Leading and lagging are methods of foreign currency risk management, where the company will make payments in advance (lead) or delay payments beyond their due dates, in order to take advantage of foreign exchange rate movements or to match the timing of payments that the timing of receipts from customers.

Matching is a process where receipts and payments in a foreign currency are paired, so that receipts into a foreign currency bank account are used to make payments in that currency.

Forward rate agreements are interest rate risk hedges that effectively fix the interest rate on future borrowing.

Smoothing is where a balance between fixed and floating rate borrowing is maintained to hedge interest rate risk.

1.  Calculate the after-tax weighted average cost of capital of A on a market value basis

     Ordinary shares, preference shares, redemption loan notes, bank notes

2.  the circumstances under which it is appropriate to use the current WACC in appraising an investment project.

     - represents the mean return required by a company’s investors, given the current levels of business risk and financial risk faced by the company.

     - used as the discount rate in appraising an investment project of the company provided that undertaking the investment project does not change the current levels of business risk and financial risk faced by            the company.

     - used as the discount rate in appraising an investment project  in the same business area as current operations, for example, an expansion of current business, as business risk is likely to be unchanged

        in these circumstances.

     - used as the discount rate in appraising an investment project  if the project is financed in a way that mirrors the current capital structure of the company, as financial risk is then likely to be unchanged.

     -The required return of the company’s investors is likely to change if the investment project is large compared to the size of the company, so the WACC is likely to be an appropriate discount rate providing  the investment is small in size relative to A.

3.  advantages for using convertible loan notes as a source of long-term finance.

      Conversion rather than redemption

If the holders of convertible loan notes judge that conversion into ordinary shares will increase their wealth, conversion of the loan notes will occur on the conversion date and A will not need to find the cash needed to redeem the loan notes. This is sometimes referred to as ‘self-liquidation’.

      Lower interest rate

The option to convert into ordinary shares has value for investors as ordinary shares normally offer a higher return than debt.Investors in convertible loan notes will therefore accept a lower interest rate than on ordinary loan notes, decreasing the finance costs for the issuing company.

      Debt capacity

If A issued convertible loan notes, its gearing and financial risk will increase and its debt capacity will decrease. When conversion occurs, its gearing and financial risk will decrease and its debt capacity will increase because of the elimination of the loan notes from its capital structure. However, there will a further increase in debt capacity due to the issue of new ordinary shares in order to facilitate conversion.

     Attractive to investors

Tufa Co may be able to issue convertible loan notes to raise long-term finance even when investors might not be attracted by an issue of ordinary loan notes, because of the attraction of the option to convert into ordinary shares in the future.

     Facilitates planning

It has been suggested than an issue of fixed-interest debt such as convertible loan notes can be attractive to a company as the fixed nature of future interest payments facilitates financial planning.

4.  Calculate the net present value of the planned investment project

5.  Calculate the discounted payback period of the planned investment project.

6.  Discuss the financial acceptability of the investment project

7. Critically discuss the views on investment appraisal

Evaluation period

Sales are expected to continue beyond year 4 and so the view of the directors that all investment projects must be evaluated over four years of operations does not seem sensible. The investment appraisal would be more accurate if the cash flows from further years of operation were considered.

Assumed terminal value

The view of the directors that a terminal value of 5% of the initial investment should be assumed has no factual or analytical basis to it. Terminal values for individual projects could be higher or lower than 5% of the initial investment and in fact may have no relationship to the initial investment at all.

A more accurate approach would be to calculate a year 4 terminal value based on the expected value of future sales.

Discounted payback method

The directors need to explain their view that an investment project’s discounted payback must be no greater than two years.Perhaps they think that an earlier payback will indicate an investment project with a lower level of risk. Although the discounted payback method does overcome the failure of simple payback to take account of the time value of money, it still fails to consider cash flows outside the payback period. Theoretically, Pelta Co should rely on the NPV investment appraisal method.

8. Economy is the acquisition of resources of appropriate quantity and quality at minimum cost. efficiency is how well inputs are converted into outputs.

9. efficient markets hypothesis,

Under strong form efficient markets, the share price will reflect all information regardless of whether it is in the public domain or not.

In a strong form efficient market the share price reflects historic information, published information and insider information. The share price of $6.00 will already reflect the NPVs of both new products as the decision to launch them was taken two days ago.

In a semi-strong form efficient market the markets value shares based on information relevant to past movements and also published information

10. 

payment for the future: Lack of cash then borrow, D2M/spot rate*1.05borrow rate=payment cost in 6 months, excluding the interest, later convert to home currency, then deposit in the bank.

11. buying a cap and selling (not buying) a floor would be an example of a collar,

12. An over-the-counter option is an agreement with a financial institution and an immediate premium is payable on taking out the option. However, it cannot be traded and it is only exercised if actual interest rates are less favourable.

13. A conservative investment policy involves carrying higher amounts of current assets, a conservative financing policy involves using more long-term finance than short-term finance.

Conservative investment strategy Relatively high level of current assets

Aggressive investment strategy Relatively low level of current assets

Aggressive financing strategy Relatively large amounts of short-term finance

Conservative financing strategy Relatively small amounts of short-term finance

14. With tax: Modigliani and Miller’s theory stated that the optimal capital structure is made up almost entirely of debt. Under this model companies should have high financial gearing.

with no tax :The weighted average cost of capital remains constant with increased gearing

15. ordering policy

Ordering cost = $200 x (600,000/100,000) = $1,200 per year

Consumption during one week lead time = 600,000/50 = 12,000 units

Buffer inventory = re-order level less lead time usage = 20,000 – 12,000 = 8,000 units

Average inventory held during the year = 8,000 + (100,000/2) = 58,000 units

Holding cost = 58,000 x $0·50 = $29,000 per year

Total cost = ordering cost plus holding cost = $1,200 + $29,000 = $30,200 per year

16. Exchange tradable options and futures contracts are the instruments which have standard contract sizes. 

16. TERP $6.60

Rights issue price $5.00

TERP is the market price before the rights issue less the value of a right per existing

share = $7.00 – $0.40 = $6.60.

The issue price can be calculated from the TERP by subtracting the value of a right.

The value of a right can be calculated by multiplying the value of a right per existing

share by the number of shares needed for one right.

Value of a right = 4 x $0.40 = $1.60

So the rights issue price is $6.60 – $1.60 = $5.00

17.  A weak $ would make imports more expensive because it would take more $ to buy the goods and services from suppliers who use other currencies. The opposite is true of exports so statement 2 is correct. Because a weaker $ would encourage exports this would be part of an expansionary policy.

18. 

Expectations theory suggests that the shape of the yield curve depends on the expectations of investors regarding future interest rates.

Market segmentation theory suggests that the borrowing market can be divided into segments (e.g. the short- and long-term ends) and that each investor has a “preferred habitat” and will be offered different yields in the segments which causes a kink in the curve.

A yield curve is “inverted” when the yield on short-term debt is higher than the yield on longer-term debt.  This can happen if government monetary policy has increased short-term interest rates with the objective of reducing inflation. 

Liquidity preference theory suggests that investors prefer to have their cash returned to them sooner rather than later.  The compensation that investors require for lending their cash therefore increases with the duration of the finance provided. Therefore, investors want less compensation for short-term lending than for long-term lending.

19. A letter of credit would mean that the contract wa with the bank of the customer, and they will be obliged to make a payment onve delivery has taken place.