Group 5 Chapter 11: Transaction Exposure Don Boulware, Mohsen, Ashley Madole, Robert Weber, Dan Pittle, Christina

Parson

Xian-Janssen: Case Questions

1. J& J has roughly 200 foreign subsidiaries worldwide. It has always pursued a highly decentralized organizational structure, in which the individual units are responsible for their own performance from the top to the bottom line of the income statement. How is this reflected in the situation XJP finds itself?

Because J&J gives no capital aid to any of its subsidiaries because of their preferred decentralized management style the individual subsidiaries are responsible for their own financial decisions. XianJanssen Pharmaceutical has found themselves in a tight situation requiring a large amount of hedging and a closing margin of profit on their products from insurance agencies reimbursing generic drugs as opposed to the ones offered by XJP. The CEO of XJP passed an expected future company earnings to its financial officers in the amount of a 20% increase or increase from 1.006 Rmb to 1.205 Rmb. Due to the fact that XJP operates independently from its parent company they are solely responsible for providing hedging methods to offset future uncertainty of exchange rates.

2. What is the relationship between actual spot exchange rate, the budgeted spot exchange rate, the forward rate, and the expectations for the Chinese subsidiarys financial results by the U.S. parent company?

At the end of 2003, the dollar closed at Rmb10.75/Euro making this the actual spot rate. The predicted spot rate, however, for 2003 was significantly lower at an average of Rmb8.60/Euro. Meeting the parent company's expectations was nearly impossible and therefore the Chinese subsidiary suffered a large loss, which was only recovered by their gains on a housing fund adjustment and an inventory valuation reversal. The budgeted spot rate for year 2004 was also inaccurate - the actual rate being near Rmb10.75/Euro and the budgeted somewhere between Rmb9.8-10.0/Euro. The forward rate for 2004 was also on the rise, leaving Young little hope for reaching parent company's goals.

Xian-Janssen Pharmaceutical Ltd. (XJP) purchased pharmaceutical products from the J&J Europe manufacturer in Belgium for euro 2,500,000. The purchase was made in June with payment due six

months later in December. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, XJP is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information.

The spot exchange rate is $1.40/euro XJP's forecast for 6-month spot rates is $1.43/euro . The six month forward rate is $1.38/euro XJPs cost of capital is 11% The Euro zone 6-month borrowing rate is 9% (or 4.5% for 6 months) The Euro zone 6-month lending rate is 8% (or 4% for 6 months) The U.S. 6-month borrowing rate is 7% (or 3.5% for 6 months) The U.S. 6-month lending rate is 6% (or 3% for 6 months) December call options for euro 625,000 per contract; strike price $1.42, premium price is $0.02 per euro. The budget rate, or the highest acceptable purchase price for this project, is $3,625,000 or $1.45/euro

3. If XJP chooses not to hedge their euro payable, what is the amount they will pay in six months.

If XJP chooses not to hedge, the the following will be likely occur:

Spot Rate @ 1.40/ X $2,500,000 = $3,500,000 Spot Rate/Six Months @1.43/ X $2,500.000 = $3,575,000

A difference of (75,000) means that the payable will become more expensive using an unhedged financial strategy.

4. How much is the cost if XJP uses a Forward Hedge?

If XJP chooses a forward hedging strategy, then they would buy the forward for $1.38/ @ 2,500,000 = $3,450,000.

5. If XJP locks in the forward hedge at $1.38/euro, and the spot rate when the transaction was recorded on the books was $1.40/euro, what will be the amount of the "foreign exchange accounting transaction loss or gain?

Recorded on the books: $1.40 X 2,500,000 = $3,500,000 At the forward rate: $1.38 X 2,500,000 = $3,450,000

The transaction exposure resulting from the forward hedge at $1.38/ against the sport of $1.40/ would result in a gain of $50,000.

6. If XJP had not hedged with the forward contract and their predicted exchange rate for 6 months had been correct would XJP be better off or worse off and by how much?

To determine whether or not XJP would be worse or better, we should look more closely at hedging costs. Remaining unhedged would cost $75,000 more, yet the forward hedge results in a gain of $50,000. XJP would have been worse off had it not hedged with a forward contract.

7. How much is the cost if XJP uses a Money Market Hedge?

XJP needs to discount the 2,500,000 by the Euro zone 6-month borrowing rate is 9% in order to determine the Euros needed today:

2,500,000/(1+(0.09 X(1/2))) = 2,392,344.50

This 2,392,344.50 needed today requires using the current spot rate:

2,392,344 X $1.40 = $3,349,281.60

This cost of $3,349,281.60 must be paid back in US dollars at an interest rate of 7%:

$3,349,281.60 X (1+(0.035*(1/2))) = $3,407,894.74

$3,407,894.74 is the total cost of the money market hedge.

8. How much is the cost if XJP uses a Call Options Hedge?

2,500,000 needs to be mutliplied by the premium price of $.02:

2,500,000 X .02 = $50,000 premium

The principal amount then needs to be converted at the exercise price:

2,500,000 X $1.42 = $3,550,000

The total cost of using call options hedging is the premium amount of $50,000 and the exercise price of $3,550,000 for a total of $3,600,000.

9. If you were Paul Young, what would you do given that you need to hedge the 2,500,000?

Paul Young needs to hedge 2,500,000 and to do this, he should follow this recommendation

Unhedge $3,575,000.00 Forward Hedge $3,450,000.00 Market Hedge $3,407,894.74 Call option $3,600,000.00

The market hedge is the better option because it is less costly than the other four options.

Of course, all of this depends on the accurate forecasting of the future spot rate out six months. The parameters of this payable require the least loss with hedging and the forward hedge provides the best protection against future rising costs.