Assume that U.S. Machine Tool has $50 million of debt outstanding that will mature next year. It currently has cash flows that fluctuate with the dollar–pound exchange rate. Over the next year, the possible exchange rates are $1.50/£ and $1.90/£, and each exchange rate is equally likely. The company thinks that it will generate $30 million of cash flow from its U.S. operations, and its expected pound cash flow is £12 million.

a. If U.S. Machine Tool does not hedge its foreign exchange risk, what will be the current market value of its debt and equity, assuming, for simplicity, that the appropriate discount rates are 0?

b. Suppose that U.S. Machine Tool has access to forward contracts at a price of $1.70/£. What is the value of the firm’s debt and equity if it hedges its foreign exchange risk? Would the shareholders want the management to hedge?

c. Suppose U.S. Machine Tool could invest $1 million today in a project that returns £1 million next period. Is this a good project for the firm?

d. Suppose that U.S. Machine Tool is unhedged, that its managers are trying to maximize the value of the firm’s equity, and that the $1 million must be raised from current shareholders. Will the managers accept the project?

e. If U.S. Machine Tool hedges its foreign exchange risk, would the firm accept the project?