United Airlines has just signed a contract to purchase some A320 planes from Airbus for 100,000,000 euros. The payment is due six months or 180 days later. You are in the Treasury department of United Airlines and need to make a recommendation to the Treasurer regarding how best to hedge the exchange rate risk of this transaction. You have gathered the following information:

• The spot exchange rate is $1.1000/. That is to say, 1 euro = 1.1000 US dollars
• The six-month forward rate is $1.1100/
• The companys cost of capital is 12% per annum.
• The euro 6-month borrowing rate is 4% per annum (or 2% for 6 months)
• The euro 6-month lending rate is 2% per annum (or 1% for 6 months)
• The US dollar 6-month borrowing rate is 5% per annum (or 2.5% for 6 months)
• The US dollar 6-month lending rate is 3% per annum (or 1.5% for 6 months)
• The premium on six-month call options on the euro with strike price $1.1100 is 2%.

You need to compute the total cost in dollars of each hedging alternative. Note that the phrase total cost in dollars refers to the total cash outflow in dollars when the payment is made in six months. Also, keep in mind that cash flows that occur at different points in time are not directly comparable. You need to put them on a common footing by computing their present value or future value.

a) Suppose that United Airlines were to hedge its transaction exposure using a forward contract. Should the firm sell or buy euros forward? What is the total cost in dollars (i.e., what will be the total cash outflow in dollars in six months)? (3 points)

b) Suppose United Airlines chooses a money market hedge. Spell out the transactions that the firm will need to undertake to implement this hedge. What is the total cost in dollars using this hedge? (3 point

c) Suppose United Airlines decides to hedge using a call option on the euro.

(i) Suppose that the spot rate in 6 months is $1.05 per euro. Will United exercise the call option? What will be the total cost in dollars after taking into account (the future value of) the cost of the option? (2 points)

(ii) Suppose that the spot rate in 6 months is $1.15 per euro. Will United exercise the call option? What will be the total cost in dollars after taking into account (the future value of) the cost of the option? (2 points)

d) Suppose that you strongly expect the euro to appreciate. In that case, which of the hedging alternatives would you recommend? Briefly justify your recommendation (2 points

e) Suppose that you expect the euro to depreciate. How much does the euro need to depreciate in order to make the call option a better alternative than the forward contract? In other words, how low does the euro have to go in value to make the call option a better alternative than the forward contract? Explain your calculations. (3

2. a) Distinguish between an illiquid and a segmented capital market. Briefly discuss what effect capital market illiquidity and segmentation may have on the cost of capital of a firm. (7 points)

b) This question is based on Exhibit 13.3 in chapter 13 of the textbook. In this example, Nestles cost of equity is calculated using two different market portfolios, a domestic market portfolio and a global market portfolio. Which of these is more appropriate? Support your answer with appropriate arguments. (8 points)

3. Duncan Associates, a U.S.-based investment partnership, borrows 300 million yen for 3 years from Mizuho bank. Interest on this loan is payable annually at a rate of 4%. The current exchange rate is 135.00/$, and the yen is expected to strengthen against the dollar by 2.5% per annum. Compute the cash flows of the loan both in yen and in dollars, and calculate the effective cost (i.e., the effective interest rate) of this yen-denominated loan in dollars (based on the expected change in the exchange rate). (10 points)

4. Slinger Wayne, a U.S.-based private equity firm, is trying to determine what it should pay for a tool manufacturing firm in Honduras named Carambola. Slinger Wayne estimates that Carambola will generate a free cash flow of 15 million Honduran lempiras (Lp) next year, and that this free cash flow will continue to grow at a constant rate of 5% per annum indefinitely.

A private equity firm like Slinger Wayne, however, is not interested in owning a company for long, and plans to sell Carambola at the end of three years for 10 times Carambola's free cash flow in that year. The current spot exchange rate is Lp 26.00 = $1.00, but the Honduran inflation rate is expected to remain at a relatively high rate of 12% per annum compared to the U.S. dollar inflation rate of only 3% per annum. Slinger Wayne expects to earn at least a 18% annual rate of return on international investments like Carambola.

What is Carambola worth if the Honduran lempira were to change in value over time according to purchasing power parity? (10 points)