Accounting for Uncertain Cash Flows Blustream, Inc., considers a project in which it will sell the use of its technology to firms in Mexico. It already has received orders from Mexican firms that will generate 3 million Mexican pesos (MXP) in revenue at the end of the next year. However, it might also receive a contract to provide this technology to the Mexican government. In this case, it will generate a total of MXP5 million at the end of the next year. It will not know whether it will receive the government order until the end of the year. Today’s spot rate of the peso is $0.14, and the one-year forward rate is $0.12. Blustream expects that the spot rate of the peso will be $0.13 one year from now. Its only initial outlay with the proposed project will be $300,000 to cover development expenses (regardless of whether the Mexican government purchases the technology). Blustream will pursue the project only if it can satisfy its required rate of return of 18 percent. Ignore possible tax effects. Blustream decides to hedge the maximum amount of revenue that it will receive from the project. Determine the NPV if Blustream receives the government contract. If Blustream does not receive the contract, it will have hedged more than it needed to and will offset the excess forward sales by purchasing pesos in the spot market at the time the forward sale is executed. Determine the NPV of the project assuming that Blustream does not receive the government contract. Now consider an alternative strategy in which Blustream hedges only the minimum peso revenuethat it will receive. In this case, any revenue due to the government contract would not be hedged. Determine the NPV based on this alternative strategy and assume that Blustream receives the government contract. If Blustream uses the alternative strategy of hedging only the minimum peso revenue that it will receive, determine the NPV assuming that it does not receive the government contract. If there is a 50 percent chance that Blustream will receive the government contract, would you advise the company to hedge the maximum amount or the minimum amount of revenue that it may receive? Explain. Blustream recognizes that it is exposed to exchange rate risk whether it hedges the minimum amount or the maximum amount of revenue it will receive. It considers a new strategy of hedging the minimum amount it will receive with a forward contract and hedging the additional revenue it might receive with a put option on Mexican pesos. The one-year put option has an exercise price of $0.125 and a premium of $0.01. Determine the NPV if Blustream uses this strategy and receives the government contract. Also, determine the NPV if Blustream uses this strategy and does not receive the government contract. Given that there is a 50 percent probability that Blustream will receive the government contract, would you use this new strategy or the strategy that you selected in question (e)?

FindFind

International Financial Management

14th Edition
Madura
Publisher: Cengage
ISBN: 9780357130698
FindFind

International Financial Management

14th Edition
Madura
Publisher: Cengage
ISBN: 9780357130698

Solutions

Chapter 14, Problem 26QA
Textbook Problem

Accounting for Uncertain Cash Flows Blustream, Inc., considers a project in which it will sell the use of its technology to firms in Mexico. It already has received orders from Mexican firms that will generate 3 million Mexican pesos (MXP) in revenue at the end of the next year. However, it might also receive a contract to provide this technology to the Mexican government. In this case, it will generate a total of MXP5 million at the end of the next year. It will not know whether it will receive the government order until the end of the year.

Today’s spot rate of the peso is $0.14, and the one-year forward rate is $0.12. Blustream expects that the spot rate of the peso will be $0.13 one year from now. Its only initial outlay with the proposed project will be $300,000 to cover development expenses (regardless of whether the Mexican government purchases the technology). Blustream will pursue the project only if it can satisfy its required rate of return of 18 percent. Ignore possible tax effects. Blustream decides to hedge the maximum amount of revenue that it will receive from the project.

  1. Determine the NPV if Blustream receives the government contract.
  2. If Blustream does not receive the contract, it will have hedged more than it needed to and will offset the excess forward sales by purchasing pesos in the spot market at the time the forward sale is executed. Determine the NPV of the project assuming that Blustream does not receive the government contract.
  3. Now consider an alternative strategy in which Blustream hedges only the minimum peso revenuethat it will receive. In this case, any revenue due to the government contract would not be hedged. Determine the NPV based on this alternative strategy and assume that Blustream receives the government contract.
  4. If Blustream uses the alternative strategy of hedging only the minimum peso revenue that it will receive, determine the NPV assuming that it does not receive the government contract.
  5. If there is a 50 percent chance that Blustream will receive the government contract, would you advise the company to hedge the maximum amount or the minimum amount of revenue that it may receive? Explain.
  6. Blustream recognizes that it is exposed to exchange rate risk whether it hedges the minimum amount or the maximum amount of revenue it will receive. It considers a new strategy of hedging the minimum amount it will receive with a forward contract and hedging the additional revenue it might receive with a put option on Mexican pesos. The one-year put option has an exercise price of $0.125 and a premium of $0.01. Determine the NPV if Blustream uses this strategy and receives the government contract. Also, determine the NPV if Blustream uses this strategy and does not receive the government contract. Given that there is a 50 percent probability that Blustream will receive the government contract, would you use this new strategy or the strategy that you selected in question (e)?

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