0.0015
Spot rate 20-08-2017 (0.92)	9,215,000
Spot rate 20-02-2018 (0.85)	8,500,000
Loss from hedge	(715,000)
Profit from transaction	700,000
Total loss in currency transaction	(15,000)

V. No Hedge at all:

Particulars	Value
Payment in USD	$             10,000,000
No Hedge	0
Spot rate 20-08-2017 (0.92)	$               9,200,000
Spot rate 20-02-2018 (0.85)	$               8,500,000
Loss from transaction	$                 (700,000)

 

Particulars	Value
Payment in USD	$        10,000,000
No Hedge	0
Spot rate 20-08-2017 (0.92)	$          9,200,000
Spot rate 20-02-2018 (1.05)	$        10,500,000
Profit from transaction	$          1,300,000

5. Providing two different examples of low-cost hedging strategies, which has not been already discussed:

            The use of forward exchange contract and money market operations can be conducted for the hedging purposes. This would eventually help in reducing the level of risk and maximise the profits, which could be generated from the hedging process. Hence, with the use of forward exchange contract the organisation could fix the rate of exchange in which the USD payment can be converted to AUD. This will drastically reduce the risk and maximise the level of returns, which can be generated from the hedging process. The fluctuations in the currency market will have no effect on the conversion price of the payment made in USD, as the contract fixes the rate of exchange in which the conversion will take place after the period of 6 months (Chege & Obwogi, 2018).

            The second contract that can be used is the money market hedging process, which helps the organisation to minimise the level of risk involved in currency conversion. The money market process mainly a loan in the payment providing country and loan in payment receiving country. Hence, the organisation needs to take a loan in USA for the amount of the payment, while the amount less interest will be transferred to AUD at spot rate, which nullifies the loss from currency conversion. The same amount transferred to AUD will be deposited in the bank for the time period of the payment, which will bring in interest. This inflow of interest in home country and interest payment in foreign country will reduce the loss that will be conducted during the foreign exchange.

References and Bibliography:

Aktas, N., Croci, E., & Petmezas, D. (2015). Is working capital management value-enhancing? Evidence from firm performance and investments. Journal of Corporate Finance, 30, 98-113.

Awais, M., Hayat, F., Mehar, N., & Ul-Hassan, W. (2015). Do Z-Score and Current Ratio have Ability to Predict Bankruptcy?. Developing Country Studies, 5(13), 30-36.

Baños-Caballero, S., García-Teruel, P. J., & Martínez-Solano, P. (2014). Working capital management, corporate performance, and financial constraints. Journal of Business Research, 67(3), 332-338.

Baum, A. E., & Crosby, N. (2014). Property investment appraisal. John Wiley & Sons.

Bhalla, V. K. (2014). Working capital management. S. Chand Publishing.

Bromiley, P., Rau, D., & Zhang, Y. (2017). Is R & D risky?. Strategic Management Journal, 38(4), 876-891.

Chege, J. M., & Obwogi, T. N. (2018). The Effect Of Currency Risk Internal Hedging Strategies On The Value Of The Firm: Evidence Of Listed Commercial Banks In Kenya. Management and Economic Journal, 315-323.

Deshmukh, N. H., & Joshi, P. V. (2016). Applicability of Sharpe model in varying time frames for small portfolio construction. KHOJ: Journal of Indian Management Research and Practices, 181-188.

Dong, L., Kouvelis, P., & Su, P. (2014). Operational hedging strategies and competitive exposure to exchange rates. International Journal of Production Economics, 153, 215-229.

Garg, M. (2015). Working Capital Management. Educreation Publishing.

Heikal, M., Khaddafi, M., & Ummah, A. (2014). Influence analysis of return on assets (ROA), return on equity (ROE), net profit margin (NPM), debt to equity ratio (DER), and current ratio (CR), against corporate profit growth in automotive in Indonesia Stock Exchange. International Journal of Academic Research in Business and Social Sciences, 4(12), 101.

Marshall, C. M. (2015). Isolating the systematic and unsystematic components of a single stock’s (or portfolio’s) standard deviation. Applied Economics, 47(1), 1-11.

Mensi, W., Hammoudeh, S., & Yoon, S. M. (2015). Structural breaks, dynamic correlations, asymmetric volatility transmission, and hedging strategies for petroleum prices and USD exchange rate. Energy Economics, 48, 46-60.

Utami, W. B. (2017). Analysis of Current Ratio Changes Effect, Asset Ratio Debt, Total Asset Turnover, Return On Asset, And Price Earning Ratio In Predictinggrowth Income By Considering Corporate Size In The Company Joined In LQ45 Index Year 2013-2016. International Journal of Economics, Business and Accounting Research (IJEBAR), 1(01).

Valipour, M., Amin, V., Kargosha, M., & Akbarpour, K. (2015). Forecasting stock systematic risk using Heuristic Algorithms. Journal of Productivity and development, 1(1), 36-41.

Vats, S., & Patel, K. (2017). Ratio Analysis of a Private Limited Company with Relevance to Change in Type of Enterprise-A Case Study of Write Fine Products Pvt. Ltd. Umbragam, Gujarat. Journal of Applied Management-Jidnyasa, 9(2), 37-43.