Ch18-NotesAns

8/13/2019 Ch18-NotesAns

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Notes Answers

)- marks*

?conomic order &uantity 0 552 x 234 x 623,444874>38'720 23,444 units

Number of orders per year 0 623,444723,444 0 23 per year

/rdering cost 0 1234 x 23 0 16,234 per year

$olding cost 5ignoring buffer stock8 0 14>34 x 523,444728 0 14>34 x '2,344 0 16,234 per year

$olding cost 5including buffer stock8 0 14>34 x 5'4,444 = '2,3448 0 1'',234 per year

Total cost of ?/@)based ordering policy 0 16,234 = 1'',234 0 1',344 per year

)- marks*

#aving for +A -o by using ?/@)based ordering policy 0 19',369 < 1',344 0 1'B,469 per

year. )1 mark*

'c(

The information gathered by the Financial anager of +A -o indicates that two areas of

concern in the management of domestic accounts receivable are the increasing level of bad

debts as a percentage of credit sales and the excessive credit period being taken by credit

customers.

Reducing ad dets

'. The incidence of bad debts, which has increased from 3C to (C of credit sales in the

last year, can be reduced y assessing the creditworthinessof new customers before

offering them credit and +A -o needs to introduce a policy detailing how this should

be done, or re"iew its existing policy, if it has one, since it is clearly not working very

well.

2. In order to do this, information aout the sol"ency, character and credit historyof

new clients is needed. This information can come from a variety of sources, such as

ank references, trade references and credit reportsfrom credit reference agencies.

:hether credit is offered to the new customer and the terms of the credit offered can

then be based on an explicit and informed assessment of default risk.

)- . / marks*Reduction of a"erage accounts recei"ale period

'. -ustomers have taken an a"erage of 0 days creditover the last year rather than the 94

days offered by +A -o, i.e. more than twice the agreed credit period. As a result, +A

-o will be incurring a sustantial opportunity cost, either from the additional

interest cost on the short+term financing of accounts receivable or from the

incremental profit lostby not investing the additional finance tied up by the longer

average accounts receivable period. +A -o needs to find ways to encourage accounts

receivable to be settled closer to the agreed date.

2. Assuming that the credit period offered y 23A Co is in line with that of its

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competitors, the company should determine whether they too are suffering from similar

difficulties with late payers. If they are not, +A -o should determine in what way its

own terms differ from those of its competitors and consider whether offering the same

trade terms would have an impact on its accounts receivable. For example, its

competitorsmay offer a discount for early settlementwhile 23A Co does notand

introducing a discount may achieve the desired reduction in the average accounts

receivable period.

9. If its competitors are experiencing a similar accounts recei"ale prolem, 23A Co

could take the initiati"e y introducing more fa"ourale early settlement termsand

perhaps generate increased business as well as reducing the average accounts receivable

period.

B. +A -o should also in"estigate the efficiency with which accounts recei"ale are

managed. Are statements sent regularly to customersD Is an aged accounts receivable

analysis produced at the end of each monthD Are outstanding accounts receivable

contacted regularly to encourage paymentD Is credit denied to any overdue accounts

seeking further businessD Is interest charged on overdue accountsD These are all matters

that could be included by +A -o in a revised policy on accounts receivable

management.

)- . / marks*

'd(

Money market hedge

+A -o should place sufficient dollars on deposit now so that, with accumulated interest, the

six)month liability of E234,444 can be met. #ince the company has no surplus cash at the

present time, the cost of these dollars must be met by a short)term euro loan.

#ix)month dollar deposit rate 0 9>372 0 '>3C

-urrent spot selling rate 0 '>( < 4>442 0 E'>6 per euro

#ix)month euro borrowing rate 0 6>'72 0 9>43C

Gollars deposited now 0 234,4447'>4'3 0 E2B3,44

-ost of these dollars at spot 0 2B3,447'>6 0 '29,46 euros

?uro value of loan in six months time 0 '29,46 x '>4943 0 '26,(34 euros

)- marks*

Forward market hedge

#ix months forward selling rate 0 '> < 4>44B 0 E'>3 per euro

?uro cost using forward market hedge 0 234,4447'>3 0 '26,3(2 euros

)& marks*

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5/15

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4ead payment

#ince the dollar is appreciating against the euro, a lead payment may be worthwhile.

?uro cost now 0 234,4447'>6 0 '23,23' euros

This cost must be met by a short)term loan at a six)month interest rate of 9>43C

?uro value of loan in six months time 0 '23,23' x '>4943 0 '2,4' euros

)& marks*

5"aluation of hedges

The relative costs of the three hedges can be compared since they have been referenced to the

same point in time, i.e. six months in the future. The most expensi"e hedge is the lead

payment, while the cheapest is the forward market hedge. "sing the forward market to

hedge the account payable currency risk can therefore be recommended. )1 mark*

Answer -

5a8

ovements in exchange rates can be related to changes in interest rates and to changes in

inflation rates. The relationship between exchange rates and interest rates is called interest

rate parity, while the relationship between exchange rates and inflation rates is called

purchasing power parity.

5xplanation of interest rate parity

Interest rate parity holds that the relationship etween the spot exchange rate and the

forward exchange ratebetween two currencies can be linked to the relati"e nominal

interest rates of the two countries.

The forward rate can be found y multiplying the spot rate y the ratio of the

interest rates of the two countries. The currency of the country with the higher

nominal interest ratewill be forecast to weakenagainst the currency of the country

with the lower nominal interest rate.

;oth the spot rate and the forward rate are available in the current foreign exchangemarket, and the forward rate can be guaranteed by using a forward contract.

)& . - marks*

5xplanation of purchasing power parity

urchasing power parity holds that the current spot exchange rate and the future

spot exchange ratebetween two currencies can belinked to the relati"e inflation

rates of the two countries. The future spot rate is the spot rate that occurs at the end of

a given period of time.

The currency of the country with the higher inflation rate will e forecast to weaken

against the currency of the country with the lower inflation rate. urchasing power

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parity is ased on the law of one price, which suggests that, in e$uilirium, identical

goods should sell for the same price in different countries, allowing for the exchange

rate.

urchasing power parityholds in the longer term rather than the shorter term

and

so is often used to provide long)term forecasts of exchange rate movements, for

example for use in investment appraisal.

)& . - marks*

5b8

The costs of the two exchange rate hedges need to be compared at the same point in time, e.g.

in six months time.

Forward market hedge

Interest payment 0 3,444,444 pesos

#ix)month forward rate for buying pesos 0 '2>(43 pesos per E

Gollar cost of peso interest using forward market 0 3,444,4447'2>(43 0 E94,B2 )1 mark*

Money market hedge

H# -o has a 3 million peso liability in six months and so needs to create a 3 million peso

asset at the same point in time. The six)month peso deposit rate is >3C72 0 9>3C.

)1 mark*

The &uantity of pesos to be deposited now is therefore 3,444,4447'>493 0 B,(',2 pesos.

The &uantity of dollars needed to purchase these pesos is B,(',27'2>344 0 E9(3,3B2 and

H# -o would borrow this &uantity of dollars now. )1 mark*

The six)month dollar borrowing rate 0 B>3C72 0 2>23C and so in six months time the debt

will be 9(3,3B2 x '>4223 0 E9B,2'. This is the dollar cost of the peso interest using a

money market hedge. )& marks*

-omparing the E94,B2 cost of the forward market hedge with the E9B,2' cost using a

money market hedge, it is clear that the forward market should be used to hedge the pesointerest payment as it is cheaper by E9,B3. )1 mark*

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Answer /

'a(

'. 2ecking order theory suggeststhat companies have a preferred order in which they

seek toraise finance, eginning with retained earnings

. The advantages of using

retained earnings are that issue costs are avoided by using them, the decision to use

them can be made without reference to a third party, and using them does not bring

additional obligations to consider the needs of finance providers.

2. /nce available retained earnings have been allocated to appropriate uses within a

company, its next preference will be for debt. 6ne reasonfor choosing to finance a new

investment by an issue of debt finance, therefore, is that insufficient retained earnings

are a"ailale and the investing company prefers issuing det finance to issuing

e$uity finance.

9. 7et financemay also be preferredwhen a company has not yet reached its optimal

capital structureand it is mainly financed by e&uity, which is expensive compared to

debt. Issuing debt here will lead to a reduction in the ACC and hence an increase

in the market "alue of the company.

B. /ne reason why det is cheaper than e$uity is that det is higher in the creditor

hierarchy than e&uity, since ordinary shareholders are paid out last in the event of

li&uidation.

3. 7et is e"en cheaper if it issecured on assetsof the company. The cost of debt is

reduced e"en further y the tax efficiency of debt, since interest payments are an

allowable deduction in arriving at taxable profit.

6. 7etfinance may be preferred where the maturity of the det can e matched to

the expected life of the in"estment pro!ect. ?&uity finance is permanent finance and so

may be preferred for investment pro!ects with long lives.

)0 marks*5b8

Annual interest paid per foreign bond 0 344 x 4>46' 0 94>3 pesos

edemption value of each foreign bond 0 344 pesos

-ost of debt of peso)denominated bonds 0 C per year

arket value of each foreign bond 0 594>3 x B>'448 = 5344 x 4>'98 0 B('>33 pesos

)- marks*

-urrent total market value of foreign bonds 0 '6m x 5B('>3373448 0 '3,B4,644 pesos

)1 mark*

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8/15

Notes Answers

5c85i8

Interest payment in one years time 0 '6m x 4>46' 0 6,444 pesos

5xplanation of market hedge

A money market hedge would involve placing on deposit an amount of pesos that, with added

interest, would be sufficient to pay the peso)denominated interest in one year. ;ecause the

interest on the peso)denominated deposit is guaranteed, ;olu!e -o would be protected against

any unexpected or adverse exchange rate movements prior to the interest payment being

made. )& marks*

Illustration of money market hedge

eso deposit re&uired 0 6,4447 '>43 0 2,32B pesos

Gollar e&uivalent at spot 0 2,32B7 6 0 E'3B,2'

Gollar cost in one years time 0 '3B,2' x '>4B 0 E'6',''(

)& marks*

5c85ii8

-ost of forward market hedge 0 6,44476>4 0 E'64,4

The forward market hedge is slightly cheaper

)& marks*

5d8

'. ;olu!e receives peso income from its export sales and makes annual peso)denominated

interest payments to bond)holders. It could consider opening a peso account in the

o"erseas countryand using this as a natural hedgeagainst peso exchange rate risk.

)1 . & marks*

2. ;olu!e -o could consider using lead payments to settle foreign currency liailities.

This would not be beneficial as far as peso denominated liabilities are concerned, as the

peso is depreciating against the dollar. It is inadvisable to lag payments to foreign

suppliers, since this would breach sales agreements and lead to loss of goodwill.

Foreign currency derivatives available to ;olu!e -o could include currency futures, currency

options and currency swaps.

-9 Currency futures

-urrency futures are standardised contracts for the purchase or saleof a specified

$uantity of a foreign currency.

These contracts are settled on a $uarterly cycle, but a futures position can e closed

out any timeby undertaking the opposite transaction to the one that opened the futures

position.

-urrency futures pro"ide a hedge that theoretically eliminates oth upside and

downside risk y effecti"ely locking the holder into a gi"en exchange rate, since any

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gains in the currency futuresmarket are offset y exchange rate lossesin the cash

market, and vice versa.

In practice however, mo"ements in the two markets are not perfectly correlatedand

asis risk existsif maturities are not perfectly matched

.

Imperfect hedgescan also ariseif the standardised si:eof currency futures does not

match the exchange rate exposureof the hedging company.

Initial margin must e pro"ided when a currency futures position is opened and

"ariation marginmay also be subse&uently re&uired.

;olu!e -o could use currency futures to hedge both its regular foreign currency receipts

and its annual interest payment.

/9 Currency options

-urrency options gi"e holders the right, ut not the oligation, to uy or sell foreign

currency.

6"er+the+counter 5/T-8 currency options are tailored to indi"idual client needs,

while exchange+traded currency options are standardised in the same way as

currency futures in terms of exchange rate, amount of currency, exercise date and

settlement cycle.

An ad"antage of currency optionsover currency futures is that currency options do

not need to e exercisedif it is disad"antageous for the holderto do so.

$olders of currency options can take ad"antage of fa"ourale exchange rate

mo"ementsin the cash market and allow their options to lapse.

The initial fee paidfor the options will still have been incurred, however.

9 Currency swaps

-urrency swaps are appropriate for hedging exchange rate risk o"er a longer period

of timethan currency futures or currency options.

A currency swap is an interest rate swap where the debt positions of the

counterparties and the associated interest payments are in different currencies. A currency swap egins with an exchange of principal, although this may e a

notional exchangerather than a physical exchange.

Guring the life of the swap agreement, the counterparties undertake to ser"ice each

others# foreign currency interest payments. At the end of the swap, the initial

exchange of principal is reversed.

); . 0 marks*

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Answer


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debt.

2. The si:e of the det could be a contriutory factor, since the =ond A issue is twice

the si:e of the =ond = issue. The greater siKe of the ;ond A issue could be one of the

reasons it has the higher cost of det.

)1 . & marks*

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Answer ;

'a('i(

2rocedure for FRAs

A company can hedge its risk by entering into a forward rate agreement with a bank that fixes

the rate of interest for borrowing at a certain time in the future. If the actual interest rate

proves to be higher than the rate agreed, the bank pays the company the difference. If the

actual interest rate is lower than the rate agreed, the company pays the bank the difference.

Ad"antages of FRAs

An advantage of FAs is that, for the period of the FA at least, they protect the borrower

from adverse market interest rate movements to levels above the rate negotiated for the FA.

:ith a normal variable rate loan 5for example linked to a bankLs base rate or to JI;/8 the

borrower is exposed to the risk of such adverse market movements. /n the other hand, the

borrower will similarly not benefit from the effects of favourable market interest rate

movements.

The FA re&uired in this situation is L9)L.

'a('ii(

At 6C because interest rates have fallen, ;ash -o will pay the bankM

At C because interest rates have risen, the bank will pay ;ash -oM

'(

Implications of a fall in interest rates for a typical companyM

'. The cost of floating rate orrowing will fall , making it more attractive than fixed rate

borrowing. For most companies with borrowings, interest charges will be reduced,

resulting in higher profitability and earnings per share.

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2. The "alue of the company>s shares will rise , both ecause of the higher le"el of

company profitaility and also ecause of the lower alternati"e returns that

in"estors could earnfrom banks and deposits, if interest rates are expected to remain

low in the longer term.

9. The higher share value results in a lower cost of e$uity capital, and hence a lower

overall cost of capital for the company. Investment opportunities that were previously

re!ected may now become viable.

B. As interest rates fall, consumers ha"e more disposale income. This may increase

demand for the company>s products. Falling returns on deposits may, however,

encourage many people to save more, rather than spend.

5c8

Change in cost of capital

As explained above, if interest rates are expected to remain low in the longer term, the

companyLs overall cost of capital will fall. The discount rates used in investment appraisal will

therefore be lower, making marginal pro!ects more profitable, with a resulting increase in the

companyLs investment opportunities.

In"estment policy re"iew

The cash flows from all possible investments should be reviewed in the light of falling

interest rates and the possible effects on consumer demand and the sterling exchange rate.

These cash flows should then be appraised at the new lower discount rates and the pro!ect

portfolio ranked and reviewed. The companyLs investment plans are likely to be expanded,

unless constrained by other factors such as lack of skills or management time.

Introduction of det

:hen interest rates are expected to fall in the future, an ungeared company may be tempted to

introduce debt into its capital structure. If fixed interest rates are high at the moment, floating

rate debt may be more attractive, because it allows the company to take advantage of fallinginterest rates.

?etting gearing le"el

New pro!ects may be financed entirely by borrowings until an appropriate gearing level is

reached. As gearing is increased, the companyLs cost of capital is usually reduced because of

the tax relief on debt interest but, if gearing is increased to too high a level, increased risks of

bankruptcy arise, causing the cost of capital to rise.

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Choice of pro!ects

If the company is tempted to increase its debt financing substantially, this may affect which

investment pro!ects are undertaken, as some pro!ects are more suitable for debt financing than

others. enerally, a pro!ect with significant tangible assets and stable cash flows will be most

suitable for financing by debt.

Answer 0

A deri"ati"e is an asset whose performance is ased on the eha"ior of an underlying

asset 5commonly called underlyings, for example, shares, bonds, commodities, currencies,

exchange rates8. 7eri"ati"e instrumentsinclude options, forward contracts, futures, forward

rate agreements and swaps. @edging protects assets against unfa"ourale mo"ements in

the underlying while retaining the ability to benefit from favourable movements. The

instruments bought as a hedge tend to have opposite)value movements to the underlying and

are used to transfer risk.

5xchanged traded deri"ati"eshave lower credit risk, higher regulation, higher li$uidity

and the aility to re"erse positions. $owever, they are not always flexile.

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?wap

A swap is an exchange of payment oligations to reduce exposure to interest rate

changes, particularly o"er the longer termwhere a swap can run the lifetime of a loan.

The swap could be aninterest rate swap

5for example between fixed and floating rate

obligations8 or currency swapwhere interest payments are in different currencies.

#waps reduce exposure to rising interest rates, enable the matching of interest rate

assets with dets, and enale lower o"erall interest rates to e achie"ed when

markets fluctuate.

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Ch18-NotesAns