Ming Yu Chan Sunil K. Dixit Alex Galiu Kevin Han Baban Pal Singh FIN 570- International Financial Management Summer 200

1. Ming Yu Chan Sunil K. Dixit Alex Galiu Kevin Han Baban Pal Singh FIN 570- International Financial Management Summer 2008 California State University, Fullerton

2. Company History • 1926: Formed from a merger between Deutsche Aero Lloyd (DAL) and Junkers Luftverkehr • 1934-1938: Opens first trans-oceanic • 1939-1945: (War-time) All flights discontinued in 1945 • 1951-1955: Post war air transport resumes • 1960: Enters the jet age • 2005: Celebrates the 50th anniversary of its postwar re-entry

3. Company Background • Corporate headquarters - in Cologne • Main base and primary traffic hub - Frankfurt International Airport in Frankfurt am Main • Second hub - Munich International Airport • Largest airline in Europe • World’s sixth largest airline

4. Company Background • Five business segments – Passenger Transportation, Logistic, MRO Business, Catering and IT Service • Core Business - Passenger Transportation • Founding member of Star Alliance, the world's largest airline alliance • Services to 209 destinations in 81 countries

5. Herr Heinz Ruhnau • Lufthansa Chairman on July 1, 1982 – Sept 1, 1991 - No private enterprise experience • Undersecretary in the Transport Ministry of West Germany • Strong affiliations with the West German Social Democratic Party • Immediate task - improve Lufthansa's thin profit margin

6. Herr Heinz Ruhnau - Contd • Chairman – Supervisor Board - Mitteldeutsche Flughafen AG (1996-2003) • Now a honorary Professor - Technical University Dresden - Institute of Economics and Logistics • Frequent speaker – on Transport and Eastern European Economies

7. Case Overview • January 1985 - purchased twenty Boeing 737 • Trading price: US$500 million due in January 1986 • Exchange rate: DM3.2/$ - January 1985

8. Exchange Rate Fluctuation • Upward USD since 1980 • If USD continued to rise, the total cost to Lufthansa would also rise Spot rate, DM 2.8/$

9. Economic Environment USA Germany • GDP Growth Rate • 1984: 6.8% • 1985: 2.4%* • Inflation • 1984: 4.3% • 1985: 3.55% • Banks Prime Lending Rate. • 1985: 10.61% Sources: 1984 – OECD; 1985 – Private Bank Forecasts (WSJ) • GDP Growth Rate • 1984: 2.6% • 1985: 3.%* • Inflation • 1984: 2.4% • 1985: 2.5%* • Banks Prime Lending Rate • 1985: 9.53% * Forecast

10. Economic Environment - Contd • Predictions Based on key economic Data • US Dollar - expected to Depreciate against German DM in 1986 • German DM - expected to Appreciate against US Dollar in 1986

11. Decision Outcome 50% forward contract @ DM3.2/$ The remaining 50% uncovered The spot rate in January 1986 = DM 2.3/$

12. Decision Outcome • Herr Ruhnau was summoned to meet with Lufthansa’s board • Was accused of recklessly speculating with Lufthansa’s money

13. DM Rate ForecastInternational Fisher Effect • US prime rate in Jan 1985: 10.61% • German banks’ prime lending rate in Jan 1985: 9.53% • Spot rate in Jan 1985: DM3.2/$ • Projected spot rate in Jan 1986: = DM 3.168/$

14. DM Rate ForecastPurchasing Power Parity US inflation in 1985: 3.55% German inflation in 1985: 2.5% Spot rate in Jan 1985: DM3.2/$ Projected spot rate in Jan 1986: = DM 3.168/$

15. January 1986 - DM Spot Rate Projections Purchasing power parity: DM3.168/$ International fisher effect: DM3.168/$ Forward rate (Given in the case): DM3.2/$

16. Lufthansa’s Issues - Basic

17. Lufthansa’s Issues - Immediate

18. Cause/Effect Analysis Basic Issues Economic Environment Purchase Contract FX Rate Forecast Hedging Decision Cost of Hedging FX Risk Aversion Adequacy of Funds

19. Cause/Effect AnalysisImmediate Issues Contract Date Hedging Method Cost of Hedging Delivery Date Covenants Restrictions

20. FX Transaction Risk • FX Exposure - Acquisition of assets - Proceeds payable in foreign currency (US $) - May result in higher costs – if DM depreciates against US $ - Reduce/manage FX Risk

21. Decision Criteria • Sound hedging policy - desirable for FX transaction risks • Our Forecast - US $ was to depreciate • Lufthansa’s covenants – restrictions on debt amounts & currencies of denomination • Assumption - jets would be delivered on time • US Operations – US $ cash inflows insufficient • Not enough facts - Boeing vs. Airbus issue or timing or purchase – Assumed Sound Business Decisions

22. Hedging Alternatives • Uncovered • Forward contract cover • Partial forward uncovered • Foreign currency option • Buy dollar now

23. Alternative Analysis#1 Uncovered Maximum Risk – Speculative Gain/Loss Possible

24. Alternative Analysis #2 Full Forward Cover Minimum Risk – Costs higher

25. Alternative Analysis#3 Partial Forward Cover Medium Risk – Partial Hedge

26. Alternative Analysis#4 DM Put Options Low Risk – Freedom to Walk Away – Sunk Cost (Premium)

27. Alternative Analysis#5 Buy Dollar Now No Risk – Availability of cash? – Covenants’ Restrictions on debt

28. Alternatives Summary

29. Recommendation • Uncovered position - not desirable • Corporate FX hedging policy • Implement 6 steps to hedge against FX exposure • Corporate decision-making • Experience does matter • Forward not the right tool in this case • Exit if US$ depreciates

30. Recommendation (Contd) • Buy DM Put Options • If US $ appreciates = USD 500 x 3.2 + 6% = DM 1.696 Billion • If dollar declined to DM 2.3/$ = USD 500 x 2.3 + DM 96 Mil = DM 1.246 Billion • Downside = costs DM 96 million more than uncovered position • Benefit = 100% hedging

31. Foreign Exchange Risk Management Steps Forecasting Risk Estimation Benchmarking Hedging Contingency Steps Reporting & Review

32. Lufthansa’s Hedging Policy 2007 • “Lufthansa Finance Cockpit” • Capital expenditure on aircraft: 50% hedging • Review every 6 months • Hedging level revised upto 90%

33. Questions?