CASE STUDY IFARM PLC
IFarm Plc
The conglomerate has its head office in the United Kingdom and subsidiaries in the United States, Germany, Italy, Jifi, Camaija, and many other regions providing useful farm equipment. Among the portfolio of its products include tractors, seed drills, ploughs, harvesters, balers among other farm equipment. Although the multinational accords some autonomy to its subsidiaries, it operates a centralized treasury management system from its London headquarters, meaning they have to seek ratification of their financial decisions before operationalizing them.
Part A: Hedging Alternatives Possible for the US Subsidiary
In this particular instance, on 1st March 2020, the US subsidiary of IFarm Plc was seeking to supply two batches of seed drills to Belgian company Brux Plc. Because of the significant cost of the equipment, which is €5,000,000, Brux Plc sought terms to pay intwo installments of €3,000,000 on 1st June and €2,000,000 on 1st September 2020. The finance director of the US subsidiary of IFarm is now faced with a tough decision of choosing between three favorable decisions available to hedge against a reversal in the recent trend of the euro. The prevailing spot rate in the market as of 1st March is $1.10/€.
The spot rate is the immediate quoted price of a currency, commodity, or security. It’s the current market value of an asset depending on the market forces of demand and supply and expected future valuation (Jon et al., 2012 p.111). The spot rate hence changes frequently sometimes showing dramatic swings especially in the current market condition of uncertain future because of the Covid-19 virus epidemic. Relevant headlines such as this are certain to result in dramatic swings, thus the need for the management to choose carefully among the hedging alternatives available.
Option 1: Hedge in the Forward Market
Forward Over the Counter (OTC) agreements contract a party to exchange currencies at a future date at a specified exchange rate. In the offered forward contract, the 3-month quoted price for the company is $1.1060/€, the 6-month quote at $1.1130/€, the 9-month quote at $1.1134/€, and the 12-month quote at $1.1138/€. Despite its numerous advantages of hedging against future fluctuations in the value of the currency, there are inherent risks in using this strategy. One such risk is the default. The risk arises because the parties to the contract commit to performing the forward contract at a future date. One of the other party may be unwilling to exercise the contract as agreed, or may simply be unable to meet the obligations. The party to settle owes the other a net amount at the date of the settlement.
In the forward alternative offered, Brux Plc will pay the US subsidiary a net amount of €3,318,000 basing on the 3-month forward exchange quote. Similarly, it will pay the US subsidiary a net amount of €2,226,000 on 1st September basing on the 6-month quote. If they agree to this, the Brux will strive to pay for the equipment ordered the net amount in the future.
The OTC forward contracts for future delivery of products often settle in cash. The forward contract will enable the US subsidiary of IFarm and Brux to hedge, position, and arbitrage. Unlike simple future contracts, it will allow the management of both companies to customize the agreement according to the agreed currency, amount, and specified delivery date. However, forward contracts do not trade on a centralized exchange, thus resulting in an increased risk of default that they have to consider. The over the counter nature of the contracts also means there will be a level of difficulty in operationalizing one as they are mostly not dominant in the retail sector such as the sale of farm equipment.
Forward contracting offers an important tool in the agricultural finance sector to secure food for the over 9 billion projected world population by 2050. Unlike futures, they offer a higher degree of market-based safety nets and longer-term investment period for sustainable growth for companies and the overall economy. However, the market suffers from risk factors such as price volatility, lack of established exchange systems, and weather risks that can result in either party not exercising the contract. Because of interest rate parity, it means forward hedges, though plagued by higher default rates, are the same as the money market hedges.
Option 2: The Money Market Hedge
It is a technique of mitigating risk against fluctuations in currency by using the money markets (Ian, 1991 p. 945). The money market has liquid assets such as short-term assets including commercial papers, treasury bills, and banker's acceptance that the US subsidiary can borrow money from the Munich branch of HSBC at 8% and deposit. The money market hedge, however, offers a comparative advantage to retail investors and small businesses rather than large corporations such as IFarm in hedging foreign currency exchange risk. Regardless, the money market hedge works similarly as the forward markets hedge, but with a few alterations.
The money market hedge may not be the ideal strategy for large corporations such as IFarm because of increased translation exposure. In the case of this transaction worth €5,000,000, the transaction exposure will be significant due to receivables dealt with or payments expected in euro foreign currency. Thusly, translation exposure will be much greater for the company as compared to a small retail business. It is also much difficult to set up than utilizing a forward contract or options.
For the US subsidiary to set up a money market hedge, it will have to undertake some necessary steps. First, it will have to borrow €5,000,000 from the Munich branch of HSBCat an 8% lending rate enough to cover the present value of the seed drills to be delivered. The amount borrowed has to correspond to the present value of the deliverables because the foreign currency dominated loan and borrowing interest rate should be equal to the present value of the amount of deliverables. Secondly, the finance director will convert the foreign currency into US dollars at the prevailing spot exchange rate. Thirdly, the converted money will be invested in liquid short-term assets in the money market such as treasury bills and commercial papers at the prevailing market interest rates. Lastly, the IFarm US subsidiary will repay the lending rates from the Munich HSBC branch as the proceeds from the investments accrue. It will retain the principal sum borrowed and as the payments of deliverables become due from Brux, they will be paid to the bank because they are dominated in the same currency. The foreign exchange risk would have been mitigated through this strategy.
Similarly, because the subsidiary will receive foreign currency payments at a defined period in the future, it can hedge in the money market using the following strategy. It will utilize the option of the loan from the Munich branch of HSBC receiving €5,000,000 equal to the expected payments due from Brux. It will deposit the loan in euro dominated money market securities. As the deposits mature, it will make the lending interest rate payments to the Munich HSBC branch and convert the principal into domestic currency at the prevailing spot rates to mitigate against future fluctuations in foreign currency exchange rates. When the payments for the seed drills become due from Brux on 1st June and 1st September, they will be remitted to the Munich branch of HSBC.
Option 3: Hedge with Foreign Currency Options
A foreign currency option avails a right but not the obligation to the US subsidiary to buy or sell currency at a specified price either on before an agreed-upon date. However, the company estimates that in utilizing this strategy it will end paying up-front premiums of 12% on its capital. It is the maximum amount the company stands to lose while the buyers have unlimited earning potential depending on the swing in the market exchange rates. However, the subsidiary can deploy this strategy to minimize the losses resulting from changes in the direction of the exchange rates.
The subsidiary possesses the option of utilizing the Put options which offer a strike price of $1.1000/€ for a premium of 2% per contract in June and $1.1000/€ at a premium of 1.2% in September. The prevailing current spot rate in the market is $1.10/€. The put options give the company the right to sell the underlying asset at the strike price, which the seller is obligated to buy at the same price. However, the company has the right to dispose of the assets before the expiry of the option. The company will utilize the put option if it expects the dollar to undergo appreciation in value against the euro. However, it will sell the options if they anticipate the dollar to devalue against the euro. The company will be at an advantageous position since they can maintain their “long” position while utilizing only a small portion of the anticipated premiums by holding the options to maturity. They can take also take a “short” position if they anticipate the foreign currency market to remain stable. However, this can result in disastrous outcomes in a downward market turn.
If the finance director opts for a call option, the company will enjoy a strike price of $1.1000/€ for a premium of 3% per contract in June and $1.1000/€ for a premium of 2.6% in September. Call options will provide the company the right, but not the obligation to purchase underlying assets at the strike price during the specified period. However, if the spot rate fails to attain the agreed strike price before the expiration of the specified rate, the option expires to become worthless. The company will buy the call option if it expects the spot rate to rise and sell if it isto fall.
Recommendation on the Hedging Strategy to Adopt
Among the three alternatives available to the US subsidiary of IFarm for hedging, the best is the foreign currency options. Large multinationals such as IFarm prefer to use the foreign currency options because they have a limit to the downside risk and may only lose the up-front premiums. On the other hand, they have unlimited upside potential. Companies such as IFarm trading across diverse forex markets can use the option to hedge open positions they are holding in the forex cash markets. Compared to forward contracts, they have immediate settlement (Murillo et al., 2011 p. 1615).
Multinationals also prefer the foreign currency options because it avails them a chance to trade and profit on speculating the market direction based on economic and political headlines. The company will adopt a trading strategy based on the call and put options they choose to adopt. Similarly choosing a reputable broker or platform for trading will determine the profit gained or loss realized. They can opt for decentralized forex exchanges where more varied options are available or centralized exchanges characteristic of stocks and futures.
However, the foreign currency options market like forward market and money market hedging has its disadvantages including the high premiums charged on contracts. The premiums can vary widely depending on the strike price and the expiration date resulting in high costs on capital. Another disadvantage is the fact that there is no secondary market such that once a company buys an option contract, they cannot be re-traded or disposed of. It is also a complex affair with many fluctuating variables making it tedious to determine their value. The risks associated with this market include market volatility, interest rate differentials, the spot rate of the currency pair, and the period of expiration.
Regardless, the advantages outweigh the disadvantages compared to the other alternatives of money market hedging and forward market. Depositing in a money market hedge is a complex process with adopting strategies difficult and volatile. As shown in the highlighted steps, the company will have to dedicate substantial time to make the strategies pay off in the money market hedging alternative. Equally, there is no established exchange market for trading in forward contracts making it difficult to operationalize one for large corporations such as IFarm. The subsidiary will also have to forgo any potential gains arising from future potential gains in the swings in the currency exchange rate.
Hence, my recommendation is for the US subsidiary to adopt call or put options from a reputable bank that allows exercise for a period of up to three months. They will also seek multiple partial currency deliveries within the currency options (Shehzad, 1996 p. 439). It will allow the company to acquire exchange-traded options for standard quantities to diversify the risk of counterparty failure. Successful hedging will enable the company to survive the uncertain market periods ahead.
Part B: Alternative Sources of Financing for Expansion into Australia and New Zealand
In early 2020, IFarm established a projection plan of expanding its market share in Australia by setting a new factory in the country. It also sought to tap a new market in New Zealand through faster supplies from the new factory. However, building the new factory and developing marketing and distribution networks would require a substantial investment of AU$450 million. Traditional sources of funding are not viable since the company is highly geared and subject to some prescriptions particularly in paying dividends and the main lender is concerned about aging debt. Hence, alternative sources of funding are necessary to realize this aggressive expansion plan.
The report analyzes how IFarm’s capital structure can evolve to minimize risk and enhance corporate performance. Capital structure is a dynamic process that changes over time depending on internal and external factors. In the case of IFarm it is highly geared according to its forecast of expected profitability resulting in a risk-return compromise such as foregoing paying dividends and providing periodic cash-flow updates to its main lender.
The corporation needs to raise alternative sources of capital away from its traditional mechanisms. It needs to raise alternative external and internal funding to build the new factory in Australia and establish marketing and distribution channels to the New Zealand market. To expand its market share, aspects such as research and development are important to fendoff the competition. While utilizing retained earnings is one of the utmost means of raising capital for expansion, its balance sheet is highly leveraged to the extent of receiving restriction in paying dividends to its shareholders. Regardless of how big companies may be, alternative sources of funding for expansion are limited for all businesses at all levels.
IFarm can continue to forego paying dividends to its shareholders and retain earning to finance its aggressive expansion plan. Regardless of any internal and external pressures, the most basic source of funds and the most prominent should be selling their products and services for more than the cost to produce them. Instead of rewarding shareholders in the short-term with dividends and share buy-backs, the company can invest in the expansion plan and grow the business for future growth prospects.
Another alternative source of capital the company can use is debt capital, which can be through lending institutions or through issuing debt instruments. The instruments include issuing corporate bonds, which allow the public to become creditors of the company. similarly, the company can seek bank loans from its main lender or other willing lenders available. The downside with using this is the company is experiencing cash-flow problems shown by the condition placed on the company by the main lender to avail periodic financial statements. Although the failure to pay creditors can lead to bankruptcy, the interest payments for debt capital is an allowable tax expense and is usually cheaper than other sources.
The company can raise the required AU$450 million by issuing equity capital. IFarm can probably meet it’s the entire capital requirements for building a factory and providing marketing and distribution channels by selling shares to investors both internally and externally. Internally, the company can do the right issues that give existing shareholders and employees the first option of subscribing to issued shares. Similarly, the company can issue additional shares that both existing and new investors can buy. The advantage of using equity funding is that shareholders do not require interest payments as compared to bondholders and lending institutions.
Hence, through equity funding the cash-flows of the company will not be hurt further by having to make monthly, quarterly, or yearly interest payments. Similarly, the company will not be in danger of filing for bankruptcy such as in the instances when it is unable to meet its debt obligations to bondholders or lending institutions. The company can successfully raise the AU$450 million for the new factory in Australia and serve its targeted new market in New Zealand. The downside to this alternative method of funding is that existing shareholders are likely to be unhappy because of the dilution of their shares. They have to share future profits of the company with new shareholders who were not there previously. Furthermore, issuing equity capital to new shareholders means decision making in the company is likely to be slow and difficult because of the voting rights they avail. Hence, issuing equity capital despite its potential of availing the required capital for expansion, means existing shareholders forfeit or dilute their ownership control and share future profits.
A weighted average cost of capital (WACC) of IFarmreveals that the company is paying a lot of interest payments due to its previous over-reliance on debt capital for expansion (Didem & John, 2013 p. 60). Accumulating too much debt from lending institutions and corporate bonds can lead the company into trouble such as falling into administration, bankruptcy, or liquidation. However, not taking advantage of available growth prospects will hurt future profitability resulting from its reduced market share as competitors capture the targeted markets.
The main lender of the company may be willing to finance the project, if it is not willing to meet additional conditions on top of providing frequent updates on its cash flows. The additional conditions can include requiring improved equity contributions by the company's shareholders. The lender can also require IFarm to provide collateral through existing assets of the company or the new factory to be built. The lender is likely to finance the project because of the possession rights provided such that in case of default it can recover its loans. Credit guarantees condition can also enable the company to secure additional loans from its main lender. The guarantees work in a way that where the borrower defaults on the loan, the guarantor will compensate the bank a pre-determined part of the outstanding loan (Wallace, 1948 p.160).
Building a new factory in Australia is a sound investment that offers unlimited growth potential for the company such as the untapped New Zealand market. Retaining earnings may be the best alternative, but it is likely to be unpopular with shareholders in the long-term who will not be receiving dividends. Therefore, a mix of debt instruments, equity capital, and retained earnings will enable the company to meet its funding requirements for the aggressive expansionary plan.
References
Didem, K. & John, H. (2013). Aggressive Marketing Strategy Following Equity Offerings and Firm Value: The Role of Relative Strategic Flexibility. Journal of Marketing, Vol. 77, No. 5, pp. 57-74.
Ian, A, (1991). Back to Basics: Regulating How Corporations Speak to the Market’, Virginia Law Review, Vol. 77, No. 5, pp. 945-999.
Jon, D, Hyun, S & Jean-Pierre, Z (2012). ‘Endogenous Extreme Events and the Dual Role of Prices’, Annual Review of Economics, Vol. 4, pp. 111-129.
Murillo, C, Chen, L, YUE, M & HONG, Z (2011) ‘The Real and Financial Implications of Corporate Hedging’, The Journal of Finance, Vol. 66, No. 5, pp. 1615-1647
Shehzad, L (1996) ‘Evidence on Corporate Hedging Policy’, The Journal of Financial and Quantitative Analysis, Vol. 31, No. 3, pp. 419-439.
Wallace, P (1948) ‘Commercial Banks and Competitive Trends in Consumer Instalment Financing’, The Journal of Business of the University of Chicago, Vol. 21, No. 3, pp. 133-167.
