Problem -
Zircon, a US based parent, considers a project in which it will sell the use of its technology to firms in Argentina. It already has received orders from Argentinean firms that will generate 3 million Argentinean pesos (ARS) in revenue at the end of the next year.
However, it might also receive a contract to provide this technology to the Argentinean government. In this case, it will generate a total of ARS 5,000,000 at the end of the next year. It will not know whether it will receive the government order until the end of the year.
Today's spot rate of the peso is $.14. The one-year forward rate is $.12. Zircon expects that the spot rate of the peso will be $.13 one year from now. The only initial outlay will be $300,000 to cover development expenses (regardless of whether the Argentinean government purchases the technology). It will pursue the project only if it can satisfy its required rate of return of 18 percent. Ignore possible tax effects. It decides to hedge the maximum amount of revenue that it will receive from the project.
a. Determine the NPV if Zircon receives the government contract.
b. If Zircon does not receive the contract, it will have hedged more than it needed to and will offset the excess forward sales by purchasing pesos in the spot market at the time the forward sale is executed. Determine the NPV of the project assuming that Zircon does not receive the government contract.
c. Now consider an alternative strategy in which Zircon only hedges the minimum peso revenue that it will receive. In this case, any revenue due to the government contract would not be hedged. Determine the NPV based on this alternative strategy and assume that Zircon receives the government contract.
d. As the financial manager of Zircon, describe the uncertainty that surrounds the estimate of future cash flows from the perspective of the US parent.
e. As the financial manager for Zircon, explain how you propose to take account of risk in evaluating whether to proceed with this project.
Words:- 2500
Harvard Reference:- 12.