Inca Breweries of Peru. Inca Breweries of Lima, Peru, has received an order for
ID: 2735893 • Letter: I
Question
Inca Breweries of Peru. Inca Breweries of Lima, Peru, has received an order for 10, 000 cartons of beer from Alicante Importers of Alicante, Spain. The beer will be exported to Spain under the terms of a letter of credit issued by a Madrid bank on behalf of Alicante Importers. The letter of credit specifies that the face value of the shipment, U.S. $720, 000, will be paid 90 days after the Madrid bank accepts a draft drawn by Inca Breweries in accordance with the terms of the letter of credit. The current discount rate on three-month banker's acceptances is 8% per annum, and Inca Breweries estimates its weighted average cost of capital to be 20% per annum. The commission for selling a banker's acceptance in the discount market is 1.2% of the face amount. How much cash will Inca Breweries receive from the sale if it holds the acceptance until maturity? Do you recommend that Inca Breweries hold the acceptance until maturity or discount it at once in the U.S. banker's acceptance market? Is there a need to hedge and which technique would you choose?Explanation / Answer
We need to recommend Inca Breweries whether to hold the acceptance until maturity or disocunt it at once in the U.S. banker's Acceptance Market. So we have to Alternatives here in given question.
If we go by Alternative 1
If Inca Breweries hold the draft for 90 days, after the bank accepts it, then Inca breweries will received the amounnt of $720000.
The present value of $720000 received in 90 days discounted at Inca's WACC 20% per annum i.e. 5%( 20% X 90/360) for 90 days
The present value shall be = $720000/ (1.05) = $685714
If we go by Alternative 2
Inca Breweries can sell the banker's acceptance in today's money market @ 8% per annum discount.
Thus , In alternative 2 the amount of cash received today is $696960, which is greater than the $685714 present value of the face value of $720000 received on maturity as per alternative 1.
Threrfore Inca Breweries should sell the acceptance in today's banker's acceptance market and take the cash at once.
The hedging is done for the risk associated with the foreign exchange.Therefore there is need for heding the transaction in foreign exchange . The type of hedging is depending upon the level of risk. Money Market Hedge technique helps a domestic company reduce its currency risk when doing business with a foreign company. Money market hedge may be feasible as a way of hedging for currencies where forward contracts are not available. Therefore we will choose Money Market Hedge Technique.