26 Accounting for uncertain cash flows. Blustream Ltd considers a project in which it will sell the use of its technology to firms in South Africa. It already has received orders from South African firms that will generate R2 000 000 in revenue at the end of the next year. However, it might also receive a contract to provide this technology to the South African government.

In this case, it will generate a total of R5 000 000 at the end of the next year. It will not know whether it will receive the government order until the end of the year.

Today’s spot rate of the rand is £0.11. The oneyear forward rate is £0.09. Blustream expects that the spot rate of the rand will be £0.10 one year from now. The only initial outlay will be £200 000 to cover development expenses (regardless of whether the South African government purchases the technology).

Blustream will pursue the project only if it can satisfy its required rate of return of 18%. Ignore possible tax effects. It decides to hedge the maximum amount of revenue that it will receive from the project.

a Determine the NPV if Blustream receives the government contract.

b If Blustream does not receive the contract, it will have hedged more than it needed to and will offset the excess forward sales by purchasing rand in the spot market at the time the forward sale is executed. Determine the NPV of the project assuming that Blustream does not receive the government contract.

c Now consider an alternative strategy in which Blustream only hedges the minimum rand revenue that it will receive. In this case, any revenue due to the government contract would not be hedged. Determine the NPV based on this alternative strategy and assume that Blustream receives the government contract.

d If Blustream uses the alternative strategy of only hedging the minimum rand revenue that it will receive, determine the NPV assuming that it does not receive the government contract.

e If there is a 50% chance that Blustream will receive the government contract, would you advise Blustream to hedge the maximum amount or the minimum amount of revenue that it may receive? Explain.

f Blustream recognizes that it is exposed to exchange rate risk whether it hedges the minimum amount or the maximum amount of revenue it will receive. It considers a new strategy of hedging the minimum amount it will receive with a forward contract and hedging the additional revenue it might receive with a put option on South African rand. The one-year put option has an exercise price of £0.11 and a premium of

£0.01. Determine the NPV if Blustream uses this strategy and receives the government contract.

Also, determine the NPV if Blustream uses this strategy and does not receive the government contract. Given that there is a 50% probability that Blustream will receive the government contract, would you use this new strategy or the strategy that you selected in question (e)?