ALTERNATIVELY:

ALTERNATIVELY:

Foreign Exchange risk is the probability that a company will be unable to adjust its prices and cost to offset changes in exchange rates. It also means the risk that the domestic currency value of cash flows denominated in foreign currency may vary due to changes in the foreign exchange rate.

Ways of heading against Foreign Exchange Risk
1. Forward Contract
This involves a contract, which is tailor-made (taken out for the exact amount of currency required. The future exchange rate is fixed at the time the contract is entered in to with the bank. The cost is then determined by the forward rate quoted by the bank.
2. Future Contract
This offers the opportunity to buy/sell currency in standard amount of a limited number of currencies at a specified time and rate.
3. Lead/Lag Payment
In the case of paying for goods in a foreign currency, it is possible to pay for the goods in advance and thereby fix the exchange rate at the spot rate.
4. Currency Options
Here, the firm has the possibility of buying (call) or selling (put) currency at an agreed rate usually at any time within a specified period.

Computation of NPV for both projects Using WACC

WORKINGS:

Cost of Capital Using WACC

Computation of NPV for both projects Using CAPM

WORKINGS:

In view of the high risk inherent in the Oil and Gas Project, the Hotel and Tourism project should be selected.

Since the Ghanaian Company has an asset of USD$75,000 and a liability of USD$264,000, maturing at the same time (3 months) they can be used to offset each other to leave a net liability of USD189,000.

Forward Market Hedge
Offset $254,000 – $75,000 = USD$189,000
Buy USD$189,000 3 months forward
Cost = $189,000 ÷ 0.9545 = GH¢198,009 payable in 3 months

* Since the company has a US$ liability it needs to create a matching US$ assets
* Place US Dollar on deposit for 3 months at an interest rate of 2.7%
* Accumulate capital at the end of 3 months to the US$189,000 required
* Pay off the net liability as follows

Deposit US$ (1 + 0.025) = USA$189,000 required in 3 months
Amount to deposit now:
US$189,000 ÷ 1.025 = 184,390

The Ghanaian company will have to buy these US$184,390 on the spot market.
Cost = US$184,390 ÷ 0.9850 = GH¢187,198 payable now

.                                                      Now                           3 months Time
Forward Market                                                                 (GH¢198,009)
Money Market:                        (GH187,198)

Compound cost of the Money Market Hedge = 187,198 (1+0.0325)
.                                                                              = GH¢193,282
As this is lesser amount than the Forward Market Hedge, it can be concluded that the money market hedge is the least cost method of hedging the company’s net liability.

Average Return Stock A
(-10% + 18% + 39% + 14% + 33%)/5 = 18.8%
Average Return Stock B
(-3% + 21% + 44% + 4% + 28%)/5 = 18.8%

The value of an acquisition can be assessed using the net present value of the acquisition and integration.
𝑁𝑃𝑉 𝑜𝑓 𝑎𝑐𝑞𝑢𝑖𝑠𝑖𝑡𝑖𝑜𝑛 = 𝑃𝑉 𝑜𝑓 𝑠𝑦𝑛𝑒𝑟𝑔𝑦−𝐶𝑜𝑠𝑡 𝑜𝑓𝑎𝑐𝑞𝑢𝑖𝑠𝑖𝑡𝑖𝑜𝑛−𝐶𝑜𝑠𝑡 𝑜𝑓 𝑚𝑒𝑐ℎ𝑎𝑛𝑖𝑠𝑎𝑡𝑖𝑜𝑛
𝑁𝑃𝑉 𝑜𝑓 𝑎𝑐𝑞𝑢𝑖𝑠𝑖𝑡𝑖𝑜𝑛 = 𝐺𝐻𝑆100𝑚−𝐺𝐻𝑆169.1𝑚−𝐺𝐻𝑆18𝑚 = 𝐺𝐻𝑆−87.1𝑚
The NPV of the acquisition is negative. Two-Pack should not go ahead with the acquisition.

Workings:
1. PV of synergy
Synergy = GHS25m per year
Discount rate = 25%
𝑃𝑉 𝑜𝑓 𝑠𝑦𝑛𝑒𝑟𝑔𝑦 = 𝐺𝐻𝑆25𝑚/0.25 = 𝐺𝐻𝑆100𝑚

2. Cost of acquisition
The cost of acquisition is the purchase consideration less the value of the target.
Purchase consideration = Value of share offer = Post-acquisition share price x Shares

EPS, Two-Pack = GHS55.8/40m = GHS1.395
Current share price, Two-Pack = P/E ratio x EPS = 18 x GHS1.395 = GHS25.11
Current value of equity, Two-Pack = GHS25.11 x 40m = GHS1, 004.4m
EPS, Anas-Expo = GHS33.7/25m = GHS1.348
Current share price, Anas-Expo = P/E ratio x EPS = 12 x GHS1.348 = GHS16.176
Current value of equity, Anas-Expo = GHS16.176 x 25m = GHS404.4m

Purchase consideration = GHS22.94/share x 25m shares= GHS573.5m
Cost of acquisition = GHS573.5m – GHS404.4m = GHS169.1m

Note: Post-acquisition value may be estimated as the product of the post-acquisition EPS and P/E ratio.

Earnings after acquisition = GHS55.8m + GHS33.7m + GHS25m = GHS114.5m
EPS = GHS114.5m / 65 = GHS1.762
The EPS of Two-Pack will increase by GHS0.367 (GHS1.762 – GHS1.395) if the expected benefit of additional GHS25m in annual after-tax net income is achieved.
Assuming the synergy is not achieved, the EPS of Two-pack will drop by GHS0.018:

Shareholders of Two-Pack:
Current value of shares = 40m x GHS25.11 = GHS1,004.4m
Value after acquisition = 40m x GHS22.94 = GHS917.6m
Potential loss in value = GHS86.8m

Shareholders of Anas-Expo:
Value of current shareholding in Anas-Expo = GHS16.176 x 25m = GHS404.4m
Value of shareholding in Two-Pack = 25m x GHS22.94 = GHS573.5m
Potential gain in value = GHS169.1m

If the acquisition takes place, existing shareholders of Two-Pack would lose value while shareholders of Anas-Expo would gain value.

(1) Impact of acquisition on shareholder’s wealth
*Potential conflict: As rational investors, shareholders of Two-Pack will prefer investments that enhance their value to those that reduce their value. Any acquisition that presents a negative NPV and reduction in value of existing shareholders would be resisted. The NPV of the acquisition is negative and the post-acquisition value of existing shareholders’ shares will be lower than their value now. What is more, the acquisition appears to serve directors’ interest because as the larger profits of a larger post-acquisition company implies bigger compensation packages for them.

*Solution: The conflict may be avoided if the acquisition proposal is discarded. The value of existing shareholders may be enhanced if Anas-Expo is acquired at a lower P/E ratio (may be offer 1 share for every two shares in Anas-Expo). In this case, EPS of post-acquisition company will be higher than Two-Pack’s current EPS and given the P/E ratio, the value of shares post-acquisition will be higher than now.

(2) Impact of mechanization on employees
*Potential conflict: The mechanization of the production process will enhance production efficiency and, at least in the short-term, yield additional profits. This will serve the interest of directors if their compensation is based on earnings. However, employees at Anas-Expo may resist the planned mechanization because of the associated job losses. Shareholders, on the other hand, may resist high redundancy packages demanded by employees.

*Solution: Employees should be consulted and educated on the mechanization programme. Those who would lose their job should be given adequate compensation and retraining to pursue opportunities elsewhere. The implementation of the mechanization programme could be delayed or done in phases to reduce tension, spread the cost of the programme over a period, and to give employees enough time to adjust.

(3) Mechanization and product quality
*Potential conflict: The mechanization of the production process implies that clothes will now be mass-produced with machines. The quality of the mass-produced clothes may fall below that of the handmade clothes. Besides, the product of Anas-Expo may have won those awards because of its quality as a handmade product. Customers may be unhappy if their cherished handmade clothes are replaced with lower-quality mass-produced versions.

*Solution: Instead of a full-scale mass production with machines, directors may consider producing a proportion of total output using machines and a proportion using hand. This middle-ground approach will enhance operational efficiency for lower cost while maintaining some level of production for the celebrated handmade products. Also, the company should make additional investment in R&D to obtain a production technology that would maintain the quality of the clothes when produced with machines.

(4) Impact of mechanization on larger society
*Potential conflict: Mechanization of the production process may enhance efficiency and reduce production costs. But since the purpose of the mechanization is to replace work done by hand, the larger society, including the community in which the factory is located and the government, may resist the programme as it will result in job losses and increase unemployment rate. Besides, if the additional net income that would result from the mechanization does not compensate for the reduction in employment income due to job losses, government will lose tax revenue.

*Solution: JB should manage the impact of the mechanization well by providing adequate redundancy package, education and training for employees who would be affected to help them adjust; phase in the implementation of the programme; and secure production technology that would enhance quality of the products to achieve higher demand, lower operating costs, and superior profits.

• Performance evaluation: In the case where units within the multinational are treated as autonomous profit centres, transfer pricing is needed to evaluate the performance of each unit effectively. Without transfer pricing, performance of selling departments may be underrated and that of buying departments may be overrated, or otherwise.
• Management incentives: An effective transfer pricing system that rewards managerial efficiency and exposes efficiencies will serve as incentive for good performance.
• Cost allocation: If there are units within the JB group that are treated as cost centres, an effective transfer pricing system will allow them to charge for their services to the group and thus permit them to recover their costs and perhaps record a mark-up. This will boost morale of managers at cost centres, and encourage economy and efficiency with the use of their services amongst units in the group.
• Financing consideration: Transfer pricing can be used to provide financing to a subsidiary by the parent company undercharging the subsidiary for goods and services transferred.
  

Advantages:

• Leveraging on relative borrowing advantage: Swaps allow companies to mutually benefit from their relative borrowing advantage by each borrowing in markets they can get the best deal and then swapping for the loan type they actually prefer.
• Flexibility and convenience: Swaps are more flexible than other derivatives, particularly futures and options, as they can be arranged in any size, and can be reversed if necessary.
• Lower transaction cost: Cost of arranging a swap is relatively lower, particularly when no intermediary is involved. Besides, it is cheaper to arrange a swap to manage interest rate swap than having to cancel existing loan contract and arranging a new one.
• Suitability for long-term exposures: Unlike other derivatives such as futures and options, swaps a typically designed for managing long-term exposures. Most of the interest rate risks that firms face are long-term in nature and swaps are well-suited for managing exposures of such maturity.

Disadvantages:

• Counterparty risk: Effectiveness of hedging interest rate risk with interest rate swap is limited by the risk that one party will default leaving the other to bear its obligations. This problem can be solved by using an intermediary to enforce compliance with the swap terms. However, this will imply higher transaction cost.
• Inability to take advantage of upside risk: Under interest rate swaps, parties have the obligation and not the right to swap. This means that a party that takes up a fixed rate commitment, will not be able to take advantage of favourable movement in interest rates. This problem can be solved using a swaption instead.
• Lack of liquidity: Swaps are typically not traded in open secondary markets, and that reduces ability and convenience of liquidating a swap contract when the need arises.
  

The recommended hedging strategy is the one that presents the lowest net borrowing cost.

Restructure the existing loan
Under this option, the existing fixed rate dollar loan is structured into a floating rate dollar loan at LIBOR + 200 basis point
Borrowing cost = LIBOR + 2%

Hedging alternative 1: Engage in interest rate swap with a swap bank
Under this arrangement, JB will get the opportunity to pay floating rate (what it prefers) at LIBOR + 100 basis points to UT bank (the swap bank) in exchange for a fixed rate payment (what it does not prefer) at the bid fixed rate, 3-year TN rate + 35 basis points. The fixed rate payments from the swap bank will be at the bid rate as in this case the swap bank will be buying a fixed rate from JB.
JB will still honour its fixed rate obligations to the loan syndicate. With the fixed rate payments received from the swap bank however, much of this fixed rate obligation is effectively shifted to the swap bank.

Note: Though the diagram above aids analysis of interest payments amongst the parties involved, it is not a requirement to answering the question. Full credit should be given to a narrative that explains interest flows even without a diagram.

That is if JB hedges the interest rate risk with an interest rate swap with UT bank, its net borrowing cost would be LIBOR + 125 basis points.

Hedging alternative 2: Engage in interest rate swap with another company
Under this arrangement, the entities will swap currency coupons for the type they prefer. That is, JB would pay to McEwen the floating rate coupons it prefers and then receive fixed rate coupons from McEwen. Thus, either entity ends up paying the interest rate type they prefer.

Comment on swap arrangement:
JB would maintain its fixed rate debt, which is at 6.5%; and McEwen keeps its floating rate debt, which is at LIBOR + 1.5%. And under the swap arrangement, JB pays floating rate (LIBOR + 1.5%) to McEwen in exchange for a fixed rate (7%). JB then pays 6.5% out of the fixed interest payment from McEwen to its creditors, and saves 0.5% on the fixed rate side. On the floating rate side, JB pays LIBOR + 1.5% to McEwen instead of LIBOR + 2% to creditors if the loan is restructured, and thus saves another 0.5%.
JB effectively ends up paying a floating rate; gains 1%, which reduces its borrowing cost to LIBOR + 1%

Working:
Take the floating rate that is swapped to be what McEwen could pay under swap (i.e. LIBOR + 1.5%).
Given that the swap gains are shared equally, the fixed rate that would be swapped is calculated as under:

Summary:
Option                                                                                                Net borrowing cost
Restructure existing loan                                                                          LIBOR + 2%
Interest rate swap with a bank                                                                LIBOR + 1.25%
Interest rate swap with another multinational company                    LIBOR + 1%

Recommended hedging strategy
Hedging with interest rate swap with McEwen Ltd is recommended as it present the lowest net borrowing cost.
JB maintains its fixed rate debt contract with loan syndicate, and engages in a fixed-for-floating interest rate swap with McEwen. Under the swap arrangement, JB pays floating rate coupons at LIBOR + 1.5% to McEwen in exchange for fixed rate coupons at 7%.
JB then pays 6.5% out of the fixed rate coupons it receives from McEwen to the loan syndicate. Thus, JB effectively shifts the risk associated with the fixed interest rate obligation to the counterparty, McEwen.

Default probability is estimated using the Black-Scholes OPM as under.
Default probability = 1 – N(d2)

From the standard normal probability table, N(d2 = 0.74) = 0.7704.
Default probability = 1 – 0.7704 = 0.2296
The chance that Lolonyo will default on bond payments is 22.96%.

Expected loss = Loss given default x default probability
Loss given default = Face value x (1 – recovery rate)
Loss given default = GHS80m x (1 – 0.6) = GHS32m
Therefore,
Expected loss = GHS32m x 0.2296 = GHS7.3472m

Calculate credit score (Y) using Kaplan Urwitz model for unlisted companies:
𝑌=4.41+0.001𝑆𝑖𝑧𝑒+6.40𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦−2.56𝐷𝑒𝑏𝑡−2.72𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒+0.006𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡−0.53𝐶𝑂𝑉
Where;
Size is measured by total assets
Profitability is measured by the ratio of net income to total assets
Debt refers to the status of the debt stock; subordinated debt is assigned score 1, and unsubordinated debt is assigned score 0
Leverage is measured by the ratio of long-term debt to total assets
Interest refers to interest cover, which is measured by net operating income (i.e. net income before interest and tax)
COV is the coefficient of variation in earnings, which measures volatility in earnings

Note: Since company has been operating since 1990, earnings record for the past five years is a sample of earnings. The standard deviation is therefore estimated as a sample standard deviation. 𝑌=4.41+0.001(150)+6.40(0.068)−2.56(1)−2.72(0.533)+0.006(12.333)−0.53(0.078)

𝑌=1.018
With a credit score of 1.018, Lolonyo falls into the BB credit rating.
The yield on 10-year corporate bonds with BB rating is 25.5%.

𝐶𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡   = 𝑌𝑇𝑀×(1 – 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒)

𝐶𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡   = 25.5% × (1 – 0.25)

.                         = 19.125%