UNIVERSITY OF CAPE TOWN - COLLEGE OF ACCOUNTING

MANAGEMENT ACCOUNTING AND FINANCE II (ACC4020W)

MODULE HANDOUT – ERT

LECTURE
TOPIC TEXTBOOK REFERENCE CONTENTS & TIME ALLOCATION
DATE

Notes: read and consolidate 50

Lecture Videos x2 30

Consolidation of notes 20

7 International Financial Management 9th Seen Tutorial:

100
September Financial Edition. Correia et al. Attempt and mark
2020 Management Chapter 19. Unseen Tutorial:
150
Attempt, videos, mark
Consolidation of tutorials 20

Vula Q&A and consult 20

TOTAL TIME 6.5 hours

1
Contents
INTRODUCTION ....................................................................................................................................... 3
LEARNING OBJECTIVES............................................................................................................................ 4
NOTES AND LECTURE CONTENT ............................................................................................................. 6
The Foreign Exchange market......................................................................................................... 8
Foreign Exchange Exposure .......................................................................................................... 12
Other Topics in International Financial Management .................................................................. 20
Consolidation of International Financial Management ........................................................................ 23
TUTORIAL QUESTIONS .......................................................................................................................... 24

Hi Team

Welcome to you SECOND LAST week of content.

I know that unbelievable timeline update could be met with a bitter-sweet reaction.
On the one hand, I am sure you cannot wait for the content to be over, but on the
other, I know that the end of content can also signal a sense of urgency to get
prepared for October and November.

I know many of you are feeling that sense of urgency toward October and are digging
deep to make up ground in MAF as a whole. Just to say, well done for all the efforts. I
have been impressed with how many of you have not lost heart in the battle and
equally impressed by those who have reached out to close the gaps in their
performance. This is what we have been waiting for from you. I will be spending some
time in the next week compiling a video to address some of the most pervasive
questions I have been fielding from you. In the meantime, please keep reaching out to
the MAF team as we all run toward that approaching finish line. Remember, there is
no problem with going slowly, as long as you are moving forward!

This week and next week’s modules serve as ‘bolt on’ modules that find themselves as
secondary questions in bigger scenarios. So, make sure you are asking yourself how
they could be incorporated in different business contexts.

Look forward to chatting to many of you this week!

Take care
Rich

2
INTRODUCTION

The management of foreign exchange has become a vital aspect of financial management. Financial
management in South Africa, specifically, represents additional challenge and importance given its
extreme currency volatility as well as its role in linking up many international economies.

In your future careers, many of you may find yourselves in different treasury roles where the
management of foreign exchange and operations will be up to you. Thus, the practical importance of
much of this content may prove huge in your futures.

All the primary companies you are going to be faced with in ITC and GDA are going to be South
African based. However, there may be foreign operations to manage and consider. Thus, ones
awareness of the South African economy in its international context will be important.

This module can also be seen as a more technical drill down of our previous ‘Risk Management’
module. The risks here are simply international financial risks that have very specific types of
mitigations (like hedging) that need to be understood.

This week, the notes will work hand in hand with the lecture videos.

The notes will make use of diagrams as well as provide some extra
annotations to explain in more detail where necessary. Please look out
for where you should watch a video for further explanations.

3
LEARNING OBJECTIVES

The Big Picture Objective:

• This module re-introduces you to the world of International Financial Management.

If you understand the various financial instruments, it will make understanding the
accounting, strategy, tax and auditing aspects a lot easier to understand, and thus allowing
you to integrate your knowledge across subjects and modules.

At the end of the chapter, you should be able to;

• Determine how exchange rates are quoted in the spot and forward markets.
• Understand the determinants of currency rate movements
• Explain the pricing of a forward exchange rate and the use of arbitrage to achieve interest
parity.
• Describe the types of foreign exchange exposure that a firm is required to manage.
• Determine how hedging techniques such as forward contracts and money market hedges can
be used to avoid transaction exposure.
• Indicate when and how currency options should be used to avoid exchange rate risk.
• Describe the use of futures contracts to hedge against foreign currency exposure.
• Discuss the motives for offshore listings.
• Discuss some of the Exchange Control considerations.
• Recognise where this module fits into the MAF syllabus and where it can be included.

SAICA’s competency framework for this module revolves around ‘Risk Management,’ specifically
around ‘financial risk’:

4
(Reminder that ‘I’ means you are able to initiate the task, so more than just be aware but not as
detailed as being an expert here)

SAICA also indicate the technical competencies you should be comfortable with, some of which this
module deals with:

5
NOTES AND LECTURE CONTENT

Students should go these notes and be referred to videos where necessary. Please pause throughout
the read through of the module, as required, to make notes and ensure understanding and attempt
and understand any examples that come up throughout the module.

In the meantime, please download the following videos, and be ready to watch them when prompted.

1. Intro to International Financial Management

2. Breaking down the FEC and the MM Hedge

Remember team, you are management! You need to wear management shoes for the rest of the
year in MAF and this module is no different.

VIDEO 1 – please watch the introductory video now.

Make your notes here:

6
Historical Context of the Rand:

7
The Foreign Exchange market

Some terms:

• Size of the SA Market – over US$30 billion per day

o The South African market is a pivotal piece of the global economy.

• Exchange rates are quoted on the market as either Direct or Indirect quotations
o Direct: FC1 = x Rands (Direct is what we are used to)
 ex. $1 = R14.30
o Indirect: R1 = x FC
 ex. R1 = $0.06993

• When buying or selling foreign exchange, this is generally performed through a bank. These
banks provide ‘bid-ask’ spreads or ‘buy-sell’ spreads.
o Essentially this just represents how many Rands the BANK is willing to BID for your
foreign exchange, versus how many Rands the bank is willing to receive from you in
order to SELL you foreign exchange. Thus, it represents the Bank’s buy and sell rates.
o The difference between the buy and sell rate = bank’s margin or spread

o Ex. Rand/US Dollar

 The bank will buy US Dollars at 14.3020 and sell US Dollars at 14.3060
 The Spread is 40 points (1 point = 0.0001 of the rate)

• Other terms:
o Mid-rate
 = the Average of buy and sell rate

o Spot and Forward Rates

 Spot rate = rate for immediate delivery of foreign currency
 Forward rate = rate fixed today, but foreign currency delivered or received at
a specified time in the future. Ex. Importer buys US Dollars at a forward rate
of R14.4858 with delivery in 3 months’ time. The spot rate today is R14.3246.

o Forward Rate Premium/Discount

 Forward rate is stated in terms of a premium or discount to the spot rate
 Ex. From above:
• Premium= (14.4858 – 14.3246)/14.3246 x 12/3 = 4.501% (annualised)

o Cross Rates
 When there is no available exchange rate directly between 2 countries, but
can be calculated as a by-product of existing rates:
 Ex. Assume that one US Dollar buys 110.65 Yen and one US Dollar buys
R14.4815. What is the Rand/Yen rate?

8
Well, this means that we have this info:

And can ultimately calculate both an indirect (1Rand for Yen) or a direct (?Rand for 1Yen) rate:

What drives movements in the Foreign Exchange Market?

Possibilities include:

1. Interest rate Parity (IRP)

o Theory explaining how foreign exchange is impacted by the differential INTEREST
rates between countries.

Shown in terms of a formula, interest parity is achieved when this equation holds:

I know…

Just when you thought

you had left ECOS
behind!

So, just by observation of the above, one can see that the differential between the forward and
spot rates has a corresponding relationship with the differential of the two countries’
corresponding interest rates.

9
The bank’s perspective helps us understand this better, as they set the price.

- Ex. I am an exporter and I know I will receive $100m in 3months time. I want to avoid currency
risk and lock in a Rand value for the $100m (for that moment t in 3 months):

- In other words, the bank takes on no risk and prices the forward rate according to what it
knows it can get as interest.
- Hence, the forward rate it offers you for your $100m dollar exposure is linked to the US
lending rate (where it will borrow to offset your future $100m position) and the SA deposit
rate (being in opposite jurisdiction to where it is borrowing).

In some cases the IRP relationship does not hold, which allows Recall the meaning of
for arbitrage opportunities in the market. Today, these arbitrage arbitrage…
opportunities are only ever short lived due to market algorithms
that would exploit those conditions very quickly.

2. Purchasing Power Parity (PPP)

o Theory how the relative INFLATION rates between countries can cause movements in
foreign exchange. i.e. PPP states that changes in exchange rates are determined by
changes in relative price levels

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Shown in terms of a formula, PPP is achieved when this equation holds:

Ex: Assume inflation rate in USA is 2% and inflation in South Africa is 4%. If the current spot rate is
R14.45, then the forecast exchange rate according to PPP would be;

14.45/S1 = 1.02/1.04

S1 = 14.45/(1.04/1.02) = 14.73333

Another, less technical, way to think about this is to recall the Big Mac Index.

• The Economist annually compares the prices of Big Macs in various currencies to determine
over and undervalued currencies.

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From The Economist

Essentially, our Big Macs are priced to suggest that our currency should be a lot stronger than it is.
There are a lot of assumptions here, but what is undeniable is that there is a lot of pressure on the
Rand in 2020 because of a lot of reasons (both economic and political).

Foreign Exchange Exposure

- Referring to the potential gains and losses due to a change in the foreign exchange rate

One can deal with 3 types of foreign currency exposure:

1. Translation Exposure

• The effect that a change in the exchange rate will have on the recorded accounting
results of a company.

2. Transaction Exposure (most NB)

• Transactions refers to the potential gains and losses from entering into transactions
whose terms are stated in foreign currency. i.e. importing / exporting goods and
services, as well as foreign loans.

3. Economic Exposure

• Referring to the long term real effects of a change in the exchange rate.

Companies can apply hedging policies to protect itself against the possibility of loss due to a change
in exchange rates. The main focus here is the hedging options for transaction exposure highlighted
above.

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Natural Hedges

• This is not active hedging through the use of hedging instruments.

• Natural hedging occurs when opposite positions are taken in Netting off your exposure
the market through the normal course of business. through your operations…
Fluctuations are thus automatically set off against each other.

• Given the intricate and interdependent nature of many transactions, coupled with the
complexities of group corporate structures, a careful analysis of the situation may reveal
natural hedges which were not clear at first glance.

– Airlines – Fuel cost in $ and revenue in $

– Borrowing at variable rate & offers customers credit at a variable rate - (interest rate
risk hedge)

– Exporter earns US$ - can borrow in US$

Hedging Instruments

1. Forward Contracts (most common for foreign currency hedge)

o In terms of a forward contract, the exchange rate is fixed today, but the
payment/receipt of foreign currency is effected at a future date.
o Also called an FEC (Forward Exchange Contract)

Example:

SA Importer buys goods from the USA at cost of $100000, payment due in 3 months.

The spot rate is R14.2000 and the forward 3 month rate is R14.4485 – which removes any price
uncertainty.

Assume the Rand falls to R15.80. – SA importer would be pretty happy.

However, if the Rand appreciates there is an opportunity loss due to hedging.

SAA incurred this type of loss, amounting to R15bn, which SAA had to report within the Statement of
Comprehensive Income. SAA unwound this forward contract thereby realising the potential loss. The
hedge will remove management’s uncertainty, but will also have those IFRS implications too.

What if?

A company that has entered into a forward contract and no longer needs the foreign currency?

It is still obliged to comply with the contract and is obliged to enter into an offsetting forward
contract or buy/sell the foreign currency in the spot market. This is referred to as a close-out of
forward contracts.

Ex: In July, an SA Importer entered a transaction where they knew they required $600 000 to make
payment in December. Import transaction is cancelled on 1 October.

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Visually:

- Company entered into FEC in July for 6 month, locking in to pay 14.2030 per $ for $600000 on
31 Dec. This cannot be avoided.
- In October company realises it doesn’t need those $600000 dollars anymore, and so it needs
to find a way to sell them (at a locked in – hedged – price) at the same date of 31 Dec.
- So they lock in to selling the $600000 (that they agreed to buy back in July) at 14.4250.

Let’s assume another example:

Assume a SA company has an export order to the USA for $1m receivable on 31 December. The
current date is 29 September. The company enters into a forward contract to sell $1m at a 3 month
forward rate of R14.0860. Yet on 29 December, when the spot rate of Rand to Dollar is 14.2710, the
US buyer does not accept $200000 of the order due to quality problems. This means the company
must buy US dollars to sell in terms of the forward contract.

How does this impact the intended hedging strategy?

Net cash flow

800k @ 14.086

Co. will receive $0.8m from export, plus purchase of $0.2m in spot market to comply with
forward contract.

This example emphasises that your hedging strategy needs to recognise that transactions can
change and companies need to be able to adapt.

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 2. Money Market Hedges

o This is where a company enters immediately into an offsetting loan or deposit position
in foreign currency.
 i.e. it takes on the opposite position to what its exposure is. For a SA company,
 it will enter a dollar loan in if it is expecting to receive dollars in the future
 it will enter into a dollar deposit if it is expecting to pay dollars in the future

Ex: SA Exporter is due to receive $500 000 in 3 months’ time, 10 March

– The company enters into offsetting loan by borrowing in the USA, switching into
Rands at spot and depositing funds in SA for 3 months.

– In 3 months’ time the company will use receipt from US customer to pay the loan
(and any interest expense it accumulated). And it will hold on to the SA interest
from the SA investment.

- Part 1, assuming:
o The Rand/Dollar spot rate at is 14.1640
o SA annual deposit rate is 10%
o US annual lending rate is 6%
o The Rand/Dollar will appreciate to 13.564 in 3 months

What is the net cost/benefit of the Money Market Hedge?

Present Value (6% rate) of $500 000 at R spot 10% p.a. quarterly in SA

N2
3. Currency Options

4. Currency of Invoice

5. Leads and Lags

6. Futures Contracts
N1
7. Currency Swaps

N1: The rand has appreciated and so the exporter would worse off by R300,000 in receiving
revenue in 3 months’ time as compared to 10 December 0.3.

N2: However, in relation to the loan transaction (the offsetting position in the Money
Market Hedge Strategy), the converted amount in Rands is only R6782000 and we have
accumulated R7151773 and so this results in a gain of R369773 and a net gain of R69773.

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 - Part 2, keeping with the same example, let’s assume:
o The Rand/Dollar spot rate at is 14.1640
o SA annual deposit rate is 10%
o The Rand/Dollar will depreciate to 14.9480.564 in 3 months

What is the net cost/benefit of the Money Market Hedge?

NB - you can see that the movement on the foreign exchange rate should have no impact on the net
position as the hedge is supposed to remove all of the foreign exchange movement.

What if?

You could have chosen between a forward contract or a money market hedge for part 2 above? If
the forward contract was available for the above scenario at a premium of 2%, which strategy
would have been more advantageous?

3 month fwd rate

From above

Here, one is simply comparing the forward Rand value (from the FEC contract) to the offsetting
position Rand value (for the Money Market Hedge).

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But why would there be a difference in the strategy at all?

Well, there shouldn’t be if the IRP condition held true. If IRP condition held, then the result of the
forward contract and the money market hedge would have the same result:

1 + (10%-6%)/ (1+6%)

OK, time for a pause…

Note: What is important at this stage is your ability to explain the difference between the
forward contract and the money market hedge.

You also need to be able to explain how each hedging strategy works so that when you are
given an example like you are in your tuts, you can think through the mechanics to show the
net impact of the hedge.

Please revisit the above again as the concepts and mechanisms can be confusing. To test
your understanding attempt to verbally (out loud) explain how one would enter into these
hedges – as an exporter and as an importer.

If you are needing to confirm you understand, please watch the video, ‘Breaking down FEC
and MM Hedge.’

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 3. Currency Options

Recall that an option is a right but not an obligation to buy or sell an underlying asset at a specified
fixed price.

So, a currency option is the right but not the obligation to purchase (a call option) or sell (a put
option) foreign currency at a fixed price (the strike price). It can be used to offer flexibility to a
company on foreign projects when underlying exposure is uncertain.

The cost of a currency option (like any option) is the option premium.

Ex. Assume company acquires the right to buy $2m at R12.90 in 3 months’ time. The current spot
rate is R12.80. Call option premium = 2.5%.

- If Rand falls to R13.20, use option to buy at R12.90.

- If Rand rises to R12.70, let option lapse as better to buy $ on the spot market.

Question – how is this different to a forward contract?

4. Futures Contracts

Future contracts, in general, are standardised contracts that are generally tradeable on exchanges
(like the SAFEX).

So a foreign exchange future would be a standardised contract to buy or sell Rands in exchange for
US Dollars (or other forex) at a price fixed today.

In order to hedge with a future contract, an importer requiring US Dollars, would sell Rand contracts
(to get $) on an exchange.

• Ex. Assume the following details;

– Importer requires $315 000 in 3 months’ time

– Futures price of R500 000 contracts is at $0.070 (R14.29)

– Importer sells 9 contracts (R500 000 x 9 = R4.5m x $0.07 = $315 000)

• i.e. 9 standardised contracts covers the necessary exposure.
• Importer essentially selling rands today for future dollars.

– In 3 months, just prior to due date and equivalent to the spot rate then, the rate is
$0.074 (R13.51).
• At this point, the he importer buys 9 contracts at $0.0740 just prior to
delivery date.
• Therefore offsetting the number of future contracts of the importer to 0.

• The importer could also just take the dollars ($315000) and sell at spot to
get Rands

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 Dollars in
Dollars out

OR you could also look at it by saying,

- The sale of the 9 contracts cost R4.5million

- The Rand value of the $315000 at the end of the contract term was (315000 x 13.51) =
R4256757.
- Thus, there was a 243 243 loss on the future, but the total outflow was always fixed at
R4.5million

Gains/losses on Futures contracts used to manage the cost on the spot market so net cost is fixed
(in this case at R4.5m).

Of course, if you had not used the future contracts (i.e. not hedged) and the exchange rate
appreciated like it did, the importer would have been better off from a profitability perspective.
However, at the time of committing to the importing transaction, it is never a certainty what the
exchange rate will do.

So, if the Rand had depreciated, then the gain from the hedge would have also reduced the cost
(which would have been unfavourable to the importer) to R4.5m

5. Currency Swaps

Currency swaps (or cross-currency swaps) are used to hedge long-term exchange rate exposure and
/ or to achieve interest cost savings.

- The idea is for a company to swap their current foreign currency exposure for a preferred
currency exposure with a willing counter party.
- These kinds of ‘swaps’ could also be used for interest rate risk where a company wanted to
‘swap’ its variable rate exposure for fixed.

Ex:

• JHB Ltd (SA company) wants to invest in the UK for 5 years and needs to borrow £10m.
• It can borrow in the UK at 6% plus a 2% premium
• LON Ltd (UK company) wants to invest R100m in South Africa and can borrow in South Africa
at 10% plus a premium of 2%
• JHB Ltd – can borrow in SA at 10% (no premium)
• LON Ltd – can borrow in the UK at 6% (no premium)
• Each company can save on borrowing costs (the premiums) if they borrow in their
respective country and enter into a swap.

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 The cash flows between the counter parties would look as follows:

6. Other hedging Methods

o Currency of Invoice
 This is a method of minimising the company’s foreign currency exposure. It
simply means you invoice your clientele using the foreign currency you are
exposed to.

o Leads and Lags

 This is not really a hedge, but is a method used to try and manage one’s
foreign currency exposure, based on expectations.
It is used when there are strong expectations (albeit speculative) of a certain
exchange rate movement. Based on the expectations, one may accelerate
(lead) or delay (lag) the timing of payments or receipts.

Other Topics in International Financial Management

The below additional topics are provided for high level understanding and awareness purposes.
Read the below to understand for any business that is looking for growth or is already operating
offshore.

• Exchange Control

South Africa’s exchange control regulates cross border capital flows through controls it puts in
place. An example was the historic limit that was placed on South African’s for foreign
investment – limits that are almost completely removed today.

The major concern for SA government is the protection of the South African tax base, which is
less about exchange control and more about managing transfer prices to offshore subsidiaries.

20
Rules/controls instituted by the South African Reserve Bank (SARB) tend to revolve around the
following areas:

- Non-resident investment
o Today, there are very little to no restrictions for non-resident investment into SA,
except if the investment is loan based
- Offshore investment
o Most individuals are not restricted by this, although foreign investment generally
results in extra fees for the admin.
o There is SARB approval needed for South African companies who make foreign
investments in excess of R1b.
o Also, local institutional investors (asset management houses) have a 30% limit for
their foreign portion of their assets under management, while specific local unit trusts
also have foreign exposure limitation. These limits are specified per Regulation 28
legislation.
- Dividends and Interest
o Listed SA companies are free to distribute their dividends to their non-resident
shareholders.
o Private and unlisted companies can only do so with a letter from their auditor (to
assure that it is acceptable based on decent profitability – Co Act requirements)
- Offshore borrowings
o South African companies can borrow and repay offshore loans, but both aspects
require approval.
- Imports and Exports
o Importers can make their foreign payments upon proof of transport/shipping.
o Exporters need to provide adequate documentation for the proceeds before they can
see it in their bank account
o Having foreign bank accounts would assist companies to be more agile in these
processes.

The current intention of the SARB and government is to progressively dismantle exchange
control in order to allow for ease of trade, while also importantly protecting its tax base.

• Offshore Listing

South African companies could look for primary/ secondary listing offshore. There are many
possible benefits to consider with foreign listing.

‒ Reduction in the firm’s cost of capital

‒ Access to a wider base of capital to finance international expansion

‒ International Profile

‒ Listing offshore may facilitate the raising of loans and the issuing of bonds in foreign
markets.

21
 ‒ The liquidity of the major foreign stock exchanges such as London and New York is
significantly higher than the JSE

‒ Foreign investors may more willing to invest in South African companies listed in London
and New York.

‒ Listing offshore obviates to some extent the effects of exchange control.

‒ Inclusion in international indices such as the FTSE 100 creates demand for the
company’s shares due to inclusion in index tracker funds.

The disadvantages from listing relate to the costs of listing, Exchange Control approval and
compliance with stricter disclosure and corporate governance rules.

• Analysis of Foreign projects

The reason for this additional topic is to highlight the need to incorporate one’s understanding
of foreign currency exposure into the analysis of big projects. Take, for example, a foreign
project’s capital budget.

When thinking about the foreign currency (FC) cash flows in the capital budgets, either 1. Discount
FC cash flows at a FC discount rate and convert NPV at the spot rate OR
2. Estimate future exchange rates (for each year of the forecast), convert future FC cash flows and
discount at the SA discount rate.
If real returns are equal and we use future inflation rates, then both methods will result in the
same NPV.
See the example below:

22
Consolidation of International Financial Management

Once you have completed going through the notes and examples as well as the tutorials below, a
reminder to refer back to the objectives of the module. Consider whether you can discuss/explain
each of the objectives listed below and do you understand some of the key terms in each objective?

• Determine how exchange rates are quoted in the spot and forward markets.
o Spreads, direct, indirect, forward, spot, forward premium?

• Understand the determinants of currency rate movements

o IRP? PPP?

• Explain the pricing of a forward exchange rate and the use of arbitrage to achieve interest
parity.
o Arbitrage?

• Describe the types of foreign exchange exposure that a firm is required to manage.
o Translation, Transaction, Economic?

• Determine how hedging techniques such as forward contracts and money market hedges can
be used to avoid transaction exposure.

• Indicate when and how currency options should be used to avoid exchange rate risk.

• Describe the use of futures contracts to hedge against foreign currency exposure.

• Discuss the motives for offshore listings.

• Discuss some of the Exchange Control considerations.

• Recognise where this module fits into the MAF syllabus and where it can be included.

23
TUTORIAL QUESTIONS

MANAGERIAL ACCOUNTING AND FINANCE II - ACC4020W

INTERNATIONAL FINANCIAL MANAGEMENT

The tutorial questions are to be attempted blind prior to looking at any solution whether discussion
or otherwise. The tutorials focus is on the thought processes and tools used to solve a problem
which you should reflect on after each tutorial and the learnings obtained. Please mark attempts
thoroughly for learning and reflect thereon.

TUTORIALS

TUTORIAL MARKS
VidBest 45
Hotel Inn 45

These tutorials are short past paper questions that involve some specific international
financial management technical questions as well as some interesting strategic thinking
questions. I know many of you have been working hard to develop your skills on critical
thinking as well as exam technique for such questions. These tuts present a great opportunity
for further practice.

Please remember that these tuts should be treated like actual question papers. Put yourself
under exam pressure and work under time constraints – particularly the unseen.

Good luck and enjoy!

24
Seen - VIDBEST (APRIL 2013) (45 marks: 60 minutes)

You have been approached to help a newly listed South African company, VidBest Ltd. You have
conducted a quick Google search and have found out that VidBest provides services, specifically at
the airport, to the airlines. VidBest owns the equipment and then has various jobs outsourced to it
from the airlines (for instance the lifts that get passengers on and off the plane as well as the busses
that transport them to the terminal).

VidBest has followed a growth strategy that has involved opening operations internationally close to
the major airports so that they can better serve the large international airlines. North America
(starting in 2004) and Europe (starting in 2010) have been the main areas where they have focussed
expansion and they have had a dominant position in the South African market for over a decade.

The international expansion has come with its challenges. Some of the large international airlines
are asking to settle all amounts in US dollars (including the South African services that they
previously paid for with Rands) and the fluctuations in foreign exchange rates have also made the
financial results more unpredictable. For instance, the current uncertainty with respect to Cyprus is
causing concern for VidBest and they want to start thinking about solutions to their foreign currency
risks.

With that in mind, VidBest has decided to obtain a short-term (3 month) loan in North America for
$80m. In North America at the moment the annualised deposit rate is 0.9% whilst the lending rate is
3.3%. That appears attractive to VidBest compared to South Africa where the annualised deposit
rate is 6.5% and the lending rate is at 10%.

The current Rand/Dollar bid spot rate is 9.054 whilst the sell spot rate is 9.059. VidBest have
enquired from a local bank about 3 month forward cover and the Rand/Dollar premium quoted was
1.8%. Due to the uncertainty with Cyprus, the directors thought it prudent not to seek Euro
denominated financing.

An additional concern of VidBest directors relates to the performance measurement of the different
international operations (North America, South Africa and Europe). Currently the required rate of
return for all the operations is 16% so as to provide a level playing field. Extracts from the
performance reviews for the past two years are presented below.

2012 2011
South Africa
Net profit R942m R935m
ROI 24% 20%
North America
Net profit $17m $11m
ROI 9% 6%
Europe
Net loss (€14m) (€30m)
ROI (2%) (22%)

The VidBest directors are particularly concerned with Europe but believe that North America is on
track to soon reach the desired rate of return. The South Africa operations manager was recently
given a large bonus for increasing the ROI substantially in 2012.

25
REQUIRED:
1. What other important considerations should have been taken into account by VidBest before
agreeing to the foreign currency loan of $80m? (10 marks)

2. Determine whether VidBest should select a forward contract or a money market hedge if it
wishes to minimise the cost of hedging the currency exposure of the $80m loan. The directors
would like the Rand cost of both options to be calculated and compared.
(10 marks)

3. What would be the cost of the money market hedge if VidBest had significant cash balances
on deposit in South Africa? (3 marks)

4. Critically evaluate the management of the different international operations of VidBest.

(14 marks)

5. Discuss whether or not it is appropriate to use the same required rate of return for all the
international operations of VidBest. (6 marks)

Effective communication such as structure, clarity and elegance of style (2 marks)

26
SUGGESTED SOLUTION

1. What other important considerations should have been taken into account by VidBest before
agreeing to the foreign currency loan of $80m? (10 marks)

Natural hedges (there might be revenue denominated in $ which case the net currency exposure is
less)
An uncovered foreign loan would be desirable if the Rand is expected to strengthen against the US
Dollar over that period.
The cost of hedging the foreign currency exposure of the loan
The desirability of the loan is reduced if it is hedged because the low interest rate is thereby negated
Capital controls (there might be restrictions on transfering funds out of the country in order to repay
the loan)
If the group has operations in a country that uses the US Dollar, borrowing funds in that currency will
reduce their exposure.
If customers are now wanting to settle in US$, the loan would represent a cash flow payment to
offset the receipts
The fact that Europe is experiencing uncertainty is not a good enough reason not to investigate the
possibility. VidBest might
receive a favourable interest rate given the uncertainty and forward cover might allow for a covered
interest arbitrage opportunity.
The fact that net investment in Europe is now €700m would indicate that it would make more sense
to obtain a Euro denominated loan
The current debt levels of the company especially with respect to debt covenants and target capital
structure

2. Determine whether VidBest should select a forward contract or a money market hedge if it
wishes to minimise the cost of hedging the currency exposure of the $80m loan. The directors
would like the Rand cost of both options to be calculated and compared. (10 marks)

COST OF MONEY MARKET HEDGE

US Dollar Loan
- Amount of USA deposit at the start 80 000 000 0.00225 79 820 404
- Amount of Rands loaned in RSA at the start 79 820 404 9.0590 723 093 041
- Amount of interest charged in RSA 723 093 041 0.025 18 077 326
Total Rand cost 741 170 367

COST OF FORWARD COVER

Total Rand cost 80 000 000 9.222062 737 764 960
Loan required today 737 764 960 0.025 719 770 693

The cost of forward cover will be cheaper.

27
 3. What would be the cost of the money market hedge if VidBest had significant cash balances
on deposit in South Africa? (3 marks)

COST OF MONEY MARKET HEDGE

US Dollar Loan
- Amount of USA deposit at the start 80 000 000 0.00225 79 820 404
- Amount of Rands loaned in RSA at the start 79 820 404 9.0590 723 093 041
- Amount of interest charged in RSA 723 093 041 0.01625 11 750 262
Total Rand cost 734 843 303

4. Critically evaluate the management of the different international operations of VidBest.

(14 marks)

2012 2011
South Africa
Net profit R942m R935m
ROI 24% 20%
Net Investment R3 925m R4 675m
North America
Net profit $17m $11m
ROI 9% 6%
Net Investment $188m $183m
Europe
Net loss (€14m) (€30m)
ROI -2% -22%
Net Investment (€700m) (€136m)

South Africa
- It has a dominant position and is well above required rate of return
- The major reason for the growth in ROI in 2012 was due to a reduction in net investment.
- The reasons for the reduction need to be investigated because it could cause a shrinkage effect as net
investment continues to be reduced
- It might therefore have been inappropriate to reward the manager will such a large bonus
- The recent turmoil with SAA and 1time might also place VidBest under pressure as they service fewer
customers who now have stronger negotiating power

North America
- The growth in net profit is pleasingly a lot higher than the growth in net investment
- For an operation started in 2004, though, it still has a small net investment (especially when
compared to Europe)
- Management might be on track to reach the required rate of return but not at a level of activity to
make a large difference to the overall performance of VidBest

28
- There needs to be greater investment in North America and perhaps the high required rate of return
has lead to the rejected of projects that should be accepted

Europe
- The poor performance can be expected to a certain extent given that the operations started in 2010
- The reduction in the net loss is pleasing but is still a concern
- The large increase in net investment is surprising and now means that Europe has by far the largest
share of net investment for the group (12 x €700m = R8 400m)
- VidBest needs to focus on making sure that Europe improves operations because all the new assets
need to be deployed optimally
- This contradicts the view of management that believes that Europe is uncertain and were therefore
unprepared to take out a Euro loan
- The ROI measure can be manipulated in this case because the net loss is made to look smaller if net
investment is increased - this could be the case here

General
- The managers are not responsible for foreign exchange fluctuations and thus working in the local
currency is correct in order to evaluate performance
- There is the possibility that North America is leasing equipment and it is therefore not appearing as
net investment

5. Discuss whether or not it is appropriate to use the same required rate of return for all the
international operations of VidBest. (6 marks)

- This would indicate that management believe that all the operations have the same risk profile
- This appears to be highly unlikely given the different risks affected the regions
- Sovereign risk relates to the repayment of debt by the respective Governments and that is a concern
with the Euro
- The political risks of South Africa have resulted in rating agencies downgrading the country and
thereby signalling that risk has increased
- The required rate of return should be risk adjusted to take country specific risks into account
- I would therefore expect the required rate of return to be highest in South Africa and then Europe
and North America would be close to each other but the increased net investment in Europe would
make further investment in that region risky and I would therefore increase the required rate of
return in order to discourage further investment in the region.

29
UNSEEN – HOTEL INN

Please note:
- An annotated Scenario and Solution for the unseen has been attached at the end of
this module pack. A walk through for part (a) of the solution (which is used in the
Solution video) has also been included at the end of the annotations.
- 3 short videos regarding the unseen have also been uploaded to assist with
your approach. The videos are with respect to the reading of the scenario, required
and part of the solution.
To maximize your benefit here, please do the following:
1. Attempt the tutorial blind
2. Watch Hotel Inn Unseen Scenario
3. Watch Hotel Inn Unseen Required
4. Watch Hotel Inn Unseen Solution
5. Review your attempt and your understanding pre and post the videos and document
any new understandings or improved exam techniques
6. Go and mark your attempt using the suggested solution.
7. Consolidate all your learnings from the tutorial.

Please see transcripts available on Vula if you cannot watch the video.

30
UNSEEN – HOTEL INN (45 marks: 60 minutes)

Hotel Inn is a JSE listed hotel chain that operates in Southern Africa. It has 32 hotels that mainly
cater to the middle-to-low income market.

30 June 2016 30 June 2015

Revenue R8 111m R8 101m
EBITDA R2 563m R2 012m
Occupancy rate 62% 64%
Average daily rate R1 734 R1 639
Total Debt R7 503m R5 672m

Recent financial performance has been below expectation and management has made several plans
for improvement. These plans are important because Hotel Inn has a debt to EBITDA cover ratio
covenant of three times. If this ratio exceeds three times, Hotel Inn will be required to immediately
settle a portion of debt and the interest rate on the remaining debt will increase by 3%. This needs
to be avoided by Hotel Inn management at all costs.

Improvement plans
The first decision is to upgrade catering facilities so as to serve better food to guests. New coffee
machines have been ordered for all the hotels at a cost of $1.2m. The order is a large one for the
coffee machine producer and so Hotel Inn has received generous payment terms. They are only
required to pay in 3 months’ time. Recent political uncertainty has caused great volatility in the
Rand and Hotel Inn management are keen to hedge the $1.2m payment.

In North America at the moment the annualised deposit rate is 0.9% whilst the lending rate is 3.3%,
whereas in South Africa the annualised deposit rate is 7.5% and the lending rate is at 12%. The
current Rand/Dollar bid spot rate is 14.55 whilst the sell spot rate is 14.56. Hotel Inn have enquired
from a local bank about 3 month forward cover and the Rand/Dollar premium quoted was 2.2%.

Another Hotel Inn initiative is to sell 20% of all its rooms to bookings.com, an online hotel
reservation site. The deal states that Hotel Inn will provide bookings.com with the cheapest rate per
room for the entire year. This room rate has been set at a 40% discount to the average room rate
from the prior year. Hotel Inn has agreed to never offer a room for less than the rate given to
bookings.com. As soon as the deal is concluded, Hotel Inn will receive a monthly upfront payment
for 20% of the rooms for the next 12 months. The business model of bookings.com is to then
advertise the rooms on its website and hopefully sell them for more than they are paying Hotel Inn.
The prices on bookings.com vary quite widely depending on the demand for rooms. Hotel Inn
management are still to sign the deal but feel like it would be a good move. They have been hit hard
by Airbnb, a website that allows people to rent rooms to each other, and believe that this will help
Hotel Inn fight back.

Activist Investor
Tumi Mjali is an investor who plays an active role in the companies her hedge fund invests in. She
has recently bought 3% of the total shares in Hotel Inn and has insisted on a meeting with the
management team. In her email to the management team she has suggested the following:

31
To: Hotel Inn Management Team
From: Tumi Mjali
Date: 10 September 2016
Subject: Value creation opportunities

To Whom It May Concern

….
I propose that Hotel Inn considers placing all its properties into a separate company that can then be
sold. At the moment the properties have shown great capital appreciation and now is the time to
sell them. Long-term operating leases will be signed with all the properties before the sale and the
focus of Hotel Inn can then be on operating the hotels as opposed to also owning and managing
properties.

We believe that this will unlock a lot of value for Hotel Inn shareholders and will also help Hotel Inn
expand more rapidly. Africa is ripe for growth and Hotel Inn should be taking advantage!
…
I look forward to discussing this with the team,
Tumi Mjali

REQUIRED
(a) Determine whether Hotel Inn should select a forward contract or a money market 10
hedge if it wishes to minimise the cost of hedging the currency exposure of the
$1.2m coffee machines payment. The directors would like the Rand cost of both
options to be calculated and compared.

(b) Critically discuss the proposal from Tumi Mjali. Your response should include both 12
the opportunities and risks associated with the suggested move.

Communication skills – clarity of expression

1
(c) Critically discuss the proposed deal with bookings.com. Your response should 8
include both the opportunities and risks associated with the deal.

(d) Critically discuss the recent financial performance of Hotel Inn. Support your 13
discussion with calculations.

Communication skills – layout and structure 1

32
HOTEL INN - Suggested Solution

(a)

(b)

Opportunities:
• Sales of hotels could realize value on potentially overvalued properties (1) which could easily
drop in value going forward (due to uncertain political climate) (1)
• Big cash inflow will help the financing problems within the business. (1) This is especially
important given the onerous debt covenant terms in place. (1)
• The big cash inflow could also help the company invest in new projects to generate growth
(like hotels in other African countries). (1)
• Can potentially pay a special dividend to our shareholders post the sale of these assets. (1)
• Can focus on operating the hotels as opposed to managing properties. (1)
• Can help us expand quickly because will not need to buy properties but could rather lease –
creating flexibility. (1)
• Other valid points

Risks:
• Selling property before its peak capital growth could create a large opportunity cost. (1)
• Operating leases are generally more expensive than owning the property themselves and so
there is a risk of effectively more cost. (1)
• What if the operating leases are cancelled and then we lose access right to the property and
cannot run our hotels. (1) For instance, opposing hotels might buy the properties and make
leasing a difficulty. (1)
• The operating lease terms might be onerous (where there is little bargaining power) when
they are renewed which would reduce margins. (1)
• Property may form part of our value proposition in the eyes of investors and the share price
might fall dramatically after sale of the properties. (1)
• Other valid points

Communication (1)

33
(c)

Opportunities

• Airbnb is taking customers away and this is an opportunity to directly compete with them in
a new way. (1)
• The upfront payments received every month will increase the cash position of the company.
(1) This is especially important given the onerous debt covenant terms. (1)
• This could lead to an increase in occupancy as at least 20% of all rooms are booked
throughout the year. (1) This would especially be the case during the slow times of the year
like winter. (1)
Risks

• Outsourcing of this function to bookings.com means the risk of admin mistakes leading to
upset customers. (1) Hotel Inn’s reputation might be damaged even if the blame lies with
bookings.com. (1)
• Bookings.com could cannibalise sales away from Hotel Inn. (1) This is a big problem given
that the price is 40% lower than the average rate. (1)
• During the peak holiday season, Hotel Inn will lose money (compared to the previous year)
because 20% of the rooms are sold for a much lower rate. (1)
(d)

Other valid calculations (1); Total for calcs = 6

Revenue has been pretty stagnant (growth of 0.12%) which is potentially concerning and
•
reinforces the need for operational improvements to be put into place. (1) The stagnant
growth may be a result of the increased competition from AirBnb. (1)
• Occupancy rates have decreased from 64% to 62%, which means that the revenue increase
has been driven by slight price increases. (1)
o This is reflected in the increase in the average daily rate of 5.8%. This is likely to be
slightly lower than inflation, which is also a concern. (1)
• Total Debt to EBITDA - this figure is creeping closer and closer to 3, which will have a
significant impact on the company as the debt covenant may be broken. (1) Will result in
higher interest costs and a significant cash out flow. (1)
• Debt has also increased dramatically but without an impact on Revenue. (1) This is a
concern, and the reason for the increase in debt would need further investigation. (1)
Communication skills – layout and structure (1)

34
UNSEEN – HOTEL INN (45 marks: 60 minutes)

Hotel Inn is a JSE listed hotel chain that operates in Southern Africa. It has 32 hotels that mainly Commented [1]: Triggers:
cater to the middle-to-low income market.
Industry – Hotel (risks and opportunities of this industry?)
Listed - legal requirements, shareholder, agency issue.
30 June 2016 30 June 2015 Size – 32 hotels, large, control across all branches?
Revenue R8 111m R8 101m Target Market – middle to low income. Affordability
EBITDA R2 563m R2 012m probably very important
Occupancy rate 62% 64%
Average daily rate R1 734 R1 639
Commented [2]: Analysis:
Total Debt R7 503m R5 672m Revenue pretty stable
Occupancy rate decreased – why?
Recent financial performance has been below expectation and management has made several plans Debt position increased a lot. We aren’t seeing the benefits
for improvement. These plans are important because Hotel Inn has a debt to EBITDA cover ratio of this at the moment.
covenant of three times. If this ratio exceeds three times, Hotel Inn will be required to immediately Commented [3]: They have made plans for
settle a portion of debt and the interest rate on the remaining debt will increase by 3%. This needs improvement. We could be asked to analyse those plans.
to be avoided by Hotel Inn management at all costs. Commented [4]: Trigger: Major risk. Where is this ratio
sitting currently? 7503/2563 = 2,92. Just on the cusp.
Major problem.
Improvement plans How could we bring this down? What will shareholders
The first decision is to upgrade catering facilities so as to serve better food to guests. New coffee say? Could the board be held responsible for any
machines have been ordered for all the hotels at a cost of $1.2m. The order is a large one for the negligence? CG concerns. Integration.
coffee machine producer and so Hotel Inn has received generous payment terms. They are only Commented [5]: Problematic/Dangerous language.
required to pay in 3 months’ time. Recent political uncertainty has caused great volatility in the Rand Want to be thinking about how far management will go to
and Hotel Inn management are keen to hedge the $1.2m payment. ensure that the covenant is not reached. CG integration,
governance concerns.

In North America at the moment the annualised deposit rate is 0.9% whilst the lending rate is 3.3%, Commented [6]:
How are we going to fund this?Foreign currency exposure.
whereas in South Africa the annualised deposit rate is 7.5% and the lending rate is at 12%. The Debt position already pretty maxed.
current Rand/Dollar bid spot rate is 14.55 whilst the sell spot rate is 14.56. Hotel Inn have enquired
Commented [7]: What are the options available to
from a local bank about 3 month forward cover and the Rand/Dollar premium quoted was 2.2%. hedge? You want to be thinking of them so that you can
compare what you know to what the scenario might give.
Another Hotel Inn initiative is to sell 20% of all its rooms to bookings.com, an online hotel reservation Commented [8]: A lot of nitty gritty information in this
site. The deal states that Hotel Inn will provide bookings.com with the cheapest rate per room for paragraph you want to think about why they could be
the entire year. This room rate has been set at a 40% discount to the average room rate from the giving us this information?
The information given here should be making you think of
prior year. Hotel Inn has agreed to never offer a room for less than the rate given to bookings.com.
a money market hedge.
As soon as the deal is concluded, Hotel Inn will receive a monthly upfront payment for 20% of the
rooms for the next 12 months. The business model of bookings.com is to then advertise the rooms
on its website and hopefully sell them for more than they are paying Hotel Inn. The prices on
bookings.com vary quite widely depending on the demand for rooms. Hotel Inn management are
still to sign the deal but feel like it would be a good move. They have been hit hard by Airbnb, a Commented [9]: There are positives and negatives
website that allows people to rent rooms to each other, and believe that this will help Hotel Inn fight from this deal. While we are ‘giving up’ 20% of our rooms
for a heavily (40%) reduced rental, we are assured of a
back. monthly upfront payment. This would allow for easier
cash flow projection and more certainty to the inflows
that Hotel Inn will receive.

Activist Investor
Tumi Mjali is an investor who plays an active role in the companies her hedge fund invests in. She Commented [10]: Good or bad? What is Tumi’s
has recently bought 3% of the total shares in Hotel Inn and has insisted on a meeting with the experience? Would we be giving up any control as
management? She only has a 3% holding?
management team. In her email to the management team she has suggested the following:

To: Hotel Inn Management Team

From: Tumi Mjali
Date: 10 September 2016
Subject: Value creation opportunities

To Whom It May Concern

….
I propose that Hotel Inn considers placing all its properties into a separate company that can then be
sold. At the moment the properties have shown great capital appreciation and now is the time to Commented [11]: What does this sound like? Sale and
sell them. Long-term operating leases will be signed with all the properties before the sale and the Leaseback. Need to be thinking Tax and Accounting
treatment. We want to be asking where the value of this
focus of Hotel Inn can then be on operating the hotels as opposed to also owning and managing company really lies. Is it in the operations or in the
properties. properties?

We believe that this will unlock a lot of value for Hotel Inn shareholders and will also help Hotel Inn What does this decision do for the debt ratios and
covenants? What is a cheaper option? Interest on loans vs
expand more rapidly. Africa is ripe for growth and Hotel Inn should be taking advantage! Rental Payments.
…
I look forward to discussing this with the team,
Tumi Mjali

REQUIRED
(a) Determine whether Hotel Inn should select a forward contract or a money market 10
hedge if it wishes to minimise the cost of hedging the currency exposure of the
$1.2m coffee machines payment. The directors would like the Rand cost of both
options to be calculated and compared.

(b) Critically discuss the proposal from Tumi Mjali. Your response should include both 12
the opportunities and risks associated with the suggested move.

Communication skills – clarity of expression

1
(c) Critically discuss the proposed deal with bookings.com. Your response should include 8
both the opportunities and risks associated with the deal.

(d) Critically discuss the recent financial performance of Hotel Inn. Support your 13
discussion with calculations.

Communication skills – layout and structure 1

HOTEL INN - Suggested Solution

(a)

Commented [12]: US lending rate needs to be

converted for use over the 3 month period. 0,9%/4 =
0,225% for the quarter.

Total Rand cost of MM hedge is only cost of SA loan and

interest. There is no ‘cost’ to the US portion of the MM as it
is a deposit (the opposite would be true if we were
receiving a foreign currency).

(b) Commented [13]: You want to be looking at 50/50 split

between Opportunities and Risk.
Opportunities:
• Sales of hotels could realize value on potentially overvalued properties (1) which could drop Commented [14]: This was triggered in the scenario by
in value (due to uncertain political climate) (1) Tumi’s communication indicating that the properties have
shown great appreciation.
• Big cash inflow will help the financing problems within the business. (1) This is especially
Commented [15]: This point directly addresses one of
important given the onerous debt covenant terms. (1) the major issues in the scenario – needed to include the
• The big cash inflow could also help the company invest in new projects to generate growth impact of this proposal on the main issue.
(like hotels in other African countries). (1)
• Can potentially pay a special dividend to our shareholders post the sale of these assets. (1)
• Can focus on operating the hotels as opposed to managing properties. (1) Commented [16]: You want to focus on what your
expertise really is. At the end of the day, Hotel Inn
• Can help us expand quickly because will not need to buy properties but could rather lease. operates hotels – they focus on the operations and that is
(1) where managements expertise is.
• Other valid points

Risks:
• Selling property that is undervalued could create a large opportunity cost. (1) Commented [17]: We don’t know if the properties are
over or undervalued. This is the opposite of the point
• Operating leases are generally more expensive than owning the property themselves. (1) above.
• What if the operating leases are cancelled and then we lose access right to the property and
cannot run our hotels. (1) For instance, opposing hotels might buy the properties and make
leasing a difficulty. (1)
• The operating lease terms might be onerous when they are renewed which would reduce
margins. (1)
• Property may form part of our value proposition in the eyes of investors and the share price
might fall dramatically after sale of the properties. (1)
• Other valid points

Communication (1)
(c) Commented [18]: You want to be looking at 50/50 split
between Opportunities and Risk.
Opportunities

• Airbnb is taking customers away and this is an opportunity to compete with them. (1) Commented [19]: This competitor was specifically
mentioned in the scenario, want to try and incorporate
• The upfront payments received every month will increase the cash position of the company.
that into your solution.
(1) This is especially important given the onerous debt covenant terms. (1)
Commented [20]: Again, reference to a major issue
• This could lead to an increase in occupancy as at least 20% of all rooms are booked identified in the scenario. You want to ensure that a point
throughout the year. (1) This would especially be the case during the slow times of the year that you for (c) does address the major issue.
like winter. (1)

Risks

• Outsourcing of this function to bookings.com means the risk of admin mistakes leading to Commented [21]: Although the risks associated with
upset customers. (1) Hotel Inn’s reputation might be damaged even if the blame lies with outsourcing are ‘generic’ you need to apply it to the
solution in order to receive the marks. You want to ask
bookings.com. (1) yourself “can this point be put into any other outsourcing
• Bookings.com could cannibalise sales away from Hotel Inn. (1) This is a big problem given solution?” If it can, it is not applied enough.
that the price is 40% lower than the average rate. (1)
• During the peak holiday season, Hotel Inn will lose money (compared to the previous year)
because 20% of the rooms are sold for a much lower rate. (1)

(d) Commented [22]: Calculations were specifically scoped

in. Need to bring them into your solution. These are there
to back up/support your discussion though, that’s
important to understand.

Other valid calculations (1)

• Revenue has been pretty stagnant (growth of 0.12%) which is potentially concerning and Commented [23]: Pulling two points from the scenario
reinforces the need for improvements to be put into place. (1) Shows the impact of together. Explaining the possible stagnation of revenue to
competitors like Airbnb. (1) the emergence of a new competitor which was specifically
mentioned in the scenario.
• Occupancy rates have decreased from 64% to 62%, which means that the revenue increase
Commented [24]: You want to be able to compare this
has been driven by slight price increases. (1) to something. If we aren’t given industry standards there
o This is reflected in the increase in the average daily rate of 5.8%. This is likely to be is always inflation which can be looked at
less than inflation. (1) (note that inflation is currently much lower and you
would have received marks had you made the comparison
• Total Debt to EBITDA - this figure is creeping closer and closer to 3, which will have a and concluded accordingly)
significant impact on the company as the debt covenant may be broken. (1) Will result in Commented [25]: Very important to highlight this
higher interest costs and a significant cash out flow. (1) major issue again.
• Debt has also increased dramatically but without an impact on Revenue. (1) This is a concern, Commented [26]: A company make is meant to take on
what was the reason for the increase? (1) additional finance so that it has a positive impact on
revenue and ultimately profit. This hasn’t happened this
Communication skills – layout and structure (1) year and needs to be highlighted. We are not given
enough information to be able to provide a potential
reason why and so we can note the issue and pose a
question.
Walkthrough to Solution Part (a)

(a) Determine whether Hotel Inn should select a forward contract or a money market hedge if it
wishes to minimise the cost of hedging the currency exposure of the $1.2m coffee machines
payment. The directors would like the Rand cost of both options to be calculated and
compared.

Therefore we are comparing the cost of each option.

Money Market:

In North America at the moment the annualised deposit rate is 0.9% whilst the lending rate is
3.3%, whereas in South Africa the annualised deposit rate is 7.5% and the lending rate is at
12%. The current Rand/Dollar bid spot rate is 14.55 whilst the sell spot rate is 14.56. Hotel
Inn have enquired from a local bank about 3 month forward cover and the Rand/Dollar
premium quoted was 2.2%

We need $1.2mil at
this point.

OUTFLOW

What can we do today to have $1,2mil in 3 months’ time and remove all uncertainty?

We know that with a MM hedge we need to take the opposite position.

Therefore, if we are going to pay in the future we need to invest now.

1st Step
Invest today a value that in 3 months will be worth 1.2mil.
- US deposit rate is 0,9%/annum
- This equals a rate of 0,225% for 3 months
$"#$$$$$
- We need to invest today ("&$,##()
= $1197036

2nd Step
How do we get $1,197mil today?
- We need to convert Rands to USD
- Today’s Spot Rate to buy USD is 14.56 (this is the rate that an SA bank would be
willing to sell us USD’s at) (buy at the sell rate and sell at the bid rate)
- Therefore we need 14,56 x $1197036 = R17 432 776 to get the required USD
today
3rd Step
How do we get R17mil?
- We take out a 3 month loan for that amount
- Total principal repayment and interest will make up the total cost our MM hedge

Conclusion
There is no longer any USD exposure
- We have an investment maturing in 3 months that will pay for the invoice of $1,2mil
- We only have an SA loan outstanding in Rands
- We know exactly how much we need to pay – the risk of this transaction has been
removed
Total cost of this option = Principal + Interest
= 17 432 776 + 522 983
= 17 955 760

Forward Contract

We enter into a forward contract today for the delivery of $1,2mil USD in 3 months’ time
- We are locking in the price today
- Forward rate is currently at a 2,2% premium
- Sell Spot rate is currently 14,56
- In 3 months it will be 14,56 x 1,022 = 14.88032
- Therefore we have locked in the deal to buy $1,2mil in 3 months at 14,88032

Therefore total cost is

= 14,88032 x 1,2mil
= 17 856 384

Forward contract hedge is the cheaper option