Topic and Instructions for Assessment 2

125.320 International Finance, Semester One 2024

Topic: International Operation and Exposure to Foreign Exchange Risk

Suppose a New Zealand company KAR manufactures and sells a variety of
microchips for applications in space, defence, automotive, telecommunication, and
consumer products. The company imports raw materials from Malaysia, therefore,
incurs production costs of raw material denominated in Malaysian Ringgit (MYR).

Currently, the company manufactures and sells 60,000 units of products each
year, including 20,000 units sold in Australasia in the New Zealand dollar
denomination at NZ$80 per unit, and 40,000 units in North America priced in the
USD denomination at $50 per unit. The variable cost of raw material is 125
Malaysian Ringgit per unit. KAR also incurs annual fixed costs of NZ$1,200,000 and
depreciation expense of NZ$600,000.

Recently, the company has received expressions of interests in its products

from several European companies. If the company decides to enter the European
market, it is estimated that an additional 16,000 units of sales can be achieve in the
first year. Products sold to the European market will be priced in the euro
denomination at €45 per unit. If the company decides to expand its operation by
exporting to the European market from next year, it will need to import more units of
raw materials from Malaysia, totaling at 76,000 units per year. KAR’s European
expansion will not affect its existing operation in the Australian and the North
American markets. Due to the existing excess manufacturing capacity the company
currently possess, KAR does not need to acquire any new assets should it decide to
go ahead with the European expansion. Therefore, the annual depreciation amount
will remain unchanged at $600,000. However, annual fixed costs will increase by
NZ$400,000 to $1,600,000.

KAR will pay for its material imports at the end of each quarter, with the next
payable due in 90 days. The annual sales quantities in each market segment
(Australasia, North America, and European) are spread over quarters in order to
avoid excessive inventories for the importers. KAR expects to receive the payments

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for these sales at the end of each quarter, with the next international receipts will
occur 90 days from now. Exhibit 1 presents a summary of the projections for KAR’s
operation for the next quarter, assuming the current exchange rates will be sustained
over the next year.

Exhibit 1. Projected operations for the next quarter:

Scenario: without expansion to European market

Sales quantity 15,000 units
Variable cost per unit MYR125 per unit
Sales price: 5,000 units @ NZ$80 per unit
Sales price: 10,000 units @ US$50 per unit
Fixed costs NZ$300,000
Depreciation NZ$150,000
Income tax rate 28%
Scenario: with expansion to European market
Sales quantity 19,000 units
Variable cost per unit MYR125 per unit
Sales price: 5,000 units @ NZ$80 per unit
Sales price: 10,000 units @ US$50 per unit
Sales price: 4,000 units @ €45 per unit
Fixed costs NZ$400,000
Depreciation NZ$150,000
Income tax rate 28%

Before making a final decision about the European expansion plan, the senior
management team would like to find out how would the expansion plan affect the
company’s quarterly financial performance measured by net income (profit after tax),
and net operating cash flow. In addition, the senior management team would like to
know how much foreign exchange risk the company is exposed to, with and without
the European expansion. They also want to know what various techniques the
company can use to protect itself from the exposures to foreign exchange risk, and
which technique is superior to the others. Therefore, the CEO asked you, who
recently joined the company as a graduate financial analyst, to quantify the risk
exposure and identify the hedging technique most appropriate for the company.

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 You have collected some information for the three currencies of exposure as
summarized in Exhibit 2, and come up with some forecasts for the probability
distributions of the spot exchange rates in 90 days which are presented in Exhibit 3:

Exhibit 2. Exchange rates and interest rates quotations

Malaysian Ringgit (MYR) US dollar (US$) Euro (€)

Current spot rate MYR2.8900/NZ$ $0.6100/NZ$ €0.5660/NZ$
90-day forward rate MYR2.8800/NZ$ $0.6090/NZ$ €0.5580/NZ$
90-day borrowing 5.60% p.a. 8.40% p.a. 4.80% p.a.
rate
90-day lending rate 2.80% p.a. 6.20% p.a. 3.60% p.a.

New Zealand 90-day borrowing rate 7.20% p.a.

New Zealand 90-day lending rate 6.00% p.a.
Note: All interest rates are quoted as annual rates.

Exhibit 3. Spot exchange rates forecasts in 90 days

Scenario Probability MYR/NZ$ USD /NZ$ €/NZ$

1 15% 2.8920 0.5970 0.5740
2 25% 2.8890 0.6000 0.5630
3 20% 2.8800 0.6080 0.5560
4 25% 2.8720 0.6150 0.5520
5 15% 2.8660 0.6280 0.5480

Based on the above information, you will need to estimate the quarterly
financial performance of the company, calculate the size of net exposure to each
foreign currency, and give advice on the detailed steps of forward hedge and money
market hedge strategies for protecting the company’s exposure to each currency
(MRY, USD and Euro). Prepare a report to present your analytical results and make
recommendations for the desirability of expansion to the European market, and the
best approach to managing the exposure to foreign exchange rate risk.

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Tasks and questions for discussion in your report:

1. Discuss what types of foreign exchange risk that KAR is exposed to?
2. Based on the existing annual sales of 60,000 units, estimate KAR’s quarterly net
income and net operating cash flow in the NZD denomination.

3. Based on the scenario of entering the European market, estimate KAR’s

quarterly net income and net operating cash flow in the NZD denomination.

4. Calculate the size of KAR’s foreign exchange exposure to each foreign currency,
namely, MRY, USD and euro.

5. If KAR decides to leave its foreign exposures unhedged, how will the exchange
rate uncertainty affect its quarterly financial performance measured in the NZD
denomination? Would you support the expansion plan? (Hint: evaluate changes
in performance outcomes in response to changes in foreign exchange rates)

6. Evaluate the outcomes of the money market hedge, and the forward hedge for
the exposures to all three currencies including MRY, the US dollar and the euro.

7. Compare the two hedging alternatives with the unhedged positions. Would you
recommend a hedge or no hedge? If you recommend a hedge, which hedging
strategy is more desirable?

8. Are there any financial hedging or operational techniques that KAR could benefit
from?

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 Instructions for report writing and submission

• You are encouraged to complete this assignment in collaboration with other

students as a group. Each group can have a maximum of three students.

• An assignment group can be organized through private arrangement or posting a

request in the "Communication Tools" section in Stream. There is no
requirement for registering your group in Stream.

• Ensure your report covers all of the points listed in the section titled “Tasks and
questions for discussion in your report”.

• The suggested length of your report is 5 to 6 pages including title page,

references and appendix.

• A useful resource for guidance on preparing and writing a report can be found
from: https://owll.massey.ac.nz/assignment-types/report.php

• When submitting a group report, make sure that only one of the group members
make a submission of the report. It is important to avoid submitting a report more
than once as Turnitin would return a give a 100% similarity rate for a report that
is submitted twice. When submitting a group report, ensure all the group
members' names and student IDs are printed on the front page of the report. All
the students within the group will receive an identical mark for this assessment.

• The reports will be marked out of 20 based on the qualities of content, structure
and writing. A marking guide is provided on the next page.

• Once completed, submit your report to “Dropbox for Assignment Reports” under
the “Assessment” section in Stream, no later than 23:59pm, the 16th of May,
2024.

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 Marking guideline

Assignment reports are marked out of 20 based on the quality in three aspects:
Criteria Value /Score
Quality of content
• coverage and depth of discussion
• accuracy of the information presented in your arguments /15
• relevance and conciseness of the evidence raised to support
your viewpoints

Quality of structure
• logical flow of discussion
• layout and visual appearance
/2

Quality of writing
• clarity and coherence of writing
• sufficient discussion, readability of discussion /3
• correct use of spelling, grammar and punctuation
• correct reference format (in APA style) is followed

Total /20

Each category is marked on a scale of 1 to 5, where 5 = Excellent, 4 = above

average, 3 = Good, 2 = Barely adequate, 1= Unsatisfactory.
Specific marks will not be allocated to each sub-category, an overall mark will be
awarded based on the criteria above.

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