the hong kong institute of ... - chartered secretaries diet (dec 2013... · administrators...
TRANSCRIPT
1
THE HONG KONG INSTITUTE OF CHARTERED SECRETARIES
THE INSTITUTE OF CHARTERED SECRETARIES AND
ADMINISTRATORS
International Qualifying Scheme Examination
CORPORATE FINANCIAL MANAGEMENT
DECEMBER 2013
Suggested Answer
The suggested answers are published for the purpose of assisting students in their
understanding of the possible principles, analysis or arguments that may be identified
in each question
2
SECTION A
1. RetailMart Limited (RL) is a public limited company with a financial year end of
31 March. The company runs a number of chain stores selling various popular
household items in Hong Kong and China. In recent years, the company has
experienced negative business growth due to the economic recession. To boost
its turnover, the company has made several plans.
At the October 2013 board meeting, RL management identified a merger target
in Malaysia. After the board meeting, all directors agreed to acquire Abnormal
Trading Limited (ATL) to increase RL’s shareholder wealth. Due diligence was
performed. An independent financial consultant estimated that the amount
needed for the merger would be around $380 million. Since the management
plans to execute the merger in December 2013, RL was going to issue shares to
raise sufficient funds to complete the potential merger. The announcement of the
proposed merger and share issue would be made public at the same time. Some
directors raised concerns about the timing of the announcement as they believed
that the timing would have a big impact on RL’s share price. At the time, the
share price was $2.00 per share.
The outlook of external business environment was bleak. At the November 2013
board meeting, the directors agreed to borrow $80 million at a fixed rate of
interest to secure sufficient resources to cope with the expansion. Since the
company’s long-term debt is rated BBB Grade by the credit rating agencies, RL’s
bankers have agreed to grant a loan at a fixed interest rate of 9.25% per annum.
Alternatively, the company could borrow floating rate funding at prime minus
2.25% per annum. The company is aware, however, that Good Supplies Limited
(GSL), one of its long-term business partners, is also looking to borrow $80
million at a floating rate; and its AAA rating will enable it to borrow funds at a
fixed rate of 7.50% per annum and at a floating rate of prime minus 1.5% per
annum. At the time, the prime rate is 5.5% per annum.
At its most recent meeting in December 2013, the board discussed not only
concerns about the sufficiency of its cash flow to meet its daily operational
expenses but also whether there would be enough cash available for future
investment opportunities. To reserve its cash flows for potential capital
expenditure in the near future, the management decided to reduce the dividend
payment for the year ended 31 March 2013. Upon the release of the decision
in reduction of dividend payment, the high share trading volume signified that the
market is sensitive to the announcement.
Ten years ago, RL opened chain stores in Mainland China. This strategy had
proved to be less successful than expected and so in December 2013 RL’s
directors decided to withdraw from the China market and to concentrate on the
local Hong Kong market. To raise the finance needed to close the China stores,
RL’s directors also decided to make a one-for-five rights issue at a discount of
3
30% on the market value at that time. The most recent income statement of RL
is as follows:
Income statement for the year ended 31 March 2013
$ m
Sales 14,000
Profit before interest and tax 520
Finance costs 240
Profit before tax 280
Profits tax 70
Profit after tax 210
Dividends paid for the year ended 31 March 2013 $140
The outstanding shares and reserves of RL as at 31 March 2013 are as follows:
$ m
Ordinary share capital, $0.25 each 600
Revaluation reserve 1,400
Retained earnings 3,200
5,200
RL’s shares currently trade on the stock exchange at a price-earnings ratio of 16
times. An investor owning 100,000 ordinary shares in RL has received
information about the forthcoming rights issue but cannot decide whether to take
up the rights issue, sell the rights or allow the rights offer to lapse.
REQUIRED:
1. (a) Discuss the market reaction on the announcement date of the
proposed merger/share issue if the pending merger announcement
has NOT been leaked. (Assume that the market is semi-strong form
efficient.)
(5 marks)
Ans (a) The share price is determined by the market. Under a semi-strong form
efficient market, all public information is fully digested by investors and is
fully reflected in the share’s current market value. This means that neither
fundamental nor technical analysis can be used to derive superior gains. If
the market is semi-strong-form efficient, the market share price in April of
$2.00 per share will reflect all public information, including all new
information which is publicly available, i.e. annual reports and company
4
public announcements. If the merger can create a higher positive NPV for
the company, provided that information in relation to the pending merger
announcement has not been leaked, the share price will rise on the
announcement date due to the expected merger gain. Given that the share
issue and merger are announced at the same time, the increase in share
price reflects both effects together.
1. (b) RL is considering whether it would be worth entering into an interest rate
swap with GSL.
Illustrate how an interest rate swap could be used so that both
companies derive equal benefit. (Assume that RL’s swap payment to
GSL is 7.50% fixed per annum under the swap agreement.)
(11 marks)
Ans (b) RL’s fixed rate = 9.25%
RL’s floating rate = 5.5% - 2.25% = 3.25%
GSL’s fixed rate = 7.5%
GSL’s floating rate = 5.5% - 1.5% = 4.0%
The quality spread differential
= (9.25% - 7.5%) – (3.25% - 4.0%)
= 1.75% – (-0.75%)
= 2.5%
Therefore, 1.25% can be saved by RL and GSL each.
RL has a comparative advantage in floating rate borrowing. GSL has a
comparative advantage in fixed rate borrowing.
RL should raise an $80m loan at a floating rate of 3.25% and pay 7.5% to
GSL. At the same time, RL will receive 2.75% (4.0% - 1.25%) from GSL.
The company saves 1.25% (9.25% – 8.0%).
GSL should raise an $80m loan at a fixed rate of 7.5% and pay 2.75%
(4.0% - 1.25%) to RL. At the same time, GSL will receive 7.5% from RL.
The company saves 1.25% (4.0% - 2.75%).
1. (c) Explain, with reasons, why some investors react positively but others
negatively when RL’s decision to reduce the dividend payment is
released to the market.
(9 marks)
Ans (c) Dividend distributions to shareholders, in cash or bonus shares in lieu of
dividends, are made from after-tax earnings. Such dividend payments
may send a signal to the market that the board of RL has confidence in the
5
company’s future earnings. Though a reduction in dividend payments will
result in an increase of both the retained earnings and cash account
balances of RL, the market may perceive it as a bad signal or bad news
showing that RL may have a problem in raising funds.
A positive reaction from investors could be due to the following reasons:
1. Investors may perceive that RL has higher growth opportunities
either in its internal growth or external growth through mergers and
acquisitions.
2. The saved cash enables RL to reduce its reliance on costly external
financing, saving related costs.
A negative reaction from investors could be the result of the following:
1. If the investors perceive that there are limited growth opportunities
for RL, they may worry that the extra cash will be sitting idle without
generating sufficient return for its shareholders.
2. The investors may worry that shareholders’ wealth is being
destroyed if the management of RL uses the saved cash to invest in
projects with negative NPVs. This would be a form of agency cost in
which management ‘over-invests’ in projects that are beneficial to
themselves at the expense of the shareholders.
3. Markets react negatively to the reduction of dividend payments
because investors fear that RL has cash flow problems, especially if
other companies in the same industry keep making regular dividend
payments. Investors may assume RL is suffering from deteriorating
business conditions, such as declining sales, increasing expenses
and decreasing profits. Investors will sell RL shares. As a result, the
share price will fall.
4. Any other reasonable answers.
1. (d) Evaluate the theoretical ex-rights price of an ordinary share in RL, and
the price at which the rights in RL are likely to be traded.
(6 marks)
Ans (d) Current total market value
= $210m × 16
= $3,360m
Market value per share
= $3,360m ÷ (600m × 4)
= $1.40
6
Rights issue price
= $1.40 × 70%
= $0.98
Theoretical ex-rights price
= (($1.40 × 5) + ($0.98 × 1)) ÷ (5 + 1)
= $7.98 ÷ 6
= $1.33
Value of rights
= Theoretical ex-rights price – cost of rights issue
= $1.33 - $0.98
= $0.35
1. (e) Evaluate each of the options regarding the rights issue available to
the investor with 100,000 ordinary shares.
(9 marks)
(Total: 40 marks)
Ans (e) Take up of rights issue
Value of shares after rights issue
= 100,000 × 6/5 × $1.33
= $159,600
Cost of rights
= 20,000 × $0.98
= $19,600
Wealth after taking up the rights
= $159,600 - $19,600
= $140,000
Sell rights
Value of shares
= 100,000 × $1.33
= $133,000
Sales of rights
= 20,000 × $0.35
= $7,000
7
Wealth after selling the rights
= $133,000 + $7,000
= $140,000
Allow rights offer to lapse
Value of shares
= 100,000 × $1.33
= $133,000 (Wealth after allowing rights offer to lapse)
If the investor either takes up the rights issue or sells his rights then his
wealth will remain the same, i.e. identical effects. The difference is that if he
takes up the rights issue he will maintain his relative shareholding but if he
sells his rights his percentage shareholding will fall, although he will gain
$7,000 in cash. However if the investor allows the rights to lapse his
wealth will decrease by $7,000. Therefore, the investor should either take
up the rights or sell the rights in order to maximise his/her gain.
8
SECTION B
2. Fashion Design Holding Limited (FDHL) is a listed company with a principal
business activity of manufacturing women’s clothes. The management is looking
to expand its business into women’s fashion retail. The company has grown
rapidly in recent years with consistent annual dividend growth; it expects that
dividends will continue to grow in line with the trend in recent dividend payments.
The seven-year dividend history, extract from statements of financial position and
some related current market information are below:
Seven-year dividend history
Year Dividends per share
2006 $17.00
2007 $19.50
2008 $22.00
2009 $26.00
2010 $29.00
2011 $31.00
2012 $33.50
Extracts from statement of financial position at 31 August 2013
$m
Equity
Ordinary $100 shares 280
6% $1 irredeemable preference shares 200
Retained earnings 388
Total equity 868
Non-current liabilities
8% irredeemable debentures (at nominal value) 1,000
7% unsecured loan (at nominal value) 720
Total non-current liabilities 1,720
9
Current market information
Ex-dividend ordinary share price $ 400.00
Ex-dividend preference share price $ 0.92
Irredeemable debentures (Ex-interest) $ 89.00 per $100 debenture
Redeemable unsecured loan (Ex-interest) $ 86.00 per $100 loan
FDHL’s current liabilities do not include any bank overdrafts. The profits tax rate is
16.5% and any interest paid in relation to debt financing generates tax savings.
The unsecured loan will be redeemable at par in ten years’ time.
REQUIRED:
2. (a) The board has decided that any financing arrangements should come from
increasing debt rather than increasing equity.
According to the above information, based on market value, evaluate
the company’s weighted average cost of capital. (Candidates may
consider using the interpolation approach in calculating the cost of
unsecured loan with discount factors 7% and 10% respectively.)
(15 marks)
Ans (a) Cost of irredeemable debentures
= 8 × (1 – 16.5%) ÷ 89 × 100%
= 7.51%
Cost of unsecured loan
By interpolation
Cash flow 7% Discount factor
Present value
10% Discount factor
Present value
At time0 86 1 86 1 86
At time1 to 10 (7 × (0.835)) 7.024 (41.06) 6.145 (35.92)
At time10 (100) 0.508 (50.8) 0.386 (38.6)
(5.86) 11.48
= 7% + 5.86 ÷ (5.86 +11.48) × (10% – 7%)
= 8.01%
10
Cost of irredeemable preference shares
= 6% ÷ $0.92
= 6.52%
By dividend growth model
$17 × (1 + g)6 = $33.5
g = (33.5 ÷ 17)1/6 – 1
g = 1.1197 – 1
g = 11.97%
Cost of equity
= D1 ÷ P0 + g
= ($33.5 × (1 + 11.97%)) ÷ $400 + 11.97%
= 21.35%
WACC
= (($890m × 7.51%) + ($619.2m × 8.01%) + ($184m × 6.52%) + ($1,120m ×
21.35%)) ÷ 2,813.2m
= 13.07%
2. (b) The company has taken out an overdraft, which is considered to be a
permanent source of finance and which is included in FDHL’s current
liabilities.
Discuss the implications of the overdraft on the calculation of FDHL’s
weighted average cost of capital.
(5 marks)
(Total: 20 marks)
Ans (b) Bank overdrafts are treated as current liabilities as they are repayable on
demand. However, some companies use them as a permanent, long-term
source of finance. If this is the case, it is reasonable that the finance costs of
bank overdraft should be treated in the WACC computation.
In order to include the finance costs of bank overdraft into the WACC
computation, the average short-term interest rate and the average size of the
bank overdraft are needed before the WACC can be computed. It is
sometimes quite difficult to obtain these two figures as the short-term interest
rate varies while the amount of the core permanent element of the bank
overdraft fluctuates daily.
11
3. Great Precision Technology Limited (GPTL) is a gears manufacturer. It has
entered into a contract to produce high-precision gears. To do this, the company
has to employ a gear-grinding machine at the final manufacturing stage to
remove the remaining few thousandths of an inch of material left by other
manufacturing methods. Since the gear-grinding machine is vital to the
company’s high-precision manufacturing requirements, GPTL plans to purchase
a new machine. Details of two machines under consideration offered by different
machine suppliers are:
Machine Super
Machine Quick
Initial cost $1,000,000 $1,800,000
Economic life (years) 5 8
Residual value $100,000 $140,000
Running costs per annum $150,000 $145,000
The discount rate is assumed to be 12% and taxation can be ignored.
REQUIRED:
3. (a) Replacement chain approach and equivalent annual cost approach are two
methods used for comparing projects with unequal lives.
Evaluate each approach and discuss why the equivalent annual cost
approach is the better approach in comparing Machine Super and
Machine Quick.
(5 marks)
Ans (a) Theoretically, both approaches can be used to make a comparison
between projects with unequal lives. The replacement chain method is
applied by creating a replacement chain for both projects until a common
point of time period is reached. This approach has a significant weakness
in that a large number of replacements may be needed to match equal time
horizons for projects. On the other hand, the equivalent annual cost
approach is the easiest way to solve the time disparity problem. As with the
replacement chain approach, however, each project is determined by its
NPV and the ‘links’ in the replacement chain can be completed by creating
cash flows with comparable time frames. Project life is irrelevant in the
equivalent annual cost approach because under this approach all projects
are treated as annuities. Thus, it is easy to choose between projects by
comparing their annuity payments. In the question, the economic lives of
Machine Super and Machine Quick are five years and eight years
12
respectively. GPTL has to look at 40 years of replacements to make the
comparison: this is not realistic. Therefore, the company should use the
equivalent annual cost approach.
3. (b) Adopting the equivalent annual cost approach, advise the company
which gear-grinding machine should be purchased. Specify any
assumptions if needed.
(15 marks)
(Total: 20 marks)
Ans (b) Assumptions:
1. The functions of the two machines are the same.
2. The capacities of them are the same.
3. They are mutually exclusive.
4. The benefits of them are the same.
5. Any other reasonable answers.
Machine Super
Year Cash flow Discount factor Present value
12% $
0 1,000,000 1.000 1,000,000
1 150,000 0.893 133,950
2 150,000 0.797 119,550
3 150,000 0.712 106,800
4 150,000 0.636 95,400
5 150,000 0.567 85,050
-100,000 0.567 -56,700
1,484,050
Equivalent annual cost Super
= $1,484,050 ÷ 3.605
= $411,664
13
Machine Quick
Year Cash flow Discounting factor Present value
12% $
0 1,800,000 1.000 1,800,000
1 145,000 0.893 129,485
2 145,000 0.797 115,565
3 145,000 0.712 103,240
4 145,000 0.636 92,220
5 145,000 0.567 82,215
6 145,000 0.507 73,515
7 145,000 0.452 65,540
8 145,000 0.404 58,580
-140,000 0.404 -56,560
2,463,800
Equivalent annual cost Quick
= $2,463,800 ÷ 4.968
= $495,934
Therefore, Machine Super should be purchased because its equivalent
annual cost is the lowest.
14
4. Forever Limited (FL) is a private limited company. The company uses a factoring
service to enhance its cash flow to meet its operational needs. The terms of the
factoring service agreement are as follows:
Service term: 2 years minimum (3 months cancellable notice)
Annual turnover: $120 million evenly distributed in the year
Sales nature: Credit only
Basic factoring charge: 2% of annual turnover (paid in arrears)
Annual saving of office or other expenses: (savings from basic factoring service)
$1.2 million at year end
Fund advancement service (optional):
90% of invoice value of factored debts
Factoring commission on funds advancement:
3.0% deducted from the gross amount of the funds advanced
Commission will be deducted from the funds advanced directly
Factoring interest on fund advancement:
10% per annum on monthly basis on gross funds (before deduction of the 3.0% commission) Interest will be deducted from the funds advanced directly
Existing average collection period:
75 days
REQUIRED:
4. (a) Evaluate the effective annual factoring cost as a percentage of the
improvement in funds (i.e. ratio of total cost of factoring and fund
advancement service to the improvement in funds from the factoring
and fund advancement) under the following options, and advise which
option should be chosen:
i. Option A: FL adopts the basic factoring service but does not use
the fund advancement service. As a result, the average collection
period is reduced to 60 days.
ii. Option B: FL ues both the basic factoring service and the fund
advancement service. The average collection period is reduced to
50 days.
(Assume a 360 day year split into 12 equal months. Taxation may be
ignored.) (15 marks)
15
Ans (a) (i) Amount of debtors before using the factoring services
= $120m × 75 days ÷ 360 days
= $25m
Amount of debtors after using the factoring services
= $120m × 60 days ÷ 360 days
= $20m
The improvement in debtors after using the factoring services
= $25m - $20m
= $5m
Annual factoring cost
= $120m × 2% - $1.2m
= $1.2m
Effective annual factoring cost as a percentage of improvement in funds
= $1.2m ÷ $5m × 100%
= 24%
(ii) Amount of debtors before using the factoring services
= $120m × 75 days ÷ 360 days
= $25m
Amount of debtors after using the factoring services
= $120m × 50 days ÷ 360 days
= $16.67m
The improvement in debtors after using the factoring services
= $25m - $16.67m
= $8.33m
The improvement in debtors after using the fund advancement service
= $16.67m × 90%
= $15m
Total improvement
= $8.33m + $15m
= $23.33m
16
Cost of fund advancement service
= (3% × 90% × $120m) + (10% [× 50 ÷ 360] × 90% × $120m) + $1.2m
= $5.94m
Effective annual factoring cost as a percentage of the improvement in
funds
= $5.94m ÷ $23.33m × 100%
= 25.46%
Since Option A has a lower effective annual factoring cost than Option
B, Option A should be adopted.
4. (b) Some directors consider that it is not worth using factoring services.
Advise, with justification, whether or not FL should keep using
factoring services.
(5 marks)
(Total: 20 marks)
Ans (b) A factor collects debts on behalf of its client. It can advance money to FL on
the security of the company’s trade debtors, usually only those that it
considers to be acceptable risks, and takes over credit checking and sales
administration as well as debt collection. The amount typically advanced is
60% to 80% of the total amount of outstanding debtors. If factoring is
without recourse, the factor takes responsibility for bad debts. Factors
usually charge a fee, which may be 1% or 2% of the annual turnover and
interest on advances through the fund advancement service.
Factoring is now an important and growing form of business finance,
broadly similar to overdrafts in volume, because of its competitive charges.
A risk of factoring is that a company may lose touch with its customers. In
addition, depending on the factor’s approach in collecting debts, there may
also be a risk of upsetting customers.
Factoring is especially useful for companies trading in markets that require
a considerable period of trade credit and for companies that are expanding
rapidly, as it leaves other lines of credit open for use elsewhere in the
business.
Factoring services may improve FL’s cash flow problems. However, FL will
need to pay a basic factoring fee for the services, and this will reduce its
profit margin. FL may also lose touch with and even upset its customers. If
FL’s business nature is high risk, factors may not want to provide services
to FL.
17
5. The management team of Columbia International Trading Limited (CITL) has
decided to take the company private through a leveraged buyout (LBO). The
following information is extracted from CITL’s books:
Current assets $200 million
Long-term debts $200 million
Liabilities other than debts $300 million
Equity $700 million
It is assumed that all other assets are non-current assets and suitable as
collateral to secure a loan; and they are saleable at their book values.
Currently, the company has 100 million outstanding shares with a market value
of $10 per share. The management team decides to make use of $500 million
cash in hand as the management's equity investment for the LBO and estimates
that the shares in the hands of the public can be purchased if a 10% premium
over the market price is offered. The company pays interest at 12% per annum
on its existing debt. However, the company is required to pay interest at 15% per
annum on any new debt offered by the bank.
REQUIRED:
5. (a) Evaluate the amount that CITL has to borrow. What percentage of the
book value of non-current assets must a bank be willing to advance to
make the deal possible?
(7 marks)
Ans (a) The amount that CITL will have to pay to buy back its shares
= 100m × $10 × 1.1
= $1,100m
The amount that CITL will have to borrow
= $1,100m - $500m
= $600m
The non-current assets of CITL
= $700m + $300m + $200m - $200m
= $1,000m
The percentage of the book value of non-current assets
= $600m ÷ $1,000m
= 60%
18
5. (b) Compare the following:
i. CITL’s capital structures and debt to equity ratio before and after
the leveraged buyout if any debt for the LBO will be financed from
debt secured by the target company’s assets. Assume that the
debt to equity ratio of the trading business sector is 0.5. Discuss
how investors will react to new bond issue if CITL plans to issue
the bonds at the same interest rate as that of the industry bond
market index after the LBO.
ii. The annual interest to be paid by CITL before and after the
leveraged buyout. Comment on the feasibility of the LBO.
(13 marks)
(Total: 20 marks)
Ans (b) i. Before LBO After LBO
Debt level $200m $800m (200m + 600m)
Equity level $700m $500m
Debt to equity ratio 2 : 7 8 : 5
If a debt to equity ratio reveals a higher amount of debt to equity ratio, i.e.
1.6, in compared with that of the trading business sector of 0.5, bond
investors may consider the company is riskier. Therefore, they may require
a higher bond interest rate than that offered by the other companies in
same industry in the bond market.
ii. Before LBO After LBO
Annual finance charge of existing debts
$200m × 12%
= $24m
$200m × 12%
= $24m
Annual finance charge of new debts
$600m × 15%
= $90m
Total finance charge $24m $114m
The LBO may not be successful:
(1) The bank may not agree to lend $600m (60% of the book value of
the non-current assets) to CITL.
(2) Even if the bank does agree to lend, the finance costs will increase
drastically. This will make CITL a very risky company.
(3) The target company’s future cash flow ability is crucial in order to
repay the loan.
19
(4) Any other reasonable answers.
6. Wing Trading Limited (WTL) is an importer and exporter of textile machinery
and textile goods. Its headquarters are in the UK but it trades extensively with
Asian countries. The company has a subsidiary in Hong Kong. It is about to
invoice a customer in Hong Kong in Hong Kong dollars, HK$750,000 payable in
three months’ time. WTL is considering two methods of hedging the foreign
exchange risk.
Method A
Borrow Hong Kong dollars now, converting the loan into sterling and repaying
the Hong Kong dollar loan from the expected receipt in three months’ time.
Method B
Enter into a three-month forward exchange contract with the company’s banker
to sell HK$750,000.
The spot rate and the three-month forward rate are HK$12.3937 = £1 and
HK$12.3178 = £1 respectively.
Annual interest rates for three months’ borrowing/deposits of Hong Kong dollars
and sterling are 3% and 5% respectively.
REQUIRED:
6. (a) Evaluate which of the two methods is the most advantageous
financially for the company.
(10 marks)
Ans (a) Method A
Borrow Hong Kong dollars now, converting the loan into sterling and
repaying the Hong Kong dollar loan from the expected receipt in three
months’ time.
Three-month borrowing rate
= 3% × 3 ÷ 12
= 0.75%
Amount of the loan
= 750,000 ÷ 1.0075
= $744,417
Sterling at spot rate
= $744,417 ÷ 12.3937
= £60,064
20
Three-month sterling deposit rate
= 5% × 3 ÷ 12
= 1.25%
Sterling value of deposit in three months
= £60,064 × 1.0125
= £60,815
Method B
Enter into a three-month forward exchange contract with the company’s
banker to sell HK$750,000.
The exchange rate is agreed in advance.
Cash received in three months is converted to produce
= $750,000 ÷ 12.3178
= £60,887
On the basis of the above calculations, Method B gives a slightly better
receipt. Banker’s commission has not been included in the above figures.
6. (b) “Before deciding the hedging approach, WTL should arrange the hedging
plan based on its risk strategy: risk-averse strategy, predictive strategy or
best strategy.”
Discuss this statement and advise WTL’s management of other ways
to reduce foreign exchange rate risk.
(10 marks)
(Total: 20 marks)
Ans (b) Factors to consider before deciding whether to hedge foreign exchange
risk using the foreign currency markets:
Risk-averse strategy
The company should have a clear strategy on how much foreign exchange
risk it is prepared to bear. A highly risk-averse or defensive strategy of
hedging all transactions is expensive in terms of commission costs but
recognises that floating exchange rates are very unpredictable and can
cause losses high enough to bankrupt the company.
Predictive strategy
An alternative predictive strategy recognises that if all transactions are
hedged, the chance of currency gains is lost. The company could therefore
attempt to forecast foreign exchange movements and only hedge those
21
transactions where currency losses are predicted. The fact is that some
currencies are relatively predictable. For instance, if inflation is high the
currency will devalue, and there is little to be gained by hedging payments
in that currency.
This is, of course, a much more risky strategy but in the long run, if
predictions are made sensibly, the strategy should lead to a higher
expected value than that of hedging everything and will incur lower
commission costs as well. The risks remain, though, that a single large
uncovered transaction could cause severe problems if the currency moves
in the opposite direction to that predicted.
Best strategy
A sensible strategy for the company could be to set a ‘cash size’ for a
foreign currency exposure above which all amounts must be hedged, but
below this limit a predictive approach is taken or even, possibly, all
amounts are left unhedged.
Other methods that can be used to hedge exchange rate risk include the
following:
Currency of invoice, which is where an exporter invoices his foreign
customer in his domestic currency, or an importer arranges with his
foreign supplier to be invoiced in his domestic currency. However,
although either the exporter or the importer can avoid any exchange
risk in this way, only one of them can deal in his domestic currency.
The other must accept the exchange risk, since a period of time will
elapse between agreeing a contract and paying for the goods, unless
payment is made with the order.
Matching receipts and payments is where a company that expects to
make payments and have receipts in the same foreign currency offsets
its payments against its receipts in the currency. As the company will
be setting off foreign currency receipts against foreign currency
payments, it does not matter whether the currency strengthens or
weakens against the company’s domestic currency because there will
be no purchase or sale of the currency.
Matching assets and liabilities is where a company which expects to
receive a substantial amount of income in a foreign currency hedges
against a weakening of the currency by borrowing in the foreign
currency and using the foreign receipts to repay the loan. For example,
US dollar receivables can be hedged by taking out a US dollar
overdraft. In the same way, US dollar payables can be matched
against a US dollar bank account, which is used to pay creditors.
Leading and lagging is where a company makes payments in advance
or delays payments beyond their due date in order to take advantage
22
of foreign currency movements.
Netting is where inter-company balances are netted off before
arranging payments. It reduces foreign exchange purchase costs and
there is less loss in interest from having money in transit.
Foreign-currency derivatives such as futures, options and swaps can
be used to hedge foreign currency risk.
END