Suggested Questions: Baker Adhesives

1. What was the revenue actually received from the original order, and how does it
affect the profitability of that order?

Baker Adhesives actually received 104,334.70 BRL, which was

transferred to USD 45,573 using realized exchange rate 0.4368
US$/BRL rather than transferred to USD 48,370. From Exhibit
TN1, we can see that based on the same estimated costs USD
44,500, less realized revenue USD 45,573 than expected revenue
USD 48,370 would lead to a dramatic decrease in profit USD
2,796 (decrease from anticipated profit USD 3,870 to realized
profit USD 1,073), which accounted for 72.26% of the anticipated
profit.

The above decrease in profit is mainly due to mistakenly

estimate expected exchange rate 0.4636 US$/BRL, meaning that
for per unit BRL, Baker Adhesives can exchange US$0.4636. But
instead, in reality, Baker Adhesives can only exchange
US$0.4368 per receiving unit of BRL. The change in value of BRL
is (5.78%).
2. How might exchange-rate risk be managed?
Baker Adhesive could manage and mitigate the foreign exchange
rate risk it is exposed to through in its sale transactions with
Novo, a Brazilian based company through the following
strategies:
a. Foreign Exchange Forward Hedge
With this strategy, Baker Adhesives will be able to sell its
products to Novo while eliminating foreign exchange exposure.
Baker would have to get into a contract with his bank. With this
contract, Baker would be entering into an agreement to deliver
104,334.70 Brazilian Real within a certain time period in
exchange of payment of $48,370 US dollars. As mentioned
before, Baker did not factor in foreign exchange risk in their
budget and as a result, when it came time for Novo to pay Baker,
they paid at the current exchange rate at that time. In this case,
they paid at a foreign exchange rate of 0.4368 versus the
original budgeted rate of 0.4636.
However, if Novo fails to pay on time, Baker may be obligated to
deliver the agreed contract amount within the specified time
period on the contract. Therefore, we would advise Baker to pick
its forward delivery date conservatively if the company intends
to get into this kind of agreement to hedge against foreign
exchange risk.
b. Foreign Exchange Option
If Baker has any doubt on whether the sale with Novo will
actually be completed or collected at a particular date, he may
consider a foreign exchange option. With this option, Baker will
acquire the right, but not the obligation, to deliver an agreed
amount of foreign currency to the lender in exchange of dollars
at a specified rate on or before the expiration date of the option.

The foreign exchange option however contains an explicit fee

which is similar to the premium paid on an insurance policy.
If the Brazilian Real goes down, Baker will be protected from the
loss. On the other hand, if the value of the Brazilian Real goes up,
Baker can sell the option back to the lender or let it expire by
selling the Brazilian Real on the spot market for more dollars
than originally expected, but the fee would be forfeited. A foreign
exchange option would provide Baker with more flexibility,
however; they can be more costly than the foreign exchange
forward hedge.
c. Money Market Hedge
With this strategy, Baker could utilize the money market hedge
to eliminate currency risk by locking in the value of the Brazilian
Real transaction with US currency. The money market hedge
relies upon borrowing and investing funds via the money market
and using the spot rate to lock-in the amount Baker Adhesives
would receive for its receivables.
3. Assume Baker decides to take the follow-on order, how might the forwardcontract and money-market rates be used to hedge the future expected inflow?
The forward contract hedge is locking in forward exchange
rate decided at current period. The contract specifies the
exchange date, the amount and the rate. This hedging method is
to avoid the risks of fluctuation in exchange rate. In the case
example, Baker Adhesives would be better-off if Brazilian dollar
appreciate (US dollar depreciate) in time T (September 5th,
2006), thus in order to avoid Brazilian dollar depreciates, Baker
Adhesive can enter in a forward contract hedge to lock in the
exchange rate of USD/BRL= 0.4227. In this case, no matter what
the exchange rate is in 3 month time, Baker Adhesive will always
convert its received payment in Brazilian dollar to USD by
applying the 0.4227 exchange rate.

However the disadvantage of this hedging method is that:

1. Bank fee will be built in to the rate.
2. If the investor were to bet on wrong direction of future
exchange rate, the investor is very likely to incur greater loss.
The money market hedge is to borrow foreign currency at
current spot exchange rate, and at time T (September 5th,
2006), when the customer pays its order (in foreign currency),
the investors can use the received money to pay back its loan to
the foreign bank. A risk associated with this hedging method is
the interest rate and inflation rate at the foreign country. If the
interest rate is very high in the foreign country, it might be costly
to borrow and pay back loan.

Based on the calculation to both methods, we can see that the

forward hedging method provide Baker Adhesive with a better
outcome (higher payment received now: $ 64,764 > $ 64,188).

4. Why do we see a preference for the forward-market hedge over the money-market
hedge?
With an expected payment by Novo of 156,502 three month in
the future and an uncertainty about the direction of exchange
rate between U.S. dollars and Brazilian real, Baker Adhesives had
two options to protect its future revenue from dollars
depreciation against the Brazilian real or the Brazilian
appreciation against the dollar:
The bank offered the firm a forward contract with a guaranteed
exchange rate of 0.4227 on Sept 5 2006
Using this exchange rate, the dollar amount of revenue ended up
to be $66,153 which leads to a present value of $64, 764 using
the 3-month effective rate the U.S. bank charged
If the firm had chosen the money market hedge, then it would
have borrowed BRL 146,950 with Brazilian bank on June 5 2006
which is the September 5, 2006 future revenue of BRL 156, 502
(The amount the inflow revenue) discounted at a 3-month
effective rate of 6.5% charge by a Brazilian bank. Once the
actual amount to borrow is converted in to US dollars using the
June 05 2006 spot rate, it comes out to be $64,188. This
borrowed amount is paid back with Novos payment in three
month time.
Without any hedges, the present value of the September 5, 2006
revenue that is converted in USD using the spot exchange rate of
June 5, 2006 becomes $64,871. However, this amount is not the
actual un-hedged result, since we used the expected spot rate
when converting to dollars instead of the actual exhcange spot
rate in three month time
The picture below compares the calculated revenues under the
three hedging options:

The forward revenue turns out to be a better option compared to

the money market revenue. Such outcome is explained by the
high interest rate (26%) charge by Brazilian banks. After
discounting future expected cash flows at such a high rate, Baker
Adhesives finds itself earning a lower than expected revenue
(revenue that they get by borrowing funds in a Brazilian bank
such that 3-month down the road the inflow money paid be Novo
will match the amount they will owe to the bank).
One might prefer the unhedged revenue over the forward hedge
revenue because it looks more attractive but there is a risk that
the expected exchange rate on September 5, 2006 might be
actually lower than the realized exchange rate on that date due
to exchange rate fluctuations. This means that the USD might
depreciate against the BRL or the BRL might further appreciate
against the USD to lead to a lower than expected realized

exchange rate. If such a situation arises, then the unhedged

revenue might actually be less than the forward hedge revenue
and even lesser than the money market revenue. In conclusion,
since the forward hedge revenue is known and guaranteed
regardless of the direction of exchange rates, whereas the
unhedged revenue still encapsulates an inherent exchange rate
risk, the forward hedge revenue is logically what the firm will go
after.
5. With the forward or money-market hedge in place, can the company be
completely sure there will be no exchange risk? What could be some unforeseen
risks which can not be hedged?
It is safe to assume that with forward or money market hedges,
the company can be certain that there will be no exchange risks.
The company could certainly stand to make substantive losses or
forgo making substantive profits in the event that the USD-Real
exchange rate is higher than expected.
However, there are still some risks associated with forward
market hedge, since it is not an option, Baker has the obligation
to convert the Brazilian dollar received to USD at the locked-in
exchange rate. Also, there are certain systematic risks
associated with money market hedge. For instance, if Novo, for
some unforeseen reason, went bankrupt after Baker delivered on
their deal, then Novo would not be able to make the payment,
forcing Baker to honor the forward contract with Reals it does not
have, or pay the Brazilian Bank with principal and interest
payments in Reals that again, it does not have. In such a case,
Baker would have to acquire Reals to honor the forward contract,
or its obligations to the Brazilian Bank.
This would be particularly egregious, if a natural calamity
occurred that directly affected Novo. In such a circumstance, not
only may Novo not be able to make its payment to Baker, but the
Reals value would depreciate relative to world currencies, as
investors would aim to unload the troubled currency for stronger
ones. Therefore, not only would Baker have to acquire Reals to
honor its forward contract or its obligations to the Brazilian Bank,
but it would have to do so at a high USD-Real exchange rate,
incurring further losses.

As a result it is important that all contracts Baker enters with

other parties must include a force majeure clause to
accommodate such contingencies.
As a result it is important that all contracts Baker enters with
other parties must include a force majeure clause to
accommodate such contingencies.
6. Should Baker accept the new order?

If Baker Adhesives considers all revenues and costs, it might

decide not to accept the new order since accepting the new
order will incur a loss of USD 1,815. From another perspective, if
Baker Adhesives considers relevant costs only, accepting new
order will bring additional positive profit of USD 23,435 so Baker

Adhesives should accept the new order to reach economic of

scale if current capacity can still accommodate the new order
production.
When Baker Adhesives needs to evaluate whether it should
accept new order or not, it should only focus on marginal
analysis (relevant revenues and costs which will change with new
order) that are associated with a decision. Irrelevant costs (sunk
costs) that do not differ between alternatives should not be taken
into account in a marginal cost analysis. We use same cost
structure (include overall revenues and costs) and modified cost
structure (include relevant revenues and costs only) in Exhibit
TN4 to analyze new order cost structure
Based on the same sales revenues USD 66,153 (150% times
sales revenues of initial order) under same cost structure and
modified cost structure, Baker Adhesives needs to further
distinguish relevant costs from all costs to make right decision.
For material costs, since 1/3 of raw materials were those that
Baker Adhesives had in excess supply and could have been
resold at a loss originally if not used in new order, they belong to
sunk costs irrelevant to new order decision, Baker should only
include 2/3 of material costs and 10% recent cost increase of a
quarter of materials purchased additionally. The only difference
of material costs between same cost structure and modified cost
structure is the 1/3 raw material costs.
For labor costs, Baker should use 150% times labor costs of initial
order because labor costs are all relevant costs and the more
units Baker produced, the more labor costs Baker would incur.
Labor costs are the same under both same cost structure and
modified cost structure.
For manufacturing overhead and administrative overhead costs,
they are both irrelevant to new order decision and will be zero
because current factory capacity is not full and can easily
accommodate new order production. Thus, the overall overhead
costs will still remain the same but will not increase with the new
order. The increase in USD 6,000 manufacturing overhead costs
and USD 3,000 administrative overhead costs under same cost
structure is merely part of overall overhead costs allocated by
direct labor hours used (150% times overhead costs of initial
order) but not overall overhead costs.

Rather than considering total costs USD 67,969 under same cost
structure, Baker should instead consider only relevant costs USD
42,719 under modified cost structure, which will produce
additional profit of USD 23,435 to the company based on the
premise of same sales revenue under both structure and thus
produce profit margin 35.42%. Due to the above reasons, we
conclude that under modified cost structure, Baker should accept
the new order.