Question 1

Lyon Plc., based in France, a country that uses the Euro (), is a company that specialises in making eco-friendly, computerized production machines for manufacturing companies around the world. It has just completed a major project in the USA and is due to receive the final payment of US$20 million in four months.

Lyon Plc. is planning to commence a major project in Kenya, in six months time. This government-owned project is expected to last for three years during which time Lyon Plc. will complete the construction and assembly of ultra-modern machines for three companies as well as providing training to these companies in maintaining the machines. The eco- friendly status of the building project has attracted some grant funding from the European Union and these funds will be provided to the Kenyan government in Kenyan Shillings (Kshs).

Lyon Plc. intends to finance the project using the US$20 million it is due to receive and borrow the rest through an Euro () denominated loan. It is intended that the US$ receipts will be converted into Euro and invested in short-dated treasury bills until they are required. These funds plus the loan will be converted into Kenyan Shillings on the date required, at the spot rate at that time.

Kenyan government requires Lyon Plc. to deposit the Kshs 2.64 billion it needs for the project, with the Kenyan central bank, at the commencement of the project. In return, Lyon Plc. will receive a fixed sum of Kshs1.5 billion after tax, at the end of each year for a period of three years. Neither of these amounts is subject to inflationary increases. The relevant risk adjusted discount rate for the project is assumed to be 12%.

Financial information Per 1

Exchange rates available to Lyon Plc.

Per 1 Per 1

Spot US$1.3585US$1.3618 Kshs101Kshs104

4-month forward US$1.3588US$1.3623 Not available

Currency futures (Contract size 125,000, Quotation: US$ per 1)

2-month expiry US$ 1.3633 = 1

5-month expiry US$ 1.3698 = 1

Currency options (Contract size 125,000, Exercise price quotation: US$ per 1)

Calls Puts

Exercise price 2-month expiry 5- month expiry 2-month expiry 5- month expiry

136 2.35 2.80 2.47 2.98

138 1.88 2.23 4.23 4.64

Lyon Plc. Local Government Base Rate 2.20%

Kenyan Government Base Rate 10.80%

Yield on short-dated Euro Treasury Bills 1.80%

assume 360-day year

Kenyas current annual inflation rate is 9.7% and is expected to remain at this level for the next six months. However, after that, there is considerable uncertainty about the future and the annual level of inflation could be anywhere between 5% and 15% for the next few years. The country where Lyon Plc. is based is expected to have a stable level of inflation at 1.2% per year for the foreseeable future. A local bank in Kenya has offered Lyon Plc. the opportunity to swap the annual income of Kshs1.5 billion receivable in each of the next three years for Euros, at the estimated annual Kshs/ forward rates based on the current government base rates.

Required

1. Advise Lyon Plc. on, and recommend, an appropriate hedging strategy for the US$ income it is due to receive in four months. (All relevant calculations should be included) (14 Marks)

2. Given that Lyon Plc. agrees to the local banks offer of the swap, calculate the net present value of the project, in six months time, in . Discuss whether the swap would be beneficial to Lyon Plc. (6 Marks)