Financial Management Assignment
1. Palladium Metals has contracted to purchase a large quantity of gold from a Swiss firm for SF 120 million. The sales contract allows Palladium to defer payment on this purchase of gold for 1 year. The U.S. interest rate is currently 1.60 percent per year, while the Swiss interest rate is 0.40 percent per year. The spot exchange rate between the dollar and the Swiss franc is $1.0500/SF1. The forward exchange rate for the exchange of dollars and Swiss francs in 1 year is $1.0595/SF1. Assuming the CFO plans to hedge against changes in the dollar value of the account payable created by Palladium's purchase of gold, explain whether the CFO should use a forward market hedge or a money market hedge.
2. The stock of Blackberry Computer is trading at a market price of $67.50 per share. During the next two years the return on Blackberry's stock will have a yearly standard deviation of 40 percent. The continuously compounded risk-free interest rate is 2 percent per year. An American call option on Blackberry having a strike price of $70 and 9 months to expiration has a hedge ratio of 0.5444. The risk-adjusted probability that the 9-month call option with a $70 strike price will finish in the money is 0.4071. Assuming that Blackberry is not expected to pay a dividend for at least two years,
a. use the Black-Scholes model to determine the value of an American call option on Blackberry Computer with 9 months to expiration and a $70 strike price.
b. determine the risk-adjusted probability that a European put option on Blackberry having 9 months to expiration and a strike price of $70 will finish in the money.
c. determine the value of European put option on Blackberry having 9 months to expiration and a strike price of $70.
3. Frisco Electronics is planning to manufacture and sell smart phones in Great Britain. Frisco's foreign subsidiary will require an initial date 0 investment of £500 million, with expected future after-tax cash inflows of £200 million per year at the end of each year during a 3-year project life. The spot exchange rate is $1.2000/£1. The risk-free interest rate in the United States is 1.75 percent. The pound-denominated risk-free interest rate in Great Britain is 0.50 percent. Assuming that Frisco Electronics has a required return of 8 percent, determine the net present value for the project.
4. Blue Star Aluminum is evaluating a proposed $250 million expansion of the production capacity at their Opelika, Alabama aluminum mill. Blue Star can invest the $250 million to expand production capacity immediately (at date 0), but has the option to delay the investment decision until the end of the year in order to obtain additional information on the value of the proposed expansion. If Blue Star invests $250 million to expand production immediately (at date 0), the mill will generate incremental after-tax cash inflows of $34 million at date 1 (the end of the year). This date 1 after-tax cash inflow will be lost if Blue Star waits until date 1 to expand production capacity. The date 1 continuation value of the future after-tax cash inflows from the proposed expansion (i.e., the date 1 present value of the after-tax cash flows from date 2 on) will be $350 million if the economy is experiencing strong economic growth at date 1, but only $225 million if the economy fails to improve.
The cost of the expansion will be $250 million, whether Blue Star expands immediately or waits until date 1 to evaluate the decision to expand production. The annual risk-free interest rate is 3 percent. Assuming that the risk-adjusted probability that the economy will have strong economic growth is .40, determine whether Blue Star should invest today, or wait until date 1 to evaluate the decision to expand production capacity.