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:

Noncash Expense

Expenses recorded on an income statement that do not involve a direct cash outflow, such as depreciation or amortization.

Traditional Income Statement

A financial statement that displays a company's revenues, expenses, and net income over a specific period, typically emphasizing historical cost accounting.

Cash Flows

The net amount of cash and cash-equivalents moving into and out of a business.

Financial Leverage

The use of borrowed money (debt) to finance the acquisition of assets, with the expectation that the profits will be greater than the interest payable.