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Question 2

 

1. a) Critically evaluate five of the theoretical explanations put forward in the finance literature for hedging corporate exposure by firms

 

 

1. b) Evaluate the extent to which empirical findings support the theoretical explanations you have considered above.

 

 

Any five of the following should be discussed:

Taxation

Agency costs

Financial distress and bankruptcy

Clientele effects

Asymmetrical information

Transaction cost

Imperfect financial markets, International CAPM and wealth transfer

Parity relations if they do not hold

“Non-diversifiability” of FX rate changes and forward rate bias

Risk aversion, human-specific capital (including managerial compensation) and unique goods

APT can apply in the sense that investors might be willing to pay a price for the shares of firms that hedge.  If APT were to hold at least for some firms, then this can be linked with the clientele effect argument as the stock prices of the firms that hedge will be priced differently from those that do not hedge. Empirical evidence (Jorion, 1991) does not provide support for the pricing of FX risk in the stock market.

 

 

Empirical evidence

Studies by Nance et al (1993) and Joseph and Hewins (1997), among others will be useful here. Booth et al (1984) show that the difference in the use of interest rate futures among US banks and savings and loan associations (S&Ls) is due to the greater size of S&Ls and the higher probability that they encounter interest rate related financial distress. While Block and Gallagher (1986) show that the difference in the use of interest rate futures and options among the Fortune 500 largest US firms is also due to size, their result that firms with higher debt/equity ratios are more likely to hedge is not statistically significant.  Nance et al (1993) addressed the theoretical rationales for hedging by identifying differences in the financial characteristics of firms that hedge and those that do not hedge.  Their empirical study shows that firms that hedge have more income tax credits and tax loss carry-forwards, and more of their pre-tax income in the progressive region of the tax schedule.  Joseph and Hewins (1997) find weak evidence for financial distress although this may have been due to the relatively large size of firms in their sample. However, they find that reducing the fluctuation of operation cash flows was the main motive for hedging. Furthermore, firms that hedged more exhibited a lower level of variability of cash flows. Recently Clark and Judge (2006, RFE) show that UK firms hedge to preserve growth opportunities, liquidity and reduce the risk of bankruptcy.  This will depend on which five arguments addressed in part a).

 

 

 

 

Question 6

 

Extracts from the Profit and Loss account of a European subsidiary of a UK parent company for the year ended 31 December 2009 are as follows:

 

Sales turnover                                                                      880

Cost of gods sold (COGS)                                                 380

Gross profit                                                                           500

 

                        (Figures in thousands of Euros)

 

The subsidiary has a long-term debt of Euros 300,000 on which it pays a fixed interest rate of 12.5% p.a. The UK parent company expects turnover and operational costs to be constant from one year to the next. The turnover and cost of goods sold are unsettled (unpaid) financial obligations and the interest on long-term debt is contractually fixed. The local corporation tax rate is 40%.  Potential changes in the sterling value of foreign debt and the foreign exchange rate are not diversified. The international (universal) price for each unit of risk which excludes foreign exchange rate risk is expected to be £0.55. The covariance of the subsidiary’s net income after tax with that of the aggregate net income of all marketable companies is expected to be 2,400 (in pounds). The parent company employs a risk-free rate of return of 5% in domestic terms. The parent company wants to value the foreign subsidiary on the expectation that it will provide a non-growing stream of cash flows for one (future) period. All debt obligations are met by the parent company.

 

For the year ended 31 December 2010, the MNC’s Treasury Department predicts that the midpoint spot rate for the Euros to be 1.350 to one US dollar. Similarly, the United States dollar is predicted to be US$ 1.500 to one pound.

 

(All values are in real terms).

 

 

 

Required:

 

(a)       Using the international capital asset pricing model (ICAPM), calculate in pounds for period t, the expected market value of the European subsidiary given the level of its fixed debt.

 

[25 marks]

 

(b)       Ignoring part (a), both the Euro and US dollars are expected to remain relatively stable during most of 2010. However, the Treasury Department predicts that during the latter part of 2010, while the Euro will appreciate against the US dollar to Euro1.200, the US dollar will depreciate against the pound to USD 1.700. As turnover and cost of sales are very short-term in nature, these are expected to be settled at the original forecast prices of 31 December 2010.  All other values are expected to remain unchanged in real terms, except for the interest on long-term local debt.  Using the ICAPM, calculate in pounds for period t, the expected market value of the foreign subsidiary under this condition.

 

[25 marks]

 

• Provide an explanation for your answers in a) and b) above and in the context of the ICAPM evaluate the extent to which hedging the value of a levered/geared foreign subsidiary is likely to be beneficial.

 

[50 marks]

1. c) The following points should be discussed:

As long as there are no structural shifts in the world economy, the real cash flow of the unlevered firm is unaffected by exchange rate changes.  Under ICAPM, PPP, IRP and IFE are all assumed to hold. In this framework, all monetary disparities disappear leaving constant real returns. With fixed long-term contractual debt and foreign exchange rate fluctuations, the value of the subsidiary will be affected since the financial obligation of the parent will alter according to the exchange rate change.

 

In our case, the Euro will have a net depreciation against the pound. That is, (1.35*1.50)= €2.025 to  one pound vs.  (1.20*1.7)=€2.04 to one pound.  This will make the debt  less expensive to the UK parent and therefore will increase the subsidiary’s value. Hence, the increase in the PV of the subsidiary from £128.226K to £128.304. The increase in the subsidiary’s value will therefore result in a transfer of wealth from lenders to the multinational’s shareholders. The reverse would have applied for an appreciation of the Canadian dollar.

 

The fluctuation in the value of the levered firm is unsystematic and the risk premium does not account for this. Students should explore the effectiveness and usefulness of hedging and the efficiency of FX markets.

 

The (in)variance of the firm’s value and the validity of monetary relations should also be considered. The fluctuation in subsidiary’s value could be hedged in the FX market or other financial market. Students may argue that in theory, the firm may not be able to hedge more cheaply and effectively than shareholders (i.e., against M&M).

 

 

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