a. With respect to foreign currency risk management, explain economic exposure and discuss generally, how a company can manage economic exposure. (8 Marks)

b. Linko Plc is a Uk-based company. It supplies medical equipment to the USA and Europe. It also buys some basic raw materials from USA.

In a typical financial year Linko has net imports of 8 million dollars from USA. This is expected to continue for the next six years.

The company’s cost of capital is 10% per year. Assume that cash flows occur at the year end. Ignore taxation.

Required:

Assuming that there is no change in the physical volume or dollar price of imports, estimate the impact on the expected market value of Linko Plc, if the market expects the dollar to strengthen by 4% per year against the pounds. The current spot rate exchange rate (US$ per £1) is 1.9156 – 1.9210. (7 Marks)

a. Economic exposure

Economic exposure is the risk that exchange rate changes affect the company’s competitive position and future cash flows, beyond transaction exposure.

Management: Operational hedging (match revenues/expenses in currency), financial hedging (forwards, options), diversification (markets, suppliers), pricing policy adjustments, natural hedging.

(8 Marks)

b. Impact on market value

Use mid spot 1.9183 $/£

Net imports 8m $ per year for 6 years.

Without change, PV = sum 8m / (1.9183 * (1.10)^t ) for t=1 to 6

But dollar strengthens 4% per year against £, so exchange rate S_t = S0 * (1.04)^t

Cost in £ year t = 8m / S_t = 8m / [1.9183 * (1.04)^t ]

PV = sum [8m / (1.9183 * (1.04)^t ) ] / 1.10^t

Compared to base where S_t = 1.9183 constant.

The strengthening makes $ cheaper in £ terms? No, dollar strengthen vs £ means more $ per £, so S increases, so £ cost of imports = $ / S decreases, so positive impact.

Calculate base PV: annuity 8m / 1.9183 ≈ 4.17m £ per year, PV = 4.17 * PVA(10%,6) = 4.17 * 4.355 = 18.16m £

With strengthening: year 1: 8m / (1.9183*1.04) = 8m / 1.995 = 4.01m

Year 2: 8m / (1.995*1.04) = 8m / 2.075 = 3.86m

Etc.

PV higher by the reduction in costs.

Impact positive, approx calculate difference.

(7 Marks)