The expected Canadian dollar cost of each hedging alternative is as follows: 1) Forward hedge: You would buy a forward contract. Though you don’t need to pay for the contract right now, 6 months later you will have to pay the Canadian dollar cost of the forward hedge, which is: £200,000 (C$2.47 / £1) = C$494,000 2) Money market hedge: For this alternative, you would borrow Canadian dollars and convert these dollars into British pounds at today’s spot rate. Then you would deposit these pounds in a British bank to earn interest. Because your deposit earns interest in British pounds, the amount of British pounds you would need today is: To get this amount of British pounds at today’s spot rate, you would need to borrow: £195,599 (C$2.48 / £1) = C$485,085.52 Since you borrowed this amount of Canadian dollars, you would have to pay interest. The Canadian dollar cost of this alternative is: C$485,085.52 (1 + 5% × 6/12) = C$497,212.66 3) Option hedge: You would purchase a call on pounds. The maximum Canadian dollar cost of this alternative is: £200,000 (C$2.45 + C$0.05) = C$500,000 One benefit unique to a purchase call option hedge is you retain the potential to reduce your cost if the exchange rate moves in your favour, that is, if the Canadian dollar appreciates against British pounds in this case. You may pay fewer Canadian dollars to get the same amount of pounds. $500,000 is the maximum cost to you.
Ron Muller 2007-08 10 4) Remaining unhedged: The Canadian dollar cost of this alternative cannot be determined now, as it depends on the spot exchange rate 6 months later, which is unpredictable. In general, the Canadian dollar cost of remaining unhedged is: £200,000 (Spot rate 6 months later) Recommendation: I would recommend the option hedge alternative. Although remaining unhedged allows you to benefit from a lower value of pounds, it is more risky because it is equally likely that the British pound will strengthen against the Canadian dollar. Both forward and money market hedges eliminate the risk of a strong pound but they also eliminate your opportunity to benefit from a weak pound. An option hedge provides you with both protection against a weaker Canadian dollar and potential to benefit from a stronger Canadian dollar.
Ron Muller 2007-08 11 Question 4 (March 2006) 15 Marks In 2004, ABC Corp. paid dividends totalling $3.6 million on net income of $10.8 million. The year 2004 was a typical year, and for the past 10 years, earnings have grown at a constant annual rate of 10%. However, in 2005, earnings are expected to increase to $14.4 million because of an exceptionally profitable new product line being introduced, and the firm expects to have profitable investment opportunities of $8.4 million. After 2005, the company will likely return to its previous 10% growth rate. ABC’s target capital structure is 40% debt and 60% equity. Required: a. Calculate ABC’s total dividends for 2005 if it follows each of the following policies: i) Its 2005 dividend payment is set to force dividends to grow at the long-run growth rate in earnings.