SCENARIO 3. S&S Ltd is a US-based company manufacturing and selling premium quality kayaks in the US market. S&S Ltd exp

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SCENARIO
3. S&S Ltd is a US-based company manufacturing and selling
premium quality kayaks in the US market. S&S Ltd exports kayak
to New Zealand and the United Kingdom. Currently, S&S Ltd has
no existing business in New Zealand but is considering establishing
a subsidiary. S&S Ltd is due to receive £6,000,000 in 3 months’
time from a customer for the United Kingdom. The top management of
the company is very much concern about the reported foreign
exchange losses. The external finical envi-ronment has become
highly volatile, the top management is intended to identify and
implement strate-gies to mitigate the foreign exchange risk of the
company.
The following information has been gathered by accounting staff
related to the transactions stated above.
Following information related to the money market has been given to
you.
Spot Rate: £ /$ 0.6822
3-month forward rate £ /$ 0.6731
Current interest rates: US prime 4.2% – 4.8% per annum
UK LIBOR 2.6% – 2.9% per annum
Following information related foreign project ( setting up as
project in New Zealand) has been given to you.
The initial investment required is 40 million in New Zealand
dollars (NZ$). Given the existing spot rate of $0.5 per New Zealand
dollar, the initial investment in U.S. dollars is $ 20 million. In
addition to the NZ$ 40 million initial investment for plant and
equipment, NZ$10 million is needed for working capital and will be
borrowed by the subsidiary from a New Zealand bank. The New Zealand
subsidiary will pay interest only on the loan each year, at an
interest rate of 8 per cent. The loan principal is to be paid in 3
years. In three years, the subsidiary is to be sold. S&S Ltd
plans to settle the New Zealand loan by using the salvage value.
The working capital will not be liquidated but will be used by the
acquiring firm when it sells the subsidiary. S&S Ltd expects to
receive NZ $28 million after subtracting capital gains taxes
(Acquiring firm will not take the bank loan). Assume that this
amount is not subject to a withholding tax.
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Forecast of demand for Kayak and other expenses.
The project will be terminated at the end of Year 3 when the
subsidiary will be sold.
The price, demand, and variable cost of the product in New Zealand
are as follows:
Year Price Demand Variable Cost
1 NZ$400 60,000 units NZ$200
2 NZ$??? ????? units NZ$???
3 NZ$??? ????? units NZ$???
✓ The expected inflation in New Zeeland is 10%, hence the selling
price of Kayak and variable cost will increase by10% every year.
(Year 2 and year 3).
✓ The demand for the product expected to increase by 20% every year
(Year 2 and year 3).
✓ The fixed costs, such as overhead expenses, are estimated to be
NZ$1,500,000 per year and assume it will not change due to
inflation.
✓ The exchange rate of the New Zealand dollar is expected to be
$0.55 at the end of Year 1, $0.60 at the end of Year 2, and $0.65
at the end of Year 3.
Tax policies of New Zealand government
The New Zealand government will impose an income tax of 25% per
cent on income. In addition, it will impose a withholding tax of
10% per cent on earnings remitted by the subsidiary. The U.S.
government will allow a tax credit on the remitted earnings and
will not impose any additional taxes.
Other information
All cash flows received by the subsidiary are to be sent to the
parent at the end of each year. The subsidiary will use its working
capital to support ongoing operations.
The plant and equipment are depreciated over 3 years using the
straight-line depreciation method. Cost of the plant and machines
was NZ$40,000,000 and salvage value is NZ$28,000,000.
S&S Ltd requires a 15% per cent rate of return on this
project.
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Required
a. S&S Ltd is due to receive £6,000,000 in 3 months’ time from
a customer for the United Kingdom. Advice the management of S&S
Ltd, the possible outcome of using the forward contract to mitigate
the forex risk exposed in the above transaction using the
information given about the money market. You may compare possible
other methods available (excluding money market hedging) for
mitigating the above Forex risk. (support your answer with
calculations) (10 marks)
b. S&S Ltd is due to receive £6,000,000 in 3 months’ time from
a customer for the United Kingdom. Advice the management of S&S
Ltd, the possible outcome of using the money market to hedge the
forex risk exposed in the above transaction using the information
given about the money market. (support your answer with
calculations)
(10 marks)
c. You are required to advise the management on taking up this
project. (Top management keen to know the following aspects)
✓ NPV of the project
✓ Political Risk Characteristics and Financial Risk Characteristics
S&S Ltd face in stating the business in New Zealand and
application of Risk-adjusted discount rate.
(30 marks)