Assignmnet

1. Caterpillar, Inc., a US corporation, has sold some heavy machinery to an Italian company for 10,000,000 euros, with the payment to be received in 6 months. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, As the Lead Risk Analyst in Caterpillar's heavy machinery division, you need to make a recommendation to the Treasurer regarding how Caterpillar should hedge the risk arising from this transaction exposure. You have gathered the following information.

• The spot exchange rate is $1.25/€

• The six month forward rate is $1.26/€

• Caterpillar's cost of capital is 10% per annum.

• The euro 6-month borrowing rate is 4% (or 2% for 6 months)

• The euro 6-month lending rate is 2% (or 1% for 6 months)

• The US dollar 6-month borrowing rate is 5% (or 2.5% for 6 months)

• The US dollar 6-month lending rate is 3% (or 1.5% for 6 months)

• The premium on 6 month put options on the euro with strike rate $1.25 is 1.5%.

You are required to compute the net receipts in dollars of each hedging alternative. The phrase "net receipts in dollars" refers to the (actual or deemed) net cash inflow in dollars in 6 months time. As you know, in general, adding cash flows occurring at different points in time is inappropriate unless the cash flows have been appropriately present-valued or future-valued.

a) Suppose that Caterpillar chooses to hedge its transaction exposure using a forward contract. Will Caterpillar sell or buy euros forward? What will be the net receipts in dollars?

b) Suppose Caterpillar chooses a money market hedge. What are the transactions that the firm will need to undertake to implement this hedge, and what will be the net receipts in dollars using this hedge?

c) Suppose Caterpillar decides to hedge using a put option.

(i) Suppose that the spot rate in 6 months is $1.15 per euro. Will the option be exercised? What will be the net receipts in dollars?

(ii) Suppose that spot rate in 6 months is $1.30 per euro. Will the option be exercised? What will be the net receipts in dollars?

d) Suppose that you strongly expect the euro to depreciate. In that case, which of the hedging alternatives would you recommend? Briefly justify your recommendation

e) Suppose that you strongly expect the euro to appreciate. In that case, which of the hedging alternatives would you recommend? Briefly justify your recommendation

f) By how much does the euro need to appreciate to make the put option a better alternative than the forward contract? In other words, by how much does the euro need to go up in value against the dollar in order for the net cash inflow from the put option to equal the cash inflow from the forward contract? Support your answer with calculations.

2. This question is based on Exhibit 13.3 on page 365 in chapter 13 of the textbook. In this example, Nestle's cost of equity is calculated using two different market portfolios, a domestic market portfolio and a global market portfolio. Which of these is more appropriate? Support your answer with appropriate arguments.

3. You are a financial analyst for a US based multinational company, and you are in the process of putting together a proposal for a foreign investment in South America. You have been tasked with estimating the cash flows from the proposed investment, calculating its NPV, and making a recommendation about the project. In accordance with standard practice, you have calculated the project's NPV from two viewpoints: (i) from the parent company's viewpoint and (ii) the local viewpoint, also referred to as the project viewpoint.

Suppose that your analysis reveals that the NPV as computed from the parent company's viewpoint is negative, but that the NPV as computed from the local or project viewpoint is positive. Give two reasons why this might occur. Would you recommend that the project should be accepted or rejected? Explain your answer.

4. Santa Isabel, a food company located in Chile in South America,is planning to expand its operations internationally, and is considering buying a relatively small California-based grocery chain store that specializes in South American food.

Annual revenues are expected to be a constant amount of $3,000,000 and the cost of goods, $1,500,000. General and Administrative expenses are estimated at $500,000 per year and annual depreciation expense at $300,000.

The operations in California will pay 80% of its accounting profit to the parent firm, Santa Isabel, as an annual cash dividend. Chilean taxes are calculated on grossed up dividends from foreign countries, with a credit for host-country taxes already paid. The corporate income tax rate in U.S. is 28% and the tax rate in Chile is lower at 25%. Therefore no additional income taxes will be payable in Chile.

Santa Isabel will base its valuation of the investment on after-tax dividends received at the end of each of the first three years plus a terminal value as at the end of year 3. The terminal value will be computed based on the assumption that annual after-tax dividends received by the parent in years 4 through infinity will be the same as the dividends received in year 3.

The Chilean currency is the Chilean peso and is denoted CLP$. The exchange rate against the US dollar is as follows. The current exchange rate is CLP$ 600.00/$, and the exchange rates for the next three years are projected to be CLP$ 620.00/$, CLP$ 640.00/$, and CLP$ 660.00/$, respectively.

Santa Isabel uses a cost of capital is 20% to evaluate all foreign investments. (The same discount rate is used for both annual dividends as well as the terminal cash flow.)

What is the maximum U.S. dollar price Santa Isabel should offer today for the investment?