VOYAGES SOLEIL: The Hedging Decision Jennifer Gore, Lani Heinemann, Kimberly Kam, Ricky Lai and Nadejda Zaitchenko Dr. Greco - Finance 570 - April 30, 2009

Agenda Company & Industry Background The Case Issues Alternatives Recommendation The Outcome Conclusion

The Company One of Canada’s leading tour operators in packaged vacations to the Caribbean and South America Headquarters located in Quebec and established in 1975 Jacques Dupuis is the president and owner Built strong relationships with customers to lend to its leadership status in the industry

The Company (Cont.) Experienced sales growth of 50% from 1997 to 2001, but experienced 5% decline since 9/11 Forecast for 2002 shows returns to pre-9/11 levels Majority of clients are from Quebec Most popular destination packages: French Caribbean, Costa Rica, Cuba, Florida and Mexico

The Canadian Tour Operating Industry Average growth rate between1998 and 9/11/2001 was greater than 8% 9/11 attack slowed US economy in general, but especially affected the travel industry Canadian travel to the US fell by 25% after 9/11 Trips to Canada’s largest markets Florida and Mexico declined by 15% and 12% respectively 30% to 50% decline in overall industry volume 2 of 7 largest tour companies declared bankruptcy

The Case Clients pay in CAD, but vendors only accept USD - VS vulnerable to FX risk April 1, 2002 deadline for VS to decide on its FX risk strategy for US$60 million in payables due October 2002 CAD has been depreciating against the USD since 1998 Canadian GDP reported to be 2.4% in March 2002 Dupuis was faced with uncertainties about the ability to pay vendors if CAD continues to weaken

Market Conditions Canadian Stock Market Index – (Exhibit 3) experiencing a great deal of volatility in recent years Canada experiencing large swings in inflation/deflation since 3Q 2001 These are both indicators that the Canadian market is volatile and unpredictable, likely due to more macro-economic factors that are affecting the Canadian economy

Market Conditions

Factors Contributed to CAD to USD Fluctuations Slower than expected recovery of financial market since the events of 9/11 High-profile corporate scandals US growing deficit United States possibly to go to war in the Middle East Overall weak economy, with business and consumer confidence expected to rise in 2002

Opportunities Canadian economy should grow at a faster rate than the US in the next 1-2 years as CAD was not affected to the same extent by the events of 9/11 Lower interest rates could potentially encourage consumer spending in Canada VS should look into expanding its packages to European customers VS should also look into destinations that accept denominations other than USD to minimize their risk exposure

Constraints Unable to predict real demand for travel packages Fulfillment of paid travel packages Hedging cost Cash Flow Justify FX Hedging decision to stakeholders (management, investors, or stockholders)

Timeline 03/30 Make a decision 10/02 – 01/03 04/01 Finalize Contracts 10/01 Payments Due

Supplier Relationships Basic Issues Importance Urgency Low High Economic Conditions Foreign Exchange Risk Competition Supplier Relationships

Immediate Issues Importance Low High Urgency Forecasted Demand Low Products Wait or Make a Bet? High Pricing

Decrease in Product Demand Short-term Profitability Cause and Effect Lack of FX Hedging Strategy Decrease in Product Demand Threat to Short-term Profitability Economic Slowdown Industry Instability

Assumptions VS has enough resources to support all alternatives Cash flow Accounting and financing capabilities 10/1/2002 – need $60 million USD available for accounts payables Using the exchange rate of 0.6000 Every $1 CAD = $0.60 USD Alternative 1-3 (data from case) Alternative 4 (data from 4/30/09)

Decision Criteria Determine the best alternative with the following considerations: Minimize cost Maximize savings Minimize accounting exposure Least amount of currency risk exposure Ease of implementation

Alternatives Wait and use the spot rate at the time payables are due Forward contract 6-month Borrow CAD to purchase USD and invest USD for 6 months Call option to purchase USD with a 6-month expiration

X-rate prediction March 2002 US Canada Interest rate 4.75% 3.75% Inflation rate 1.1456% 1.8538% Method Formula Projected rate IFE 0.6328 PPP 0.6276 At current exchange rate of 0.6298 US$60M payable would cost Cdn$95,268,339.16 Under IFE Canadian dollar is expected to appreciate Under PPP Canadian dollar is expected to depreciate

Alternative 1 Do nothing, exchange Canadian dollars in October Rate used X-rate Amount (CAD$) Case 0.6000 $100,000,000.00 IFE 0.6328 $94,816,687.74 PPP 0.6276 $95,602,294.46 Actual Oct. 1, 2002 0.6305 $95,162,569.39

Alternative 2 Forward contract for US$60 million locking in a 6-month forward rate at 0.6271 Regardless of what happens to exchange rates, CAD required = $95,678,520.17 Bank typically requires a 15% to 18% line of credit for this 6-month contract VS would need to use cash as collateral

Alternative 3 Borrow CAD to buy USD on April 1 and invest US dollars for 6 months Deposit USD with 1.65% interest rate USD needed to deposit is $59,026,069.85 CAD$ at 2.7% interest plus principal= $96,252,419.40 Difficult to explain the interest payment for accounting purposes

Alternative 4 Call option to purchase USD that expires in 6 months April 30, 2009 rate = 0.8333 Premium cost = USD $2,285,000 3.8% of USD $60,000,000 Assuming 3% money market rate for 2002 3% annual yield = 1.5% for 6 months 3.8% - 1.5% = 2.3% Real Cost

Alternative 4 (Cont.) Strike Price = 0.8333 Breakeven = 0.8529 CAD needs to appreciate by 2.4% to breakeven 0.8529 – 0.8333 = 0.0196/0.8333 = 2.4% Using 0.60 rate, CAD would only need to increase to 0.614 to breakeven Strike Price < Spot Rate = Profit (In-the-money)

Evaluating Alternatives Do Nothing $95,162,569 Too much risk Unpredictable Best result on 10/1/02 Forward $95,678,520 Locked in contract Need LOC Safe bet with certainty Better than #3 Borrowing USD $96,252,419 Too costly & less savings than #2 Accounting Call Option Unknown Flexible Profitable Possible best option

Expectations CAD is considered as a commodity currency closely tied to crude oil More uncertainties US has engaged war with the Middle East US economy expected to weaken USD less in demand

Outcome

Recommendation Forward contract Need Call Option premium cost on 4/1/02 to determine if Alternative 4 would be better If making a decision today, Alternative 4 would be the best recommendation

Additional Recommendations Implement FX risk sharing strategy with suppliers Set up a multi-currency account to purchase and hold USD Offer travel packages to Europe and Japan Management should take Dr. Greco’s FIN 570 class

Conclusion Currency forecasting has many variables and has certain unpredictable elements Firms NEED to have FX hedging strategy in placed Can not only rely on quantitative analysis Always consider micro and macro factors

Questions?