CASE Page 483 Baker Adhesives In early June 2006, Doug Baker met with his sales manager Alissa Moreno to discuss the results of a recent foray into international markets. This was new territory for Baker Adhesives, a small company manufacturing specialty adhesives. Until a recent sale to Novo, a Brazilian toy manufacturer, all of Baker Adhesivessales had been to companies not far from its Newark, New Jersey, manufacturing facility. As U.S. manufacturing continued to migrate overseas, however, Baker would be under intense pressure to find new markets, which would inevitably lead to international sales. Doug Baker was looking forward to this meeting. The recent sale to Novo, while modest in size at 1,210 gallons, had been a significant financial boost to Baker Adhesives. The order had used up some raw-materials inventory that Baker had considered reselling at a significant loss a few months before the Novo order. Furthermore, the company had been running well under capacity and the order was easily accommodated within the production schedule. The purpose of the meeting was 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 Baker was looking forward to paying down some of the balance on the firms 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 reais (BRL), the payment from 1 Novo had to be converted into U.S. dollars (USD) 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 of 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! Adhesives Market Page 484 The 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 savvy 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 were key drivers of success. Baker Adhesives had both. The business was started by Doug Bakers 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 Bakers 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, were 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 USD180,000 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 waterproof and the adhesive, therefore, needed very specific properties. Through a mutual friend, Moreno had been introduced to Novos purchasing agent. Working with Doug Baker, she had then negotiated the original order in February (the basis for the pricing of that original order is shown in Exhibit 38.1). Novo had agreed to pay shipping costs, so Baker Adhesives simply had to deliver the adhesive in 55-gallon drums to a nearby shipping facility. EXHIBIT 38.1 | Novo Price Calculation on Initial Order (figures in U.S. dollars unless otherwise specified) Notes: The exchange rate used in the calculation was obtained from the Wall Street Journal. Overhead was applied based on labor hours. The raw materials expense was based on the original cost (book value) of the materials. The rounded price of BRL90.15 per gallon was used in negotiations with Novo. Thus, for the final order, Novo was billed a total of BRL90.15 1,210 = BRL109,081.50. Source: Created by case writer. 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 facility. Baker anticipated a five-week manufacturing cycle once all the 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; Page 485 that was about how long the original order took. For this reason, Moreno expected receipt of payment on the new order, assuming 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 38.2. 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 a forecasting service. EXHIBIT 38.2 | Exchange Rate and Money-Market Information Source: Created by case writer. Moreno had discussed her concerns about exchange-rate changes with the bank when she had arranged for 2 conversion of the original Novo payment. 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 reais 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 reais against the future inflow from Novo. The amount the company Page 486 would borrow would be an amount such that the Novo receipt would exactly cover both principal and interest on the borrowing. 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 0.4227 USD/BRL. An affiliate of the bank, located in Brazil and familiar with Novo, was 3 willing to provide Baker with a short-term real loan, secured by the Novo receivable, at 26%. Moreno was initially shocked at this rate, which was more than three times the 8.52% rate on Bakers domestic line of credit; however, the bank described Brazils 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. The 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. The Baker Adhesives case explores the concept of exchange-rate risk and the management of that risk with a forward-contract hedge and a money-market hedge. After reading the case and analyzing the data provided address the following questions: How might exchange-rate risk be managed? Identify the risk and discuss the mechanisms used for hedging. Highlight the various operating and financial decisions that would address the currency risk. Assume Baker decides to take the follow-on order, how might the forward-contract and money-market rates be used to hedge the future expected inflow? Calculate an expected amount without any hedging, then calculate forward-contract and money-market rate hedges. What can you say about the cost of eliminating the currency risk? With the forward-contract and money-market hedge in place, can the company be completely sure there will be no exchange risk? Identify and discuss the assumptions implicit in these hedging strategies. Are there any residual risks that make the hedge less than perfect? With a hedging strategy in place should Baker accept the new order? Consider the costs outlined in the case and how they may be adjusted for rising costs as well as the impact of the new exchange rate. Note that not all costs will be relevant for this analysis.