Westwood Plastics Inc. Foreign Currency Risk Hedging Strategies

Westwood Plastics Inc.Foreign Currency Risk Hedging Strategies

Jason CowneKazuo Shirai

Yen-nhi DoJulie Nguyen

Chatree Jirakranjanavanit

FIN 570 Dr. Greco

July 6, 2009

Outline• Economic Outlook • Company/Case Background

a. Productsb. Industry

• Define the issuea. Transaction Risk

• Analyze the case dataa. Basic Issuesb. Immediate Issuesc. Cause/Effect Diagramd. Critical Exchange Ratee. Exchange Rate Trends

• Generate alternatives• Select decision criteria• Analyze & evaluate alternatives• Conclusions

Case Data Analysis -Economic Outlook

Year 2005 Year 2006 Year 2007 Year 2008

Real GDP Growth CAD % 2.4 2.9 2.7 2.7

Real GDP Growth EUR % 2.3 3.3 2.5 2.2

Inflation CPI CAD % 3.4 2.5 3.1 2.4

Inflation CPI EUR % 2.0 1.8 1.9 2.0

Unemployment CAD % of labor force 7.0 6.8 6.4 6.0

Unemployment EUR % of labor force 6.7 7.5 6.9 6.6

CAD Long-term interest rates 4.1 4.2 4.3 4.1

EUR Long-term interest rates 4.3 3.8 4.2 4.3

Source: CIA World Factbook

Company Background

• Westwood Plastics– Core competency – Manufacture & sales of

proprietary plastic products in Canadian marketplace.

• License Agreement with Schalle Industry (Cologne, Germany)– Exclusive manufacturing and distribution rights to

Cryolac

Case Background

Westwood Plastics

Canadian Bank

Loan

Schalle Industrie (AG)

Mfg. Cryolac

Payment

Payment is a note (9.1%, n = 10)• Financing from two sources: Schalle & bank• Revenue is in CAD• Expenses is in EUR•The right to manufacture & distribute premium product, Cryolac

Company Background - Cryolac Products

Dough BoxWhite Cryolac Plastic

ABS

Plastic manufacturing processes: 1. Injection Molding II. Extrusion Molding

Cryolac is a specialized proprietary plastic

Company Background -Plastic Industry

• Over 3,400 companies• Employing 113,000 workers

• $33 billion Canadian dollars in Total Revenues

• 85% of plastics exports are bound for the U.S.

• Lowest production costs for the plastics sector among G7 countries

Define the Issue

• Time frame: March 01, 2006– Revenues are in CAD– Expenses are in EUR

• Currency market is highly volatile• Effects of depreciating CAD currency

– Pay more EUR – Understand effects of income & cash flows

(Projected fiscal 2007 results)

Define the Issue

Projected EBT is $12 Mill CAD @ EUR=$1.3536 CAD

Loan covenant EBT > $9 Mill CADUnderstand tools to manage currency

exposureRecent trend shows CAD appreciatingIf CAD depreciates, projected EBT not met

Define the Issue - Transaction Risk

A large portion of its expenses are paid in EUR

• All of the company’s revenues are denominated in CAD

• A monthly licensing fee of 250,000 EUR• Raw materials necessary for the

manufacturing of Cryolac• Costs of servicing: 1 million EUR note for

partial payment of the upfront licensing fee

Analyze the Case

Projected EBT@ CAD $1.3536/EUR• Projected Expense in CAD $ 49,944,000(will

pay in EUR)• Converted to EUR 36,897,163 at the budgeted

exchange rate of 1.3536 CAD/EUR• Budgeted EBT (CAD/EUR)• CAD $62,002,000-CAD $49,944,000 = CAD

$12,058

Case Data Analysis - Basic Issues

IMPORTANCE

URGENCY LOW HIGH

LOW

HIGH

Case Data Analysis - Basic Issues

IMPORTANCE

URGENCY LOW HIGH

LOW Economic Risks

HIGH

Case Data Analysis - Basic Issues

IMPORTANCE

URGENCY LOW HIGH

LOW Economic Risks R&D in Domestic

HIGH

Case Data Analysis - Basic Issues

IMPORTANCE

URGENCY LOW HIGH

LOW Economic Risks R&D in Domestic

HIGHShipment Risks

Case Data Analysis - Basic Issues

IMPORTANCE

URGENCY LOW HIGH

LOW Economic Risks R&D in Domestic

HIGHShipment Risks Increasing

market shares

Case Data Analysis - Immediate Issues

IMPORTANCE

URGENCY LOW HIGH

LOW

HIGH

Case Data Analysis - Immediate Issues

IMPORTANCE

URGENCY LOW HIGH

LOWPolitical risks

HIGH

Case Data Analysis - Immediate Issues

IMPORTANCE

URGENCY LOW HIGH

LOWPolitical risks Competitors

HIGH

Case Data Analysis - Immediate Issues

IMPORTANCE

URGENCY LOW HIGH

LOWPolitical risks Competitors

HIGHUnderstanding the effect of currency exposure

Case Data Analysis - Immediate Issues

IMPORTANCE

URGENCY LOW HIGH

LOWPolitical risks Competitors

HIGHUnderstanding the effect of currency exposure

Currency Exchange Risks

Cause/Effect diagram

Comparing the decision criteria

Sources of financial restriction facing

Westwood

The best alternative hedging strategy for

the company

Measurement of hedges and exposures

Currency trends

CAD per 1 EUR Exchange Rate Chart(Jan 1999 – Jan 2006)

Trend Line

•If CAD continue to appreciate against EUR at present rate, then year end EBT will be C$13,069 thousand.

CAD per 1 EUR Exchange Rate Chart (Jan 2005 – Jan 2007)

EBT forecast without hedge (Assume exchange rate move on 3/1/06 and stay at level)

€/C$ exchange rate 1.3336 1.3536 1.3736 1.3936 1.4136 1.4365

Revenue (C$) 160,000 160,000 160,000 160,000 160,000 160,000

COGS (€ component) 45,084 45,760 46,436 47,112 47,788 48,562

COGS (C$ component) 67,935 67,935 67,935 67,935 67,935 67,935

Gross Margin 46,981 46,305 45,629 44,953 44,277 43,503

License Fee (€) 4,001 4,061 4,121 4,181 4,241 4,310

Depreciation (C$) 9,640 9,640 9,640 9,640 9,640 9,640

Selling and Admin. (C$) 19,232 19,232 19,232 19,232 19,232 19,232

Interest (€ component) 121 123 125 127 128 131

Interest (C$ component) 1,191 1,191 1,191 1,191 1,191 1,191

Total expense 34,185 34,247 34,309 34,371 34,432 34,503

EBT 12,796 12,058 11,320 10,582 9,844 9,000

1/3/2005

1/27/2

005

2/20/2

005

3/16/2

005

4/9/2005

5/3/2005

5/27/2005

6/20/2005

7/14/2

005

8/7/2005

8/31/2

005

9/24/2

005

10/18/2005

11/11/2005

12/5/2005

12/29/2005

1/22/2

006

2/15/2

006

3/11/2

006

4/4/2006

4/28/2006

5/22/2

006

6/15/2

006

7/9/2006

8/2/2006

8/26/2

006

9/19/2

006

10/13/2006

11/6/2006

11/30/2006

12/24/2006

1/17/2007

2/10/2

0071

1.1

1.2

1.3

1.4

1.5

1.6

1.7

1.8

EURCAD Projectionfrom current trend

Hisotical C$ appriciate MinEBT C$ Depreciate

1.4365

Generate AlternativesHedging Vehicles

Call Option

Premium

Put Option

Premium

Forward Contract

Margin – 8% of face value

Decision CriteriaAlternatives

Decision Criteria

Risk Cost Profit Flexibility

Put OptionHigh( - )

Medium(0)

High(+)

High(+)

Call OptionLow( + )

Medium(0)

High(+)

High(+)

Forward Contract

Low(+)

Low(+)

Low(-)

None(-)

Use of Put option is speculative!

Analyze & Evaluate AlternativesCall Options Put Options Forward

Contract Cost = 50,960,000

(1,016,000 + 49,944,000) CAD

Premium % of EBT = 8.4%

= 49,944,953 (953,000 + 49,944,000) CAD

Premium % of EBT = 7.9%

= 50,343,412 CAD

Analyze & Evaluate Alternatives

Alternative Hedge method

Up-font Hedge Cost (Premium)

Margin Req.

Average balance

Loss of interest income

Hedged EBT

Potential Loss if rate is

Potential Loss

Amount

Potential Gain if rate is

1 No Hedge

- -

-

-

> 1.3536

Unlimited < 1.3536

2 Buy Call Option 1,016

-

-

11,042 None

1,016 < 1.3260

3Enter into Forward

Cont.

-

2,186 109

11,659 None None None

4 Buy Put Option

953 -

-

-

> 1.3536 953 < 1.3278

Conclusions

• Westwood Plastics will use the call option as the optimal hedging strategy– Call Options Advantages

• Doesn’t tie up a lot of capital• Limits potential losses without limiting

potential gains

Historical Exchange Rate Trend(Jan 2004 – Jan 2009)

Questions???