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Ocean Drilling, Inc Case study

Lastly, the down payments for both the bids have been deducted in 1981, which is the first year. Then the free cash flows have been calculated. The cost of debt of 20% of the company has been used as the cost of capital for the appraisal of both the bids. The net present value for both the bids has been calculated which has been computed to be around $ 337.65 million for bid 1 whose shipyard is located in France and $ 347.29 million for bid 2 whose shipyard is located in Japan. Therefore, based on the net present value, if the company accepts bid 2, then it is going to create more value for its shareholders.

Future Outlook of Exchange Rates

If we look at exhibit 7 that provides the economic data for France and Japan against US dollars, then we can easily forecast the future exchange rate movements for the French franc and the Japanese yen using the historical exchange rates (Evans, 2005). First of all, if we look at the growth rates of French franc, then based on those growth rates the average exchange rate growth rate has been calculated that is 4%. This is favorable for the company since the French franc is depreciating against the US dollars. This means that in future years, the company could get more French francs in return for each dollar as compared to the current spot exchange rates (Rime, 2007). It is shown in the table below:

On the other hand, when the average growth rate for the Japanese Yen has been calculated, then it can be seen that the average exchange growth rate for the Japanese yen for the next couple of years is -5%. This is unfavorable for the company since the Japanese yen is appreciating against the US dollars. This means that in the future, the company could get less Japanese Yen in return for each dollar as compared to the current spot exchange rates. It is shown in the table below:

Valuation of Financial Subsidies

The valuation of the financial subsidies has been provided again on the basis of the present value method. First of all, the cash flows related to the subsidized loans have been accumulated in US dollar terms. Then based on the forecasted exchange rates that have been calculated previously, all the US dollar cash flows for bid 1 have been converted into French francs and the US$ cash flows for bid 2 have been converted into Japanese yen.

Along with this, Ocean Drillings cost of capital is 20%, but for valuing the financing subsidies of both the bids, this cost of capital has been converted into the foreign cost of capital for France and Japan based upon the exchange rate movements. Lastly, in order to compare the valuation of the financial subsidies of both the bids, the valuation figure in foreign currency has been converted in dollars based on the spot exchange rates.

The valuation of the financing subsidies for bid 1 is $ 69.11 and for bid 2 is $ 60.08. Despite the fact that the net present value for the bid 2 is higher, the valuation of the financial subsidies for bid 2 is lower than bid 1. This shows that the difference in the valuation of both the bids is strongly associated with the changes in the exchange rate movements.

Alternatives

The board of directors of Ocean Drilling Incorporation has received two bids and both the bids are mutually exclusive. Therefore, this means that the management of the company has two alternatives that are either to go ahead and accept bid 1 or accept bid 2.

Alternative 1: Accepting Bid from France Shipyard

The movement of the future exchange rate for the company if it accepts bid 1 would be favorable. Furthermore, the net present value for this bid has been calculated to be around $ 337.65 million. Although the future exchange rate in France seems to be favorable however, still the company needs to consider the hedging strategies. Two hedging strategies have been considered to hedge for the risk of unfavorable exchange rate movement in future. The first hedging strategy is the forward contract hedging. Under this option, the management would lock the future exchange rate and then sell the US dollars at that forward exchange rate (Alayannis, 2001). Nonetheless, the management would not be able to take the advantage of the favorable exchange rates in future. Under this option, the cost of the management would be 8% in percentage terms.

The second hedging option for the company is to go for a money market hedge. Under a money market hedge, the company would borrow the loan amount in the domestic currency, convert those proceeds into foreign currency and invest it in foreign market (Albuquerque, 2007). Since the company is looking for short term investment therefore, short term interest rate has been used. Based on this option, the cost would be 12%.

Alternative 2: Accepting Bid for Japan Shipyard

The movement of the future exchange rate for the company if it accepts bid 1 would be unfavorable. Furthermore, the net present value for this bid has been calculated to be around $ 347.29 million. As the future exchange rate in France seems to be unfavorable, therefore the company needs to consider the hedging strategies to mitigate the foreign exchange risk.

Then again two hedging strategies have been considered for the company. The first one is the forward hedge and the cost of the company under this option would be 19%. The second hedging strategy is the money market hedge. The process would remain same as for bid 1. The total cost under a money market hedge would be 17%