External and Internal Hedging Techniques in Corporate Finance

The assignment provides a comprehensive overview of external and internal hedging techniques used in corporate finance. It starts by discussing the importance of hedging in managing risk and uncertainty in foreign markets. The document then delves into internal hedging techniques such as lead and lag, restructuring, and matching, which are essential in determining a company's hedging process and removing the risk of operating business in foreign markets. External hedging techniques like forward and market hedging are also evaluated, providing options that create opportunities while providing services in different countries.

Corporate Finance

Table of Contents
INTRODUCTION...........................................................................................................................1
PART 1............................................................................................................................................1
1. Importance of dividend decision.............................................................................................1
2. Reviewing company's dividend policy and performance on the basis of last 5 years............2
3. Outline the major dividend policy theories.............................................................................4
4. Recommendation about company's future dividend policy ...................................................5
PART 2............................................................................................................................................6
1.Three types of foreign exchange and their relative importance...............................................6
2.Internal hedging strategies and assessing their relevance to the organisation.........................7
3. Analysis of two External hedging policies..............................................................................9
CONCLUSION..............................................................................................................................10
REFERENCES..............................................................................................................................12
APPENDIX....................................................................................................................................13

INTRODUCTION
Corporate finance is the part of a company that deals with investment and financial
decisions. It deals in maximizing the stakeholder value through short and long term financial
planning. It also use in implementation of several strategies. Rolls-Royce Holdings PLC is a
large multinational organisation operating in the defence/ aerospace industry. It was founded in
1971 with headquarter in London, United Kingdom.
This report consist of two parts, In first part importance of dividend decision is explained
below. Company's performance and dividend policy is evaluated on the basis of past five years.
Major dividend policies theories are analyse and recommendation is given for future about it's
this policy. In part 2, company's exposure to types of foreign exchange risk is identified and
evaluates four internal hedging strategies in relevance to it's operations. In last, two basic
external hedging techniques is analysed for studying market also covered in this report (Berk and
et. al., 2013).
PART 1
1. Importance of dividend decision
Dividend is define as distribution of a part of organisation's earning to its stakeholders as
decided by the board of directors. Decision regarding dividend is the most important aspects of
corporate financial policy. It also effect on the funds availability and cost of capital. This
decision is primary to the management of company and shareholders. Decision makers have
short and long term objectives at the time when they evaluate these decisions. It determine the
division of incomes between retained earnings and payments of shareholders. It is an essential
part of corporate world because dividend influence company's stock price and capital structure. It
also aid in determination of the amount of tax which is paid by shareholders. Free cash flow,
clients of dividend and signalling of information are various factors that influence dividend
decision and directors consider these issues while making this decisions. Free cash flow is the
primary factor of consideration at the time of taking decision. In this concept, organisations
provide the shareholders with the amount that remains with company after investing in all
projects (Brealey, Myers and Marcus, 2012). Providence of information has been observed
which increases the worth of stocks in share market is equal to company's dividend information
available in the market. The price of share increases, than organisation announces to give more
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dividend to its shareholders. Clients of dividends also help director to consider their need at the
time of taking dividend decisions because it directly linked to specific type of shares distribution.
By this company makes decent profits and minimize their expenses by providing dividends to
particular group of stakeholders. With the help of above factors, organisation make balance
between the distribution of dividend to shareholders and company's growth in order to create its
market value. It also create a balance between wealth maximisation and long run financial
decision by distributing dividend in absence of investment opportunities. If company pays less
dividend it affect market price.
Borrowing ability, debt obligation, legal requirements, effect of trade policy etc. are he
factors that sometimes negatively influence dividend decisions. Liquidity of funds, profit rates,
stability of earnings, attitude of investor group, growth needs of company positively influence
this decision. The action taken by management in creating policy affects the company's growth
rate, share prices, credit standing and in last on the image of business (Brealey and et. al., 2012).
2. Reviewing company's dividend policy and performance on the basis of last 5 years
Dividend policy decide the amount of dividend that company's pay to its shareholders in
return of their investments. Regular, constant and residual are the three types of dividend
policies. In regular policy, investor get dividend regularly at usual rate and company is earning
continuously. Organisation paid a fixed amount of dividend to shareholders when its earning are
not enough under constant dividend policy. Rolls-Royce Holdings plc follow regular plus stock
dividend policy, where company gives options regarding amount of dividend to its shareholders.
Whether shareholders retain some parts of its shares in cash or redeem all for reinvesting. It pay
highest dividend in 2013 i.e. 600000 after then amount is continuously decreasing every year as
presented in below statement and graph.
Evaluation of RR.L dividend policy in last 5 years
Years Dividend Paid
2013 600000
2014 406000
2015 421000
2016 301000
2017 214000
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Interpretation: Company's amount of dividend decreases from 600000 to 406000 in 2014
that shows debt reduction, poor earnings in operations. Then it increases to 421000 that means
company is trying to improve it performance. In 2016, 2015, it again fall and reach to 214000
which indicators unstable position of company and its time to reinvestment in it's operations.
Overall performance of Rolls-Royce Holdings plc is evaluated on the basis of its
financial statements attached in Appendix. It's revenue decreases from 15513000 in year 2013 to
13725000 in 2015, then it increases every year and reach to 16307000 in 2017 & indicate good
revenue position. Company's net income decreases from 1535000 in 2013 to 1267000 in 2014,
then it increases to 1431000 in 2015. In 2016 it decreases to 262000 which shows negative
impact on its operating income but in 2017 its again increase to 1157000 which indicate
favourable position. Company's total assets are more than its total liabilities in past five years for
example its total assets is 30002000 in 2017 and total liabilities are 23832000 that interpret its
decent condition. Its goodwill was decreases in 2015 from 1659000 to 1503000, then increasing
every year and reaches to 1545000 in 2017. This interpret its good image is market (Clayman,
Fridson and Troughton, 2012).
Company's cash flow from operating activities is continuously increasing every from
2015 to 2017 i.e. 1094000, 1411000, 1810000 which shows large amount of inflows from
operating activities. Cash flow from investing and financing activities are negative in most of the
3
2013 2014 2015 2016 2017
0
100000
200000
300000
400000
500000
600000
700000
Dividend Paid

years which shows unfavourable conditions that means company's inflow are less than its
outflows.
3. Outline the major dividend policy theories
Dividend policy theories indicates that company's dividend doesn't affect its capital
structure or stock prices. These theories are divided into two parts i.e. relevance and irrelevance
theory. Modigliani Miller Hypothesis and residual theory are the irrelevant theory because it
doesn't affect the value of firm. Walter's and Gordon's Model are the relevant theory of dividend
policy that influence the company's value. These theories are explained below in detail:
Modigliani Miller (M-M) Hypothesis: In this theory author describe the irrelevant
concept of dividend in a broad manner. According to them, dividend does not influence the share
price of a company. Therefore it doesn't effect on stakeholders financial condition. This approach
works on several assumptions such as fixed investment policies, investors rational behaviour, no
transaction and floating cost etc. Under pricing, tax differential, desire for distinct dividend v/s
current income are criticism of this approach. Rolls-Royce Holdings plc should follow this MM
approach because it finds dividend does not impact on shareholder's share prices. In above part
of report it present that dividend is decreases every year but still company's overall performance
is excellent. It finds M-M theory is irrelevant as its dividend price reducing every year but it not
affect on its investors share price (Cronqvist, Makhija and Yonker, 2012). Market conditions of
organisation is uncertain and data is asymmetric which determines dividend are evaluated
different from their capital gain. These theories are based on various assumption like discounting
rate is greater than growth rate, it is only financed by equity and their will be no existence of
corporate tax etc. That helps company in implementing divided policy.
Residual theory: Funds are not necessary for company's operations but distributed as its
dividend. In this theory stakeholders doesn't differentiate between retentions and dividends by
the company. Company can follow this theory by using its earning on capital expenses and then
paid dividend from remaining earnings.
Walter's model: This theory suggest that investment and dividend policy of company
can't be isolated but they are interconnected. In this relation between company's cost of capital
and its internal rate of return is clearly declared. Organisation should retain its incomes exceeds
the cost of capital and its distribution to shareholders (Damodaran, 2016). Rolls-Royce Holdings
plc follow this dividend policy theory for evaluating its dividend model. By this company
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determine its position. If its internal rate of return is more than required rate of return, then
company's will grow in future and investors earn more than its expectations. But if IRR is less
than cost of capital, then organisation profitability declines and if required rate of return is equal
to internal rate of return that means company is normal. Company should follow Walter's model
which determine that dividend and investment policy are separated but interrelated. With the
help of this, company determine the relation between its required and internal rate of return. This
aid in evaluating its financial status on the basis of IRR and cost of capital (Edmans and et. al.,
2012).
Gordon's Model: This theory is formed by Myron Gordon. According to author, shares
market value is always remains equal to present value of dividends. This is based on various
assumptions like there will be no availability of external funding, discounting rate always
remains same, no corporate taxes etc. Company's does should not follow this theory because it
can not make assumptions that are mentioned in Gordon's model. It also does not consider that
market value of shares are equal to dividend present value.
4. Recommendation about company's future dividend policy
These theories help in long term financing and wealth maximisation decision. It also
implies price of Company's share is directly related to its dividend payouts. Therefore, Rolls-
Royce Holdings plc should follow regular dividend policy because it set a profitable records for
the company that increases confidence among the stakeholders. It also aid in long run financing
and offers financing easier. Company stabilise its market price of shares for shareholders. If
organisation doesn't distribute profit regularly investors have to pay higher tax rate in year when
profit are distributed. Dividend graph of Rolls Royce shows declining stages from past years. In
terms of dividend, company gave the rights to shareholders that can be redeem all the C shares
for cash, redeem all the type C shares for cash and reinvest the revenues in the C shares plan
(CIRP) and retain the shares. 71 shares in total was issued with nominal value of 7.1p per share
and issued 46 C shares in respect of each shares in the form of interim dividend. Organisation
currently following the regular dividend plus stock dividend policy (Ehrhardt and Brigham,
2016).
It is recommended that company should follow regular stock policy in terms of shares
instead of sharing divined in cash. Dividend ratio is fluctuating and found declining form past
years. There is no specific rate is decided by organisation to retain the specific share of dividend
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to shareholders. This policy will help organisation to dividend option in terms of converting
existing shares, revalue of existing share price. It will reduce the burden of sharing dividend in
fully cash or any other monetary forms. However, this policy is not advisable for long term
perspective because shareholders seeks for dividend in cash rather then getting extra shares. So,
company should adopt the policy to reform its dividend structure to attain the level of dividend
pay out ratio in cash and monetary forms.
PART 2
1.Three types of foreign exchange and their relative importance
Foreign exchange risk: It is said to be financial risk that arises when a financial
transaction is been denominated in a currency other than that of their base currency of the
company. It can be more effective threat of losing all investment due to change in overall
exchange rates. It is essential known as currency risk of any particular nations. Like for example,
companies used to buy products and services from a foreign supplier for which payment is due in
the supplier currency at the later date (Fan, Wei and Xu, 2011). Rolls Royce deals in
international market due to which they have to deal in multiple Currencies and has to face few
foreign exchange risks which are mentioned below:
Transaction risk - These types of risk are arising in case the contractual cash flows such
as receivables and payables values are subject to unanticipated alteration in exchange rate
because of denominated in international currency. In order to realize the local value of their
foreign denominated cash flows, Rolls-Royce Holdings plc must exchange international currency
for domestic values. The firm can easily be able to exchange contracts with available set prices
and delivery dates in the face of unstable inevitable exchange market with overall exchange rate.
In some cases, Rolls-Royce Holding plc uses certain portion of their equities, assets, debts and
incomes during any kind of foreign exchanges.
Economic risk – This type of risk is more influential than transaction risk as it impacts
an organisation for a longer time period. This risk can affect market value of the company and
can impact its profitability over the years. If Rolls Royce is affected by a unavoidable risk of
foreign exchange, than it can be said that this company is facing economic risk.
Translation risk – When severe issues of converting a currency is faced by an
organisation, those risk are referred as translation risks. Rolls Royce is a energy company which
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deals in multiple countries due to which is exposed to translation risk. This risk can arise from
the loss of conversion cost.
The above mentioned risks are usually involved in an organisation which operates in
multiple countries and has to deal with foreign exchange. Risks has various limitations but the
approach of risk is parallel to return. Whenever there is a chance of risk, there will also be
chances of suitable returns (Grenadier and Malenko, 2011). The above risks are important for
this company as they also holds some benefits. These importance are discussed below:
Possibilities of gain – Transaction risks occurs due to time lag between a transaction's
execution and settlement. These risks comprises risk of losses but when there is a risk of loss
there is also equal possibilities of gains. Rolls-Royce Holdings plc (RR) can get befitted by
transactional risks as these risks also has positive or favourable exchange rate movement. For
example: the above mentioned company has initiated payment using foreign exchange and due to
sound and growth in global market for-ex rate is favourable due to which they can earn profit.
Stability – Here stability refers to the continuous growth in an organisation. Rolls-Royce
Holdings deals in defence industry due to which various economic factors such as policies and
regulations affects this company. Economic risks affects this organisation for a longer time
period but this risk can also result in benefit. If the economy in which company is dealing is
sound and stable than the company will be benefited by stable economic conditions. Economic
conditions of the company and country is directly proportional and the level of risk can be
equally beneficial and disadvantageous too (Parrino, Kidwell and Bates, 2011).
Scope for currency swaps - This importance is associated with translation risk. Rolls-
Royce is a company which deals in multiple countries and in order to export and import products
they have to face translation costs. These translation cost hold high risks of loss but these risks
can also brings scope for various methods which can help in reducing translation cost such as
currency swap and hedging.
2.Internal hedging strategies and assessing their relevance to the organisation
Hedging is a process of reducing or eliminating risk which is involved in a transaction.
Rolls-Royce is a company which is uses these strategies of hedging in order to minimise their
risk involvement. Internal hedging is a technique which is a part of company's daily operations.
This process is used in an organisation to insulate itself from the adverse rate movements. The
main aim of using this process and its strategies is to minimise the risk involved in foreign
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exchange. The above mentioned company that is Rolls-Royce Holdings operates in defence
industry and distributes its goods to multiple countries due to which level of foreign exchange
risk are very high. In order to eliminate or minimise their risks involvement, the top level
management of this company has decided to use few hedging strategies (Internal Hedging,
2017). Some of the strategies of hedging process used by Rolls-Royce are mentioned below:
Denomination in local currency – While distributing a product in international market
or to any other country, it is important to conduct foreign exchange. While transacting a foreign
exchange, a company should denominate in local currency. This strategy can help Rolls-Royce
to avoid exchange risk. By denominating in local currency, the cost of translation will be borne
to opposite party and then they have to bear transactional costs. In case of international trade
done by Rolls-Royce, the transactions either in either the currency of the importer or the
exporter shifts the exchange risk onto the other party. This hedging strategy is internal as it
involves dominating the importer's currency and balance in the currency of the exporter.
Leads and lags – According to this external hedging strategy, exporters and importers
keep forecasts as to whether the transaction currency will weaken or not. In the case of Rolls-
Royce, weak currency refers to depreciated or devalued currency. By using this strategy, the
company can get benefited to pre pone or postpone the time of receipt or payment of the foreign
currency. The process of the timing of receipts and payments is known as leads and lags. Rolls-
Royce can get benefited by using this strategy as this strategy is the most relevant for this
organisation (Scholes, 2015).
Relevance of this strategy can be referred as, When Rolls-Royce expects a currency to
depreciate or devalued, they delay the payment so that they may have to pay less in domestic
currency terms. This repositioning of the payment liability is known as lag. When this company
expects the currency to appreciate, management of the company decides to pay in foreign
currency to settle the liability earlier than the maturity date.
Restructuring – According to this strategy, an organisation reduces exchange rate
fluctuations by restructuring its operations which may involve increasing or reducing the sales in
market. This market can be domestic or international. Rolls-Royce can increase or reduce their
dependency on foreign supplies. This company can also restructure their structure by
establishing or eliminating production facilities in foreign market.
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By reducing or increasing the level of debt denominated in foreign countries, this
company can restructure their organisation and can get benefited. Hedging is a process of
minimising risk of involved in foreign exchange. The strategy of restructuring is considered as
the most appropriate technique of internal control as it does not involve any external party and
can be resolved only using internal affairs.
Matching – In this type of hedging strategy, Rolls-Royce involves matching of assets
and liabilities in the same currency. Financing foreign investment with the foreign loan would
reduce the exposure to exchange rate risk. This strategy of internal hedging is relevant of the
selected organisation that is Rolls-Royce. This relevance has few reasons such as their nature of
activities is involved in defence industry due to which it can be said that by matching assets and
liabilities according to the foreign exchange will help them in obtaining benefit of reducing the
foreign exchange risk (Strebulaev and Whited, 2012).
The above internal hedging risk strategies helps this company Rolls-Royce to reduce or
minimise their risk involvement in foreign exchange. The most relevant strategy for this
company is denominating in local currency. The reason behind its relevancy is its simpler nature
which allows to minimise risk by involving no cost and negligible efforts. The above mentioned
strategies which discussed should be used by Rolls-Royce in order to eliminate the risk involved
in their foreign exchange. These strategies or techniques are used by this company because they
are in need to minimise their risks.
3. Analysis of two External hedging policies
Forward hedge: It is a medium to protect exposure in the forward currency, interest rate
and financial assets market. When it is engaged with large contracts, it is dominated by the
government, regulatory bodies and other corporate entities. It is over the counter market for
forward contracts, which is not used to trade on an established exchange. It is undertaken by
large investors such as financial management institutes, in large contracts. It is based on a
contract in which assets or securities are bought on a specific date at a given or pre decided date.
Investors use forward hedges to avoid prime losses, in the situation where price of the security
changes frequently before it has been exchanged by an investor. It includes straight out purchase
of a currency at a decided exchange rate. Hedge rate in this market is affected by various interest
rates of two countries whose currencies are involved in the contract and spot exchange rate of
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those two currencies. Forward market hedge leads to offsetting an anticipated payable or
receivable chosen in foreign currency to the determined receipt or payment date of the same.
Example: For Rolls-Royce Holdings plc company which is based in UK the investors of the
company can know in advance how much the UK pound they are going to receive for future
payments in foreign currency. They have option to sign a forward advance contract with a local
financial institution for a payment in other country's currency that may be received in six month
or a year. They may be agree to the American currency which is dollar. The investor may agrees
on an exchange rate of 1.35 dollar per pound, so if the exchanges rate goes up or down to 1.33 to
1.29. The investor will receive the same amount of pound at 1.31dollar per pound.
From the above example it can be understood that whether the value goes up or down the
investor will receive the same amount according to the current market value of the currency.
Money market hedging: It is an approach used to set foreign currency transaction in an
organisation's domestic currency. Treasury bills, certificate of deposit, banks acceptance and
commercial paper are the types of money market instruments. It help in reducing its currency
risk when business is run with foreign companies. It allows domestic organisation to lock a
amount to its partner's currency. By this certainty in future transaction creates and ensures to lock
in a price which company is able and willing to pay. It creates flexibility in order to cover
amount. Rolls-Royce Holdings plc follow this hedging techniques to reduce its foreign exchange
risk by fixing future rate and eliminate risk exposure. Money market hedge used to provide
flexibility in accordance to the value which is going to be covered. Like for example, a company
can only want to hedge half of their value of the transactions. It would be useful for hedging in
exotic currencies as per the decided norms of the country. Placing the foreign buying currency on
the deposit and receiving rate of interest until payment is made accordingly (Welch, 2011).
CONCLUSION
From the above project report, concluded that company is following regular plus stock
dividend policy in order to satisfy its shareholders which improve its overall performance.
Organisation's various dividend policy theories are analyse and recommendation is made to
improve its existing company's policy. Foreign exchange risks are identified that help in
company's operations to easily establish in foreign market. At last, internal hedging like lead &
lag, restructuring and matching identify in determining hedging process and removal the risk of
operating business in foreign market. External hedging techniques such as forward and market
10

hedging are evaluated that aid in foreign exchange market as they provide many options which
help to create opportunities while providing services in different countries.
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REFERENCES
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Berk, J., and et. al., 2013. Fundamentals of corporate finance. Pearson Higher Education AU.
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Clayman, M. R., Fridson, M. S. and Troughton, G. H., 2012. Corporate finance: a practical
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Cronqvist, H., Makhija, A. K. and Yonker, S. E., 2012. Behavioral consistency in corporate
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Fan, J. P., Wei, K. J. and Xu, X., 2011. Corporate finance and governance in emerging markets:
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Grenadier, S. R. and Malenko, A., 2011. Real options signaling games with applications to
corporate finance. The Review of Financial Studies. 24(12). pp.3993-4036.
Parrino, R., Kidwell, D. S. and Bates, T., 2011. Fundamentals of corporate finance. John Wiley
& Sons.
Scholes, M. S., 2015. Taxes and business strategy. Prentice Hall.
Strebulaev, I. A. and Whited, T. M., 2012. Dynamic models and structural estimation in
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Vernimmen, P., and et. al., 2014. Corporate finance: theory and practice. John Wiley & Sons.
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Online
Internal Hedging. 2017. [Online]. Available through:
<https://explainry.com/hedging/>.
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APPENDIX
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