Question 31 – Answer all parts
Mitch Plc, a UK-based smart phone manufacturer, is considering adding a new model of smart phones to its current production line. The success of the new model depends on general market conditions. Mitch’s current share price is £100.
If the conditions are good, the revenues from the project are estimated to be £30 million a year for 5 years, starting a year from now, and the share price will be £150. On the other hand, if the conditions are bad, the revenues are expected to be £5 million a year for the first 3 years, and £2 million for the remaining 2 years of the project, and the share price will be £50. The initial cost of the project is £50 million. The risk-free rate is 10%.
Required
a) Calculate the Net Present Value (NPV) of the project.
b) Mitch’s CEO thinks that the project is too risky and wants to wait for a year and only invest in the project if the conditions are good. Assume that, if the decision is delayed, the project’s cash flows and its time duration will not change but the positive cash flows will start in 2 years’ time. Also, assume that Mitch’s competitors are not ready to produce a similar smart phone model within the next 12 months.
Calculate
i. the NPV of the project if the CEO’s proposal is accepted
ii. the value of the option to delay the project.
c) Calculate the price of a call option on Mitch’s stock that expires in one year’s time, with an exercise price of £100, and show all your workings, using
i. Risk-neutral binomial valuation approach and
ii. Tracking portfolio (no arbitrage) approach.
d) Mitch’s CEO is considering increasing the firm’s leverage from 20% to 30%. Briefly discuss how the market is expected to react to this decision, and why.
Question 32 – Answer all parts
LorBoh GmbH is a medium-sized tea producer company, based in Berlin. It is now 1 December and the following transactions have been contractually agreed:
i. Sale of packaged tea, cash receipt due 1 February of US$197,000
ii. Purchase of production equipment, invoice payable 1 May, for US$447,000
iii. Sale of packaged tea, US$154,000 cash receipt due 1 May.
Money market interest rates are:
Euros 4% per annum
US dollars 5% per annum
Required
a) Demonstrate how you would hedge LorBoh’s foreign exchange risk exposure on the forward markets.
b) Demonstrate how you would hedge LorBoh’s foreign exchange risk exposure on the money markets.
c) Compare the forward market hedge to that of the money market hedge.
d) Calculate the hedge efficiency that LorBoh could achieve on its foreign exchange risk exposure using a futures market hedge, if
