Reference no: EM132768911

Mia Caruso Enterprises, a U.S. manufacturer of children's toys, is considering a new project located in Great Britain. The expected free cash flows from the project are detailed below:

Year Free Cash Flow (£ millions)
0 -20
1 10
2 15
3 18

• You know that the spot exchange rate is S = $1.8862/£. In addition, the risk-free interest rates on dollars and pounds are 5.4% and 4.6% respectively. Assume that these markets are internationally integrated and the uncertainty in the free cash flow is not correlated with uncertainty in the exchange rate. You have determined that the dollar WACC for these cash flows is 10.8%.

Problem a. Calculate the pound-denominated cost of capital for Mia Caruso Enterprises's project.

Problem b. Calculate (i) the pound present value of the project, and (ii) the dollar present value of the project?

Problem c. Mia Caruso Enterprises plans to send all profits back to the U.S. at the end of the project. Provide discussions on:

i. the exchange rate risk that Mia Caruso Enterprises is exposed to.
ii. how Mia Caruso Enterprises can adopt currency forwards and options contracts to hedge its exchange rate risk.
iii. how Mia Caruso Enterprises can use a cash-and-carry strategy to hedge its exchange rate risk (No calculation is required).
iv. advantages and disadvantages of the cash-and-carry strategy in comparison with the forward contracts.