:Solve.

Question 1

Harvey plc, a UK-based multinational corporation, expects to make a payment of 4 million New Zealand dollars (NZ$) to a New Zealand supplier, in 90 days' time. The current spot exchange rate is 2.11 NZ$/. Harvey plc is concerned about the exchange rate risk associated with this payment and has estimated the following probability distribution for the exchange rate in 90 days time:

Exchange rate NZ$/ Probability

2.15 0.25

2.10 0.5

2.05 0.25

Harvey plc has obtained the following information: ?

An over-the-counter call option on the NZ$ is available, with an exercise price of 2.11 NZ$ and at a premium cost of 0.01 per NZ$. ? A 90-day forward exchange contract is available at a rate of 2.08 NZ$/. ? Alternatively, Harvey plc could leave the payment unhedged.

a) Calculate the expected value outcome of each hedging strategy and of leaving the payment unhedged.

b) Assume now that annual interest rates for New Zealand and the UK are as follows:

NZ$Deposit rate % NZ$Borrowing rate %

5.8 6.2

Deposit rate % Borrowing rate %

6 6.6

Explain how Harvey plc could make use of a money market hedge to manage the risk of its payment to the New Zealand supplier and calculate the outcome of this strategy.

c) Discuss your results from parts

(a) and (b) and advise Harvey plc on their choice of strategy.

Question 2

a) Discuss the motives for multinational corporations to attempt to forecast future currency exchange rates.

b) Assume that the spot rate of the Australian dollar is 0.67. The three-year annualized interest rate in the United Kingdom is 2 per cent and the three-year annualized interest rate in Australia is 4.25 per cent. Assume also that interest rate parity holds for a three-year horizon. If the forward rate is used to forecast exchange rates, calculate the forecast spot rate for the Australian dollar in three years' time.

c) Assume that the spot rate of the pound in US dollars is $1.50 and that the spot rate of the Danish krone is 0.11. Assume also that the following information is available regarding one-year interest and inflation rates:

US UK Denmark

Nominal interest rate 2% 5% 5%

Expected inflation 1% 3% 2%

Using both purchasing power parity and International Fisher Effect theories, calculate the expected spot rate of the Danish krone in one year's time with respect to the US dollar.

d) The table below shows forecast and actual values for the Canadian dollar and Hong Kong dollar over several time periods:

Period C$ Forecast Actual C$ value HK$ forecast Actual HK$ value

1 0.63 0.62 0.080 0.080

2 0.64 0.62 0.081 0.083

3 0.62 0.63 0.080 0.082

4 0.63 0.65 0.082 0.081

Using appropriate calculations, determine which of the two currencies was forecast with greater accuracy.

You will demonstrate the importance of diminishing returns to capital in the Solow-Swan model. Draw a Solow-Swan diagram in which there are constant returns to capital. This would happen if the production function were Yt = AKt. Furthermore, assume that the sum of population growth and the depreciation rate is less than the saving rate. Does the economy converge to a steady state in this case?

To answer this question, you should draw a Solow-Swan diagram in terms of output per person, as we did in class. Use this diagram to explain why the economy converges to a steady state or not.

27. Consider a company XYZ. As of today, it has 1,000,000 shares of stock outstand- ing, trading at $50 per share and no debt. Assume that tomorrow the company de- cides, unexpectedly, to invest in a new project, which requires an initial investment of $10,000,000 today and is expected to produce a growing stream of cash flows, start- ing from $1,200,000 in one year from now and growing at 3% per year. The cost of capital for the new project is estimated at 12%. These new investment plans are not yet known. The company decides to finance the new project by issuing equity. It would like to issue just enough shares to raise the necessary $10,000,000 for the initial investment. (a) How many shares should the company issue? (b) What will be the share price after the new project is adopted? (c) How would your answer change if the investment in the new project was not unexpected, but rather was well known to the market a month in advance? 28. Your rich aunt has died. Her will gives you ownership of 5,000 shares of Plum Creek Timber Company, currently trading at $22 per share. But various legal complications will delay distribution of your aunts shares to you until October 2008. Plum Creek now pays an annual dividend of $1.40 per share. Assume for simplicity that the next dividend will be paid in September 2008, just before you will receive the shares. (Therefore you will not receive the next dividend.) In the past Plum Creeks dividend has increased by 3% per year. This is a reasonable long-term trend, but security analysts are pessimistic for the immediate future. They forecast no growth in earnings and dividends for the next 3 years. Plum Creek is a relatively safe security. Investors are content with an 8% expected rate of return. A bank offers to buy the shares from you for $18.50 per share paid immediately. (The bank would pay $18.50 per share now and receive the shares next October.) Is this a fair offer? 29. Chucky Cheese has a cost of capital of 9% per year. Its expected EPS next year is $5.00. The firm plans to plow back 40% of its earnings for new investments in the following years. The ROE on the new investments is 12%. (a) Calculate the share price and the P/E ratio of this firm. (b) If the plowback ratio increases, will the P/E ratio increase, decrease or remain unaffected? State any assumptions you make and give a brief justification. (c) Given your answer to b), what will be your advice to this firm on its dividend policy? 30. iDoc, a health service company, is expected to generate $1 in earnings per share next year and in the years to follow, from its existing assets. It plans to announce a new program to expand its business. This new program will increase its plow back ratio Fall 2008 Page 33 of 66 from zero to 50% next year. The return on equity for the new investments will be 12%. The expansion is expected to continue forever at the same rate. The cost of capital is 10%. (a) What is the expected dividend next year and its future growth under the new program? (b) What is the change in iDoc's stock price in response the announcement? (c) Is iDoc a growth company? What is its P/E ratio before and after the announce- ment? 31. MW Co. expects earnings of $1.25 per share next year, out of which $0.50 will be paid out as dividends. Earning and dividends are expected to grow at a constant rate g each year afterwards. MW shares are now traded at $20. The cost of capital for MW Co. is 10%. (a) What is the expected growth rate of earnings g? (b) What is the ROE for MW? (c) Is MW a growth company? Justify your answer.53. Assume the spot rates for year 1, year 2 and year 3 are 3.5%, 4% and 4.5%, respectively. There are a 3-year zero coupon bond and a 3-year coupon bond that pays a 5% coupon annually. (a) What are the YTMs of the bonds? (b) Calculate all 1-year forward rates. (c) Calculate the realized returns of the two bonds over the next year if the yield curve does not change. (In year 1 the 1-year spot rate is 3.5%, the 2-year spot rate is 4% and the 3-year spot rate is 4.5%.) 54. A pension plan is obligated to make disbursements of $1 million, $2 million and $1 million at the end of each of the next three years, respectively. Find the durations of the plan's obligations if the interest rate is 10% annually. 55. A local bank has the following balance sheet: Asset Liability Loans $100 million | Deposits $90 million Equity $10 million The duration of the loans is 4 years and the duration of the deposits is 2 years. (a) What is the duration of the bank's equity? How would you interpret the duration of the equity? (b) Suppose that the yield curve moves from 6% to 6.5%. What is the change in the bank's equity value? The term structure is flat at 6%. A bond has 10 years to maturity, face value $100, and annual coupon rate 5%. Interest rates are expressed as EARs. 56. (a) Compute the bond price. (b) Compute the bond's duration and modified duration. (c) Suppose the term structure moves up to 7% (still staying flat). What is the bond's new price' (d) Compute the approximate price change using duration, and compare it to the actual price change. 57. Suppose Microsoft, which has billions invested in short-term debt securities, undertakes the following two-step transaction on Dec. 30, 2009. (1) Sell $1 billion market value of 6-month U.S. Treasury bills yielding 4% (6 month spot rate). (2) Buy $1 billion of 10- year Treasury notes. The notes have a 5.5% coupon and are trading at par. Microsoft does not need the $1 billion for its operations and will hold the notes to maturity. Fall 2008 Page 24 of 66 (a) What is the impact of this two-step transaction on Microsoft's earnings for the first 6 months of 2010? (b) What is the transaction's NPV? Briefly explain your answers. 58. The Treasury bond maturing on August 15, 2017 traded at a closing ask price of 133:16 (i.e., $133 16/32) on August 31, 2007. The coupon rate is 8.875%, paid semi-annually. The yield to maturity was 4.63% (with semi-annual compounding). (a) Explain in detail how this yield to maturity was calculated. (b) Discount the bond's cash flows, using the yield to maturity. Can you replicate the ask price? (The replication should be close but won't be exact.) Show your calculations