Foreign Exchange Risk Management and Investment Decisions - Troop Inc. Case Study

Reasons for hedging foreign exchange risk

The following scenario relates to many of the questions in this exam paper and you might to use the scenario to frame your answer to the others.

Troop Inc. is a US based multinational who has subsidiaries in Switzerland and Malaysia. The Malaysian subsidiary produces treadmills which are then transported to the US parent for sale in the US and Canada.

ANSWER ALL PARTS OF THE QUESTION

Troop Inc (US) has recently purchased equipment from Tread plc, an unrelated company based in the UK, for �800,000. The currency risk of this purchase is of particular concern to Troop Inc (US) and the payment is due in 6 months� time. The following data has been compiled:

Required:

a) Identify and calculate the costs of the alternative strategies available for hedging this risk and advise which strategy would have produced the best outcome for Troop Inc (US) assuming the actual spot rate in 6 months� time is �0.75/$.

b) Explain the reasons for and against companies hedging their foreign exchange risk.

c) Describe the operating exposures Troop Inc (US) is exposed to and describe the strategies the company might undertake to reduce its level of economic exposure.

d) Briefly describe how translation practices result in a foreign exchange exposure for the multinational enterprise and how the enterprise might hedge this risk.

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ANSWER BOTH PARTS OF THE QUESTION

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a) Troop Inc. (US) is considering whether to set up a subsidiary in India, to produce digital devices that customers can choose to add to their treadmills. Alternatively, Troop Inc.�s management have identified an existing company which has production facilities which can be adapted to produce the devices. Discuss the factors and risks �Troop Inc. should consider when deciding whether to establish a new subsidiary in India or acquire the existing company which is based in India.

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b) Describe the motives multinational companies may have to engage in Foreign Direct Investment and provide examples for each.

3. ANSWER ALL PARTS OF THE QUESTION

a) Troop Inc. (US) has decided to build a new factory in India. Explain the benefits of subsequently borrowing in India rather than in the US.

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b) Explain the options available to Troop Inc. to raise equity in international financial markets and suggest potential advantages from cross-listing on the Indian stock exchange.

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c) Explain what is meant by a segmented market and an illiquid market and what circumstances may cause them to arise.

Hedging strategies for Troop Inc.

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Troop Inc. is considering building a factory in India. The estimated cash flows for the project are given below and management consider that a discount rate of 12% reflects the riskiness of the venture. The Indian government has agreed to purchase the factory at the end of three years operation for Rupees 250 million.

Required

a) Calculate the net present value of the project and advise whether Troop Inc should build the factory.

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b) Describe the factors Troop Inc. should consider when estimating the value of the project to build a factory. Explain whether the value of the project should be estimated as a stand-alone project in India, or whether the value should be based on the parent�s perspective.

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c) Troop Inc (US) has agreed to sell the factory to the Indian government in (a) above. Explain how Troop Inc (US) should evaluate the project if, instead of agreeing to sell �the factory at the start of the project, they could decide whether or not to sell at the end of the three years. In addition, explain the potential impact on the value of the project to build the factory.

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ANSWER ALL PARTS

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a) Troop Inc (US) is setting up a subsidiary in India and is considering the price to charge for one of the components ( a digital device that attaches to the treadmills) that it will produce in India and will ship to the US for further processing. The cost of producing the unit in India is 250 Rupees. Additional costs in the US would be $6 per component. The US tax rate is currently 30%, whereas the Indian tax rate for the subsidiary would be 25%.

Using an exchange rate of Rupees76/$ calculate the total tax payable in $�s if the transfer price is (i) $8.00 per unit and (ii) $9.00 per unit. Troop Inc (US) expects to sell the digital device to customers in the US for $32. If Troop Inc (US) wishes to minimise global taxes which transfer price should it use? �

b) Explain what is meant is meant by the term �transfer price�. Explain the arm�s length rule with respect to transfer pricing and why governments may insist that multinational organisations use it as their transfer price.

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c) Nations typically structure their tax systems along one of two basic approaches: the worldwide approach or the territorial approach. Describe the two approaches and include an explanation of why problems arise due to countries using different systems.

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d) Describe the tax incentives a government might offer a multinational company and explain their potential advantages and disadvantages.

Reasons for hedging foreign exchange risk:

1. Protection against loss: Hedging provides protection to companies against potential losses caused by unexpected changes in exchange rates. By using hedging techniques, companies can reduce the impact of currency fluctuations on their financial performance, making it easier to forecast cash flows and manage budgets.

2. Competitive advantage: Hedging can provide a competitive advantage by allowing companies to price their products or services more accurately in foreign markets. This can help them to win business against competitors who do not hedge their foreign exchange risk.

3. Strategic planning: Hedging can also help companies to plan their investments and expansion into new markets. By reducing uncertainty about future cash flows, companies can make more informed decisions about how to allocate resources and invest in new initiatives.