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Dozier Industries was a U.S. manufacturer of electronic security systems. In 1986, it received a large order from the United Kingdom, which stipulated payment in British pounds. The company received a deposit, with the balance expected to be paid in 90 days. The contract provided a slim profit margin, which could be easily eliminated by an unfavorable change in exchange rates. The chief financial officer had to decide whether to accept the foreign exchange risk or to hedge the exposure.
A2 i) Given that Dozier industries does nothing to hedge this risk, assuming that spot exchange rate remains the same as on Jan 14,1986 levels, Total …show more content…
So, we need a way to compare dollars today with dollars in three months; i.e., we need an interest rate. So we ask, what can Dozier do with dollars today? Well they could invest the money in a safe investment, providing an 8.0% annual interest rate. If we assume that the company's opportunity cost of funds is investment at 8.0% (2% for three months), we can calculate how much money they would have in three months time.
$1,464,701.21 x (1.02) = $1,493,995.23 Relative to the value of the contract at the current exchange rate,
£1,057,500 x 1.4370 $/£ = $1,519,627.50 Dozier would be accepting a reduction in the revenue from the contract of $1,519,627.50 - $1,493,995.23 = $25,632.27 $25,632.27 / $1,519,627.50 = 1.69%
On January 13, 1986 Dozier Industries, an American based firm, received notice that a bid on a project in the United Kingdom had been accepted. The project was to bring in £1,175,000 in revenue. Therefore, the revenue received for this project will need to be transferred into US dollars. When Dozier issued the bid on December 3, 1985 the project the exchange rate was $1.4820/£. This rate would have provided Dozier with the desired 6% profit on the project. On January 13, the day the bid was accepted, the exchange rate had changed to $1.4480/£. On January