Case study. Answer all the questions relative to the case.

The directors of Palm Co expect that interest rates will fall over the next year and they are looking forward to paying less interest on the companys debt finance. The dollar is the domestic currency of Palm Co. The company has a number of different kinds of debt finance, as follows:

	Loan Notes	Loan Notes	Bank Loan	Overdraft
Denomination	Dollar	Pesos	Dollar	Pesos
Nominal Value	$ 20 million	300m pesos	$ 4 million	$ 3 million
Interest Rate	7% p.a	10% p.a	8% p.a	10% p.a
Interest type	Fixed Rate	Fixed Rate	Variable Rate	Variable Rate
Interest due	6 months time	6 months time	6 months time	Monthly
Redemption	8 years time at Nominal value	8 years time at Nominal value	Instalments	Continuing at current level

The 7% loan notes were issued domestically while the 10% loan notes were issued in a foreign country. The interest rate on the long-term bank loan is reset to bank base rate plus a fixed percentage at the end of each year.

The annual payment on the bank loan consists of interest on the year-end balance plus a capital repayment.

Relevant exchange rates are as follows:

	Offer	Bid
Spot rate (Pesos/$)	58.335	58.345
6-month forward rate (Pesos/$)	56.585	56.597

Palm Co can place pesos on deposit at 3% per year and borrow dollars at 10% per year.

The company has no cash available for hedging purposes. Required: Evaluate the risk faced by Palm Co on its peso-denominated interest payment in six months time and advise how this risk might be hedged!

1. Calculate the current dollar cost of this interest payment!

a.$ 514,271

b.$ 530,176

c.$ 514,183

d.$ 530,063

2. Evaluate the risk faced by Palm Co on its peso-denominated interest payment in six months time and advise how this risk might be hedged!

Calculate the 6-month dollar cost of the interest payment!

a.$ 530,176

b.$ 514,271

c.$ 514,183

d.$ 530,063

e.$ 5,530,063

3. By how much interest cost payment has changed (increased/decreased)?

a. Increased, by $ 15,905

b. Decreased, by $ 15,905

c. Decreased, by $ 15,880

d. Increased, by $ 15,880

e. Not possible to calculate, more data needed

4. Palm Co can use a money market hedge by placing pesos on deposit now, financed by borrowing dollars for repayment in six-months time. To find answer you need to calculate the six-month interest rate for placing pesos on deposit.

Pesos interest rate is:

a. 1.5 %

b. 3.0 %

c. 6.0 %

d. 5.0 %

e. 4.5 %

5. Palm Co can use a money market hedge by placing pesos on deposit now, financed by borrowing dollars for repayment in six-months time. To find answer you need to calculate the six-month interest rate for borrowing dollars.

The interest rate (6-months) for borrowing dollars is:

a. 5.0 %

b. 1.5 %

c. 6.0 %

d. 7.0 %

e. 4.5 %

6. Palm Co can use a money market hedge by placing pesos on deposit now, financed by borrowing dollars for repayment in six-months time.

How much pesos do you need to deposit now?

a. 29,556,650 pesos

b. 506,671 pesos

c. 532,005 pesos

d. 30,450,000 pesos

e. 30,000,000 pesos

7. Palm Co can use a money market hedge by placing pesos on deposit now, financed by borrowing dollars for repayment in six-months time.

How much dollars do you need to have (to borrow now) for buying pesos now?

a. $ 506,671

b. $ 532,005

c. $ 514,271

d. $ 530,176

8. Palm Co can use a money market hedge by placing pesos on deposit now, financed by borrowing dollars for repayment in six-months time.

How much shall be the dollar cost of hedging the peso interest payment after 6 months?

a. $ 532,005

b. $ 506,671

c. $ 530,176

d. $ 514,271

9. The dividend growth model (DGM) values the ordinary shares of a company as the present value of its expected future dividends and the model assumes that these future dividends increase at a constant annual rate.

What is the main problem with the DGM - considering problems provided?

a. You cant make predictions of future dividends

b. Future dividends cannot be known with certainty

c. DGM assumes that the cost of equity is constant

d. The capital asset pricing model suggests that the cost of equity will vary with changes in systematic risk

e. The dividends are of great importance to many shareholders

10. Interest Rate Parity Theory generally holds true in practice. However, it suffers from several limitations.

Which of the following is NOT a limitation of Interest Rate Parity Theory?

a. Government controls on capital markets

b. Controls on currency trading

c. Intervention in foreign exchange markets

d. Future inflation rates are only estimating