BREAKEVEN RATE (IRR) AND NPV
The breakeven rate at which the management of the company would be indifferent between the two options would be the average USD rate that will be needed to be applied to the dollars received from UK borrowing for Dozier. This rate could simply be calculated as:
$1,464,701.21 x (1 + i) = $1,501,438.50
(1 + i) = $1,501,438.50/$1,464,701.21 = 1.02508
Which in an annual rate is 10.03%? If having cash in the US is worth more than 10% then United Kingdom borrowing would be a better hedging method.
dozier industries b case solution
The NPV for each of the projects has been calculated. The workings are shown in the excel sheet. The NPV has been calculated based on the perpetuity formula. The NPV for the forward contract is $ 289505 in thousands and for the money market contract is $ 298593 in thousands. Based on the NPV, the firm could go with the money market hedge as it is slightly higher than the forward hedge.
PARITY OF MONEY AND FORWARD MARKETS
Yes the money markets and the forward market seem to be in parity. The results under both the approaches are almost same and the net present value is also similar. Interest rate parity is known as the concept when the forward hedge is similar to the money market hedge. The reasons for this are the interest rate differentials between the two countries. However, in this case both the markets show little difference therefore, they are in parity.
MANAGING EXHANGE RATE RISK
Following are some of the techniques to manage the exchange rate risks:
- Matching the currency inflows and outflows.
- Back to back loans or credit swaps where two companies in two different currencies borrow loans for each other.
- The company can also enter into options contract so that it will have the right but not the obligation to execute the transaction or not.
- Improved financial forecasting and realistic budgeting.
CONCLUSION
The bid preparation by the management of the company was negligent in this case. If Dozier had looked into the historical spot rates then they could have incorporated the risks in this project into the spot exchange rate by agreeing to a lower spot rate. However, the results of any of the hedging strategies are not satisfactory and the business would be better off by doing nothing at the moment. Apart from this, one of the alternative to the hedging would be that the company could insist the UK firm to send dollars instead of pounds. However, there would be less chances of this to be agreed by the UK firm. However, if still the company wants to manage some of the risk, then they could enter into the forward contract at $1.4198 per pound which offers them a profit margin of 1.7%. The current strategy of the company focuses on the expansion in the foreign markets. However, given the current sales level and the proposed strategy, Dozier cannot take higher risks. Therefore, the little profit generated by the contract will assist the company to expand in the foreign markets...................................
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