AUTO STAR:

Edith Cooper, treasurer of Auto Star, a U.S.-based importer of automobile parts, paused before phoning Rob Rough, a corporate finance associate at Auto Star's investment bank. Edith was calling Rob to discuss a strategy for hedging Auto Star's exposure on its prime-based, variable rate liabilities. Edith was concerned that Auto Star's extreme leverage and reliance on variable rate financing exposed the company to an unacceptable level of financial risk, and had asked Rob to consider a strategy for hedging Auto Star's interest costs in the financial futures markets. Auto Star imported auto parts from both Europe and the Far East, marketing products under its own and private labels. Auto Star's products were targeted at the "do-it-yourself" segment of the auto repair market, and were distributed through auto parts and discount stores. Price competition in this market segment, which was dominated by U.S. auto parts manufacturers, was exceptionally keen.

In preparing for her discussion with Rob, Edith had compiled a variety of data relating movements in the prime rate to changes in other short-term interest rates. Because futures contracts on prime-based instruments were not available, Edith realized she would have to cross-hedge her prime rate exposure using T-bill or CD futures contracts. She hoped that Rob could advise her on the construction of such a hedge. She also wanted help in estimating the probable magnitude of variation margin calls on an 18-month hedge. Edith feared that Auto Star would have to secure a new line of credit to finance margin calls on its position. Given the weakness of Auto Star's balance sheet, Edithhad been unable to secure additional credit from its lenders in recent months.

"No problem," Edith thought to herself. "Once I hedge Auto Star's rate exposure, our company's financial risk will be reduced to a level even our conservative bankers will find acceptable!"

1. If you were Rob Rough, what advice would you give to Edith Cooper?

COm inbox 15b7e13a3d9e6f3a? projector 1 Exhibit 1 Auto Star Historical Financial Statements INCOME STATEMENTS (1979-1981) 1981 1980 $93,764 $103,140 Net sales Cost of goods sold 4.978 $31,880 38,162 Gross margin 21,566 23,722 Selling and administrative expense Interest expense 4,501 5,570 8,870 5,813 Profit before taxes 2,674 Taxes 4.080 Profit after tax 3,139 $4,790 BALANCE SHEET (December 30, 1981) LIABILITIES ASSETS 3,094 Short-term notes payable Cash and securities Current maturities of LTD 12,377 Trade receivables (net) 23,207 Trade payables Inventory 518 Other current assets Total current liabilities $44,196 Total current assets Long-term debt Deferred taxes Fixed assets 7.375 Net Worth Total Liabilities and Net Worth Total Assets 1979 $85,240 59.668 $25,572 19,605 3,921 1,804 $2,117 $18,565 1,650 $32,077 6,188 516 2.7