I Exercises
1. Determination of the Exchange Rates
On 01.05.2012 Euro per Great Britain Pound was 1.2265, whereas in the beginning of the previous month, on 01.04.2012 this relation was equal to 1.2. By how much has Euro appreciated against the Great Britain Pound? By how much the GBP depreciated against Euro?
New value = 1.2265 1 / 1.2265=0.8153
Old Value= 1.2 1 / 1.2= 0.8333
(0.8153-0.8333)/ 0.8333=-0.2216 GBP depreciated against Euro by 22.16%
(1.2265-1.2)/ 1.2= 0.1887 Euro appreciated against GBP by 18.87%
2. Bid-Ask Spread
On 10.05.2012 EUR/USD pair is quoted at 1.2926-1.2934. This day the Bank traded 165 000 USD, calculate the bid–ask percent spread and the profit on trading the US currency of the day.
Solution:
Percent Spread=((1.2934-1.2926)/1.2934)*100=0.06%
Bid- 165000*1.2926=213279
Ask -165000*1.2934=213411 Profit= 132 EUR
3. Cross Currency Exchange Rates
If the Euro is quoted $1.29259-335 and Australian dollar is quoted $1.00380-494 what will be the direct quote for Euro in Australia?
Solution:
The direct quote for the Euro will be 1.2862-85
4. Forward premium(Discount)
US Company that wants to make investment into the Australian market of food industry, quotes a credit in one of the local banks of Spot on Australian dollars $1.00380-494 with 60 days forward rates of 6-15. Define 60 day forward rates in Australian dollars, bid –ask spread and forward discount/premium with buying 60 days Euros.
Solution:
((B-A)/B )*100
0.113%
60 days forward
((1.00386-1.00380)/1.00380)*360/60= 0.0003 Premium
5. Application of Foreign Market Beta
In 2000 there was obtained the following data of foreign markets correlation with US:
Standard deviation of the United states 53.2
Standard deviation of France 67.19
Correlation of Spin with US market 0.24
If compared to 2000, in 2010 standard deviation of the US market has increased by 27% and standard deviation of France has decreased by 13%. What is the beta of French market with the US perspective if correlation between the two markets showed rise by 0.85%.
French Market Beta in 2010 = 0.28*(54.19 / 67.6)=0.23
6. PPP exchange Rates.
On May 5, 2012 the AUD/GBP exchange rate was 1.58 and the price of a cup of tea in Australia was AUD 4.50 and in London – GBP 2.50. According to PPP, by how much was the Australian dollar overvalued/undervalued and what should have been the price of a cup of tea in London to maintain equilibrium?
Solution:
GBP 2.50/ AUD 4.50=0.56
(0.56-1.58)/1.58=-0.44% the GBP was devalued
The price of a cup of coffee in London should have been GBP 2.51.
7. Use of hedging techniques
U.S. importer makes a payment under the contract in euros (€ 4 million) in October. Given the current price of the September 1 € - $ 1.1400, for the purchase of € 4 million he will need $4.56 million. Analyzing the forex market, he concludes that it is possible that euro price will grow during this period. How can he make the best deal?
Solution:
When deciding on insurance of the transaction, the U.S. importer acquires in September futures contracts for delivery for $ 4 million in October, when the price for euro is 1 € - $ 1.1420. Given that the total value of this transaction is 4000000 x 1.1420 = $ 4.568 million, the required security deposit to open a position is about 2% of contract value - only $ 91,000.
Forecasts of the American importer justified - in October, the euro rose to $ 1.1750. Selling previously purchased futures contracts at that price, the importer makes a profit of:
(1.1750 - 1.1420) x 4,000,000 = $ 132,000.
At the same time, buying at this price € 4 million for payment under the contract, the U.S. importer overcharged:
(1.1750 - 1.1400) x 4,000,000 = $ 140,000.
However, the profit on his futures transaction decreases expenses to:
II. International capital budgeting problem for Intel Corp.
Intel Corporation is one the leaders in the American and world market of semiconductor chip producers. It is headquartered in Santa Clara, California, and was founded on July 18, 1968, by Gordon Moore and Robert Noyce. Among its products there are network interface controllers, flash memory, motherboard chipsets, graphic chips and some other devices directly applied in the sphere of computing. A distinguishing feature of the company is its combination of world-class design capability and modern capability of manufacturing. While in the 1990s the company didn’t face any actual competition, today its main and most serious competitor is AMD.
In 2006 there were about 100 000 employees in the company and 200 facilities around the world. In 2005 its revenues equaled $38.8 billion. The largest customers of the company in 2009 were Dell and Hewlett-Packard. Today the company’s market capitalization is $140.84 billion. To stand through the competition, the company decides to invest in expanding to one of the three countries: China, Spain or Turkey. It is planned to open an office and a warehouse in the chosen country and the investment horizon is set at 4 years. The expected life span is 10 years. The most attractive project should be chosen as a result of the careful analysis of all the proposed projects. The main question that has to be answered is the following: What country is it better to choose for investment and why?
Modified Internal Rate of Return
All the calculations are presented in MS Excel file.
Analysis of the three projects showed what country it is better to invest to for Intel Corp. First of all, the net present value was analyzed for each country. There were no negative values, which means that in each of the countries Intel investment will be profitable. In China and Spain this indicator was considerably higher, which should be taken into account. Profitability index is also similar in the countries, which means that profit in them will be greater than the initial investment. Analysis of the IRR and MIRR showed that Spain and Turkey have better perspectives for development. As a result, it is possible to draw a conclusion that Spain is the best country for the investment decision, because it has the best balance of all the four indicators, all of them being high.
III. Optimization of Capital Structure
The company's activity is subject to certain life cycles. To evaluate the structure of the enterprise capital and to take the decision for its optimization, it is necessary to understand what stage of development the company is at now. The most dynamic stage is the one of development and diversification of business, when it comes to making decisions about investments and their sources. Financial modeling techniques help to get the answer to the question from which source it is more profitable to receive investment.
In practice, most often there forms a situation where the use of credit can significantly reduce the time to achieve the economic effect, because the accumulation of profits for the project is a long process and time costs a lot. In the end, saving time leads to more rapid growth of the company and maximization of profits. At the stage of stabilization, the need for long-term loans may simply not occur. At this stage it is normal to have such a capital structure where the proportion of debt capital is minimal.
In the period of a downturn or crisis, plans for further activities of the company are developed (Levya and Hennessy, 2007). Typically, at this point anti-recessionary measures are discussed, or the decision on liquidation. If the plan of crisis overcoming is created, then at this stage profitability is deteriorating and financial stability is reduced. In this situation, the company gets into debts and the ratio of equity to debt is very low (which indicates a crisis situation). In such cases capital structure is not so important as trends in the financial portfolio and future indicators, calculated on the basis of a plan to overcome the crisis.
It should be noted that there are no universal criteria for the formation of an optimal capital structure (Titman and Tsyplakov, 2007). The approach to each company should be individualized and take into account both industry of interest and stage of development. What is characteristic of the capital structure of companies, specializing in, for example, real estate management, may be not appropriate for the company from trade or services. These companies have different needs in their own working capital and capital ratio is different. Such factors as publicity should also be taken into account: non-public companies with a small group of founders (shareholders) are more mobile in the decisions about the use of profit, which allows them to vary the value and structure of the capital quite easily.
Capital structure reflects the ratio of debt and equity capital raised to finance long-term development of the company (Hackbarth, 2008). On how the structure is optimized, depends the success of implementing the financial strategy of the company as a whole. In turn, the optimal ratio of debt and equity capital depends on their value.
There is a common misconception, according to which equity is considered to be free. This approach ignores the obvious fact that dividends serve as a price that makes the funding from its own funds the most expensive (Zhang, 2005). For example, if a business owner is able to receive dividends, for example, at 40%, the cost of equity capital is higher than the cost of raising loans.
As the world practice shows, the development only through own resources (i.e., by reinvesting profits in the company) reduces certain financial risks in the business, but at the same time, it greatly reduces the rate of increment of the size of the business, and first of all its revenue. On the contrary, the involvement of additional loan capital with the right financial strategy and high-quality financial management can dramatically increase the income of owners of the company on their invested capital. The reason is that the increase in financial resources, with proper management leads to a proportional increase in sales volume and frequently net profit (Alti, 2006). This is especially true for small and medium-sized companies.
However, an overloaded leveraged capital structure imposes excessive demands on its profitability because of higher probability of non-payments and increasing risks for the investor. In addition, customers and suppliers, noting the high proportion of borrowed funds, may start looking for a reliable partner that will lead to a drop in revenue. On the other hand, too low proportion of debt means the under-utilization of the funding source that is potentially cheaper than equity. This structure leads to higher costs of capital and excessive demands on future investment returns. The optimal capital structure is a relation of debt and equity sources, at which there is an optimal balance reached, i.e., the market value of the company is maximized.
Alti, A., 2006. How Persistent Is the Impact of Market Timing on Capital Structure? The Journal of Finance, 61(4), pp. 1681–1710.
Hackbarth, D., 2008. Managerial Traits and Capital Structure Decisions. Journal of Financial and Quantitative Analysis, 43, pp. 843-881.
Levya, A., and Hennessy, C., 2007. Why does capitalstructure choice vary with macroeconomic conditions? Journal of Monetary Economics, 54(6), pp.1545–1564.
Titman, S., and Tsyplakov, S., 2007. A Dynamic Model of Optimal Capital Structure. Review of Finance, 11 (3), pp.401-451.
Zhang, X., 2005. Financial Viability Analysis and Capital Structure Optimization in Privatized Public Infrastructure Projects. J. Constr. Eng. Manage., 131, p.656.
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