Instruction 10.1: Use the Information for the Following Problem(s)

question 55

Multiple Choice

Instruction 10.1:
Use the information for the following problem(s) .
Central Valley Transit Inc. (CVT) has just signed a contract to purchase light rail cars from a manufacturer in Germany for €3,000,000. The purchase was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, CVT is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information.
• The spot exchange rate is $1.250/euro
• The six-month forward rate is $1.22/euro
• CVT's cost of capital is 11%
• The Euro zone 6-month borrowing rate is 9% (or 4.5% for 6 months)
• The Euro zone 6-month lending rate is 7% (or 3.5% for 6 months)
• The U.S. 6-month borrowing rate is 8% (or 4% for 6 months)
• The U.S. 6-month lending rate is 6% (or 3% for 6 months)
• December call options for euro 750,000; strike price $1.28, premium price is 1.5%
• CVT's forecast for 6-month spot rates is $1.27/euro
• The budget rate, or the highest acceptable purchase price for this project, is $3,900,000 or $1.30/euro
-Refer to Instruction 10.1. What is the cost of a call option hedge for CVT's euro receivable contract? (Note: Calculate the cost in future value dollars and assume the firm's cost of capital as the appropriate interest rate for calculating future values.)

• A) $57,600
• B) $59,904
• C) $62,208
• D) $63,936

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Definitions:

Average Variable Cost

The variable costs associated with production when divided by the total units manufactured, indicating the cost per unit that varies.

Average Fixed Cost

The fixed costs of production (costs that do not change with the level of output) divided by the quantity of output produced, decreasing as production increases.

Short Run

A period during which at least one factor of production is fixed, affecting a firm's ability to adjust to market changes.

Hold-Up Problems

Situations where one party in a negotiation exploits their bargaining advantage at the expense of others, often after a mutual investment or commitment is made.