The Baker Adhesives, Case Study Example

The globalization of business has necessitated that companies expand their reach into international markets in order to remain competitive, profitable, and relevant in their industries.  For the Baker Adhesive Company, this means expanding their sales to include a client in Brazil and their expectations of profitability depend on their understanding of foreign currency exchange rates.  In financial markets, hedging is a risk-management tool used as insurance against the likelihood of a negative event to protect the company’s financial standing and ensure profitability.  In regards to the futures, options and warrants markets, hedging reduces the firm’s risk by making a transaction in one market to protect against a loss in another. The principle behind hedging is to provide security by ensuring producers will recoup a guaranteed price for their product regardless of any increases or decreases in market prices.  This provides insurance to the consumer too, since they are also guaranteed a set price regardless of any market fluctuations.

Question One

The three kinds of foreign currency exposure are Translation, Transaction, and Operational or Economic and they can simultaneously impact a transaction since they are not mutually exclusive. Companies need to translate their foreign currency values typically have operations overseas and they have to convert each of these assets and liabilities into their home currency in order to consolidate them with currency assets and liabilities at home before publishing their consolidated financial reports (Singh, 2015).  Since the Baker Adhesive Company is a local business, they do not have assets that need to be converted.

Companies experience transaction risk when there is a commitment for cash to be paid or received in a foreign currency following the sale of products or services and this type of exchange becomes a risk when there is a delay of 90-120 days (Singh, 2015). The risk becomes a factor because the currency exchange rate can shift dramatically during the period between the sale and the receipt of funds, which will change the value of the sale and could result in a loss for the company (Singh, 2015).

Economic risk is similar to transaction risk in that it affects the company’s cash flow, but it differs from transaction risk in that it relates to uncommitted cash proceeds or those expected from future product sales but not yet committed (Singh, 2015). These future cash flows and sales can diminish when a competing retailer in the buyers home currency moves favorably selling to the same customer to exploit the exchange rate while the company’s exchange rate moves unfavorably, causing exposure to economic risk (Singh, 2015).

In the financial markets, options and warrants can be used to hedge a portfolio position where shares have been sold, the purchase of equivalent call options, which is the option to buy shares, ensures that if the share price rises, a corresponding rise in the value of the option will offset the notional loss expected on the remaining shares.  The uncertain climate that modern firms operate within makes risk management a dire concern amongst financial executives and hedging is the most frequently used tool financial firms use to manage this risk.

Question Two

If the Baker Adhesive Company chose to refuse the second order due to the unfavorable exchange rates, this can stagnate their attempts to grow and expand in foreign markets.  The absence of international clientele may impede their ability to remain competitive with the leading adhesive distributors that already have large international distribution.

If the Baker Adhesive Company chooses to hedge the exposure, the two main approaches to corporate hedging are equity value maximizing strategies and strategies determined by managerial risk aversion (Ammon, 1998).  Equity value maximizing strategies suggests that managers act in the best interest of shareholders, in which case hedging is intended to reduce real costs like taxes, costs of financial distress, costs of external finance, or to replace individual hedging by shareholders (Ammon, 1998).  Strategies determined by managerial risk aversion involves managers maximize their personal utility rather than the market value of equity, in which case, their hedging strategy is determined by their compensation plan and reputational concerns (Ammon, 1998).

The common procedure of hedging is undertaken under five main theories of practice, which are tax and regulatory arbitrage, under-investment, volatility of earnings and future planning, financial distress, managerial self-interest, and economies of scale (Dhanani, Fifield, Helliar, & Stevenson, 2007).  The expectation in these practices is that this will prevent companies from defaulting due to financial distress considering the interest rate volatility that has recently plagued UK firms in recent years (Dhanani, Fifield, Helliar, & Stevenson, 2007).

Should the Baker Adhesive Company decide to set up a money-market hedge, the drastic fluctuations in interest rates, the increase in the use of corporate debt through firms financing a growing amount of their funding through short-term borrowing rather than equity, and an increase in the amount of highly leveraged transactions like management buy-outs and take-overs can all tremendously increase the probability of default, which has enhanced the importance of risk management strategies exponentially (Dhanani, Fifield, Helliar, & Stevenson, 2007).  More and more companies recognized the cost of financial distress and the probability of default, and more and more companies are hedging their risks.

If the Baker Adhesive Company executives decide to enter into an option contract with First Philadelphia, this will cost them additional money when the local banker puts Ms. Moreno in touch with larger city bank, First Philadelphia, with which it has a correspondent relationship, and that this bank is willing to enter into an OTC currency option contract with the Baker Company. First Philadelphia offers to write BRL the right to sell the Brazilian currency for US dollars at a rate of USD 0.4320 per BRL, at a premium of 0.0405 USD per BRL and calls the right to buy BRL at the same premium.  Additionally, the First Philadelphia Bank is offering a loan at a rate of 26% secured by the funds to be received from the second deal, which necessitates that the Baker Adhesive Company accept the second deal.

Should the Baker Adhesive Company accept the order but leave the exposure un-hedged, and sell the BRL in the market when it is received from the customer, the risk is presented in the uncertainty surrounding a firm’s ability to serve its debts and obligations based on the fluctuating exchange rate.  Bank, debtors, and investor have the incentive to understand the probabilities of default of a company as one of the important element before decision making.  Since default is costly and violations to the absolute priority rule in bankruptcy proceedings are common, in practice shareholders have an incentive to put the firm into the receivership before the asset value of the firm hits the debt value.  Prior to default, there is no way to discriminate unambiguously between firms that will default and those that won’t.  At best we can only make probabilistic assessments of the likelihood of default.

Question Three

If the Baker Adhesive Company refuses the order and the USD/BL exchange rate in the spot market remains stable during the three months, this can read as a loss since the company will lose the expected profits to be gained from the sale.  Under the same assumption, if the Baker Adhesive Company does choose to hedge, this can be complicated and expensive since, especially is they accept the new Novo order and the deal with First Philadelphia Bank for the loan at a 26% rate and they would not succeed and makes it extra complicated for administrators to connect variables.  On behalf of bank establishments and administrators, well-timed and precise calculations of debtor equivocation probability embraces the solution to creating the main receptive and effectual device for imperil administration.  Should the Baker Adhesive Company executives chose to accept the new Novo order and establish a money market hedge scheme,

Generally regulating these influences should enhance the agreement conditions that is acquired from their creditors, involving amenities that holds profitable calculations and have little investment expense boundaries. Furthermore, it is probable for corporations to disentangle their equivocation after endorsing indentures with their creditors.  For example, after the finance, administrators could by recent mechanisms that counteract their current locations or possibly will terminate their prevarication all at once.  In regards to this conception, interpreters submits a hypothesis presenting that it is best for administrations facing losses due to fluctuating exchange rates to keep their hedges after increasing economical debits.  There are numerous structured models that have the capability of calculating the hedging probabilities of perilous business debits.

Should the executives from the Baker Adhesive Company choose to accept the hedge option and secure an exchange rate of USD 0.4250 per BRL, the spot rate at the end of the three months, there is a strong possibility that the exchange rate can deviate by as much as 6.53%, which will significantly diminish the expected revenue to be earned from the sale.  The expected default probabilities within structural models regarding empirical confirmation demonstrate the calculated projected equivocation probabilities for an illustration of unsuccessful and successful real estate industries.  Primarily the consequences are continuous with models interpretations and the calculations of expected default probabilities for dissimilar models are compactly entangled.

Question Four

By matching the interest rate exposure of the liabilities to that of their assets, firms can reduce the variability of their cash flows.  As a result, firms may lower their expected costs of financial distress as well as minimize how often they have to raise expensive external capital (Froot, 2007).  Both approaches have advantages and restrictions regarding the possibility of encountering losses based on claim expansion and calculating expecting default probabilities.  The structural entrance has the benefit of connecting directly the assessment of the corporation to the profit of its precautions and pricing the acclaim hazards that is explicit to an obligor.  Credit-affairs are a purpose of the industries value that may pursue a stochastic procedure, relative to a credit occurrence producing verge or hindrance.  The condensed- form method, regardless of its objectivity intrinsic in the selection of the practical structure of prearranged capricious, has the advantage of tractability and experiential fit. However, the contributions of condensed-form replicas cannot be sincerely correlated to perceptible company’s rudiments such as the determinant of prevarication given the financial and the instinctive demands of the structural method, in this examination estimates analysis in the performance of six structural components.

While considering the securities delivered by a company as contingent allegations on its own assets, consequently, can value the securities as imitative this exhibition was considered to be tangible with the encouragement from enhanced to a first passage model whereby bondholders can force the reorganization or liquidations of a firm if its value falls to a particular profit or trigger assets.  Primarily the derived closed-form solutions relating the value the long-term corporate debt and optimal investment structure to firm risk, taxes, liquidation prices and bond contracts.  Their models describes endogenously the equivocation hindrance, with a partially closed outline clarification expand a two factor replica to value chancy debit, presuming that interest estimates pursue a mean reverting stochastic procedure and that are deviations from stringent complete precedence.  Although certain reviews demonstrates that the significance of strategic asset service on a risky debt increase can be considered sometimes non-profitable and unsuccessful, mode companies debt as a discrete coupon risky bond also to can be an unexceptional assessment.  Whilst the structural models have made great advances in approximating the features of the real economy, some empirical studies have found that these models tend to systematically underestimate the observed yield extensions.

Sometimes overlooked option, but an affective one, is for firm’s to use operational strategies as effective hedges against exchange rate and input price uncertainties.  Operational hedging strategies, as clearly defined and illustrated in integration of production and financial hedging decisions, can be viewed as real compound options that are exercised in response to demand, price, and exchange- rate contingencies faced by firms in a global supply chain context.  Such real options include postponement of assemblies and distribution logics decisions, delaying final commitment of capacity and process technology investments or switching production locations and sourcing partners contingent on demand and exchange rate scenarios.  We are going to restrict our attention operational hedges with real option to postpone the deployment of some of the firm resources in response to demand and exchange rate scenarios.  We study the integration of operational and financial hedging policies of risk-averse global firm’s within a stylized but representative, modelling setting.

Cash-flow is particularly important in this case because The time value of money is based on the fact that money paid now is better than funds received later.  This principle of finance influences managerial decisions across all four facets relative to financial management, which includes the planning organizing, leading, and controlling phases.  In regards to planning, organizing, leading, and controlling the ebb and flow of currency within the organizational paradigm, financial managers need to understand the concepts of the time value of money so that their projections regarding the availability of funds to pay operational and other costs accurately reflects the true denominations of the funds available.  Financial managers need to be able to plan a year or more in advance regarding the finances of the business, so correctly anticipating how money will be valued at future dates is important to knowing whether the company will be able to successfully operate.  This is also relevant to interest rates and the plausibility of investments.

Question Five

Based on profitability calculations and the information in the case, Ms. Moreno should decide to hedge decide the transaction to secure a profitable exchange rate for the second transaction that will ensure profitability from the sale, as shown in Table 1.

This suggests that for firms that are closer to distress, structural models can provide useful predictions of default risks and credit extensions.  In our opinion, the empirical findings of the under estimations of pragmatic yield increases is due to limitations of the obtainable practical studies in capturing all the relevant components of yield spreads.  Surveyors also examine incorporate functioning and monetary conclusions faced by an international industry that retails to both home and native markets.

Production transpires either at a particular facility located in one of the marketplaces or at two amenities, one in each souk.  The corporation has to invest in quantity before the retailing season begins when the demand in each market and the currency trade velocity are indecisive.  The currency exchange rate hazard can be prevaricated by impediment distributions of the capacity to specific markets until each currency and requirement uncertainties are determined and by purchasing financial alternative written agreements on the investment exchange rate when the volume allegiance is created.  Generally the mean-variance utility performance is utilized to model the corporation risk revulsion in decision making.  Researchers obtain the mutual optimal capacity and economical substitutions, on quantity obligation and the industries performance.

The examiner demonstrates that the financial hedging approach bonds directly to and can have both quantitative and qualitative on the company operational strategy.  The use and the deficiency of the utilization of economical equivocation can proceed beyond influencing the importance of capacity levels by changing global resource chain structural selections, such as considered locality and a volume of production facilities to be employed to meet inclusive requirements.  Primarily as the firm locate activities of their supply chain all over the world, and commodity flow across global boundaries, managers encounters the uncertainties complexities of the global environment.  Exchange rates and value reservations in manufacture inputs are two of the obscured factors in the global supply chain environment.  Exposure to the exchange rates, and particular, affects the underlying economics of any firm dealing with foreign buyers, suppliers, or competitors through its impact on input costs, sales prices, and volume.

Such currency fluctuations can be significant and fluctuations of 1% in a day or 20% in a year are not unheard of, with a drastic impact on production and sourcing costs.  Companies have employed different risk management approaches to cope with exchange rate and input price uncertainties.  The typical way is to use financial, whenever possible, to hedge against such risks.  Currency options are the most frequently used tools for hedging currency exposures.  Options are financial instruments that allow a firm to buy the right, but not the obligation to sell or by currencies at set prices.

We consider a firm to both home and foreign markets.  In a two-stage decision framework, early capacity and production commitments and financial hedging are decided in the presence of demand exchange-rate (price) uncertainty in the first stage while in the second stage, after observing demand and exchange-rate realizations, the firm exercises its production “allocation” option in supplying the domestic and foreign market demand, such as how many units to localize and distribute to the two markets.  The emphasis of our analysis is on clearly establishing the value of joint use of the operational hedge, and understanding their effects on a risk-averse firm’s capacity decisions and performance.  Furthermore, interesting insights are obtained on the nature of optimal, or whenever possible perfect, financial hedges for our modelled environment.  We analyze the production and financial hedging decisions of a global selling two markets: market1, its domestic, defined for our purpose as the market trading in the home country currency, which is the currency the firm uses to report its consolidated financial statements, and market, instead of a foreign country market with an uncertain currency exchange rate.

References

Ammon, N. (1998). Why Hedge ? A Critical Review of Theory and Empirical Evidence. ZEW Discussion Paper No. 98-18.

Dhanani, A., Fifield, S., Helliar, C., & Stevenson, L. (2007). Why UK companies hedge interest rate risk. Studies in Economics and Finance, 24(1), 72-90. doi:10.1108/10867370710737391

Froot, K. A. (2007). Risk management, capital budgeting, and capital structure policy for insurers and reinsurers. The Journal of Risk & Insurance(2), 273. doi:10.1111/j.1539-6975.2007.00213.x

Singh, P. (2015). Corporate Currency Risks Explained. Retrieved from Investopedia: http://www.investopedia.com/articles/forex/09/corporate-currency-risks.asp