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Dozier Industries Essay

1516 words - 7 pages

Dozier Industries

Rupinder Kaur
[Pick the date]

Dozier Industries was a U.S. manufacturer of electronic security systems. In 1986, it received a large order from the United Kingdom, which stipulated payment in British pounds. The company received a deposit, with the balance expected to be paid in 90 days. The contract provided a slim profit margin, which could be easily eliminated by an unfavorable change in exchange rates. The chief financial officer had to decide whether to accept the foreign exchange risk or to hedge the exposure.

i) Given that Dozier industries does nothing to hedge this risk, assuming that spot exchange rate ...view middle of the document...

By doing this, Dosier would incur an obligation to deliver pounds 90 days from now at the rate established today.
The contract would obligate Dozier Industries to pay £1,057,500 in exchange for
£1,057,500 x 1.4198 $/£ = $1,501,438.50

Assuming the transaction was at the quoted 3-month forward rate.
Relative to the value of the contract at the current exchange rate,
£1,057,500 x 1.4370 $/£ = $1,519,627.50

Dozier would accepting a reduction in the revenue from the contract of
$1,519,627.50 - $1,501,438.50 = $18,198.00 or
$18,198 / $1,519,627.50 = 1.20%

Cost of forward hedge = (Forward – Spot) / Spot
= (1.4198 – 1.4370) / 1.4370
= –0.0120 or –1.20 %

Since, the number is negative it shows that this is a "cost". If the result is positive, you are "benefiting" from the hedge relative to the value of the contract at current spot exchange rate.
There are no profits to account for in this type of hedging.

Hedging risk using a spot contract, works similarly in that it also creates a pound obligation 90 days hence. Dozier would borrow pounds and exchange the proceeds into dollars at the spot rate.
Give the interest rate is 1 and a half times that of prime lending rate,
At an interest rate of 15% per year (3.75% for three months, the amount to borrow equals
£1,057,500 / (1.0375) = £1,019,277.11

Dozier would immediately exchange the pounds into dollars at the current exchange rate. So Dozier would have
£1,019,277.11 x 1.4370 $/£ = $1,464,701.21

The problem with this alternative is that we have dollars today (if you want to consider that a problem) and we need to compare the results with the forward hedge which gives us dollar three months from now. So, we need a way to compare dollars today with dollars in three months; i.e., we need an interest rate. So we ask, what can Dozier do with dollars today? Well they could invest the money in a safe investment, providing an 8.0% annual interest rate. If we assume that the company's opportunity cost of funds is investment at 8.0% (2% for three months), we can calculate how much money they would have in three months time.

$1,464,701.21 x (1.02) = $1,493,995.23

Relative to the value of the contract at the current exchange rate,
£1,057,500 x 1.4370 $/£ = $1,519,627.50

Dozier would be accepting a reduction in the revenue from the contract of
$1,519,627.50 - $1,493,995.23 = $25,632.27
$25,632.27 / $1,519,627.50 = 1.69%

On January 13, 1986 Dozier Industries, an American based firm, received notice that a bid on a project in the United Kingdom had been accepted.   The project was to bring in £1,175,000 in revenue.   Therefore, the revenue received for this project will need to be transferred into US dollars.   When Dozier issued the bid on December 3, 1985 the project the exchange rate was $1.4820/£.   This rate would have provided Dozier with the desired 6% profit on the project.   On January 13, the day the bid was accepted, the...

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