Question

BF2207 Question 5 GP Industries Ltd. is a Singaporean company that develops, manufactures, markets, and retails electronic and acoustic products. It is considering a project in Thailand that has an initial cash outlay of 8 million Singapore dollars (SGD), GP will accept the project only if it can satisfy its required rate of return of 18 percent. The project would definitely generate 90 million Thai baht (THB) in one year from sales to a large corporate customer in Thailand. In addition, GP also expects to receive 145 million THB in one year from sales to other customers in Thailand. If GP accepts the project, it would hedge all the receivables resulting from sales to the large corporate customer, and none of the expected receivables due to expected sales to other customers. Today, the spot rate of the THB, interest rate for SGD and THB, and expected inflation in Singapore and Thailand are as follow: Spot rate of THB 1-year interest rate for SGD 0.040 SGD 5.0% 1-year interest rate for THB Expected annual inflation in Singapore 2.5% 2.0 % Expected annual inflation in Thailand 4.5% Assume that interest rate parity and purchasing power parity hold. Estimate the SGD net present value (NPV) of the project, accurate to the nearest cent. Should GP invest in Thailand? (a) (10 marks) Assume that GP considers alternative financing for the project, in which it would use 5 million SGD cash, and the remaining initial outlay would come from borrowing THB. Determine the amount GP would need to repay the THB loan (principal plus interest) at the end of one year. Estimate the SGD NPV of the project, accurate to the nearest cent, under these conditions. Assume no tax effects due to this alternative financing. (b) (10 marks) Do you think the GP's exposure to exchange rate risk due to the project if it (c) uses the alternative financing (explained in part b) is higher, lower, or the same as if it has an initial cash outlay of 8 million SGD (and does not borrow any funds)? Explain. (4 marks) (TOTAL: 24 marks) - END OF PAPER

Answer 1

(a) If Interest Rate Parity holds good then,

Forward Rate / Spot Rate = (1+Interest Rate of Base Currency) / (1+Interest Rate of Foreign Currency)

Here Spot Rate is 0.04 SGD/ THB

Interest Rate of Base Currency = 5%

Interest Rate of Foreign Currency = 2.5%

Therefore, Forward Rate after one year = Spot Rate X 1.05/1.025

Forward Rate = 0.04 X 1.05/1.025 = 0.041 SGD / THB (GP shall hedge 90 Mil THB to be received at this Forward Rate)

Therefore inflow after 1 year in SGD from large corporate customer = 90 Mil X 0.041 SGD = 3.69 Mil SGD

If Purchasing Power Parity holds good then,

Spot Rate = (Cost of Goods in Base Currency) / (Cost of Goods in Foreign Currency)

Expected Inflation Rate in Singapore = 2%

Expected Inflation Rate in Thailand = 4.5%

Therefore, Cost of Goods in Base Currency = 0.04 X 1.02 = 0.0408 SGD

Cost of Goods in Foreign Currency = 1 X 1.045 = 1.045 THB

Note : Here we took spot rate as cost of goods at present day and multiplied with the inflation to get the cost after in 1 year

Therefore , Spot Rate after 1 year = 0.0408 SGD /1.045 THB = 0.039 SGD / THB (GP shall convert 145 Mil to be received after one year at this Spot Rate)

Therefore inflow after one year in SGD from sale to other customers = 145 Mil X 0.039 SGD = 5.655 Mil SGD.

Calculation of Estimated SGD NPV of the project :

Inflow after One year = (3.69 Mil + 5.655 Mil ) SGD = 9.345 Mil SGD

(i) PV of Inflow at present with Required rate of return 18 % = 9.345 Mil SGD / 1.18 = 7.92 Mil SGD

(ii) Initial Outlay = 8 Mil SGD

(iii) Net Present Value of the Project = (i) - (ii) = 7.92 Mil SGD - 8 Mil SGD = - 0.08 Mil SGD (Negative NPV)

Since the NPV of the Project is negative hence GP should not Invest in Thailand.

(b) If GP invest 5 Mil SGD in cash.

Then it shall borrow 3 Mil SGD in THB which shall amount to 75 Mil THB (3 Mil SGD / (Spot Rate -> 0.04 SGD / THB) @ an interest rate of 2.5% per annum.

Outlay after one year to repay the above loan = 75 Mil THB X 1.025 = 76.875 Mil THB

Under this condition GP shall hedge 90 Mil THB under future which shall come to 3.69 Mil SGD [ As calculated in (a) above]

Again the amount of 145 Mil THB received from other customer since not hedged shall be first utilised to pay off the loan of 76.875 Mil THB .

Remaining amount of 68.125 Mil THB [(145 - 76.875)Mil THB ] shall be converted into SGD at the future Spot Rate 0.039 SGD / THB.

This shall result in Inflow of 68.125 x 0.039 Mil SGD = 2.66 Mil SGD

Calculation of Estimated SGD NPV of the project :

Inflow after One year = (3.69 Mil + 2.66 Mil ) SGD = 6.35 Mil SGD

(i) PV of Inflow at present with Required rate of return 18 % = 6.35 Mil SGD / 1.18 = 5.38 Mil SGD

(ii) Initial Outlay = 5 Mil SGD

(iii) Net Present Value of the Project = (i) - (ii) = 5.38 Mil SGD - 5 Mil SGD = 0.38 Mil SGD (Positive NPV)

(c) Exchange Rate Risk Exposure is the term used for the risk involved in case where a receivable is expected in future and the same is not hedged. In this case we have to exchange the foreign currency (THB ) into Base Currency (SGD ) but the spot rate after one year is uncertain and may be different from the expected spot rate calculated in (a) hence can result in loss or profit.

In option (a) GP is having an exchange rate risk exposure of 145 Mil THB since it is not hedging the amount with futures.

But comparatively since in (b) GP is raising loan in THB for financing the project and again at the end of one year repaying it with THB itself hence it is having an exchange rate risk exposure for only 68.125 Mil THB which is less compared to in above (a) .

Hence as compared to the alternate financing as discussed in (b) with (a) GP's exposure to exchange rate risk due to the project is lower in alternate financing (b).