Reference no: EM13656512
Question :On June 1, Northwind Energy, a wholly owned subsidiary of GE, sold a 12 megawatt compression turbine to Groningen Engineering of the Netherlands for ?4,000,000, payable ?2,000,000 on September 1 and ?2,000,000 on December
1. The Northwind sales team derived its price quote of ?4,000,000 on May 1 by dividing its normal U.S. 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 June 1, the euro had strengthened to $1.1000/?, so the sale was in fact worth ?4,000,000 x $1.1000/? = $4,400,000. Northwind had already gained an extra $80,000 from favorable exchange rate movements. Nevertheless, Northwind's director of finance now wondered if the firm should hedge against a reversal of the recent trend of the euro.
Four approaches were possible:
Hedge in the forward market. The three-month forward exchange quote was $1.1060/? and the six-month forward quote was $1.1130/?.
Hedge in the money market. Northwind could borrow euros from the Frankfurt branch of its U.S. bank at 8.00% per annum.
Hedge with foreign currency options. September put options were available at strike price of $1.1000/? for a premium of 2.0% per contract, and December put options were available at $1.1000/? for a premium of 1.2%. September call options at $1.1000/? could be purchased for a premium of 3.0%, and December call options at $1.1000/? were available at a 2.6% premium.
Do nothing. Northwind could wait until the sales proceeds were received in June and September, hope the recent strengthening of the euro would continue, and sell the euros received for dollars in the spot market.
Assumptions
Values
90-day forward rate, $/?
$1.1060
180-day forward rate, $/?
$1.1130
U.S. Treasury bill rate
3.600%
Northwind''s borrowing rate, euros, per annum
8.000%
Northwind''s cost of equity
12.000%
a) Discuss if Northwind should hedge its transaction exposure of EUR 4,000,000. If you recommend that the company should hedge, which of the hedging alternatives would better serve Northwind shareholders?
b) Northwind circumstance has changed. If Northwind can borrow at 2% per annum in Europe and need the proceed to invest in the U.S. in a short term project using its WACC rate, which alternative would be better for the company?
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