International Finance Case Study on

Transnational Corporate Advisory Services

Submitted to Mr. Surya Bahadur GC Faculty Member Pokhara College of Management Submitted by Nikesh Dwa Roll no. 24 (M)

Table of Contents S.no. Title 1 Introduction 1.1 Background of the Case 1.2 The Problem/Risk 1.3 Objectives of the Case 2 Case Analysis 2.1 Exchange Rate Forecast 2.2 Need For Hedging 2.3 Hedging Alternatives 3 Summary 3.1 Conclusion and Recommendations Page no. 1 1 1 1 2 2 5 7 12 13

/ A e w s w d t w e o . f p i e n c d v i e t a s . t i c n o p m e t / d h a i e r a t . c i u c o r l m r e / e s t n / b e t r a s m a s c i c / s d o u / 0 d n e t 4 / b t s 0 5 r h a o 0 7 t w 0 i s o 4 . t h a s e p # c o i x u n z z t 1 r y r Y b p U i m E h s t P A 5 1 j s Q j A p 4 b e q

1. Introduction
1.1 Background of the Case
Transnational Corporate Advisory Services (TCAS) Inc was a financial training and consulting firm founded by three partners in 1984. It merged with Computer Software and Systems Company in 1988. TCAS, Inc.'s business line included development of specialized softwares, financial training, business consulting and management information systems setup. TCAS, Inc. experienced rapid growth in net income and assets in the 1980s due to the dramatic changes in computer technology and communication, the deregulation of financial markets, and the increased emphasis on globalization. However, starting 1993, TCAS, Inc. started facing sharp competition from much larger competitors. This brought about a significant reduction in the company's net income and the company was in heavy debt. So TCAS, Inc. decided to break national barriers and make an entry into the international market. In 21st March 1995, TCAS, Inc. tendered a bid for the delivery and installation of a new management information software system and an extensive local area network computer system for a Canadian government agency, Canadian Crown Corporation. The bid got accepted on 15th May and as per the terms, 10% of the purchase price (C$was wired as a deposit on 16th May.

1.2 The Problem/Risk

The total value of the bid was Canadian $2,900,000. The spot rate at the time of tendering the bid i.e. 21st March was US$1 = C$1.4096 while the spot rate when the deposit was paid i.e. 16th May was US$1 = C$1.3594. The C$/US$ exchange rate moved unpredictably within a narrow range over the past several months. Mr John Christopher, the assistant treasurer of TCAS, Inc. realised that there was a possibility of the Canadian dollar depreciating against the US dollar during the next 90 days before he received his final payment from the Canadian government agency.

1.3 Objectives of the Case

In this case, we take the job of Judy Wright, Mr. Christopher's account manager and assist Mr Christopher in selection of the appropriate hedging alternative. To be more specific, our objectives will be to: Analyze the exchange rate movements and forecast the possibilities Make a financial analysis of the company and explain the need for hedging Calculate the outcomes of each hedging alternative and choose the best alternative.

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2. Case Analysis
2.1 Exchange Rate Forecast
The Canadian dollar had remained relatively stable against the US% until mid-April. It declined during early May and had recovered slightly by mid-May. This was a rather unpredictably currency movement.
The US dollar and the Canadian dollar Month January 3 February 7 March 7 April 4 May 2 Avg. C$/US$ 1.4027 1.3978 1.4168 1.4005 1.3553

Macroeconomic Analysis For the purpose of forecasting the exchange rates, we will now carry out a macroeconomic analysis.
Exhibit 3 Macroeconomic data 1989 Real GDP Growth % Canada Real GDP Growth % US Inflation CPI % Canada Inflation CPI % US Unemployment Rate % Canada Unemployment Rate % US Gov. Deficit as % GDP Canada Current Account as % of GDP Canada Gross Savings as % of GDP Canada Investment as % of GDP Canada Current Account C$ (billions) Capital Account C$ (billions) Short-term Interest Rates Canada Short-term Interest Rates US Long-term Interest Rates Canada Long-term Interest Rates US C$/US$ Exchange Rate Gov. Deficit as % of GDP US Source: OECD Economic Outlook (June 1998) 2.4 2.5 5.0 4.8 7.5 5.3 1.4 -3.9 19.4 21.9 -22.8 24.1 12.3 8.1 9.9 8.5 1.184 -1.5 1990 -0.2 1.2 4.8 5.4 8.1 5.5 0.7 -3.4 16.4 19.1 -21.6 23.2 13.0 7.5 10.8 8.6 1.167 -2.5 1991 -1.8 -0.6 5.6 4.2 10.4 6.7 -2.0 -3.7 14.3 20.0 -23.6 22.1 9.0 5.4 9.8 7.9 1.146 -3.2 1992 0.8 2.3 1.5 3.0 11.3 7.4 -2.9 -3.6 13.2 19.7 -21.4 16.8 6.7 3.4 8.8 7.0 1.209 -4.3 1993 2.2 3.1 1.8 3.0 11.2 6.8 -2.6 -3.9 13.7 20.2 -22.3 22.9 5.0 3.0 7.9 5.9 1.290 -3.4 1994 4.6 4.1 0.2 2.6 10.4 6.1 -0.5 -2.7 15.4 18.6 -16.3 12.3 5.4 4.2 8.6 7.1 1.366 -2.0 -10.1 9.9 7.1 5.5 8.3 6.6 1.370 -1.6 1994 Est 2.4 3.3 1.9 2.8 9.6 5.6 1.0 -0.5

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GDP Real GDP Growth % Canada Real GDP Growth % US - 2.4 - 3.3

The higher growth in the US compared to Canada will simulate foreigners to buy American assets thereby appreciating the US dollars in relation to the Canadian dollar (possibility of Canadian dollar depreciating). Inflation Inflation CPI % Canada Inflation CPI % US - 1.9 - 2.8

A country with a lower inflation exhibits a rising currency. So in this case, there is a chance that the Canadian dollar will appreciate. Unemployment Unemployment Rate % Canada Unemployment Rate % US - 9.6 - 5.6

Unemployment slows down overall economic performance. As a result, investors' confidence declines and lowers the demand for the currency. Here, there is possibility of the Canadian dollar depreciating against the US dollar. Interest Rates Short-term Interest Rates Canada Short-term Interest Rates US Long-term Interest Rates Canada Long-term Interest Rates US - 7.1 - 5.5 - 8.3 - 6.6

Higher interest rates means that investors get a higher return for their investment. This increases the demand for the currency of the country with a higher interest rate which ultimately appreciates the exchange rate value of the currency. The spread between short term interest rates is an important factor in estimating the C$/US$ exchange rates in this case. The greater the spread, stronger the Canadian dollar. The short-term interest spread between Canada and the United States had increased from virtually zero in November 1994 to 2% in early April 1995. However the Canadian Central Bank had indicated that it would soon push interest rates lower in order to stimulate employment. This would drive down the value of the Canadian dollar against the US dollar.

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Current Account Current Account C$ (billions) - -10.1

A deficit in the current account shows the country is spending more on foreign trade than it is earning. In other words, the country requires more foreign currency than it receives through sales of exports. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests. This also signals a possibility of the Canadian dollar depreciating against the US dollar. Overall, there is a high chance that the Canadian dollar will depreciate against the US dollar during the 90 day period after which TCAS, Inc. will receive its final payment.

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2.2 Need For Hedging

In the previous section, we concluded that there was a higher probability that the Canadian dollar will depreciate against the US dollar. This itself is the first and foremost reason that TCAS, Inc. should hedge against the foreign exchange risk. We will now carry out the financial analysis of TCAS, Inc.
EXHIBIT 1 Year Ended Dec 31 1987 1988 1989 1990 1991 1992 1993 1994 1994 Balance Sheet ASSETS Current Assets Cash and Securities Accounts receivable Inventories Total Current Assets Property, plant and equipment Cost Less: Accumulated depreciation Goodwill and intangibles TOTAL ASSETS LIABILITIES Current Liabilities Bank loans Accounts payable Notes payable Long-term liabilities Debt TOTAL LIABILITIES Equity and retained earnings TOTAL LIABILITIES AND EQUITY 620.0 2030.0 1350.0 3380.0 810.0 480.0 120.0 2240.0 (330.0) 520.0 3380.0 (US$ 000) 250.0 620.0 80.0 950.0 TCAS, INC. Sales and Income Statement Sales (US$ 000) 1250 1930 2200 2270 2940 3150 2870 2650 Net Income (US$ 000) 550 850 1120 1050 1640 1700 550 -250

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Looking at the Sales and Income statement above, it is evident that the sales and net income of TCAS, Inc. has been on a declining trend since the past two years. The company has even incurred a net loss of US $250,000 in the past year. Current Ratio = Current assets/ Current liabilities = 950 / (810+480+120) = 950 / 1410 = 0.6738 The current ratio of TCAS, Inc. is below one, i.e. the current liabilities exceed the current assets. This indicates that the company may have some problems paying off its debts in the short-run. Debt-to-equity ratio = Total liabilities / Equity and retained earnings = 2030 / 1350 = 1.5037 We can interpret a debt-to-equity ratio of 1.5037 as saying that the company is using $1.5037 of liabilities in addition to each $1 of shareholders' equity in the business. If the debt-to-equity ratio is greater than 1, the majority of the companys assets are financed through debt. If the ratio is less than 1, its assets are primarily financed through equity. Though it is normal for capital intensive companies like auto manufacturing companies to have a debt-to-equity ratio of over 2, the debt-to-equity ratio of TCAS, Inc. is quite high for its sector. TCAS, Inc. does not have much more borrowing capacity.
EXHIBIT 2 Bid Preparation (US$) Design Materials Labor & installation Shipping Direct overhead Allocation of indirect overhead Sub-total Mark-up(5%) TOTAL BID Conversion to C$ at March 21 Spot rate of US $1 = C $1.4096 300,000 779,287 724,500 32,466 84,000 39,100 1,959,353 97,967 US $2,057,320 C $2,900,000

The data above shows that the mark-up for the project is pretty high for TCAS, Inc. considering that it has incurred a net loss in the previous year. This single project was capable of solving most of the company's financial woes. However we can also see that the company is in immediate need of funds to get the project started. Though a performance bond and the 10% deposit would secure some funds for the company, it would still need about a million dollars more. From our overall financial analysis, we can safely conclude that TCAS, Inc. is in a tough financial position. The company is heavily in debt and the sales are declining. We also realize that the current contract is of high importance to the company. Since there are chances of the Canadian dollar depreciating against the US dollar, hedging is the ideal course of action that Mr John Christopher should take.

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2.3 Hedging Alternatives

In this section, we closely examine the different foreign currency hedging alternatives that are available to Mr. John Christopher. First of all, we calculate the net receivable amount based on the spot rate of May 16th Pre-hedge amount receivable = C $2,610,000 / (C $1.3594/US $) = US $1,919,964.69 US $1,919,965 1. Forward Contract: Three-month forward rate Current spot rate (May 16) : US $1 = C $1.3653 : US $1 = C $1.3594 OR C $1 = US $0.7324 OR C $1 = US $0.7356

A forward contract is a non standardized contract between two parties to buy or sell an asset at a predetermined price on an agreed date. In this case, TCAS, Inc. must take a short position (agree to sell) on the forward contract. Guaranteed receivable amount = C $2,610,000 / 3 month forward rate = C $2,610,000 / (C $1.3653/ US $) = US $1,911,667.765 US $1,911,668 The guaranteed receivable amount after a forward contract is less than the pre-hedge amount receivable because of the forward premium.

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2. Foreign Currency Loan: As per this alternative, TCAS could take a Canadian dollar loan from Ms. Wright's bank for 90 days and then use the proceeds on completion of the contract to repay the principle and accrued interest. The borrowed amount could be converted into US dollar at the prevailing spot rate. Any gain or loss on the receivable amount due to the change in exchange rate would be balanced by the equivalent losses or gains on the loan amount itself. Three-month loan interest rate Arrangement fee Total cost of obtaining the loan = (10.25%+2.25%)/4 = 3.125% = 0.125% = loan interest rate + arrangement fee = 3.125% + 0.125% = 3.25%

Amount to be borrowed

= C $2,610,000/(1+0.0325) = C $2,527,845.36

Borrowed amount in USD = C $2,527,845.36 / (C $1.3594/US $) = US $1,859,529.966 Amount to be repayed after 3 months = C $2,527,845.36 * (1+0.0325) = C $2,610,000.33 C $2,610,000 So the bank loan can be repayed using the proceeds from the Canadian company Total amount to be received from the bank at the end of 3 months (assuming that TCAS gets the prime rate in deposits) = US $1,859,529.966 * (1+8.875%/4) = US $1,900,788.287 3. Foreign Currency Options: Call Option In this case, we sell the right but not the obligation to buy a specified amount of Canadian dollars at a specified strike price on a specified date from us. In exchange, we receive the call premium. Call premium Underlying asset Strike Price = C $2,610,000 * US $0.0356 / C$ = US $92,916 = C $2,610,000 = US $ 0.7200 / C$

Expected spot rate US $0.50/C$ US $0.60/C$ US $0.70/C$ US $0.71/C$ US $0.72/C$ US $0.73/C$ US $0.74/C$

Exercise? No No No No Yes Yes Yes

Page 8 Amount if exercised US $1,305,000 US $1,566,000 US $1,827,000 US $1,853,100 US $1,879,200 US $1,879,200 US $1,879,200

Premium US $92,916 US $92,916 US $92,916 US $92,916 US $92,916 US $92,916 US $92,916

Receivables on August 16 (US$) US $1,397,916 US $1,658,916 US $1,919,916 US $1,946,016 US $1,972,116 US $1,972,116 US $1,972,116

If the spot rate moves above US $0.72/ C$, the call option buyer will exercise the option and we earn the premium plus the exercised amount. However, if the spot rate moves down significantly, TCAS, Inc. might face severe risks. Put Option Here, we buy the right but not the obligation to sell a specified amount of Canadian dollars at a specified strike price on a specified date. In exchange, we pay the put premium. Put premium Underlying asset Strike Price = C $2,610,000 * US $0.0225 / C$ = US $58,725 = C $2,610,000 = US $ 0.7200 / C$
Exercise? Yes Yes Yes No No No Amount if exercised US $1,879,200 US $1,879,200 US $1,879,200 US $1,905,300 US $1,931,400 US $1,957,500 Premium US $58725 US $58725 US $58725 US $58725 US $58725 US $58725 Receivables on August 16 (US$) US $1,820,475 US $1,820,475 US $1,820,475 US $1,846,575 US $1,872,675 US $1,898,775

Expected spot rate US $0.70/C$ US $0.71/C$ US $0.72/C$ US $0.73/C$ US $0.74/C$ US $0.75/C$

If the spot rate moves above US $0.72/C$, we can take advantage of the appreciation of the Canadian dollar so we will not exercise the put option. 4. Foreign Currency Futures: A futures contract is a standardized contract between two parties to buy or sell a standardized quantity of an asset at a predetermined price on an agreed date. August Future Price Current spot rate (May 16) : C $1 = US $0.735 : C $1 = US $0.7356 = US $50 = C $100,000 OR US $1 = C $1.3605 OR US $1 = C $1.3594

Cost of a round turn per contract One Canadian Dollar Future Contract

Number of future contracts required = C $2,610,000 / C $100,000 = 26.1 Total cost of the futures contract = 26.1 * US $50 = US $1305 Amount receivable on August 16th = (C $2,610,000 * US $0.735/C$) - US $1305 = US $1,917,045
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5. Pre-sale of Foreign Contract: Using this option, TCAS, Inc. could sell the Canadian dollar contract at a discount to Ms Wright's bank's export finance subsidiary. Discount rate = 7.375% + 1.825% = 9.2% Arrangement fee = 0.5% Total receivable amount = C $2,610,000 Discounted amount = C $2,610,000 / [1+(9.2% / 4)] = C $2,610,000 / 1.023 = C $2,551,319.648 = 0.5% of discounted amount = 0.5% of C $2,551,319.648 = C $12756.598

Arrangement fee

Canadian dollars receivable on the sale of contract = Discounted amount arrangement fee = C $2,551,319.648 C $12,756.598 = C $2,538,563.05 US dollars receivable on the sale of the contract Amount receivable at the end of 90 days = C $2,538,563.05 * US $ / C $1.3594 = US $1,867,414.337

= US $1,867,414.337 * (1+8.875%/4) = US $1,908,847.593

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6. Tunnel Forwards: This is a hedging alternative that fully protects TCAS, Inc. from foreign exchange risks. Being a call option seller and a put option buyer, it can create a range within which the settlement will fall. Furthermore, there is no upfront premium paid. Upper settlement limit Lower settlement limit = C $2,610,000 * US $0.7533/C$ = US $1,966,113 = C $2,610,000 * US $0.7133/C$ = US $1,861,713

The current spot rate is C $1.3594 / US$. If it rises above C $1.3275 / US$, the benefits are dissolved because the call option buyer will exercise the option. If the spot rate moves below C $1.4019, we can eliminate the losses by exercising the put option. Thus the risks and

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3. Summary
The returns from all the hedging alternatives are listed below:
Alternative Original Expectation (March 21 spot rate) Remain unhedged Forward contract Foreign currency loan Foreign currency call option Foreign currency put option Foreign currency futures Pre-sale of foreign contract Tunnel Forwards (upper limit) Tunnel Forwards (lower limit) Settlement amount (Aug 16) US $1,851,589.103 US $1,919,965.690 US $1,911,668.765 US $1,900,788.287 US $1,972,116.000 US $1,820,475.000 US $1,917,045.000 US $1,908,847.593 US $1,966,113.000 US $1,861,713.000

Original Expectation This should have been the receivable amount on August 16th according to the calculations of the accounting department in order to get a mark up of 5%. Remain Unhedged - The return from this alternative is calculated based on the May 16 th spot rate. The return might look attractive but we know from our exchange rate forecasts that the spot rate on August 16th is unlikely to stay the same. Forward Contract - This alternative guarantees TCAS, Inc. a return of US $1,911,668.765. Even if it gives a lower return than the return from the May 16th spot rate, it is higher than the calculated return of March 21st and so it will help the company maintain a markup higher than 5%. Foreign Currency Loan Here too, the return is guaranteed but the proceeds are lower than that of a forward contract. Moreover, TCAS, Inc. is not in a position to increase its debts. Foreign Currency Call Option The return here is quite attractive but we must keep it in mind that if the value of the Canadian dollar depreciates by a considerable amount, TCAS, Inc. might have to face severe risks. Foreign Currency Put Option This alternative allows TCAS, Inc. to take advantage if the value of the Canadian dollar appreciates but according to our forecasts, it is unlikely that the Canadian dollar will appreciate. If it depreciates, the return will not be sufficient for TCAS, Inc. to earn a markup of 5%. Foreign Currency Futures The return here is guaranteed to be US $1,917,045.000. It is an attractive return and there are no risks too. Pre-Sale of Foreign Contract Here, TCAS can immediately get the much needed cash but the return is lower than the guaranteed returns from the forward and futures contracts.

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Tunnel Forwards Tunnel forwards involves taking a short position on call option and a long position on put option. In this case, though the ceiling of the alternative is quite attractive and the initial investment is null, we know that the chances of the Canadian dollar appreciating is quite low. The floor return is not very attractive compared to the other alternatives.

3.1 Conclusion and Recommendation

Considering the economic benefits and the mitigation of risk, foreign currency futures seems to be the reasonable choice for TCAS. Of course, there are other factors that can be used as the decision criteria such as ease of implementation, cost and the need for working capital. But these variables are secondary in nature and risk minimization and economic benefits are the need of the hour for TCAS, Inc. I hereby would like to suggest Mr John Christopher that buying foreign currency futures would be the ideal decision for TCAS, Inc.

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