Topic and Instructions for Assessment 2

125.320 International Finance, Semester One 2024

Topic: International Operation and Exposure to Foreign Exchange Risk

KAR Ltd. is a New Zealand manufacturer of specialized microchips for applications in space, defence, automotive, telecommunication, and consumer products. The company imports raw materials from Malaysia, therefore, incurs production costs of raw material denominated in Malaysian Ringgit (MYR).

Currently, KAR produces 60,000 units of products each year. It sells 20,000

units of products locally in the New Zealand dollar denomination priced at NZ$80 per unit, and sells 40,000 units of products to international the North American market in  the USD denomination priced at $50 per unit. The variable cost of raw material is

125 Malaysian Ringgit per unit. KAR also incurs annual fixed costs of NZ$1,200,000 and depreciation expense of NZ$600,000.

Recently, several European companies expressed interests in purchasing

KAR’s products but required the products to be priced in euro. KAR estimated that it  would sell an additional 16,000 units of products each year by entering the European market, at a price of €45 per unit. If the company decides to go ahead with the

European expansion next year, it will need to increase its import of raw materials from Malaysia to totaling at 76,000 units per year. KAR’s European expansion will not affect its existing operation in the local market or the North American market.

Due to the existing excess manufacturing capacity the company currently possess, KAR does not need to acquire any new assets should it decide to go ahead with the European expansion. Therefore, the annual depreciation expense will remain unchanged at $600,000. However, annual fixed costs will increase by NZ$400,000 to $1,600,000.

KAR will pay for its material imports at the end of each quarter, with the next payable due in 90 days. The annual sales quantities in each market segment

(Australasia, North America, and European) are spread over quarters in order to avoid excessive inventories for the importers. KAR expects to receive the payments for these sales at the end of each quarter, with the next international receipts will occur 90 days from now. Exhibit 1 presents a summary of the projections for KAR’s operation for the next quarter, assuming the current exchange rates will be sustained over the next year.

Exhibit 1. Projected operations for the next quarter

Scenario: without expansion to European market

Scenario: with expansion to European market

Before making a final decision about the European expansion plan, the senior management team would like to find out how would the expansion plan affect the company’s quarterly financial performance measured by net income (profit after tax), and net operating cash flow. In addition, the senior management team would like to know how much foreign exchange risk the company is exposed to, with and without the European expansion. They also want to know what various techniques the company can use to protect itself from the exposures to foreign exchange risk, and which technique is superior to the others. Therefore, the CEO asked you, who recently joined the company as a graduate financial analyst, to quantify the risk  exposure and identify the hedging technique most appropriate for the company.

You have collected some information for the three currencies of exposure as summarized in Exhibit 2, and come up with some forecasts for the probability distributions of the spot exchange rates in 90 days which are presented in Exhibit 3:

Exhibit 2. Exchange rates and interest rates quotations

Note: All interest rates are quoted as annual rates.

Exhibit 3. Spot exchange rates forecasts in 90 days

Based on the above information, you will need to estimate the quarterly

financial performance of the company, calculate the size of net exposure to each foreign currency, and give advice on the detailed steps of forward hedge and money market hedge strategies for protecting the company’s exposure to each currency (MRY, USD and Euro). Prepare a report to present your analytical results and make recommendations for the desirability of expansion to the European market, and the  best approach to managing the exposure to foreign exchange rate risk.

Tasks and questions for discussion in your report:

1.  Discuss what type(s) of foreign exchange risk that KAR is exposed to?

2.  Suppose the spot exchange rates remain stable, estimate KAR’s quarterly net income and net operating cash flow in the NZD denomination with and without the European expansion.

3.  Estimate the size of KAR’s foreign exchange exposure to each foreign currency, namely, MRY, USD and euro.

4.  Analyze the sensitivities of KAR’s quarterly net income and net operating cash flow, in the NZD denomination, to the movements in future spot exchange rates.

5.  If KAR decides to leave its foreign exposures unhedged , how will the exchange rate uncertainty affect its quarterly financial performance measured in the NZD denomination? Would you support the expansion plan? (Hint: evaluate changes in performance outcomes in response to changes in foreign exchange rates)

6.  Evaluate the outcomes of the money market hedge, and the forward hedge for the exposures to all three currencies including MRY, the US dollar and the euro.

7.  Compare the two hedging alternatives with the unhedged positions. Would you recommend a hedge or no hedge? If you recommend a hedge, which hedging  strategy is more desirable?

8.   Are there any financial hedging or operational techniques that KAR could benefit from?

Instructions for report writing and submission

•   You are encouraged to complete this assignment in collaboration with other students as a group. Each group can have a maximum of three students.

•   Assignment groups can be organized through private arrangement or posting a request in the "Communication Tools" section in Stream. There is no requirement for registering assignment groups.

•    Ensure your report covers all of the points listed in the section titled “Tasks and questions for discussion in your report” .

•   The suggested length of your report is 5 to 6 pages including title page, references and appendix.

•    Prepare your assignment submission in the format of a business report following

the structure guidelines provided on Massey’s OWLL website:

https://owll.massey.ac.nz/assignment-types/business-report.php

•   When submitting a group report, make sure that only one of the group members make a submission of the report. It is important to avoid submitting a report more than once as Turnitin would return a give a 100% similarity rate for a report that is submitted twice. When submitting a group report, ensure all the group members' names and student IDs are printed on the front page of the report. All the students within the group will receive an identical mark for this assessment.

•   The reports will be marked out of 20 based on the qualities of content, structure and writing. A marking guide is provided on the next page.

•   Once completed, submit your report to “Dropbox for Assignment Reports” under the “Assessment” section in Stream, no later than 23:59pm, the 10th of May, 2024.

Marking guideline

Assignment reports are marked out of 20 based on the quality in three aspects:

Criteria                                                                             Value /Score

Quality of content

• coverage and depth of discussion

• accuracy of the information presented in your arguments

• relevance and conciseness of the evidence raised to support your viewpoints /15

Quality of structure

• logical flow of discussion

• layout and visual appearance / 2

Quality of writing

• clarity and coherence of writing

• sufficient discussion, readability of discussion

• correct use of spelling, grammar and punctuation

• correct reference format (in APA style) is followed /3

Total /20

Each category is marked on a scale of 1 to 5, where 5 = Excellent, 4 = above average, 3 = Good, 2 = Barely adequate, 1= Unsatisfactory.

Specific marks will not be allocated to each sub-category, an overall mark will be awarded based on the criteria above.