1. Fleur de France has a project that will provide £20 million in revenue in 1 year. The project has a euro cost of :30 million that will be paid in 1 year. The cost of the project is certain, but the future spot exchange rate is not. Assume that there are only two possible future spot exchange rates. Either the spot rate in 1 year will be :1.54 >£ with 55% probability, or it will be :1.48 >£ with 45% probability. Assume that the French tax rate on positive income is 45%, that a firm's losses are immediately refunded at a rate of 35%, and that the forward rate of euros per pound equals the ex- pected future spot rate.
a. If Fleur de France chooses not to hedge its foreign exchange risk, what is the expected value of its after-tax income on the unhedged project?
b. If Fleur de France chooses to hedge its foreign exchange risk, what is the expected value of its after-tax income on the hedged project?
c. How much does Fleur de France gain by hedging?
2. How would your answer to problem 1 change if instead of allowing refunds at 35%, the refund rate were only 25%?
3. How would your answer to problem 1 change if the possible exchange rates in the future were :1.56 >£ and 1.46 >£?
4. Assume that U.S. Machine Tool has $50 million of debt outstanding that will mature next year. It currently has cash flows that fluctuate with the dollarpound exchange rate. Over the next year, the possible exchange rates are $1.50 >£ and $1.90 >£, and each exchange rate is equally likely. The company thinks that it will generate $30 million of cash flow from its U.S. operations, and its expected pound cash flow is £12 million.
a. If U.S. Machine Tool does not hedge its foreign exchange risk, what will be the current market value of its debt and equity, assuming, for simplicity, that the appropriate discount rates are 0?
b. Suppose that U.S. Machine Tool has access to forward contracts at a price of $1.70 >£. What is the value of the firm's debt and equity if it hedges its foreign exchange risk? Would the stockholders want the management to hedge?
c. Suppose U.S. Machine Tool could invest $1 million today in a project that returns £1million next period. Is this a good project for the firm?
d. Suppose that U.S. Machine Tool is unhedged, that its managers are trying to maximize the value of the firm's equity, and that the $1 million must be raised from current stockholders. Will the managers accept the project?
e. If U.S. Machine Tool hedges its foreign exchange risk, would the firm accept the project?