Suggested Questions: Baker Adhesives
1. What was the revenu revenuee actually recei received ved from from the original original order order, and how does it it affect the profit p rofitability ability of that order?
Baker Adhesives actually received 104,334.70 BRL, which was transferred to U! 4","73 usin# reali$ed e%chan#e rate 0.43&' U()BR U( )BRL L rat rather her tha than n tr trans ansfer ferre red d to U! 4' 4',37 ,370. 0. *ro ro+ + %h %hi-i i-itt /1, we can see that -ased on the sa+e esti+ated costs U! 44,"00, less reali$ed revenue U! 4","73 than e%ected revenue U! 4',370 would lead to a dra+atic decrease in rot U! 2,7& 2,7 & dec decrea rease se fro fro+ + antic anticiate iated d ro rot t U! 3,'7 3,'70 0 to re reali$ ali$ed ed rot U! 1,0735, which accounted for 72.2&6 of the anticiated rot.
he a-ove decrease in rot is +ainly due to +istakenly esti+ate e%ected e%chan#e rate 0.4&3& U()BRL, +eanin# that for er unit BRL, Baker Adhesives can e%chan#e U(0.4&3&. But instead, in reality, Baker Adhesives can only e%chan#e U(0.43&' er receivin# unit of BRL. he chan#e in value of BRL is ".7'65. 2. How might exchange-rate ris be managed?
Baker Adhesive could +ana#e and +iti#ate the forei#n e%chan#e rate risk it is e%osed to throu#h in its sale transactions with /ovo, a Bra$ilian -ased co+any throu#h the followin# strate#ies a. *orei#n %chan#e *orward 8ed#e 9ith this strate#y, Baker Adhesives will -e a-le to sell its roducts to /ovo while eli+inatin# forei#n e%chan#e e%osure. Baker would have to #et into a contract with his -ank. 9ith this contract, Baker would -e enterin# into an a#ree+ent to deliver 104,334.70 Bra$ilian Real within a certain ti+e eriod in e%chan#e of ay+ent of (4',370 U dollars. As +entioned -efore, Baker did not factor in forei#n e%chan#e risk in their -ud#et and as a result, when it ca+e ti+e for /ovo to ay Baker, they aid at the current e%chan#e rate at that ti+e. :n this case, they aid at a forei#n e%chan#e rate of 0.43&' versus the ori#inal -ud#eted rate of 0.4&3&. 8owever, if /ovo fails to ay on ti+e, Baker +ay -e o-li#ated to deliver the a#reed contract a+ount within the secied ti+e eriod on the contract. herefore, we would advise Baker to ick its forward delivery date conservatively if the co+any intends to #et into this kind of a#ree+ent to hed#e a#ainst forei#n e%chan#e risk. -. *orei#n %chan#e ;tion :f Baker has any dou-t on whether the sale with /ovo will actually -e co+leted or collected at a articular date, he +ay consider a forei#n e%chan#e otion. 9ith this otion, Baker will ac
he forei#n e%chan#e otion however contains an e%licit fee which is si+ilar to the re+iu+ aid on an insurance olicy. :f the Bra$ilian Real #oes down, Baker will -e rotected fro+ the loss. ;n the other hand, if the value of the Bra$ilian Real #oes u, Baker can sell the otion -ack to the lender or let it e%ire -y sellin# the Bra$ilian Real on the sot +arket for +ore dollars than ori#inally e%ected, -ut the fee would -e forfeited. A forei#n e%chan#e otion would rovide Baker with +ore =e%i-ility, however> they can -e +ore costly than the forei#n e%chan#e forward hed#e. c. ?oney ?arket 8ed#e 9ith this strate#y, Baker could utili$e the +oney +arket hed#e to eli+inate currency risk -y lockin# in the value of the Bra$ilian Real transaction with U currency. he +oney +arket hed#e relies uon -orrowin# and investin# funds via the +oney +arket and usin# the sot rate to lock@in the a+ount Baker Adhesives would receive for its receiva-les. !. "ssume #aer decides to tae the follow-on order, how might the forwardcontract and money-maret rates be used to hedge the future expected inflow?
he forward contract hedge is lockin# in forward e%chan#e rate decided at current eriod. he contract secies the e%chan#e date, the a+ount and the rate. his hed#in# +ethod is to avoid the risks of =uctuation in e%chan#e rate. :n the case e%a+le, Baker Adhesives would -e -etter@o if Bra$ilian dollar areciate U dollar dereciate5 in ti+e ete+-er "th, 200&5, thus in order to avoid Bra$ilian dollar dereciates, Baker Adhesive can enter in a forward contract hed#e to lock in the e%chan#e rate of U!)BRL 0.4227. :n this case, no +atter what the e%chan#e rate is in 3 +onth ti+e, Baker Adhesive will always convert its received ay+ent in Bra$ilian dollar to U! -y alyin# the 0.4227 e%chan#e rate.
8owever the disadvanta#e of this hed#in# +ethod is that 1. Bank fee will -e -uilt in to the rate. 2. :f the investor were to -et on wron# direction of future e%chan#e rate, the investor is very likely to incur #reater loss. he money market hedge is to -orrow forei#n currency at current sot e%chan#e rate, and at ti+e ete+-er "th, 200&5, when the custo+er ays its order in forei#n currency5, the investors can use the received +oney to ay -ack its loan to the forei#n -ank. A risk associated with this hed#in# +ethod is the interest rate and in=ation rate at the forei#n country. :f the interest rate is very hi#h in the forei#n country, it +i#ht -e costly to -orrow and ay -ack loan.
Based on the calculation to -oth +ethods, we can see that the forward hed#in# +ethod rovide Baker Adhesive with a -etter outco+e hi#her ay+ent received now ( &4,7&4 C ( &4,1''5.
$. Why do we see a preference for the forward-maret hedge over the money-maret hedge?
9ith an e%ected ay+ent -y /ovo of 1"&,"02 three +onth in the future and an uncertainty a-out the direction of e%chan#e rate -etween U.. dollars and Bra$ilian real, Baker Adhesives had two otions to rotect its future revenue fro+ dollars dereciation a#ainst the Bra$ilian real or the Bra$ilian areciation a#ainst the dollar he -ank oered the r+ a forward contract with a #uaranteed e%chan#e rate of 0.4227 on et " 200& Usin# this e%chan#e rate, the dollar a+ount of revenue ended u to -e (&&,1"3 which leads to a resent value of (&4, 7&4 usin# the 3@+onth eective rate the U.. -ank char#ed :f the r+ had chosen the +oney +arket hed#e, then it would have -orrowed BRL 14&,"0 with Bra$ilian -ank on Dune " 200& which is the ete+-er ", 200& future revenue of BRL 1"&, "02 he a+ount the in=ow revenue5 discounted at a 3@+onth eective rate of &."6 char#e -y a Bra$ilian -ank. ;nce the actual a+ount to -orrow is converted in to U dollars usin# the Dune 0" 200& sot rate, it co+es out to -e (&4,1''. his -orrowed a+ount is aid -ack with /ovoEs ay+ent in three +onth ti+e. 9ithout any hed#es, the resent value of the ete+-er ", 200& revenue that is converted in U! usin# the sot e%chan#e rate of Dune ", 200& -eco+es (&4,'71. 8owever, this a+ount is not the actual un@hed#ed result, since we used the e%ected sot rate when convertin# to dollars instead of the FactualG e%hcan#e sot rate in three +onth ti+e he icture -elow co+ares the calculated revenues under the three hed#in# otions
he forward revenue turns out to -e a -etter otion co+ared to the +oney +arket revenue. uch outco+e is e%lained -y the hi#h interest rate 2&65 char#e -y Bra$ilian -anks. After discountin# future e%ected cash =ows at such a hi#h rate, Baker Adhesives nds itself earnin# a lower than e%ected revenue revenue that they #et -y -orrowin# funds in a Bra$ilian -ank such that 3@+onth down the road the in=ow +oney aid -e /ovo will +atch the a+ount they will owe to the -ank5. ;ne +i#ht refer the unhed#ed revenue over the forward hed#e revenue -ecause it looks +ore attractive -ut there is a risk that the e%ected e%chan#e rate on ete+-er ", 200& +i#ht -e actually lower than the reali$ed e%chan#e rate on that date due to e%chan#e rate =uctuations. his +eans that the U! +i#ht dereciate a#ainst the BRL or the BRL +i#ht further areciate a#ainst the U! to lead to a lower than e%ected reali$ed
e%chan#e rate. :f such a situation arises, then the unhed#ed revenue +i#ht actually -e less than the forward hed#e revenue and even lesser than the +oney +arket revenue. :n conclusion, since the forward hed#e revenue is known and #uaranteed re#ardless of the direction of e%chan#e rates, whereas the unhed#ed revenue still encasulates an inherent e%chan#e rate risk, the forward hed#e revenue is lo#ically what the r+ will #o after. %. With the forward or money-maret hedge in place, can the company be completely sure there will be no exchange ris? What could be some unforeseen riss which can not be hedged?
:t is safe to assu+e that with forward or +oney +arket hed#es, the co+any can -e certain that there will -e no e%chan#e risks. he co+any could certainly stand to +ake su-stantive losses or for#o +akin# su-stantive rots in the event that the U!@Real e%chan#e rate is hi#her than e%ected. 8owever, there are still so+e risks associated with forward +arket hed#e, since it is not an otion, Baker has the o-li#ation to convert the Bra$ilian dollar received to U! at the locked@in e%chan#e rate. Also, there are certain syste+atic risks associated with +oney +arket hed#e. *or instance, if /ovo, for so+e unforeseen reason, went -ankrut after Baker delivered on their deal, then /ovo would not -e a-le to +ake the ay+ent, forcin# Baker to honor the forward contract with Reals it does not have, or ay the Bra$ilian Bank with rincial and interest ay+ents in Reals that a#ain, it does not have. :n such a case, Baker would have to ac
As a result it is i+ortant that all contracts Baker enters with other arties +ust include a force +aHeure clause to acco++odate such contin#encies. As a result it is i+ortant that all contracts Baker enters with other arties +ust include a force +aHeure clause to acco++odate such contin#encies. &. 'hould #aer accept the new order?
:f Baker Adhesives considers all revenues and costs, it +i#ht decide not to accet the new order since accetin# the new order will incur a loss of U! 1,'1". *ro+ another ersective, if Baker Adhesives considers relevant costs only, accetin# new order will -rin# additional ositive rot of U! 23,43" so Baker
Adhesives should accet the new order to reach econo+ic of scale if current caacity can still acco++odate the new order roduction. 9hen Baker Adhesives needs to evaluate whether it should accet new order or not, it should only focus on +ar#inal analysis relevant revenues and costs which will chan#e with new order5 that are associated with a decision. :rrelevant costs sunk costs5 that do not dier -etween alternatives should not -e taken into account in a +ar#inal cost analysis. 9e use sa+e cost structure include overall revenues and costs5 and +odied cost structure include relevant revenues and costs only5 in %hi-it /4 to analy$e new order cost structure Based on the sa+e sales revenues U! &&,1"3 1"06 ti+es sales revenues of initial order5 under sa+e cost structure and +odied cost structure, Baker Adhesives needs to further distin#uish relevant costs fro+ all costs to +ake ri#ht decision. *or +aterial costs, since 1)3 of raw +aterials were those that Baker Adhesives had in e%cess suly and could have -een resold at a loss ori#inally if not used in new order, they -elon# to sunk costs irrelevant to new order decision, Baker should only include 2)3 of +aterial costs and 106 recent cost increase of a
Rather than considerin# total costs U! &7,& under sa+e cost structure, Baker should instead consider only relevant costs U! 42,71 under +odied cost structure, which will roduce additional rot of U! 23,43" to the co+any -ased on the re+ise of sa+e sales revenue under -oth structure and thus roduce rot +ar#in 3".426. !ue to the a-ove reasons, we conclude that under +odied cost structure, Baker should accet the new order.
