Hedging, Leverage, Return on Assets The Cheesecake Factory Inc.'s December 31, 2012, balance sheet shows total liabilities of $700 million and total assets of $1 billion; measured financial leverage is therefore 0.70. Included in current liabilities is $400 million (C$500 million) payable on April 1, 2013, to a Canadian supplier. Cheesecake Factory's management expects exchange rates to converge to $0.83/C$ on March 31, 2013, and April 1, 2013.
Required
Assuming that Cheesecake Factory's management always seeks to portray the most positive financial picture possible, assess the effects of the following actions. Disregard income taxes.
a. On January 1, 2013, management enters into a 90-day forward purchase contract for C$500 million, costing $440 million. Compute the expected gain or loss from hedging compared with not hedging. Assuming total assets and liabilities are unchanged except as indicated by exchange rate movements, analyze how the hedge affects Cheesecake Factory's financial leverage when first quarter 2013 interim financial statements are issued.
b. If Cheesecake Factory can borrow domestically at 12% per annum, evaluate the wisdom of using the forward contract described in part a above to neutralize the exchange rate risk.
c. Cheesecake Factory's operating income for 2012 was $152 million; its annual return on average total assets (ROA) in 2012 was 16 percent. Cheesecake Factory projects the same relationship for 2013 at current exchange rates. Management considers purchasing C$500 million on January 1, 2013, for delivery in 90 days for $405 million to hedge the payable to the Canadian supplier. Cheesecake Factory projects total assets at $1.2 billion at March 31, 2013. Holding March 31, 2013, assets at $1.2 billion, analyze how hedging the payable, compared with not hedging, affects the first quarter ROA. Assume that foreign exchange gains and losses are part of operating income.