Question 3 In one year, Raby Ltd, a UK company, expects cash flows of £160,000 from its UK operations and €480,000 from
Posted: Mon May 23, 2022 10:09 am
Question 3
In one year, Raby Ltd, a UK company, expects cash flows of
£160,000 from its UK operations and €480,000 from its sales in the
European Union (EU). Raby also has debt of £550,000 due in one
year. If the firm goes bankrupt, the bankruptcy costs will be
£80,000. The exchange rate for one euro in one year is forecast to
be £0.75 (probability 30% ) £0.85 (probability 40% ), or £0.90
(probability 30%). Assume the firm has no other cash flows, all
investors are risk-neutral and the discount rate is zero
(a) What is the expected value of the equityholders' and
debtholders' stakes in Raby, and the total value of the firm?
(b) Suppose Raby can hedge its euro exposure with a forward
exchange contract at € £0.84. What will be the expected cash flows
to debtholders and equityholders? What will be the total value of
the firm?
(c) Suppose now that Raby can hedge its euro exposure with a put
option with an exercise price of £0.85 and a premium of £0.025 per
euro. What will be the expected cash flows to debtholders and
equityholders? What will be the total value of the firm?
(d) Which of the three strategies in (a), (b) or (c) maximises
the value of the firm? What strategy will Raby's managers choose?
Are they the same? Carefully explain why/why not (max. of 150
words)
In one year, Raby Ltd, a UK company, expects cash flows of
£160,000 from its UK operations and €480,000 from its sales in the
European Union (EU). Raby also has debt of £550,000 due in one
year. If the firm goes bankrupt, the bankruptcy costs will be
£80,000. The exchange rate for one euro in one year is forecast to
be £0.75 (probability 30% ) £0.85 (probability 40% ), or £0.90
(probability 30%). Assume the firm has no other cash flows, all
investors are risk-neutral and the discount rate is zero
(a) What is the expected value of the equityholders' and
debtholders' stakes in Raby, and the total value of the firm?
(b) Suppose Raby can hedge its euro exposure with a forward
exchange contract at € £0.84. What will be the expected cash flows
to debtholders and equityholders? What will be the total value of
the firm?
(c) Suppose now that Raby can hedge its euro exposure with a put
option with an exercise price of £0.85 and a premium of £0.025 per
euro. What will be the expected cash flows to debtholders and
equityholders? What will be the total value of the firm?
(d) Which of the three strategies in (a), (b) or (c) maximises
the value of the firm? What strategy will Raby's managers choose?
Are they the same? Carefully explain why/why not (max. of 150
words)