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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

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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

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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

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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

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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

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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

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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.

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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

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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%

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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.

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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

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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

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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.

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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)

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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

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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.

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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%

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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.

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(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

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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

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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