. S&S Ltd is a US-based company manufacturing and selling premium quality kayaks in the US market. S&S Ltd exports kayak to New Zealand and the United Kingdom. Currently, S&S Ltd has no existing business in New Zealand but is considering establishing a subsidiary. S&S Ltd is due to receive 6,000,000 in 3 months time from a customer for the United Kingdom. The top management of the company is very much concern about the reported foreign exchange losses. The external finical environment has become highly volatile, the top management is intended to identify and implement strategies to mitigate the foreign exchange risk of the company. The following information has been gathered by accounting staff related to the transactions stated above. Following information related to the money market has been given to you. Spot Rate: /$ 0.6822 3-month forward rate /$ 0.6731 Current interest rates: US prime 4.2% 4.8% per annum UK LIBOR 2.6% 2.9% per annum Following information related foreign project ( setting up as project in New Zealand) has been given to you. The initial investment required is 40 million in New Zealand dollars (NZ$). Given the existing spot rate of $0.5 per New Zealand dollar, the initial investment in U.S. dollars is $ 20 million. In addition to the NZ$ 40 million initial investment for plant and equipment, NZ$10 million is needed for working capital and will be borrowed by the subsidiary from a New Zealand bank. The New Zealand subsidiary will pay interest only on the loan each year, at an interest rate of 8 per cent. The loan principal is to be paid in 3 years. In three years, the subsidiary is to be sold. S&S Ltd plans to settle the New Zealand loan by using the salvage value. The working capital will not be liquidated but will be used by the acquiring firm when it sells the subsidiary. S&S Ltd expects to receive NZ $28 million after subtracting capital gains taxes (Acquiring firm will not take the bank loan). Assume that this amount is not subject to a withholding tax. 5 Forecast of demand for Kayak and other expenses. The project will be terminated at the end of Year 3 when the subsidiary will be sold. The price, demand, and variable cost of the product in New Zealand are as follows: Year Price Demand Variable Cost 1 NZ$400 60,000 units NZ$200 2 NZ$??? ????? units NZ$??? 3 NZ$??? ????? units NZ$??? The expected inflation in New Zeeland is 10%, hence the selling price of Kayak and variable cost will increase by10% every year. (Year 2 and year 3). The demand for the product expected to increase by 20% every year (Year 2 and year 3). The fixed costs, such as overhead expenses, are estimated to be NZ$1,500,000 per year and assume it will not change due to inflation. The exchange rate of the New Zealand dollar is expected to be $0.55 at the end of Year 1, $0.60 at the end of Year 2, and $0.65 at the end of Year 3. Tax policies of New Zealand government The New Zealand government will impose an income tax of 25% per cent on income. In addition, it will impose a withholding tax of 10% per cent on earnings remitted by the subsidiary. The U.S. government will allow a tax credit on the remitted earnings and will not impose any additional taxes. Other information All cash flows received by the subsidiary are to be sent to the parent at the end of each year. The subsidiary will use its working capital to support ongoing operations. The plant and equipment are depreciated over 3 years using the straight-line depreciation method. Cost of the plant and machines was NZ$40,000,000 and salvage value is NZ$28,000,000. S&S Ltd requires a 15% per cent rate of return on this project. 6 Required a. S&S Ltd is due to receive 6,000,000 in 3 months time from a customer for the United Kingdom. Advice the management of S&S Ltd, the possible outcome of using the forward contract to mitigate the forex risk exposed in the above transaction using the information given about the money market. You may compare possible other methods available (excluding money market hedging) for mitigating the above Forex risk. (support your answer with calculations) (10 marks) b. S&S Ltd is due to receive 6,000,000 in 3 months time from a customer for the United Kingdom. Advice the management of S&S Ltd, the possible outcome of using the money market to hedge the forex risk exposed in the above transaction using the information given about the money market. (support your answer with calculations) (10 marks) c. You are required to advise the management on taking up this project. (Top management keen to know the following aspects) NPV of the project Political Risk Characteristics and Financial Risk Characteristics S&S Ltd face in stating the business in New Zealand and application of Risk-adjusted discount rate. (30 marks) (. S&S Ltd is a US-based company manufacturing and selling premium quality kayaks in the US market. S&S Ltd exports kayak to New Zealand and the United Kingdom. Currently, S&S Ltd has no existing business in New Zealand but is considering establishing a subsidiary. S&S Ltd is due to receive 6,000,000 in 3 months time from a customer for the United Kingdom. The top management of the company is very much concern about the reported foreign exchange losses. The external finical environment has become highly volatile, the top management is intended to identify and implement strategies to mitigate the foreign exchange risk of the company. The following information has been gathered by accounting staff related to the transactions stated above. Following information related to the money market has been given to you. Spot Rate: /$ 0.6822 3-month forward rate /$ 0.6731 Current interest rates: US prime 4.2% 4.8% per annum UK LIBOR 2.6% 2.9% per annum Following information related foreign project ( setting up as project in New Zealand) has been given to you. The initial investment required is 40 million in New Zealand dollars (NZ$). Given the existing spot rate of $0.5 per New Zealand dollar, the initial investment in U.S. dollars is $ 20 million. In addition to the NZ$ 40 million initial investment for plant and equipment, NZ$10 million is needed for working capital and will be borrowed by the subsidiary from a New Zealand bank. The New Zealand subsidiary will pay interest only on the loan each year, at an interest rate of 8 per cent. The loan principal is to be paid in 3 years. In three years, the subsidiary is to be sold. S&S Ltd plans to settle the New Zealand loan by using the salvage value. The working capital will not be liquidated but will be used by the acquiring firm when it sells the subsidiary. S&S Ltd expects to receive NZ $28 million after subtracting capital gains taxes (Acquiring firm will not take the bank loan). Assume that this amount is not subject to a withholding tax. 5 Forecast of demand for Kayak and other expenses. The project will be terminated at the end of Year 3 when the subsidiary will be sold. The price, demand, and variable cost of the product in New Zealand are as follows: Year Price Demand Variable Cost 1 NZ$400 60,000 units NZ$200 2 NZ$??? ????? units NZ$??? 3 NZ$??? ????? units NZ$??? The expected inflation in New Zeeland is 10%, hence the selling price of Kayak and variable cost will increase by10% every year. (Year 2 and year 3). The demand for the product expected to increase by 20% every year (Year 2 and year 3). The fixed costs, such as overhead expenses, are estimated to be NZ$1,500,000 per year and assume it will not change due to inflation. The exchange rate of the New Zealand dollar is expected to be $0.55 at the end of Year 1, $0.60 at the end of Year 2, and $0.65 at the end of Year 3. Tax policies of New Zealand government The New Zealand government will impose an income tax of 25% per cent on income. In addition, it will impose a withholding tax of 10% per cent on earnings remitted by the subsidiary. The U.S. government will allow a tax credit on the remitted earnings and will not impose any additional taxes. Other information All cash flows received by the subsidiary are to be sent to the parent at the end of each year. The subsidiary will use its working capital to support ongoing operations. The plant and equipment are depreciated over 3 years using the straight-line depreciation method. Cost of the plant and machines was NZ$40,000,000 and salvage value is NZ$28,000,000. S&S Ltd requires a 15% per cent rate of return on this project. 6 Required a. S&S Ltd is due to receive 6,000,000 in 3 months time from a customer for the United Kingdom. Advice the management of S&S Ltd, the possible outcome of using the forward contract to mitigate the forex risk exposed in the above transaction using the information given about the money market. You may compare possible other methods available (excluding money market hedging) for mitigating the above Forex risk. (support your answer with calculations) (10 marks) b. S&S Ltd is due to receive 6,000,000 in 3 months time from a customer for the United Kingdom. Advice the management of S&S Ltd, the possible outcome of using the money market to hedge the forex risk exposed in the above transaction using the information given about the money market. (support your answer with calculations) (10 marks) c. You are required to advise the management on taking up this project. (Top management keen to know the following aspects) NPV of the project Political Risk Characteristics and Financial Risk Characteristics S&S Ltd face in stating the business in New Zealand and application of Risk-adjusted discount rate. (30 marks) (