Washi Co is a large, unlisted company based in Japan and its local currency is the Japanese Yen (JPY). It manufactures industrial equipment and parts. Initially Washi Co’s customers consisted of other Japanese companies, but over the last 12 years it has expanded into overseas markets and also sources its materials from around the world. The company’s board of directors (BoD) believes that the strategy of overseas investments, through subsidiary companies, branches and joint ventures, has directly led to the company’s substantial increase in value in the past few years.
Washi Co’s BoD is considering investing in a project based in Airone, whose currency is the Airone Rand (ARD). It believes that the project will be an important addition to the company’s portfolio of investments, because Washi Co does not currently have a significant presence in the part of the world where Airone is located. It is intended that the project will commence in one year’s time. Details of the project are given below.
Washi Co intends to finance the project through proceeds from an agreed sale of a small European subsidiary, with any remaining funding requirement being met by additional debt finance issued in Japanese Yen. The company is due to receive the proceeds from the sale of a European subsidiary company in six months’ time and it will then invest these funds in short-dated Japanese treasury bills for a further six months before they are needed for the project. Washi Co has a centralised treasury department, which hedges expected future cash flows against currency fluctuations.
Funding and financial information
The agreed proceeds from the sale of the European subsidiary company receivable in six months’ time are Euro (EUR) 80 million. The BoD is concerned about a negative fluctuation in EUR/JPY rate between now and in six months when the EUR 80 million will be received. Therefore, it has asked Washi Co’s treasury department to hedge the expected receipt using one of currency forwards, currency futures or exchange traded currency options. Washi Co’s treasury department has obtained the following information:
JPY per EUR 1 ARD per EUR 1
Spot 129·2–132·4 92·7–95·6
Six-month forward rate 125·3–128·6
Currency futures (contract size EUR 125,000, quotation JPY per EUR 1)
Four-month expiry 126·9
Seven-month expiry 125·2
Currency options (contract size EUR 125,000, exercise price quotation: JPY per EUR 1, premium quotation: JPY per EUR 1)
At an exercise price of JPY 126·0 per EUR 1
Four-month expiry Seven-month expiry
Calls 2·3 2·6
Puts 3·4 3·8
Annualised yield on short-dated Japanese treasury bills 1·20%
Airone’s annual inflation rate is 9% currently, but has fluctuated markedly in the last five years. The Japanese annual inflation rate is 1·5% and has been stable for many years.
Pato Bank has offered Washi Co the possibility of using over-the-counter options to hedge the EUR receipt instead of exchange traded currency options.
Airone project information
A member of Washi Co’s finance team has produced the following estimates of the Airone project which is expected to last for four years. The estimates are based on the notes given below but not on the further information. The estimates have been checked and verified independently for their numerical accuracy.
All figures are in ARD millions
Discuss how investing in overseas projects may enable Washi Co to gain competitive advantage over its competitors, who only invest in domestic projects.
Washi Co may want to invest in overseas projects for a number of reasons which result in competitive advantage for it, for example:
Investing overseas may give Washi Co access to new markets and/or enable it to develop a market for its products in locations where none existed before. Being involved in marketing and selling products in overseas markets may also help it gain an understanding of the needs of customers, which it may not have had if it merely exported its products.
Investing overseas may give Washi Co easier and cheaper access to raw materials it needs. It would therefore make good strategic sense for it to undertake the overseas investment.
Investing in projects internationally may give Washi Co access to cheaper labour resources and/or access to expertise which may not be readily available in Japan. This could therefore lead to reduction in costs and give Washi Co an edge against its competitors.
Closer proximity to markets, raw materials and labour resources may enable Washi Co to reduce its costs. For example, transportation and other costs related to logistics may be reduced if products are manufactured close to the markets where they are sold.
Risk, such as economic risk resulting from long-term currency fluctuations, may be reduced where costs and revenues are matched and therefore naturally hedged.
Washi Co may increase its reputation because it is based in the country within which it trades leading to a competitive edge against its rivals.
International investments might reduce both the unsystematic and systematic risks for Washi Co if its shareholders only hold well diversified portfolios in domestic markets, but not internationally.
(Note: Credit will be given for alternative valid areas of discussion)
Discuss the advantages and drawbacks of exchange traded option contracts compared with over-the-counter options.
Advantages
Exchange traded options are readily available on the financial markets, their price and contract details are transparent, and there is no need to negotiate these. Greater transparency and tight regulations can make exchange traded options less risky. For these reasons, exchange traded options’ transaction costs can be lower.
The option buyer can sell (close) the options before expiry. American style options can be exercised any time before expiry and most traded options are American style options, whereas over-the-counter options tend to be European style options.
Disadvantages
The maturity date and contract sizes for exchange traded options are fixed, whereas over-the-counter options can be tailored to the needs of parties buying and selling the options.
Exchange traded options tend to be of shorter terms, so if longer term options are needed, then they would probably need to be over-the-counter.
A wider range of products (for example, a greater choice of currencies) is normally available in over-the-counter options markets.
Prepare a report for the board of directors of Washi Co which:
(i) Estimates the expected amount of JPY receivable under each hedge choice and the additional debt finance needed to fund the Airone project for the preferred hedge choice;
(ii) Estimates the net present value of the Airone project in Japanese Yen, based on the end of year one being the start of the project (year 0);
(iii) Evaluates the preferred hedge choice made, the debt finance needed and whether the Airone project should be undertaken, considering both financial and non-financial factors.
Professional marks will be awarded in part (c) for the format, structure and presentation of the report.
Report to the board of directors (BoD), Washi Co
Introduction
This report evaluates whether or not Washi Co should invest in the Airone project and the amount of debt finance required of JPY 3,408·6 million (appendix 1) to fund the project. The evaluation considers both the financial and the non-financial factors.
Evaluation of the preferred hedge choice and debt finance required
The income from the sale of the European subsidiary is maximised when futures contracts are used. Therefore, these are chosen as Washi Co will borrow the least amount of debt finance as a result. However, compared to the forward contract, futures are marked-to-market daily and require a margin to be placed with the broker. This could affect Washi Co’s liquidity position. The assumption has been made that basis reduces proportionally as the futures contracts approach expiry, but there is no guarantee that this will be the case. Therefore, basis risk still exists with futures contracts. Although forward contracts give a smaller return, there is no basis risk and margin requirements. However, they do contain a higher risk of default as they are not market traded. Options give the lowest return but would give Washi Co the flexibility of not exercising the option should the Euro strengthen against the Yen.
Although the EUR 80 million receipt from the sale of the subsidiary has been agreed, there may be a risk that the sale may fall through and/or the funds or some proportion of the funds are not received. Washi Co may need to assess and factor in this risk, however small it may be.
The amount of interest on deposit is based on the current short-dated Japanese treasury bills and the estimate of the borrowing requirement is computed from the predicted exchange rate between ARD and JPY in a year’s time, based on the purchasing power parity. Both these estimates could be inaccurate if changes occur over the coming months. Although insufficientinformation is provided for a financial assessment, Washi Co should explore the possibility of converting the EUR into ARD immediately on receipt and keeping it in an ARD bank account until needed, instead of first converting EUR into JPY and then into ARD.
Using debt finance to make up any shortfall in the funding requirement may be appropriate for Washi Co given that it is an unlisted company and therefore access to other sources of funding may be limited. Nevertheless, Washi Co should assess how the extra borrowing would affect any restrictive covenants placed on it and the impact on its cost of capital. Since the amount seems to be small in the context of the project as a whole, this may not be a major problem.
Washi Co should also explore whether or not investing in the Airone project restricts its ability to fund other projects or affects its ability to continue normal business activity, especially if Washi Co is facing the possibility of hard capital rationing.
Evaluation of the Airone project
The net present value of the Airone project is estimated to be JPY (457) million (appendix 2). Given the negative net present value, the initial recommendation would be to reject the project. However, given that the result is marginal, Washi Co should consider the following factors before rejecting the project.
At present, Washi Co does not have a significant presence in the part of the world where Airone is located. Taking on the project may make good strategic sense and provide a platform for Washi Co to establish its presence in that part of the world.
Furthermore, once Washi Co has established itself in Airone, it may be able to develop further opportunities and new projects. The value of these follow-on options has not been incorporated into the financial assessment. Washi Co should explore the possibility of such opportunities and their possible value.
The financial assessment ends abruptly at the end of the four years. No indication is given on what would happen to the project thereafter. It may be sold as a going concern or, if closed, its land and assets may be sold. The cash flows from these possible courses of action need to be incorporated into the assessment, and these could make the project worthwhile
A number of assumptions and estimates would have been made in the financial assessment. For example, the rate of inflation used for future figures is the current rate and the tax rate used is the current rate, these may well change in the coming years. Therefore, it is best to undertake sensitivity analysis and produce a number of financial assessments before making any firm commitment to proceed with the project or deciding to reject it.
Conclusion and recommendation
The income from the sale of the European subsidiary is maximised when futures contracts are used, but Washi Co should weigh this against the benefits and drawbacks of all hedging instruments before making a final decision.
Although the project is currently giving a negative net present value, rejecting it at the outset is premature. A number of factors, discussed above, need to be considered and assessed before a final decision is made. Sensitivity analysis would be very helpful in this respect.
Finally, Washi Co should consider alternative uses for the funding which will be dedicated to the project. These alternative uses for the finance need to be considered before any decision is made, especially if Washi Co is facing the possibility of hard capital rationing.
Report compiled by:
Date
APPENDICES:
Appendix 1 (Part (c) (i)): Japanese Yen receivable from sale of European subsidiary under each hedging choice and the additional debt finance needed to fund the Airone project
Forward rate
Since it is a EUR receipt, the lock-in rate of JPY125·3 per EUR will be used.
Expected receipt from sale: EUR 80m x 125·3 = JPY 10,024m
Futures contracts
The futures contracts need to show a gain when the Euro depreciates against the Yen, therefore a short position is needed, using the seven-month contracts. It is assumed that basis will depreciate proportionally to the time expired.
Predicted futures rate
125·2 + 1/3 x (126·9 – 125·2) = 125·8
[Or: 125·2 + 1/7 x (129·2 – 125·2) = 125·8]
Number of contacts sold = EUR 80,000,000/EUR 125,000 = 640 contracts
Expected receipt from sale: EUR 125,000 x 640 x 125·8 = JPY 10,064m
Options contracts
640 seven-month put options contracts will be purchased to protect against a depreciation of Euro.
If options are exercised:
EUR 125,000 x 640 x 126 = JPY 10,080m
Premium payable = JPY 3·8 x 125,000 x 640 = JPY 304m
Net income = JPY 10,080m – JPY 304m = JPY 9,776m
Conclusion
Futures contracts give the highest receipt and will, therefore, be used to hedge the expected Euro receipt.
Receipt invested
Invested for further six months till needed for the Airone project.
JPY 10,064m x (1 + (0·012/2)) = JPY 10,124·4m
Spot cross rates: 0·70 – 0·74 ARD per JPY 1
[92·7/132·4 = 0·70 and 95·6/129·2 = 0·74]
Expected ARD/JPY conversion spot rate in 12 months = 0·70 x 1·09/1·015 = 0·75
Additional debt finance needed to fund Airone project
Investment amount required = ARD 10,150m/0·75 = JPY 13,533m
Debt finance required = JPY 13,533m – JPY 10,124·4m = JPY 3,408·6m
Appendix 2 (Part (c) (ii): Airone project net present value
Washi Co’s chief operations officer (COO) has suggested that it would be more beneficial for the company to let its major subsidiary companies have their own individual treasury departments, instead of having one centralised treasury department for the whole company.
Required:
Discuss the validity of the COO’s suggestion.
It is difficult to conclude definitively whether a centralised treasury department is beneficial or not in all circumstances and for all companies. It depends on each company itself and the circumstances it faces. Washi Co should take this into account before making a final decision.
Benefits of a centralised treasury department
Having a centralised treasury management function avoids the need to have many bank accounts and may therefore reduce transactions costs and high bank charges.
Large cash deposits may give Washi Co access to a larger, diverse range of investment opportunities and it may be able to earn interest on a short-term basis, to which smaller cash deposits do not have access. On the other hand, if bulk borrowings are required, it may be possible for Washi Co to negotiate lower interest rates, which it would not be able to do on smaller borrowings.
A centralised treasury function can offer the opportunity for Washi Co to match income and expenditure and reduce the need for excessive risk management, and thereby reduce costs related to this.
A centralised treasury management department could hire experts, which smaller, diverse treasury management departments may not have access to.
A centralised treasury function may be better able to access what is beneficial for Washi Co as a whole, whereas local treasury functions may lead to dysfunctional behaviour.
Benefits of separate (decentralised) treasury departments
It could be argued that decentralised treasury departments are better able to match and judge the funding required with the need for asset purchases for investment purposes on a local level. Therefore, they may be able to respond quicker when opportunities arise and so could be more effective and efficient.
Individual departments within a subsidiary may have better relationships with the treasury departments of that subsidiary and are therefore able to present their case without lengthy bureaucratic delays.
Ultimately, the benefits may be implicit rather than explicit. Having decentralised treasury departments may make the subsidiary companies’ senior management and directors more empowered and have greater autonomy. This in turn may increase their levels of motivation, as they are more in control of their own future, resulting in better decisions being made.