 An organization has just started exporting goods to a new client in country Zee, a

territory theorganization if not familiar with. What are the advantages to an

organisation of using a debt-factoring agency to collect their debts in country
Zee? (5 marks)b) Staveley Electronics Ltd has an annual turnover of £25 million of
which £0.2 million prove to bebad debts. Credit controls within the business have been
weak in recent years and the averagesettlement period for its trade debtors is
currently 70 days. All sales are on credit and turnoverhas been stable in recent years.
The business has been approached by a debt-factoring businesswhich has offered to
provide an advance equivalent to 80% of its debtors (based on an averagesettlement
period of 30 days) at an annual interest charge of 14%. The factor will
takeresponsibility for the collection of credit sales and will charge a fee of 2.5% of
sales turnover forthis service.The use of a factoring service is expected to lead to cost
savings in credit administration of£120,000 per annum and will reduce bad debts by
half. The settlement period for debtors will bereduced to an average of 30 days which
is in line with the industry norm. The business currentlyhas an overdraft of £6.2 million
and pays interest at the annual rate of 15%.Required:Calculate the net annual cost or
savings resulting from a decision to employ the services of afactor. (10 marks)
(Total 15 marks)

a)
Explanation:
Advantages of using a debt factoring agency to collect debts in country Zee:
1. Expertise in local regulations and customs: Debt factoring agencies often
have a deep understanding of the legal and cultural landscape of the
countries they operate in. This can be beneficial for navigating local
regulations related to debt collection in country Zee.

2. Efficient debt collection: Debt factoring agencies specialize in debt

collection, which can lead to faster and more effective recovery of
outstanding payments from clients in country Zee. This can help improve
cash flow for the organization.

3. Risk mitigation: Exporting goods to a new client in an unfamiliar territory

like country Zee can involve risks related to non-payment or delayed
payments. Utilizing a debt factoring agency can help mitigate these risks
by transferring the responsibility of debt collection to professionals who
are experienced in handling such situations.

4. Focus on core activities: Outsourcing debt collection to a factoring agency

allows the organization to focus on its core activities such as production,
marketing, and expansion, without the need to divert resources towards
chasing unpaid invoices in country Zee.

5. Improved cash flow management: By outsourcing debt collection to a

factoring agency, the organization can receive immediate advances on its
 outstanding invoices, which can improve cash flow and provide funds for
ongoing operations or investments.

 You are the Finance Director of a UK Business and you need to finance the purchase of a
newmolding machine, in three months time, at a price of $2,440,000.You have decided to hedge
the exchange rate risk by buying a three month sterling call optiongiving you the right, but not
the obligation, to deliver American dollars, in exchange for pounds,at a price of $1.9052, when
the machine is delivered in three months time.Three months later the American dollars are
delivered on the due date and you have to decidewhether or not to exercise the right to
exchange the American dollars for pound sterling at$1.9052.Scenario 1The dollar has
strengthened against the pound to $1.7638.Scenario 2The dollar has weakened against the
pound to $2.1062.Required:For each of the two scenarios above determine the best course of
action for you as theFinance Director. Give reasons for your answer. (10 marks)b) Briefly
describe three types of risk that operate in the international marketplace. (5 marks

The main concepts involved are:

1. Exchange Rate Risk:

- This is the risk of fluctuations in the exchange rate between two currencies.

- In the scenario, the Finance Director is concerned about the risk of the US dollar (USD) strengthening
or weakening against the British pound (GBP) between the time the decision is made to purchase the
molding machine and the actual delivery of the machine.

- Exchange rate risk can impact the cost of the machine purchase, as the machine is priced in USD, but
the company's functional currency is GBP.

2. Hedging:

- Hedging is a risk management strategy used to mitigate the exposure to exchange rate risk.
 - In this case, the Finance Director has decided to hedge the exchange rate risk by purchasing a three-
month sterling call option.

- A call option gives the holder the right, but not the obligation, to purchase a specific amount of the
underlying asset (in this case, GBP) at a predetermined price (the strike price) on or before a specific
date.

3. Exercise of the Call Option:

- At the end of the three-month period, the Finance Director has to decide whether to exercise the call
option or not, based on the prevailing exchange rate in the market.

- If the dollar has weakened against the pound (i.e., the exchange rate is higher than the strike price), it
would be beneficial to exercise the option and buy the pounds at the lower, predetermined strike price.

- If the dollar has strengthened against the pound (i.e., the exchange rate is lower than the strike
price), it would be better to forgo the option and buy the pounds in the spot market at the more
favorable exchange rate.

4. Spot Market:

- The spot market refers to the immediate, or "on the spot," exchange of one currency for another at
the current market rate.

- In the scenario, the Finance Director has the choice of either exercising the call option or buying the
pounds in the spot market, depending on the prevailing exchange rate.

The key is for the Finance Director to evaluate the two scenarios based on the current exchange rate
and the strike price of the call option, and then determine the best course of action to minimize the
exchange rate risk and the cost of the machine purchase.

Explanation:

a) Scenario 1: The dollar has strengthened against the pound to $1.7638.

In this scenario, the best course of action for the Finance Director is to exercise the call option and
exchange the American dollars for pound sterling at the agreed price of $1.9052.

Explanation:

- The current market exchange rate is $1.7638 per pound, which means the dollar has strengthened
against the pound.

- By exercising the call option, the Finance Director can lock in the exchange rate of $1.9052 per pound.

- This is more favorable than the current market rate of $1.7638 per pound, resulting in a gain of
$0.1414 per pound ($1.9052 - $1.7638).

- Exercising the call option allows the Finance Director to mitigate the exchange rate risk and ensure a
known and favorable exchange rate for the purchase of the molding machine, which was the primary
objective of the hedging strategy.

Scenario 2: The dollar has weakened against the pound to $2.1062.

In this scenario, the best course of action for the Finance Director is to not exercise the call option and
instead buy the pounds in the spot market.

Explanation:

- The current market exchange rate is $2.1062 per pound, which means the dollar has weakened against
the pound.

- If the Finance Director were to exercise the call option, they would be locked into the less favorable
strike price of $1.9052 per pound.
- By not exercising the call option and buying the pounds in the spot market, the Finance Director can
take advantage of the more favorable spot market exchange rate of $2.1062 per pound.

- Forgoing the exercise of the call option allows the Finance Director to minimize the cost of the molding
machine purchase, as they can acquire the pounds at a better rate in the spot market.

b) Three types of risk that operate in the international marketplace:

1. Foreign Exchange Risk:

- This refers to the risk of fluctuations in exchange rates, which can impact the value of a company's
assets, liabilities, and cash flows denominated in foreign currencies.

- For example, if a company has receivables in a foreign currency and the value of that currency
declines, the company's revenue may decrease.

2. Political Risk:

- This encompasses the risks associated with changes in political systems, government policies, or
social unrest in a country.

- These changes can affect a company's operations, investments, or ability to repatriate funds.

- For instance, a sudden change in government or political instability in a country where a company
operates can lead to disruptions in the business environment.

3. Country Risk:

- This refers to the risk of doing business in a particular country, which can be influenced by factors
such as economic stability, legal and regulatory environment, infrastructure quality, and the overall
business climate.
 - These factors can impact a company's ability to operate effectively and profitably in a foreign market.

- For example, a country with a weak legal system and frequent changes in regulations can pose
significant risks for a company investing in that market.

Understanding and managing these types of risks are critical for companies engaged in international
trade, investment, or operations to ensure the success and sustainability of their global activities.

Step 2

a) Scenario 1: The dollar has strengthened against the pound to $1.7638.

In this scenario, the best course of action for the Finance Director would be to exercise the call option
and exchange the American dollars for pound sterling at the agreed price of $1.9052.

Reasons:

1. The current market exchange rate is $1.7638 per pound, which means that the dollar has
strengthened against the pound. This implies that if the Finance Director were to buy pounds in the spot
market, they would get more pounds per dollar compared to the agreed strike price of the option.
2. By exercising the call option, the Finance Director can lock in the exchange rate of $1.9052 per pound.
This is more favorable than the current market rate of $1.7638 per pound, resulting in a gain of $0.1414
per pound ($1.9052 - $1.7638).

3. Exercising the call option allows the Finance Director to mitigate the exchange rate risk and ensure a
known and favorable exchange rate for the purchase of the molding machine, which was the primary
objective of the hedging strategy.

Scenario 2: The dollar has weakened against the pound to $2.1062.

In this scenario, the best course of action for the Finance Director would be to not exercise the call
option and instead buy the pounds in the spot market.

Reasons:

1. The current market exchange rate is $2.1062 per pound, which means that the dollar has weakened
against the pound. This implies that if the Finance Director were to buy pounds in the spot market, they
would get fewer pounds per dollar compared to the agreed strike price of the option.

2. By not exercising the call option, the Finance Director can take advantage of the more favorable spot
market exchange rate of $2.1062 per pound, rather than being locked into the less favorable strike price
of $1.9052 per pound.
3. Forgoing the exercise of the call option allows the Finance Director to minimize the cost of the
molding machine purchase, as they can acquire the pounds at a better rate in the spot market.

b) Three types of risk that operate in the international marketplace:

1. Foreign Exchange Risk: This refers to the risk of fluctuations in exchange rates, which can impact the
value of a company's assets, liabilities, and cash flows denominated in foreign currencies.

2. Political Risk: This encompasses the risks associated with changes in political systems, government
policies, or social unrest in a country, which can affect a company's operations, investments, or ability to
repatriate funds.

3. Country Risk: This refers to the risk of doing business in a particular country, which can be influenced
by factors such as economic stability, legal and regulatory environment, infrastructure quality, and the
overall business climate.

These risks can have significant implications for companies engaged in international trade, investment,
or operations, and must be carefully evaluated and managed to ensure the success and sustainability of
their global activities.

ANSWER

To summarize the key points:

1. Exchange Rate Risk:

- The Finance Director is concerned about the risk of the US dollar (USD) strengthening or weakening
against the British pound (GBP) between the decision to purchase the molding machine and its actual
delivery.

- This exchange rate risk can impact the cost of the machine purchase, as it is priced in USD but the
company's functional currency is GBP.

2. Hedging:

- The Finance Director has decided to hedge the exchange rate risk by purchasing a three-month sterling
call option.

- A call option gives the holder the right, but not the obligation, to purchase a specific amount of the
underlying asset (GBP) at a predetermined price (the strike price) on or before a specific date.

3. Exercising the Call Option:

- At the end of the three-month period, the Finance Director has to decide whether to exercise the call
option or not, based on the prevailing exchange rate in the market.

- If the dollar has weakened against the pound (exchange rate is higher than the strike price), it would be
beneficial to exercise the option and buy the pounds at the lower, predetermined strike price.

- If the dollar has strengthened against the pound (exchange rate is lower than the strike price), it would
be better to forgo the option and buy the pounds in the spot market at the more favorable exchange
rate.

4. Spot Market:

- The spot market refers to the immediate exchange of one currency for another at the current market
rate.

- The Finance Director has the choice of either exercising the call option or buying the pounds in the spot
market, depending on the prevailing exchange rate.

The key is for the Finance Director to evaluate the two scenarios based on the current exchange rate
and the strike price of the call option, and then determine the best course of action to minimize the
exchange rate risk and the cost of the machine purchase.