helpHorward Bay $($HB$)$ is a Canadian company. It manufactures high quality footwear and

handbags and operates its own outlets in major cities in Canada. Recently, the

management of $HB$ made a strategic decision to increase its presence and sales in

foreign countries. As a start, $HB$ has agreed to open an outlet in Kuala Lumpur,

Malaysia. HB will establish a foreign subsidiary in Kuala Lumpur to operate this new

outlet

Kuala Lumpur has been identified as a strategic location for the new outlet based on a

few favorable factors. The political condition in Malaysia has been stable and therefore

the investment is regarded as low$-$risk investment, The cost of operating a business in

Kuala Lumpur reasonable. Furthermore, Kuala Lumpur is one of the top tourist

destinations in Southeast Asla. However, the management of HB is concerned with the

fluctuation in the foreign exchange rate as that would affect the company financial

performance. HB will be facing with the translation exposure. Any unfavorable

movement in exchange rates would have a negative effect on the group consolidated

earnings

The initial investment outlay in the Canadian dollar $($CAD$)$ to establish the new outlet

is estimated at CAD$2$ million. The forecasted net cash flows after tax $($at the end of year$)$

in ringgit $($RM$)$ from this new outlet for the next five years are as follows:

HB$\text{'}$s capital structure consists of equity and debt. its equity has a market value of

CAD$300$ milion. The value of its debt is CAD$200$million. it pays a $5$ percent rate of

interest on its debt and it has a beta of $1\mathrm{.}5.$ The market return in Canada is $9$ percent,

while the risk$-$free rate is $3$ percent. The tax rate in Canada is $30$ percent. The risk$-$free

rate in Malaysia is $5$ percent.

The current spot exchange rate is CAD$0\mathrm{.}291/$RM$.$ The purchasing power parity holds

with respect to the ringgit and the Canadian dollar, The inflation rate per year is

estimated at $2$ percent in Canada and $4$ percent in Malaysia over the next five years.

REQUIRED:

$($a$)$Discuss the importance of cost of capital in investment appraisal.

$(5$ Marks$)$

$($b$)$ Compute HB$\text{'}$s cost of capital.

$(5$ Marks$)$

$($c$)$ Determine whether it is appropriate for $HB$ to undertake the investment in Kuala

Lumpur, Malaysia.

$(10$ Marks$)$

$($d$)$ Explain whether the translation exposure should be a concern to the management of

$HB.$

$(5$ Marks$)$

$($e$)$ Discuss the strategy that $HB$ could implement to manage the translation exposure if

$HB$ uses a forward hedge.

$(5$ Marks$)$