Voyages Soleil

8 Pages   |   2,253 Words

Voyages Soleil: The Hedging Decision
Case Analysis

EXECUTIVE SUMMARY

This is a complete strategic and financial analysis in order to solve the problem faced by VOYAGE SOLEIL. The company is facing a dilemma because of the currency risk which would shrink the profit margins because of the worsening political and economic conditions all over the world.
The company receives payment in Canadian dollars and pays for purchases and reservations in US dollars with a gap of six months. Due to 9/11 incidence, the Canadian dollar is expected to depreciate against the US dollar.
The company has three options. It can do nothing, employ forward contract or borrow and invest dollars. By calculating the risk and return associated with every option, the report craves the best way out for the company and also warns it of any possible risk.
 

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Analysis

VOYAGE SOLEIL is one of Quebec’s leading tour operators in packaged tour vacations to the Carrabin and South America. It had been operating in an extremely profitable industry till September 2001. The industry was growing at good pace with good profit margins available to the companies. VOYAGE SOLEIL was known for provision of good quality service at very reasonable prices.
After the incident of 9/11, the whole scenario changed. The industry which was very profitable for the companies became a night mare and many companies declared bankruptcy. The profit margins for all the companies went down as the terrorism got its way. Passengers were reluctant to travel for vacations and therefore, the customer base also shortened. Although VOYAGE SOLEIL had good customer loyalty, it could not translate itself into unstained earning base for the company.
The nature of the business has also been a big problem for the company. This has mainly been due to its diversified nature of business. It had faced exchange rate risk many times in the past and many other companies had faced extreme losses due to this risk. This risk also exists for VOYAGE SOLEIL because it collects its revenue in Canadian dollars from the customers. But, when it has to pay for the purchases, it pays in US dollars six months after the booking. The company has to pay 60 million US dollars for reservations which according to the current exchange rate translate itself into 95.26 million Canadian Dollars.
Therefore, a gap gets its way in the form of currency risk. If the Canadian Dollar appreciates during that time period, it would translate itself into profits for the company. But, if it depreciates itself during that tenure, it would mean losses for the company.
Before 9/11, the currency issue was not a big one. The fluctuations were quite smooth and predictable. The currency fluctuated within safe margins. But after the incident, the fluctuations became wild. No one was able to predict the movement of US dollars after the incident with great accuracy. Similarly, no one was able to predict the movement of Canadian Dollar in the future because of the terrorism issue. This uncertainty translated itself into big worries as the companies could not understand the current and future positions of the businesses.
VOYAGE SOLEIL has three options. It can leave everything for time and wait for the unexpected to happen. In this case, the company would have to go with the rate and deal in spot market. This means that if the Canadian Dollar appreciates, the company would earn good margins in the form of a bigger spread. On the other hand, if the Canadian Dollar depreciates against the US dollar, the margins for the company would go down and the company can face losses because of all that. Another option of the company is to employ a forward contract and agree to pay the compound at a pre decided rate of 0.6271 US dollar / Canadian Dollar. Still another option for the company is to borrow US dollars and invest them at a specific rate and then pay the amount in the future.
Under such circumstances, it is very important for the company to forecast the future of the industry and the currency. After the incident, the industry has seen a decline and hopes of recovery are very low. This is primarily because of the terrorism issue which the industry is facing. But, it is also important to note that such issues not only create downs but also ups for a company or an industry. Due to the elimination of two big companies from the industry, the competition seems to be gone with the wind. The extent of competition has gone down because two companies have declared bankruptcy. This is a condition of decline in the industrial life cycle. When an industry faces decline, the companies in it start vanishing out because of financial as well as business constraints. Such conditions are ideal for those companies which have a very strong repute and brand name in the industry. Elimination and extinction of major competitors from the industry would result in the creation of greater options for the company. This is because now, the company has the option to increase the price to keep up with the currency fluctuations.
The currency would also not see many fluctuations because the US economy would face shrinkage. The shrinkage would be there because of the decrease in investment in US after the big incident. This decrease in investment would weaken the US dollar internationally and therefore the Canadian dollar might get strength in the future. But, the reverse can happen too. The US government might intervene in order to strengthen the dollar internationally. If that happens, tables would turn the other way around.
Based upon this point of view, there is a greater chance that the Canadian dollar would appreciate against the US dollar. This is because the American Dollar would lose strength against the Canadian dollar within the next 12 months.
Due to a decrease in the overall level of investment in the US economy, it would see a current as well as trade deficit. In order to keep things under control, the US government would finance. The deficit and would loosen the monetary policy. This would result in an increase in dollars in the US economy which would result in the depreciation of the US dollar.
However, this cannot be predicted with great certainty. This is because these fiscal and monetary moves are dependent no only upon the economic circumstances but also upon non-economic and social circumstances. Therefore, the direction of the change of US dollar versus the Canadian dollar cannot be predicted with great accuracy.
Before considering the three options available to the company, it is important to note that it would be suitable for the company to look at the options from a very conservative point of view. As nothing can be said about the direction of the change with great accuracy, the company is not is a position to take risk. In other words, it is in a weak financial and strategic position and would not be able to bear anunexpected move against the strategic planning. Therefore, while considering the options, it should consider that option with which the lowest financial risk or loss is associated.
The first option is to do nothing and leave the decision till the time come. This is a spot decision and if the company implements it, it would have no option of financial or strategic maneuvering. If this option is taken into consideration, the company would not have any power regarding hedging in the time frame. As the Figure a shows, if the currency rate declines i.e. if the Canadian dollar depreciates, the company would face losses up to 5% of the current value. This loss would in turn translate itself into shrinkage of profit margins for the company. On the other hand, if the currency appreciates and gains value against the US dollar, the company would enjoy gains up to 5%. So, in the first option, the company would be left at a position which can change from -5% to 5%.
The second option for the company is to employ a forward. The rate at which the company can do that is 0.6271 American dollar / Canadian dollar. This rate is lower than eh current rate of Canadian dollar. In simple words, if this option is exercises, the company would agree to pay the 60 million US dollars at a rate of 0.6271 per Canadian dollar. Figure bshows that if this option is exercises, the company will face a loss of 0.43% in the future provided that the exchange rate does not change. However, if the rate moves up, the losses of the company would increase. On the other hand, if the rate goes down, the losses would minimize.
The third option for the company is to borrow Canadian dollars and then use them to buy US dollars and then invest those dollars. The loan could be repaid using the Canadian dollars available for the hotel payments. 
Figure c shows that if the company borrows the Canadian dollars at the Euro Canadian rates, it would incur an interest expense of $1.286. Therefore, the total amount which the company will have to return would be $96.554. Using the borrowed amount, the company can buy the 60 million US dollars form the market and then invest those dollars at 1.28%. This would generate an interest income of 0.765 million. Therefore, if this option is considered and the currency rate does not change till six months the company would face a loss of 0.074 million only. The most interesting part to note is that if this option would yield gains if the Canadian dollar depreciates.
Figure c also shows that if the company borrows the Canadian dollars at the Euro dollar rates, it would incur an interest expense of $0.8812. Therefore, the total amount which the company will have to return would be $94.14. Using the borrowed amount, the company can buy the 60 million US dollars form the market and then invest those dollars at 0.83%. This would generate an interest income of 0.495 million. Therefore, if this option is considered and the currency rate does not change till six months the company would face a loss of 0.095 million only, however, if the exchange. The most interesting part to note is that if this option would yield gains if the Canadian dollar depreciates.
Looking at the options strategically, the most suitable option for the company is the third one and to use the euro Canadian rate. It should consider this option because of the following reasons:
  • The current position of the company does not allow it to adopt an aggressive strategy. Therefore, the best way would be to be conservative and adopt that route which leads to minimum financial losses. The first option has a potential of yielding a loss up to 5%. The second option has a potential to yield a loss of -0.43%. The third Therefore, if we consider the three options, the best suited option from this perspective seems to be the third one. Within this third option, the Euro Canadian interest rate should be considered. This is because it yields better spread as compared to the Euro Dollar rate.
  • It is also important to note that the company expects the US dollar rate to go up to and therefore it expects the Canadian dollar to depreciate. In case the Canadian dollar depreciates, the third option would generate profits rather than losses for the company. This means that if the future exchange rate falls below the current level, the company would benefit from the increased profits by considering the option.
Therefore, due to the above mentioned reason, it is strongly recommended that the company adopts the third route to solve the problem. However, the company should also keep in mind future fluctuations in interest rate being offered. This is because the worsening social and political conditions would also have a significant Impact upon the interestrates. In this case, the best option would be to choose the third option with fixed rather than floating rate and still consider the interest rate risk in the market.
 
APPENDIX
FIRST OPTION (DO NOTHING)
IF CDN DEPPRECIATES
  Current p1 p2 p3 p4 p5 Difference Gain / Loss
Exchange Rate 0.6298 0.62 0.615 0.61 0.605 0.6 -0.0298 -5%
CDN Dollar 95.268339 96.7742 97.561 98.3607 99.1736 100 -4.73166 -5%
US Dollar 60 60 60 60 60 60    
IF CDN Appreciates
  Current p1 p2 p3 p4 p5 Difference Gain / Loss
Exchange Rate 0.6298 0.6368 0.6438 0.6508 0.6578 0.6648 0.035 6%
CDN Dollar 95.268339 94.2211 93.1966 92.1942 91.2131 90.2527 5.015632 5%
US Dollar 60 60 60 60 60 60    
 
(Table A)
 
SECOND OPTION (EMPLOY FORWARD)
  Current Forward rate Difference Gain / Loss
Exchange Rate 0.6298 0.6271 -0.0027 -0.43%
CDN Dollar 95.26834 95.67852017 -0.410181 -0.43%
US Dollar 60 60    
 
(Table B)
 
BORROW & INVEST
EURO CANADIAN RATES EURODOLLAR
  Rate US Dollar CDN Dollar   Rate US Dollar CDN Dollar
Amount to Borrow   60 95.26833916 Amount to Borrow   60 95.26833916
Borrowing Rate 1.35%     Borrowing Rate 0.93%    
Total Interest Payment   1.286122579 Total Interest Payment     0.881232137
Total Amount     96.55446173 Total Amount     96.14957129
Invested Amount     60 Invested Amount     60
Deposit Rate 1.28%     Deposit Rate 0.83%    
Total Interest Income     0.765 Total Interest Income     0.495
Total Income (USD)     60.765 Total Income (USD)     60.495
Total Income (CDN)     96.48301048 total Income (CDN)     96.05430295
Net Gain / Loss (dollars)   -0.071451254 Net Gain / Loss (dollars)     -0.095268339
Net Gain / Loss (%)     -0.074% Net Gain / Loss (%)     -0.099%

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