# Hedging Case Study

*Register to read the introduction…*(2 MARKS)

By buying pesetas forward, DKNY can lock in a dollar cost of $534,351 (70,000,000/131).

(b) What is the hedged cost of DKNY's payable using a money market hedge? (3 MARKS)

DKNY can hedge its payable by borrowing the dollar equivalent of the present value of the Ptas 70 million payable, which equals Ptas 69,135,802 (70,000,000/1.0125) or a dollar amount of $531,814 at the current spot rate of Ptas 130/$ (Ptas 69,135,802/130). This is financed by borrowing these dollars at the monthly rate of 0.625% (7.5%/12). At the end of 30 days, DKNY will pay off this dollar loan. The cost of doing so is $535,138 ($531,814 x 1.00625).

(c) What is the hedged cost of DKNY's payable using a put option? (3 MARKS)

By buying a put option, DKNY can lock in a cost of $548,055 = the sum of the 1% put premium of $5,385 (0.01 x 70,000,000/130) taken to the end of the period $5,419 (5,385 x 1.00625) plus the $542,636 (70,000,000/129) cost of buying pesetas through the put option at a rate of Ptas 129/$. (Note that a put option on dollars with peseta receipt is exactly the same as a call option on pesetas.)

cont/…

QUESTION

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For an outlay of $150 million, the project is expected to generate annual cashflows of $30 million in perpetuity. The debt to equity ratio of the project is 1:2. The cost of equity is 20% and the cost of debt is 10%. The tax rate is 30%.

(a) Calculate the WACC for the project.

(2 MARKS)

WACC = D/Vrd(1-t) + E/Vre = 1/3x0.1x(1-0.3) + 2/3x0.2 = 0.1567

(b) How large does the probability of expropriation in year 4 have to be before the project has a negative NPV? Assume that the expropriation, if it occurs, will occur prior to the year 4 cash inflow or not at all. There is no compensation in the event of expropriation.

(4 MARKS)

The net present value of these cash flows, discounted at a 15.67% required return, is

-150 + 30/1.1567 + 30/(1.1567)2 + 30/(1.1567)3 + 30(1 - p)/(1.1567)4 + ... + 30(1 - p)/(1.1567)t

= -150 + 30/0.1567 - (30p/0.1567)/(1.1567)3

= -150 + 191.45 – 123.71p

Setting this quantity equal to 0 yields a solution of p = 33.5%. This means that the probability of expropriation has to be 33.5% before the investment no longer has a positive NPV.

(c) Describe three ways the company could reduce the project’s political