Hi everybody
I have the following assignment due in 3 days, so any body can solve that, or give his comments, then i will be really thankful.
Regards
Irfan Saeed
Objectives of Assignment:
To test, via practical contingency/
Course Assessment: 10%
Question 1
Blue Sky is an Australian company conducting a financial plan for the next year. It has no foreign
subsidiaries, but more than half of its sales are from exports. Its foreign cash inflows to be received
from exporting and cash outflows to be paid for imported supplies over the next year are disclosed
below:
| Currency | Total Inflow | Total Outflow |
| Canadian dollars (C$) | C$ 32,000,000 | C$ 2,000,000 |
| | NZ$ 5,000,000 | NZ$ 1,000,000 |
| Mexican pesos (MXP) | MXP 11,000,000 | MXP 10,000,000 |
| | S$ 4,000,000 | S$ 8,000,000 |
The spot rates and one-year forward rates as of today are:
| Currency | Spot Rate | One-Year Forward Rate |
| C$ | $0.90 | $0.93 |
| NZ$ | 0.6 | 0.59 |
| MXP | 0.18 | 0.15 |
| S$ | 0.65 | 0.64 |
a. Based on the information provided, determine the net exposure of each foreign currency in
dollars
| Currency | Net Inflow or Outflow | Spot Exchange Rate | Net Inflow or Outflow Measured in $A | |
| Canadian dollars (C$) | C$ | | | |
| | NZ$ | | | |
| Mexican pesos (MXP) | MXP | | | |
| | S$ | | |
b. Assume that today's spot rate is used as a forecast of the future spot rate one year from now.
The
against the dollar over the next year. The Canadian dollar movements are expected to be
unrelated to movements of the other currencies. Since exchange rates are difficult to predict,
the forecasted net dollar cash flows per currency may be inaccurate. Do you anticipate any
offsetting exchange rate effects from whatever exchange rate movements do occur? Explain
c. Given the forecast of the Canadian dollar along with the forward rate of the Canadian dollar,
what is the expected increase or decrease in dollar cash flows that would result from hedging
the net cash flows in Canadian dollars? Would you hedge the Canadian dollar position?
d. Assume that the Canadian dollar net inflows may range from C$20,000,000 to C$40,000,000
over the next year. Explain the risk of hedging C$30,000,000 in net inflows. How can Blue
Sky Company avoid such a risk? Is there any tradeoff resulting from your strategy to avoid
that risk?
e. Blue Sky Company recognizes that its year-to-year hedging strategy only hedges the risk over
a given year, but does not insulate it from long-term trends in the C$ value. It has considered
establishing a subsidiary in
subsidiary and distributed by the subsidiary. The proceeds received would be reinvested by
the Canadian subsidiary in
convert C$ to dollars each year. Has Blue Sky eliminated its exposure to exchange rate risk
by using this strategy? Explain
Question 2
Dingo Blue (DB) is an Australian firm that is considering a joint venture with a Chinese firm to
produce and sell video cassettes if a new free trade agreement (FTA) between
becomes a reality. DB will invest $A12 million in this project, which will help to finance the Chinese
firm's production. For each of the first three years, 50 percent of the total profits will be distributed to
the Chinese firm, while the remaining 50 percent will be converted to dollars to be sent to
The Chinese government intends to impose a 20 percent income tax on the profits distributed to DB.
The Chinese government has guaranteed that the after-tax profits (denominated in Yuan, the Chinese
currency) can be converted to $A. dollars at an exchange rate of CHY1 = $.20 per unit and sent to DB
Company each year. If the FTA takes place, there will be no withholding tax imposed on profits to be
sent to
paid in
received by DB Company. After the first three years, all profits earned are allocated to the Chinese
firm.
The expected total profits resulting from the joint venture per year are as follows:
| Year | Total Profits from Joint Venture (in Yuan, CHY) |
| 1 | CHY60 million |
| 2 | CHY80 million |
| 3 | CHY100 million |
DB's average cost of debt is 13.8 percent before taxes. Its average cost of equity is 18 percent.
Assume that the corporate income tax rate imposed on DB is normally 30 percent. DB uses a capital
structure composed of 60 percent debt and 40 percent equity. DB automatically adds 4 percentage
points to its cost of capital when deriving its required rate of return on international joint ventures.
While this project has particular forms of country risk that are unique, DB plans to account for these
forms of risk within its estimation of cash flows.
There are two forms of country risk that DB is concerned about. First, even if a FTA does take place,
the Chinese government will increase the corporate income tax rate from 20 percent to 40 percent (20
percent probability)
taxes on the profits from this joint venture. Second, there is the risk that the Chinese government will
impose a withholding tax of 10 percent on the profits that are sent to
(20 percent probability)
subject to a 10 percent Australian tax on profits received from
country risk are mutually exclusive. This is, the Chinese government will only adjust one of its tax
guidelines (the income tax or the withholding tax), if any.
a. Determine DB's cost of capital. Also, determine DB's required rate of return for the joint
venture in
b. Determine the probability distribution (weighted probability'
the joint venture
Capital budgeting analyses should be conducted for these scenarios:
• Scenario 1 Based on original assumptions
• Scenario 2 Based on an increase in the corporate income tax by the Chinese government
• Scenario 3 Based on the imposition of a withholding tax by the Chinese government
SCENARIO 1: BASED ON ORIGINAL ASSUMPTIONS
(Probability = 60%)
| | Year 0 | Year 1 | Year 2 | Year 3 | |
| Total profits (in CHY) | | | | | |
| Profits allocated to DB Co.(50% of total) | | | | | |
| Corporate income taxes imposed by Chinese GOVT (20%) | | | | | |
| Profits to DB after paying corporate income taxes in | | | | | |
| DB's dollar profits received from | | | | | |
| AUS taxes paid (10%) | | | | | |
| Cash flows from joint venture | | | | | |
| PV of cash flows (using a 17% discount rate) | | | | | |
| Initial investment | | | | | |
| Cumulative NPV of cash flows | | | | |
SCENARIO 2: BASED ON INCREASE IN CORPORATE INCOME TAX
BY CHINESE GOVERNMENT
(Probability = 20%)
| | Year 0 | Year 1 | Year 2 | Year 3 | |
| Total profits (in CHY) | | | | | |
| Profits allocated to DB Co.(50% of total) | | | | | |
| Corporate income taxes imposed by Chinese GOVT (40%) | | | | | |
| Profits to DB after paying corporate income taxes in | | | | | |
| DB's dollar profits received from | | | | | |
| AUS taxes paid (0.0%) | | | | | |
| Cash flows from joint venture | | | | | |
| PV of cash flows (using a 17% discount rate) | | | | | |
| Initial investment | | | | | |
| Cumulative NPV of cash flows | | | | |
SCENARIO 3: IMPOSITION OF A WITHHOLDING TAX BY CHINESE GOVERNMENT
(Probability = 20%)
| | Year 0 | Year 1 | Year 2 | Year 3 | |
| Total profits (in CHY) | | | | | |
| Profits allocated to DB Co.(50% of total) | | | | | |
| Corporate income taxes imposed by Chinese GOVT (20%) | | | | | |
| Profits to DB after paying corporate income taxes in | | | | | |
| Withholding (10%) | | | | | |
| Profit to be sent to | | | | | |
| DB's dollar profits received from | | | | | |
| AUS taxes paid (10%) | | | | | |
| Cash flows from joint venture | | | | | |
| PV of cash flows (using a 17% discount rate) | | | | | |
| Initial investment | | | | | |
| Cumulative NPV of cash flows | | | | |
SUMMARY OF SCENARIOS
| Scenario | NPV for This Scenario | Probability that This Scenario will Occur | |
| Original scenario | | | |
| Increase in corporate income tax by Chinese Govt. | | | |
| Imposition of withholding tax by Chinese Govt. | | |
Expected value of NPV = ?
c. Would you recommend that DB participate in the joint venture? Explain
d. What do you think would be the key underlying factor that would have the most influence on
the profits earned in
e. Is there any reason for DB to revise the composition of its capital (debt and equity) obtained
from
f. When DB was assessing this proposed joint venture, some of its managers recommended that
DB borrow the Chinese currency rather than dollars to obtain some of the necessary capital
for its initial investment. They suggested that such a strategy can reduce DB exchange rate
risk. Do you agree? Explain
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