Diva shoes is an international shoes company that is experiencing rapid growth. Due to this rapid growth, the company never established a robust hedging strategy to protect itself against fluctuations of the multiple currencies it engages with. This situation became more severe in Japan. The company’s growth in Japan exceeded all expectations, and unlike other countries in which the company conducted business (Italy for example) the company had almost no expenses there, and had to convert all the Yens it generated from selling its merchandise to dollars.
In the last few years, the Yen appreciated against the dollars, making the company’s lack of hedging strategy have little to no impact on the bottom line. However, there are several signs that suggest that the Yen might become susceptible to weakening due to several geo-political reasons: 1. The weakening of the Mexican peso, which helped depreciate the dollar, was coming to an end. There are some concerns that as the peso go up and Mexico’s economy recovers so will the dollar. 2. There were rumors that due to the increased appreciation of the Yen, the G-7 summit might agree to take steps and prevent its further appreciation.
Such intervention will have a direct impact on the Yen/Dollar exchange ratio and might adversely impact the profitability of Diva Shoes. This was an excellent time, according to Diva’s financial consultant Stone, to hedge Diva’s position on the Yen and lock it at a rate that will guarantee to meet the company’s goal of 15% growth. Stone explored 2 options for hedging, forward contact and options, each with its pros and cons. By locking the rate using a forward contract, the company is completely protected from severe fluctuation in the exchange rate.
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The company signs a guaranteed contract in which it commits to selling its Yen at a known rate. This means that regardless of the exchange rate at the time of the transaction, the company knows how many dollars it will receive for its Yens. However, the company minimizes its gains since if the Yen appreciates further, it will not harness those gains. The other option considered is buying the option to sell Yens at a certain price. By choosing this option, the company has the option (but not the obligation like it has in a forward contract) to sell its Yens at a certain price.
So, if the Yen depreciates greatly, the company can use its option to sell it at the previously determined price. However, if the Yen appreciates a lot, the company only loses the premium it paid to purchase the options, but is not required to sell the Yen at agreed price. The company can then proceed to sell the Yen at the new, higher price, maximizing its profit. The main cost using this option is the premium. Since the market is efficient, the price of the option will reflect the expected value of the Yen, making it very expensive if the market expects the option will be exercised, or cheap if it does not.
Answers: 1. There are several reasons Diva shoes is more exposed to FX-Risk in Yen than other currencies: a. It does not have any expenses in Yen, which means that any income that is generated in Japan must be brought back to the States and in the process gets converted to dollars. b. The Japanese market shows tremendous growth and becomes a major component of Diva shoe’s income. As such, it becomes paramount to its growth and has a much bigger impact on the bottom line. 2. The company is doing a little to hedge itself against Yen rate fluctuations.
Currently it engages infrequently in forward contracts and sometimes tries to time the selling of the Yen “when an opportunity presents itself”. In other words, not so much. 3. In order to forecast the revenue for 1995 I had to make a few assumptions: c. I estimated the cost of goods sold as relative to the revenue. I calculated the relationship between the two in 1994, and then used the same ratio for 1995. This is shown in the attached excel spreadsheet. d. I used a similar estimate to project the SG&A.
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Again, I used the SG&A expenses as a percent of the revenue for 1994, then used the same ratio for 1995. I’m aware that this is not a great projection, as it ignores economies of scale and efficiency improvements as the company grows, but for the purposes of this projection, it’s the best I can do. The calculation is shown in the excel spreadsheet. e. I estimated the Yen/Dollar exchange rate to be 90. It is a bit higher than the current spot rate, but follows the trend according to exhibit 1. Exhibit 1 shows an appreciation to the Yen, which slows down to a crawl near the beginning of 1995.
Based on the case I believe it is safe to assume a minor depreciation to the Yen for Sep 1995. Based on the assumptions above I project revenues for 1995 to be $93,939,025. 90 4. Similar to question 3, this question require me to make several assumptions. I’ve used the exact same assumptions as the ones made in question 3. Using these assumptions, I project net income to be $8,874,315. 89. This means that the EPS for 1995 is $0. 74 which reflects a 20. 71% growth year over year. The full calculation and income statement for 1995 is shown in the attached spreadsheet. 5. The statement is accurate.
If Diva Shoes hedges with either an option or a forward contract that locks the exchange rate of the Yen to 92 Yen/Dollar the EPS growth will still be above 15%. Full calculation can be shown in the attached spreadsheet. In order to view the impact of different exchange rates, I’ve done a sensitivity analysis and came up with the following results: As shown in the graph above, Diva shoes will meet its corporate objective of EPS growth higher than 15% unless the Yen depreciates significantly compared to its current value. Per my calculations, the 15% goal is achieved as long as the Yen/Dollar relationship holds above 109. 0303 Yen/Dollar.
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This calculation also shows that the bottom line (Net Income) is impacted greatly as the Yen appreciates/depreciates. This is a result of the company’s income in Yen that become more/less valuable due to the different exchange rates. This shows that a company can grow its profit in Japan, and lessen its overall profit at the same time (profit in Yen goes up, Yen depreciates, total profit goes down).
The first item that gets hit by the fluctuating rate is the total revenue, since all the other items in the statement are derivatives of that, this change then impact the gross profit, operating profit and at the end, the net income. . I would recommend Benjamin to remain a shoe salesman and ignore FX-Risk. Even though this goes against what we learned in class, and might cost me several point in the test, I will do my best to justify the answer: f. Hedging is not Diva’s shoes core business. They specialize in making shoes and not understanding the financial market and its very complex financial packages. In order to start hedging intelligently, Diva shoes will be required to spend significant resources to either hire in-house financial experts, or outsource their hedging activities to an external company.
Either of these solutions will be very expensive, and will immediately impact their bottom line. g. In an efficient market, the price of forward contract and options will reflect the current expected change to the Yen value. If there’s a strong expectation that the Yen will depreciate (major tsunami just his Japan last week, North Korea prepares to invade Japan) the value of these options and forward contract will be very high, expecting businesses to hedge themselves against this incoming depreciation, and making sure the bank who gives these options does not lose money. h.
No one can predict the future, including hedge funds and financial experts. The assumption that anyone can tell when will the next financial crisis going to occur and if the Yen will depreciate tomorrow. By spending time and money trying to gamble on the direction of the Yen, Diva shoes distracts itself from its core business. It should focus on making great (and horrendously expensive) shoes, instead of playing the financial roulette. i. Hedging has a heavy price tag. By buying options, the company at the minimum pays the premium for the option, by conducting forward contracts; the company pays the fee to the bank, etc etc.
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