On May 1, Larkin Hydraulics, a wholly owned subsidiary of Caterpillar (U.S.), so

ID: 2778136 • Letter: O

Question

On May 1, Larkin Hydraulics, a wholly owned subsidiary of Caterpillar (U.S.), sold a 12-megawatt compression turbine to Rebecke-Terwilleger Company of the Netherlands for €4,000,000 payable as €2,000,000 on August 1 and €2,000,000 on November 1. Larkin derives its price quote of €4,000,000 on April 1 by dividing it's normal US dollar sales price of $4,320,000 by the then current spot rate of $1.0800/€.

By the time the order was received and booked on May 1, the euro had strengthened to $1.1000/€, so the sale was in fact worth €4,000,000 c $1.1000/€ = $4,400,000. Larkin had already gained an extra $80,000 from favorable exchange rate movements. Nevertheless, Larkin's Director of finance now wondered if the firm should head against a reversal of the recent trend of the euro. Four approaches were possible:

1.Hedge in the forward market: The 3-month forward exchange quote was $1.1060/€ and the 6-month forward quote was $1.1130/€.

2.Hedge in the money market: Larkin could borrow the euros from the Frankfurt branch of its US bank at 8.00% per annum.

3.Hedge with foreign currency options: August put options were available at strike price of $1.1000/€ for a premium of 2.0% per contract, and November put options were available at $1.1000/€ for a premium of 1.2%. August call options at $1.1000/€ could be purchased for a premium of 3.0%, and November call options at $1.1000/€ were available at a 2.6% premium.

4.Do nothing: Larkin could wait until the sales proceeds were received in August and November, hope the recent strengthening of the euro would continue, and sell the euros received for dollars in the spot market.

Larkin estimates the cost of equity capital to be 12% per annum. As a small firm, Larkin Hydraulics is unable to raise funds with long-term debt. US T-bill yield 3.6% per annum. What should Larkin do?

Explanation / Answer

Total Euro receivable

Receivable on August 1 = € 2,000,000

Receivable on November 1 = € 2,000,000

Current spot rate = $ 1.1000 / €

Cost of equity = 12%

Treasury Bill yield = 3.6%

Option 1 Hedge in Forward market

3-month forward quote = $1.1060 / €

6- month forward quote = $ 1.1130/€

Amount receivable after three months = € 2,000,000 * 1.1060 = $ 2,212,000

Amount receivable after six months = € 2,000,000 * 1.1130 = $ 2,226,000

Present Value of amount receivable after three months = $2,212,000/(1+12%/12)^3

= $ 2,212,000 /1.01^3

= $ 2,146,945.41

Present Value of amount receivable after six months = $ 2,226,000/(1.01)^6

= $2,096,992.69

Total present value of the amount receivable from futures = $ 2,146,945.41 + $2,096,992.69

= $ 4,243.938.10

Option 2

Borrow Euros at Frankfurt at 8% per annum, convert them into USD at current spot rate. On maturity, the Euro liability is paid off with the receivables. The USD amount received can be utilised by the company either in production activities or invested at T-Bill rate

Present value of the amount to be borrowed for three months = 2,000,000/(1+8%/12)^3

= 2,000,000/1.00667^3

= € 1,960,527.47

Present Value of the amount to be borrowed for six months = 2,000,000/1.00667^6

= € 1,921,833.97

Total amount borrowed = € 1,960,527.47 + € 1,921,833.97 = € 3,882,361.44

Convert the borrowed euro amount into USD at spot rate = € 3,882,361.44 * 1.1000

USD amount available with the firm = $ 4,270,597.58

Option 3

Buy 3 month put options at $ 1.1000 /€ at a premium of 2% for € 2,000,000

Buy 6 month put options at $ 1.1000 /€ at a premium of 1.2% for € 2,000,000

Premium paid at the time of purchasing the put options = 2,000,000 * 0.02 + 2,000,000 * 0.012

= $ 40,000 + $ 24,000

= $ 64,000

The guaranteed amount which can be received is when option is exercised at the strike price.

Total guaranteed amount receivable after 3 months = € 2,000,000 * 1.1000 - $ 40,000

= $ 2,200,000 - $ 40,000 = $ 2,160,000

Total guaranteed amount receivable after 6 months = € 2,000,000 * 1.1000 - $ 24,000

= $ 2,200,000 - $ 24,000 = $ 2,176,000

Total present value of guaranteed amount receivable = $ 2,160,000/1.01^3 + $ 2,176,000/1.01^6

= $ 2,096,474.72 + $ 2,049,890.43

= $ 4,146,365.15

Option 4

Do not hedge the exposure

Assuming that the current spot rate of $1.1000/€ hold good after 3 months as well as 6 months

The amount receivable by company = € 2,000,000 * 1.1000 + € 2,000,000 * 1.1000 = $ 4,400,000

Present Value of the amount receivable = $ 2,200,000/1.01^3 + $ 2,200,000/1.01^6

= $ 2,135,298.33 + $ 2,072,499.52

Total Present Value = $ 4,207,797.85

Present values of receivables based on options is as follows

Forward Market

$ 4,243.938.10

Money Market

$ 4,270,597.58

Option Market

$ 4,146,365.15

Do not hedge

$ 4,207,797.85

Based on the above, borrowing euro funds at 8% at Frankfurt and convert them into US Dollars at current spot price appears to be the better option available to the company