Finance — Integrated Problem 2
Scenario (90 minutes)
Pembroke Pulp and Paper Inc. (PPPI) operates a pulp and paper mill that produces and sells newsprint. The primary inputs to production are raw materials, composed largely of wood fibres and recycled materials, as well as chemicals and additives. The company also consumes significant amounts of fuel oil, natural gas, and electricity in its processes. The chemicals and additives are paid for in U.S. dollars.
About 70% of the company’s annual sales are to customers in the United States. Most customer sales contracts are for fixed volumes of newsprint, with the selling price tied to a market price. This is standard for the industry, as many customers will not commit to fixed-price arrangements.
In addition to other debt with fixed interest rates, the company has a short-term line of credit bearing interest at prime plus 2%.
You, CPA, work as an associate with Campbell and Associates LLP, a financial and business advisory firm. PPPI’s board of directors has engaged Campbell and Associates to assist in assessing and managing its risk exposures. It is
February 15, 2022, and you have been asked by your boss, Heather Larimer, to assist on this engagement for PPPI.
The board of PPPI wants its specific exposure risks identified and a discussion of the implication of each of these risks. Specifically, for the foreign currency risk, the board would like further analysis on PPPI’s net exposure in U.S. dollars. To assist with this calculation, a forecast of revenues and variable expenses for the next 10 months (March 1 to December 31, 2022) has been provided in Appendix I.
The board is looking at forward contracts and options to manage their foreign currency risk. The CFO of PPPI has been able to obtain quotes from the Bank of Northern Savings for foreign exchange forward contracts and options on U.S. dollars maturing in September 2022 (Appendix II). The board would like a calculation detailing the impact on PPPI’s contribution margin if 75% of the net U.S. dollar exposure is hedged with either the forward contract or the options. A recommendation should be made as to which of these risk management tools should be used for 2022.
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Task #1
Identify PPPI’s sources of financial risk exposure, discuss the implications of each risk, and provide a recommendation on the most appropriate type(s) of hedging for each risk type.
Your response should be no longer than two pages.
Task #2
Discuss how forward contracts and options can be used as risk management tools to hedge PPPI’s foreign currency exposure. Specifically, discuss how these two types of hedging instruments work and the advantages and disadvantages of each.
Your response should be no longer than two pages.
Task #3
Based on information provided in Appendix I, calculate the amount of PPPI’s net U.S. dollar exposure. Calculate the net impact on contribution margin if the C$/US$ exchange rate is at 0.97 and 0.85 over the 10 months versus the current rate of 0.92. Make a supported conclusion as to whether the contribution margin is sensitive to C$/US$ exchange rate changes.
Your response should be no longer than one page, excluding any Excel files.
Task #4
Using the information provided in Appendix II:
- Design two different hedging strategies using foreign exchange forward contracts and options to hedge 75% of the net U.S. dollar exposure, rounded to the nearest
$10 million.
- Calculate the impact on the contribution margin for each strategy.
- Make a recommendation on which hedging strategy the company should accept.
Your response should be no longer than one page, excluding any Excel files.
Appendix I Pembroke Pulp and Paper Inc.
Forecasted operating income for March 1 to December 31, 2022 (Under IFRS and in ’000s)
| Forecast | ||
| Newsprint selling price (US$) | US$/MT | $ 640 |
| Foreign exchange | C$/US$ | 0.920 |
| Newsprint selling price (C$) | C$/MT | $695.65 |
| Total revenue (newsprint only) | (Note 1) | $69,565 |
| Operating costs | ||
| Variable operating costs | ||
| Raw materials | $ 7,200 | |
| Chemicals and additives | (Note 2) | 5,200 |
| Direct labour | 4,450 | |
| Electricity | 10,500 | |
| Fuel costs (oil/gas) | 7,900 | |
| Other variable overheads | 1,750 | |
| $37,000 | ||
| Contribution margin | (Note 3) | $32,565 |
| Notes: The company’s forecast newsprint sales from March 1 to December 31, 2022, is 100,000 metric tons (MT). The Canadian Dollar price of newsprint is fixed annually and doesn’t vary. The price for this period is locked in at $695.65. The chemicals and additives are paid for in U.S. dollars, and this is the Canadian dollar equivalent using the exchange rate of 0.92 above.Assume that there is little timing difference between when sales are made and collected and when purchases are made and paid. Revenue and operating costs are essentially equal to cash flows. |
Appendix II
Quotes provided by the Bank of Northern Savings
1. Foreign exchange forward contract
The forward contract can be for any amount of U.S. dollars in excess of US$100,000. The forward rate to sell U.S. dollars in September 2022 is at an exchange rate of C$/US$ = 0.928. The unhedged forecast rate is 0.92.
2. Foreign exchange option
Each option contract is for US$10,000 and costs $95 per US$10,000 contract (that is, the option premium is $95 per US$10,000 contract). The option is to sell U.S. dollars at an exchange rate of C$/US$ = 0.92 in September 2022.
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