Advise UK subsidiary SMT on the hedging strategies should

JF Group is a multinational company based in France and was founded in 1992. The company specialises in financial services to private equity companies operating in the industrial and commercial property construction and development industry. JF's head office is currently based in France and has subsidiaries in Germany, UK, Austria, America, Monaco and Poland. The parent company is home to the treasury management team and Board of Directors of the company. The corporation currently operates a centralised treasury management system, operating from France.

The multinational corporation currently has a market capitalisation of 2.2 billion euros and has a gearing level of approximately 82%. JF Group currently turns over 58 million euros per annum in worldwide sales and profits have stabilised over the last 5 years, averaging a trading profit of approximately 2.8 million euros per annum. A UK subsidiary of JF, has offered financial services to a German company AB for€6,000,000 on 1st March 2018, payable €3,000,000 on 1st June and €3,000,000 on 1st December. UK subsidiary's director of finance now wondered if the firm should hedge against a reversal of the recent trend of euro. UK subsidiary estimates its cost of capital to be 10%. Four approaches were possible for JF: 1) Do nothing. 2) Hedge in forward market. The 3 month forward exchange quote was €1.1361/£, the 6 month quote was €1.1403/£, the 9 month quote was €1.1468/£, and the 12 month quote was €1.1522/£. 3) Hedge in the money market. JF could borrow euros from the Munich branch of HSBC at 6%. 4) Hedge with foreign currency options. June put options were available at strike price of €1.1300/£ for a premium of 3% per contract, December put options were available at strike price of €1.1300/£ for a premium of 1.8%. June call options were available at strike price of €1.1300/£ for a premium of 4% per contract, December call options were available at strike price of €1.1300/£ for a premium of 2.8%.

The subsidiaries have operations within their home country, offering financial services locally and throughout the Eurozone region. The company is currently undertaking 5 year strategic review for the period 2019 - 2023 and is looking closely at its operations to identify how it can achieve its expansion and growth objective which is a 5% increase over the next 5 years. The company is considering expansion in Asia - namely China and India as there is much growth in these regions over the last few years. It has been estimated that 300 million euros will be needed to fund the proposed expansion over the next 5 years.

However, the financial services industry has experienced a range of global macro-environmental forces affecting the industry, particularly in Eurozone, which has led to both increased competition and increased regulation. JF Group has been winding down their German subsidiary (which has been making a trading loss for the last 5 years) with a view to divesting their investment operations, which are run here, and specialising in other services, which they offer.

They have been approached by a new entrant into the market, JAS Group who has offered 2 million euros in a 50:50 joint venture deal over 4 years. Hence the total cost of the joint venture will be 4 million euros. JAS Group is an investment fund management company based in Germany.

JF AG 2017 (German Subsidiary) - Book values


 

Fixed asset

Investment (some of which is leased from Parent company)

Euros

 

17.0m

Working capital

3.0m

Total

20.0 m

JF AG 2017 (German Subsidiary)


 

Equity

Euros

 

18.0m

Debt

12.0m

Total

30.0m

Note 1

The shareholders of JF Group can invest their money in an alternative investment that yields a return of 15%. Interest of 8% was paid on debt.

Note 2

Cost of capital projected is based on the current weighted average cost of capital (WACC). It is this rate which should be used to evaluate the joint venture (to the nearest %)

The company is currently faced with the following strategic issue;

Whether to enter into the Joint Venture with AG Group. (There is insufficient information to make a comparison between divestment and JV, so just evaluate the JV).

Joint Venture Information

The Finance Directors of both companies have come together and listed the following assumptions. JF Finance Director, Alf has asked you as the capital projects accountant to put together a report evaluating the proposed joint venture based on the following information which relates to JF Group only.

The Joint venture agreement is initially set for 4 years, with the option of a company buy-out in year 4 or continuation of joint venture beyond year 4

JF Group will pay 50% of investment in year 0 and the remaining 50% of investment in year 1 relating to their share of the investment.

Projected annual gross cash flows from the joint venture are expected to be 1.060 million Euros and £0.860 million in year 1 and are expected to increase by 12% per annum.

All sales will be generated from Eurozone and UK market
The spot rate is £0.8620/€
Operational costs of the subsidiary are expected to be 0.328 million euros per annum which includes 0.028 million euros for depreciation
The annual rate of inflation in Germany is expected to be 1.8% (this should be applied to operational costs only)
The interest rate for UK is expected to be 1.8% and the rest of the Eurozone is 1%.
The tax rate in Germany is currently 30%
Tax will be paid on profits generated in Germany by subsidiary company
A double taxation treaty exists between UK and Germany

Required:

You are asked to write a 3,000 word consultancy report to senior management team (SMT) on the THREE strategic issues below.

1) Advise UK subsidiary SMT on the hedging strategies should be adopted based on the business with company AB. Show all workings and calculations in the appendices of your report.

2) Evaluate the proposed joint venture using financial and non-financial analysis. Clearly state which capital investment appraisal method you have used and it appropriateness.

Clearly state any assumptions and show all workings and calculations in the appendices of your report.

3) Clearly state what options of sources of finance the multinational corporation has to fund the proposed expansion across Asia. What factors should the company consider when deciding what sources of finance to access to find the restructuring of the company?


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