ACC 7020 Module 4 Written Assignment: Exchange Rates, Hedging and a Foreign Investment Example

Euros Payable, Pesos Receivable: Hedging and Valuing a Packaging Company's Foreign Exposure

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MBA in Accounting, Thomas Edison State University

ACC-7020: Financial Essentials for Accountants

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Month Day, Year

Euros Payable, Pesos Receivable: Hedging and Valuing a Packaging Company's Foreign Exposure

Introduction

A company that buys, sells or invests abroad faces exchange rate risk: transaction exposure on specific foreign currency payments, economic exposure on the value of future foreign cash flows and translation exposure on consolidated statements. Parity relationships link exchange rates to interest rates and inflation, and they guide both hedging and international capital budgeting (Ehrhardt & Brigham, 2024).

Part A: Interest Rate Parity and the Forward Rate

The spot rate is $1.0850 per euro. Six-month interest rates are 4.6 percent a year in the United States and 3.0 percent in the euro area, or 2.3 and 1.5 percent for six months. Interest rate parity sets the forward rate so that investors earn the same return in either currency: $1.0850 times 1.023 divided by 1.015 gives a six-month forward rate of about $1.0936. Lower euro interest rates put the euro at a forward premium.

If the forward rate differed from parity, an arbitrage would exist: an investor could borrow in one currency, convert, invest in the other and lock in the return with a forward contract, earning a riskless profit until rates adjust. That is why, in liquid currencies such as the euro, quoted forward rates stay very close to the parity value.

Part B: Three Hedges of the Payable

The Hedging Alternatives

A forward contract locks in $1.0936, a cost of $19.68 million. A money market hedge borrows dollars today, converts them at spot and invests the euros for six months: Ridgeline needs €17.73 million now, or €18 million divided by 1.015, which costs $19.24 million at spot; repaying that loan with 2.3 percent interest costs $19.68 million, the same as the forward, as parity predicts. A call option giving the right to buy €18 million at $1.10 costs a premium of $0.02 per euro, $360,000.

Choosing a Hedge

The forward removes all uncertainty but gives up gains if the euro weakens. The option caps the cost at $20.16 million while keeping the gain if the euro falls, at the price of the premium. Because the equipment price is already in the capital budget at the forward rate, and an overrun would squeeze the project's thin margin, the forward is the better choice. Allayannis and Weston (2001) found that firms using foreign currency derivatives to hedge exposure had higher market values on average, consistent with hedging reducing costly volatility in cash flows.

Part C: Valuing the Monterrey Plant

The plant would cost MXN 400 million, $21.05 million at the spot rate of 19.00 pesos per dollar, and generate MXN 180 million of after-tax cash flow a year for three years, with an estimated value of MXN 250 million at the end of year 3. Expected Mexican inflation is 4.5 percent and U.S. inflation 2.5 percent, so relative purchasing power parity implies the peso will weaken about 2 percent a year.

Graham and Harvey (2001) found that many firms apply one company-wide rate to every project, which is why the explicit premium matters here. Discounting at 12 percent, Ridgeline's WACC plus a country risk premium for political, legal and repatriation risk, gives a present value of $30.76 million and an NPV of about $9.71 million. The project is attractive, but the result depends heavily on the terminal value, which accounts for about 29 percent of the present value, and on the assumption that all cash can be sent home. Ridgeline should finance part of the plant with peso borrowing, which matches the currency of its debt to its peso cash flows and reduces economic exposure, and it should review the tax treaty and the trade rules that affect exports from Mexico to the United States.

The forecast exchange rates rely on purchasing power parity, which holds poorly over short periods. A sensitivity check shows that if the peso weakened 5 percent a year instead of 2 percent, the NPV would fall by roughly $2 million, to about $7.8 million, but remain positive.

Part D: Other Global Considerations

Translation exposure will cause reported equity to move with the peso, though it does not affect cash. Transfer prices between the plant and the U.S. parent must meet arm's-length rules in both countries. Operating in Mexico also diversifies production, giving Ridgeline a natural hedge if the peso's weakness makes Mexican output cheaper for U.S. customers.

References

Allayannis, G., & Weston, J. P. (2001). The use of foreign currency derivatives and firm market value. Review of Financial Studies, 14(1), 243-276. https://doi.org/10.1093/rfs/14.1.243

Ehrhardt, M. C., & Brigham, E. F. (2024). Corporate finance: A focused approach (8th ed.). Cengage Learning.

Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), 187-243. https://doi.org/10.1016/S0304-405X(01)00044-7