Baker Adhesives Foreign Exchange: Case Study

The purpose of the meeting Nas to finalize details on a new order from Novo that was to be 50% larger than the original order. Also, payment for the earlier Novo order had Just been received and eager was looking forward to paying down some of the balance on the firm’s line of credit. As Baker sat down with Moreno, he could tell immediately that he was in for bad news. It came quickly. Moreno pointed out that since the Novo order was denominated in Brazilian real (BRB), the payment from Novo had to be converted onto U. S. Dollars (USED) at the current exchange rate. Given exchange-rate changes since the time Baker Adhesives and Novo had agreed on a per-gallon price, the value f the payment was substantially lower than anticipated. More disappointing was the fact that Novo was unwilling to consider a change in the per-gallon price for the follow-on order. Translated into dollars, therefore, the new order would not be as profitable as the original order had initially appeared. In fact, given further anticipated changes in exchange rates the new order would not even be as profitable as the original order had turned out to be! He Brazilian currency is referred to as real in the singular (as in “the Brazilian real”) and real in the plural (as in “sales are denominated in real”). This case was prepared by Associate Professor Marc Lipton. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright 7 by the University to Virginia Darken School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to [email protected] Mom. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means?electronic, mechanical, photocopying, recording, or otherwise ?without the permission of the Darken School Foundation. -adhesives Market ere market for adhesives was dominated by a few large firms that provided the vast bulk of adhesives in the United States and in global markets. The adhesives giants had international manufacturing and sourcing capabilities.

Margins on most adhesives were quite slim since competition was fierce. In response, successful firms had developed ever more efficient production systems which, to a great degree, relied on economies of scale. The focus on scale economies had left a number of specialty markets open for small and technically sax. . Y firms. The key to success in the specialty market was not the efficient manufacture of large quantities, but figuring out how to feasibly and economically produce relatively small batches with distinct properties.

In this market, a good chemist and a flexible production system Nerve key drivers of success. Baker Adhesives had both. The business was started by Doug Baker’s father, a brilliant chemist who left a big company to focus on the more Interesting, if less marketable, products that eventually became the staple of Baker Adhesives’ product line. While Baker’s father had retired some years ago, he had attracted a number of capable new employees, and the company was still an acknowledged leader in the specialty markets.

The production facilities, though old, Nerve readily adaptable and had been well maintained. Until Just a few years earlier, Baker Adhesives had done well financially. While growth in sales had never been a strong point, margins were generally high and sales levels steady. The company had never employed long-term debt and still did not do so. The firm had a line of credit from a local bank, which had always provided sufficient funds to cover short-term needs. Baker Adhesives presently owed about ISSUED,OHO on the credit line.

Baker had an excellent relationship with the bank, which had been with the company from the beginning. Novo Orders The original order from Novo was for an adhesive Novo was using in the production of a new line of toys for its Brazilian market. The toys needed to be Interferon and the adhesive, therefore, needed very specific properties. Through a mutual friend, Moreno had been introduced to Nova’s purchasing agent. Working Ninth Doug Baker, she had then negotiated the original order in February (the basis for the pricing of that original order is shown in Exhibit 1).

Novo had agreed to pay hipping costs, so Baker Adhesives simply had to deliver the adhesive in 55-gallon drums to a nearby shipping facility. The proposed new order was similar to the last one. As before, Novo agreed to make payment 30 days after receipt of the adhesives at the shipping tactility Baker anticipated a twelve maturating cycle once all raw materials were in place. All materials would be secured within two weeks. Allowing for some flexibility, Moreno believed payment would be received about three months from order placement; that was about how long the original order -3- took.

For this reason, Moreno expected receipt of payment on the new order, issuing it was agreed upon immediately, somewhere around September 5, 2006. Exchange Risks With her newfound awareness of exchange-rate risks, Moreno had gathered additional information on exchange-rate markets before the meeting with Doug Baker. The history of the dollar-to-real exchange rate is shown in Exhibit 2. Furthermore, the data in that exhibit provided the most recent information on money markets and an estimate of the expected future (September 5, 2006) spot rates from forecasting service.

Moreno had discussed her concerns about exchange-rate Changes with the bank when she had arranged for conversion of the original Novo moment. 2 The bank, helpful as always, had described two ways in which Baker could mitigate the exchange risk from any new order: hedge in the forward market or hedge in the money markets. Hedge in the forward market Banks would often provide their clients with guaranteed exchange rates for the future exchange of currencies (forward rates). These contracts specified a date, an amount to be exchanged, and a rate.

Any bank fee would be built into the rate. By securing a forward rate for the date of a foreign-currency-denominated cash flow, a firm could eliminate any risk due to currency fluctuations. In this case, the anticipated future inflow of real from the sale to Novo could be converted at a rate that would be known today. Hedge in the money markets Rather than eliminate exchange risk through a contracted future exchange rate, a firm could make any currency exchanges at the known current spot rate.

To do this, of course, the firm needed to convert future expected cash flows into current cash flows. This was done on the money market by borrowing “today’ in a foreign currency against an expected future inflow or making a deposit “today’ in a foreign account so as to be able to meet a future outflow. The amount to be borrowed or deposited would depend on the interest rates in the foreign currency because a firm would not wish to transfer more or less than what would be needed. In this case, Baker Adhesives would borrow in real against the future inflow from Novo.

The amount the company would borrow Mould be an amount such that the Novo receipt would exactly cover both principal and interest on the borrowing. Though Baker Adhesives had a capable accountant, Doug Baker had decided to let Alias Moreno handle the exchange-rate issues arising from the Novo order until they better understood the decisions and tradeoffs that needed to be made. 4- After some discussion and negotiation with the bank and bank affiliates, Moreno was able to secure the following agreements: Baker Adhesives’ bank had agreed to offer a forward contract for September 5, 2006, at an exchange rate of 0. 227 USED/BRB. An affiliate of the bank, located in Brazil and familiar with Novo, was willing to provide eager with a short-term real loan, secured by the Novo receivable, at 26%. 3 Moreno Nas initially shocked at this rate, which was more than three times the 8. 52% rate on Baker’s domestic line of credit; however, the bank described Brazier’s historically high Inflation and the recent attempts by the government to control inflation with high Interest rates. The rate they had secured was typical of the market at the time. ere Meeting It took Doug Baker some time to get over his disappointment.

If international sales were the key to the future of Baker Adhesives, however, Baker realized he had already learned some important lessons. He vowed to put those lessons to good use as he and Moreno turned their attention to the new Novo order. Note that the loan from the bank affiliate was a 26% annual percentage rate for a three-month loan (the bank would charge exactly 6. % on a three-month loan, to be paid when the principal was repaid). The effective rate over three months was, therefore, 6. 5%. The 8. 52% rate for Baker’s line of credit was an annual percentage rate based on monthly compounding.

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