- 20 Marks
FM – DEC 2023 – L2 – Q5 – Cost of capital | Foreign exchange risk and currency risk management
Calculation of the effective cost of various financing options and explanation of internal strategies to manage foreign currency risk.
Question
a) Markwei Pharmaceuticals Ltd plans to import active ingredients to produce vitamin syrup. The company’s managers are considering three financing options for the cedi equivalent of an invoice value of GH¢2.5 million. The options are detailed below:
Option 1: Use supplier’s credit. The credit term is 1.5/10 net 45.
Option 2: Issue a commercial paper to raise the money from the Ghanaian money market. The commercial paper will pay interest at the rate of 18% per annum. Issue costs totaling GH¢15,000 will be incurred.
Option 3: Obtain a 3-month bank loan. The interest rate on the loan is 22% per annum. Loan arrangement and processing fees are expected to be GH¢5,000.
Required:
i) Compute the effective annual cost of each financing option and recommend the most cost-effective option. (10 marks)
ii) Explain TWO (2) advantages of financing the invoice through the issue of a commercial paper instead of a bank loan. (5 marks)
b) Abongo Shoes Ltd (Abongo) imports leather from Italy. Abongo’s demand for euros to settle its import bills exposes its cash flow to foreign exchange risk. Abongo’s Management is looking for internal strategies they can deploy to hedge the company’s currency risk exposure as external hedging strategies might be too expensive for the company.
Required:
Explain TWO (2) internal strategies for managing foreign currency risk exposures that Abongo’s Management can use. (5 marks)
Find Related Questions by Tags, levels, etc.
- Tags: Bank Loan, Commercial Paper, Cost of Finance, Currency risk, Hedging Strategies, Trade Credit
- Level: Level 2