Ivy

9A92BO21

OGIES INC

Sandra Galli prepared this case under the supervision of Professor James E. Hatch solely to provide material
for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a
managerial situation. The authors may have disguised certain names and other identifying information to
protect confidentiality.

Ivey Management Services prohibits any form of reproduction, storage or transmittal without its written
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Copyright @ 1992, Ivey Management Services Version. (A) 1999-05-05

On October 1, 1992, Eileen Harrison, vice-president finance for Advance

Technologies, was contemplating the effects that a weakening Canadian dollar
would have upon the company's projected 1993 financial results. The upcoming
Canadian Constitutional Referendum (on whether Quebec can secede from the rest
of Canada) was having marked effects on the value of the Canadian dollar, which
had fallen 3 .56 cents in value relative to the U.S. dollar since the first of
September. Advance had recently entered into a loan agreement with a major
Canadian bank, to finance its expansion into manufactured specialty plastics . To
remain in compliance with the covenants of the loan, Advance was required to
generate a minimum level of profitability throughout the term of the loan . In light
of the recent volatility in currency markets worldwide, Harrison knew it was
ortant to understand the effects that an ever-weakening dollar would have on
e's income and cash flows, and the tools available to manage them.

THE COMPANY

Technologies engaged in the manufacture and sale of a wide range

of engineered plastic pro :ts in the Canadian marketplace. A decision was made
1990 to aursue a strategy focused on specialty, proprietary products .
believed this approach to the Canadian marketplace was essentia
ce to build a lasting competitive advantage. After a long search, Advance
agreement s, a large plastic resin
 her 30, 1991 . The agreement granted
Advance exclusive Canadian manufacturing and distribution rights to a
is called Clyokc. While Cryolac was a premium product it
ed competition produced plastics . In exchange,
ed to pay an u sum, a monthly licensing fee of US$250,000, and was
required to purchase raw rials necessary to the manufacture or Cryolac Fi,om
h pure e made in U.S. dollars at prices neollsed Annuab,

e the upfront investment in Cryolac and the purchase of specialty

factoring equ ned financing from two sources - a
Canadian b tries. Contained in the Canadian loan agreement
were several covenants regarding profitability. Advance was required to generate,
at a minimum, a before tax profit of $9 million . Hart agreed to accept a
million note from Advance as partial payment of the upfront licensing fee.
note was payable in full ten years from the date of the agreement.

THE SITUATION

Advance was exposed to significant foreign exchange risk as a result of the Hart
agreement While all of the company's revenues were denominated in Canadian
dollars, a large part of its expenses were paid in U.S . funds. Thus, Advance had to
regularly convert its Canadian dollar cash flows to cover expenses in the United
States . As the Canadian dollar weakened, Advance's cash flow and profitability
were adversely affected .

ison was faced with a great deal of uncertainty regarding the relative exchange
rate of the Canadian and U.S. dollars over the next twelve months . The historical
elationship between these two currencies is illustrated graphically in Exhibit 1 .
oth domestic and international events were creating unprecedented levels of
volatility in currency markets, and the Canadian dollar was dropping rapidly in
response . A Globe and Mail article (September 29, 1992) discussing the situation
is presented in Exhibit 2.

rison's concerns were compounded by the loan covenants regarding

profitability. While Advance's projected income before tax of $12 .5 million was
more than acceptable, Advance's budget was based on a U.S, dollar equal to
CDN$1 .2195 and the dollar was currently trading at $1 .2536 . Exhibit 3 outlines
envy budgeted financial statements for the current fiscal year.

Hedging Vehicles

estigated various alternatives for hedging Advance's foreign

They included: 1) call options, 2) put options, and 3) forward
 9A9213021

contracts.
obligation, to pure
or before a specified date . The amount paid for this privilege is called the option
premi

lwmer of a put option has the option to sell foreign curren rice
for i p,ii- ti,~iil,ii time period . pwpned to
ACK m_

Two
types of options were available - American and European . American-style
options could be exercised any time between the date of purchase and the maturity
date, whereas European-style options could only be exercised on the maturity date .

Forward contracts obligate the buyer to purchase a specific amount of foreign

currency at a specified date in the future at a locked-in exchange rate . The
exercise of a forward contract is not optional .

Alternative Hedging Strategies

rison was considering a number of strategies including the purchase of a call

option, the simultaneous purchase of a call option and sale of a put option, and the
purchase of a forward contract .

Advance could purchase U.S. dollar call options only. This strategy involves the
purchase of a number of call options in amounts equal to the anticipated monthly
U .S . dollar cash outflow. The result of this strategy would be to set an upper limit
the
to cost of future purchases of U .S, dollars . The call premiums for options with
a strike price equal to the current exchange rate (i.e ., 1 .2536) are provided in
bit
4.

A second strategy that Advance could follow would be to purchase a number of

call options as noted above and simultaneously sell a number of put options for
alent dollar amounts. The impact of this strategy would be to set an upper
to the cost of future purchases of U.S . dollars and generate some money for
the firm from the put premiums . However it would also limit the benefit that
would accrue to Advance of anv increase in the value of the Canadian dollar. This
strategy is called a "collar" . Since Advance would be committing to the poten
purchase of foreign currency at some future date it would be required to put up
"margin" equal to four per cent of the face value of the option . Thi
take the form of a guaranteed line of credit at the bank,

rd strategy considered by Harrison was similar to the second . In thi

would purchase calls and sell an equivalent dollar amount of puts, but the
 contract would be set in such a way
would be just offset by revenue from the sale of the put. The advantage
up this "zero cost tunnel" is that there is no net cash outlay to create the
position . and, the "protection" afforded by this strategy war
somewhat through time. A of the arrangements for a zero cost tunnel

ally, ids .iii,-e could forward contracts and lock in the cost of future
purchases of foreign currency . Since Advance is committing to the purchase of a
fixed amount of foreign currency at some future date,
equal to eight per cent of the face amount of the purchase . Forward contract rates
offer price.
are seen in Exhibit 6 . Advance would be expected to pay the

Advance's U.S, dollar cash flow requirements are relatively stable throughout the
course of the year. Therefore, any hedging strategy would involve the purchase of
twelve monthly contracts or options of equal amount, to match Advance's cash
requirements,

CONCLUSION

ison was unsure which hedging alternative to suggest to Advance

management . She wanted to show the other managers the effect on projected
income and cash flow of a Canadian dollar at 1 .2395, 1 .2595, 1 .2795, and 1 .2995
without the use of a hedging strategy . Then she intended to show the costs and
benefits of each of the proposed hedging vehicles . In order to show the worst case
scenario she decided to assume that any movement in the exchange rate would
occur on the first day of the 1993 fiscal year. Harrison's counterparts would be
very interested in the results of her analysis, since if the company did not earn $9
million before taxes, the company would be in violation of the Bank's covenants .
a 9A92802',

Exhibit 1

COST OF US$1 .00

IN CANADIAN DOLLARS

1.46
L44-
1 .42
1.40-I
138
136

132
130
118

112
110
lAs
1.16
W
W
1.10-bTnT=
 9A028

Exhibit 2

GLOBE AND MAIL ARTICLE

Tuesday, September 29192

Fears Torpedo
Canadian dollar

nged yesterday to Maastricht Treaty sent the British pound,

point in more than four years, amid
massive selling sparked by fears that the No
side had gained ground in the referendum
campaign and by last week's report
suggesting there will be economic
devastation if the country breaks up .
Despite aggressive intervention by the
Bank of Canada, the dollar came perilously
close to falling below 80 U.S . cents, a level it
has not seen since April of 1988, tumbling
0.51 cents to close at 80 .15. It came under
heavy selling pressure at noon, and then
again about two hours later. Selling began in
Tokyo early in the trading day, and
continued in North America.
Investors have begun examining their
Canadian holdings after recent polls in
Quebec and Western Canada showing
diminished support for the Charlottetown
constitutional accord, along with Friday's
Royal Bank report that Canada's standard of
living would drop and the jobless rate would
soar to 15 percent if the country broke apart .
"The No side has been getting most of the
attention, and there has been a lack of
progress by the Yes side ." said Andrew Pyle,
economist with MMS International, a
financial market information service. "The
situation is looking more dismal ."
Although the Royal Bank report appeared
to support the Yes camp, in Quebec it was
,7ed as a scare tactic by an "anglo
r. Pvle said . With `
rs," he added investors have
ided to sell Canadian holdings.
The selling pressure on the currency has
been increasing since Labour Day, when
turmoil in currency markets over
d the French referendum on
the Italian lira and other weak European
currencies reeling. Since the vote a week
ago, attention has focused on North America
and Canada's Oct. 26 referendum on the
constitutional agreement.
U.S . press reports on the weekend
speculated about a victory for the No forces .
One story dubbed the Canadian dollar the
"British pound of North America," referring
to the 10 per-cent drop in value of the pound
against the German mark in the past two
weeks. That conjures up memories of the
mid-1980s, when the currency was being
labelled the "Hudson Bay peso ."
With no end to the market turmoil in sight,
the dollar could lose another 1 .5 cents in
value by the time of the referendum, said
Mare Chandler, a New York-based currency
analyst with IDEA Inc., a financial market
information service. Even after the
referendum it is expected to fall further,
because the Canadian economy is behind the
U.S . recovery by about six months, Mr .
Chandler said .
Some of the recent selling of Canadian
investments by Japanese institutions relates
to adjusting their portfolios halfway through
their financial year.
The Canadian dollar has fallen 4.2 per cent
in value against its U.S . counterpart since
Sept . 1 . Since peaking at 89 .29 cents last
November ; it has tumbled 10 .2 per cent.
st rates on money-market
ents rose dramatically, pointing to a
of Canada rate
is week, and a potential jump of half a
percentage point in the prime
from its current 19-year low of 6.25 per cent .
Pane 7 9A92802

Exhibit 3

PRO FORMA INCOME STATEMENTS

Year Ended September 30, 1993

(CAD $000's, USD 1 .00 = CAD 1 .2195)

USD Component CAD Component Total

enue $160,000 $160,000

COGS $45,760 67,935 113,695
Gross Margin (45,760) ,065 46,305
License Fee 3,658 - 3,658
Depreciation 9,640 9,640
Selling and in . 19,232 19,232
AdmInters 91 1,191 1,282
al 3,749 30,063 33,812
EBT (49,509) 62,002 12,493
Tax (40%) 4,997 4,997
Net Income $(49,509) $57,005 496

PRO FORMA BALANCE SHEET

As at September 30, 1993

(CAD $000's, USD 1 .00 = CAD 1 .2195)

USD Component CAD Component Total

Cash - $ 678 $ 678

A/R - 17,280 17,280
Inventory - 11,555 11,555
Net Fixed s - 30,065 30,065
AsetToal $59,578 59 578

A/P $6,668 $9,492 $16,160

Debt 1,220 13,233
- 28,965 28,965
$7,888 51 b_90 59 578
 9A92BU21

Exhibit 4

AT-THE-MONEY OPTION
STRIKE PRICE = 1 .2536

PUT CALL
EXPIRY PREMIUM PREMIUM
DATE JL. OF CDN$j M OF CDN$)

1 .14 1 .25
I A4 1 .52
ec. 31, 1992 1 .65 1,74
Jan . 31, 1993 1 .73 112
Feb. 28,1993 112
Mar, 31, 1993 1 .90 9
Apr . 30, 1993 108 2.09
May 31, 1993 2.06 220
June 3, W 2.14 2,31
July 31, 1993 2.24 2.42
Aug, 31,1993 2.35 2.53
Sept. 30, 1993 2 .45 214
Average 1008 2134

Exhibit 5

ZERO COST TUNNEL

STRIKE PRICES

EXPIRY DATE PUTS CALLS

Oct. 31, 1992 $1 .2491 $12690

?4ov.30,1992 12508 1 .2749
We. 31, 1992 1 .2541 12799
an. 31, 1993 1 .2541 10821
Feb. 28, 1993 12542 1 .2842
Pdar. 31, 1993 1 .2542 12863
Apr . 30, 1993 12553 1 .2880
May 31, 1993 1 .2564 1 .2897
June 30, 1993 12575 1 .2915
July 31, 1993 12580 1 .2927
Aug . 31, 1993 12585 1,2938
Sept. 30, 1993 12590 12950
Average 1 .2551 1,2856
 Exhibit 6

1
FORWARD CONTRACT RATES

BID OFFER

628 12639
.2669 12686
4 months 1 .2681 1 .2695
onths 1 .2692 1 .2706
months 12703 12718
months 1 .2716 1 .2736
8 months 1 .2731 1 .2750
9 months 1 .2745 1 .2765
10 months 1 .2753 12775
11 months 1 .2762 1 .2784
12 months 1 .2770 1 .2794
Average 1,2703 12719

ance expected to pay the offer rate .