WACC and Foreign Exchange Risk Hedging

This assignment content discusses the calculation of Net Sterling Receipts and the Weighted Average Cost of Capital (WACC) for XYZ Ltd. The content provides two methods to calculate the net sterling receipts: forward foreign exchange market and money market hedge. It also highlights the issues to be considered in deciding which method to use, including the availability of forward contracts in the market, currency fluctuations, and complexity of the money market hedge. Additionally, it references various sources to support the calculation of WACC and cost of debt.

1
Weighted Average Cost of Capital
1.
A. Using the Dividend Valuation Model, we can arrive at the cost of equity as follows:
As dividends for past 5 years has been given, we shall use Dividend Valuation Model to arrive
at the cost of equity. This model uses the historic data to arrive at growth rate of dividends.
Ke = [D0 (1+g) / P0)] + g ,where, Ke = cost of equity; D0 = current level of dividend; P0 =
Current Share Price; g = estimated growth rate in dividends
Given, D0 = $0.137; P0 = $1.42; g = (D0/Dividend n years ago)1/2 - 1
where, n = 5 years; Dividend 5 years ago = $0.1
g = (0.137/0.1)1/2 - 1 = 0.1705 or 17.05%
Therefore, Ke = [0.137 (1+0.1705)/1.42] + 0.1705
Ke = 0.2834 or 28.34%
B. We can arrive at the cost of debenture as follows:
The par value of debentures to arrive at the cost is taken as $100 per debenture.
Kd = I / Po, where I = Annual Interest Paid; Po = ex interest market value of the debt
Given, I = 7% of $100 = $7; Po = $76
Therefore, Kd = 7/76 = 9.21%
C. Cost of Long Term Loan = 15% + 1.5% = 16.5% (Given)
Weighted Average Cost of Capital:
It is the cost of different sources of capital multiplied by the proportion of such source of capital
against the entire capital
For the given scenario, it shall be
WACC = (Ke * We) + (Kd * Wd) + (Kl * Wl)
Where, Ke = cost of equity; kd = cost of debt; kl = cost of Long Term Loan
Where, We = weightage of equity; Wd = weightage of debt; Wl = weightage of Long Term Loan

2
Type Amount as at
31 Dec 2009
Cost of Capital Weightage Product
7% Debentures 7,30,000 9.21% 35.10% 3.23
Long Term Loan 8,50,000 16.5% 40.86% 6.74
Capital and Reserves 5,00,000 28.34% 24.04% 6.81
Total 20,80,000 100% 16.78
Therefore, the WACC of XYZ Ltd is 16.78%.
2.
Weighted Average Cost of Capital (if corporate tax rate at 30%):
Cost of Equity would remain same at 28.34% as the tax rate does not affect the earning of
equity shareholders. However, it shall vary for the interest bearing capital, being recomputed as
follows:
Kd = 7(1-0.3)/76 = 4.9/76 = 6.45%
Kl = 16.5% * (1-0.3) = 11.55%
(The effect of tax has been removed to arrive at the respective cost of capital.)
Type Amount as at
31 Dec 2009
Cost of Capital Weightage Product
7% Debentures 7,30,000 6.45% 35.10% 2.26
Long Term Loan 8,50,000 11.55% 40.86% 4.72
Capital and Reserves 5,00,000 28.34% 24.04% 6.81
Total 20,80,000 100% 13.79
Therefore, the WACC of XYZ Ltd is 13.79%.

3
NET Sterling Receipts
1. (a) Net Sterling Receipts if foreign exchange risk hedged on the forward foreign
exchange market:
We can compute the net sterling receipts using the forward rates in force:
Given, 3 months forward = 0.82 – 0.77
And 6 months forward = 1.39 – 1.34 (or) 1/1.39 – 1/1.34
For 3 months forward:
Nature of
Transaction
Inflow/Outflow
of Funds
Amount of
Inflow/Outflow
Exchange Rate Amount (in
Sterling
Pounds)
Purchase of
Components Outflow 1,16,000 1 1,16,000
Sale of finished
goods Inflow 1,97,000 0.77 1,51,690
Net Flow 35,690
Whenever there is funds inflow in foreign currency, we need to sell the foreign currency to buy
the domestic currency. The sell rate is always less when compared to buy rate.
For 6 months forward:
Nature of
Transaction
Inflow/Outflow
of Funds
Amount of
Inflow/Outflow
Exchange Rate Amount (in
Sterling
Pounds)
Purchase of
Components Outflow 4,47,000 1.39 3,21,583
Sale of finished
goods Inflow 1,54,000 1.34 1,14,925
Net Flow (2,06,658)
2. (b) Net Sterling Receipts if foreign exchange risk hedged on the money market:
For 3 months:
(i) For purchase of components, no hedge is required as the transaction is in domestic currency
i.e, Sterling Pounds. The outflow would be 1,16,000.

4
(ii) However, for the sale of finished goods, the cash dues is $1,97,000. We shall use the Money
Market Hedging by the following means.
As the borrowing rate in dollars is lower and deposit rate is higher in sterling pounds, we shall
borrow US$ equivalent to present value of the sale proceeds received being discounted at 6%
p.a or 1.5% per quarter. Therefore, 1,97,000/1.015 = 1,94,088.
We shall deposit these dollars into Sterling to yield 4.5% p.a interest, i.e, 1.125% per quarter.
$1,94,088 converted at spot rate of 1.4106 = 1,37,593.
After 3 months, the amount shall be 1,37,593*101.125% = 1,39,140
Therefore, the inflow shall be 1,39,140
The Net inflow of sterling pounds shall be = 1,39,140 – 1,16,000 = 23,140
For 6 months:
(i) For purchase of components, the outflow would be $4,47,000.
We shall borrow Sterling pounds in an amount equivalent to the present value of the payment to
be made that is ($4,47,000/101.5%) = $4,40,394. At the spot rate1.4140, it shall be 3,11,452
sterling pounds.
The amount borrowed shall be repayable after 6 months at 7.5% interest p.a which is 3,23,131
sterling pounds.
(ii) Sale of finished goods, the inflow would be $1,54,000.
As the borrowing rate in dollars is lower and deposit rate is higher in sterling pounds, we shall
borrow US$ equivalent to present value of the sale proceeds received being discounted at 6%
p.a or 1.5% per quarter. Therefore, 1,54,000/1.03 = 1,49,514.
We shall deposit these dollars into Sterling to yield 4.5% p.a interest, i.e, 1.125% per quarter.
$1,49,514 converted at spot rate of 1.4106 = 1,05,993.
After 6 months, the amount shall be 1,05,993*102.25% = 1,08,378
Therefore, the inflow shall be 1,08,378
The Net inflow of sterling pounds shall be = 1,08,378 – 3,23,131 = (2,14,753)

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(c) Issues to be considered in deciding which method to be used:
a. Availability of forward contracts in the market.
b. The fluctuations in the currency needs to be borne in mind as it is quite unpredictable.
c. Money market hedge is complicated when compared forward contract.
References:
(2016). Kfknowledgebank.kaplan.co.uk. Retrieved 21 December 2016, from
http://kfknowledgebank.kaplan.co.uk/KFKB/Wiki%20Pages/Cost%20of%20Equity.aspx
Elvis Picardo, C. (2016). The Money Market Hedge: How It Works. Investopedia. Retrieved 21
December 2016, from http://www.investopedia.com/articles/forex/020414/money-market-
hedge-how-it-works.asp
How to Calculate the Cost of Debt - Part 1. (2016). Management Accounting Mastery. Retrieved 21
December 2016, from http://www.managementaccountingmastery.com/how-to-calculate-the-
cost-of-debt-part-1/
Methods of Calculating Redeemable and Irredeemable Debt. (2016). YourArticleLibrary.com: The
Next Generation Library. Retrieved 21 December 2016, from
http://www.yourarticlelibrary.com/financial-management/cost-of-capital/methods-of-
calculating-redeemable-and-irredeemable-debt/43865/