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Mini Case: 23 - 8
MINI CASE
Assume that you have just been hired as a financial analyst by Tennessee Sunshine Inc., a
mid-sized Tennessee company that specializes in creating exotic sauces from imported
fruits and vegetables. The firm's CEO, Bill Stooksbury, recently returned from an
industry corporate executive conference in San Francisco, and one of the sessions he
attended was on the pressing need for smaller companies to institute corporate risk
management programs. Since no one at Tennessee Sunshine is familiar with the basics of
derivatives and corporate risk management, Stooksbury has asked you to prepare a brief
report that the firm's executives could use to gain at least a cursory understanding of the
topics.
To begin, you gathered some outside materials on derivatives and corporate risk
management and used these materials to draft a list of pertinent questions that need to be
answered. In fact, one possible approach to the paper is to use a question-and-answer
format. Now that the questions have been drafted, you have to develop the answers.
a. Why might stockholders be indifferent whether or not a firm reduces the
volatility of its cash flows?
b. What are six reasons risk management might increase the value of a
corporation?
Answer: There are no studies proving that risk management either does or does not add value.
maintain their capital budget over time; (3) avoid costs associated with financial
Mini Case: 23 - 9
c. What is COSO? How does COSO define enterprise risk management?
setting and across the enterprise, designed to identify potential events that may affect
the entity, and manage risk to be within its risk appetite, to provide reasonable
assurance regarding the achievement of entity objectives.” (We added italics for
emphasis.) .
Here are some key points. ERM is an ongoing process, not something a company
reporting and monitoring system.
d. Describe the eight components of the COSO ERM framework.
Answer: The COSO ERM framework has eight components.
5. Risky event responses. These include prevention and should correspond with the
previously identified risk appetite. Responses should consider the portfolio of
risky events and not just each event in isolation.
6. Control activities. These are ways to ensure that people apply the previously
identified responses. Control activities include handbooks, guidelines, policies,
Mini Case: 23 - 10
e. Describe some of the risks events within the following major categories of risk:
Answer: 1. Strategy and reputation. A company’s strategic choices simultaneously influence
and respond to its competitors’ actions, corporate social responsibilities, the
public’s perception of its activities, and its reputation among suppliers, peers, and
customers.
3. Hazards. These include fires, floods, riots, acts of terrorism, and other natural or
man-made disasters.
7. Financial management. This category includes risk events related to (1) foreign
customer credit risk, and (7) portfolio risk (the risk that a portfolio of financial
assets will decrease in value).
.
f. What are some actions that companies can take to minimize or reduce risk
exposures?
Answer: There are several actions that companies can take to minimize or reduce their risk
exposure. First, companies can transfer risk to an insurance company by paying
periodic premiums. Second, companies can transfer functions that produce risk to
third parties, such as eliminating risks associated with transportation by contracting
with a trucking company. Third, purchase derivatives contracts to reduce input and
Mini Case: 23 - 11
g. What are forward contracts? How can they be used to manage foreign exchange
risk?
Answer: A forward contract is an agreement between two parties. One party agrees to sell a
U.S. retailer is going to import ¥1 million of electronic games from Japan and the
current exchange rate is 70 yen per dollar. The company might be able to take a
h. Describe how commodity futures markets can be used to reduce input price risk.
Answer: Futures markets involve contracts that call for the purchase or sale of a financial (or
real) asset at some future date, but at a price which is fixed today.
Futures are similar to forwards, except futures require daily marking-to-market,
future purchase of the input material at today's price, even if the market price on the
good has risen substantially in the interim.
i. It is January and Tennessee Sunshine is considering issuing $5 million in bonds
in June to raise capital for an expansion. Currently, TS can issue 20-year bonds
at 7 percent, but interest rates are on the rise and Stooksbury is concerned that
long-term interest rates might rise by as much as 1 percent before June. You
looked online and found that June T-bond futures are trading at 111’25. What
are the risks of not hedging and how might TS hedge this exposure? In your
analysis, consider what would happen if interest rates all increased by 1 percent.
Mini Case: 23 - 12
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
Answer: If TS waits until June to issue its bonds, and if interest rates rise, then TS will have to
pay a higher interest rate on its debt. How much does that cost TS? One way to
calculate the cost is to see how much the 20-year 7 percent semi-annual bonds that it
intended to issue would be worth at the new discount rate of 8%. Input N = 40, I/YR
= 8/2, PMT = -5,000,000(7%/2) = 175,000, FV = -5,000,000 and solve for PV =
$4,505,181.
Since they were going to be worth $5 million if they were issued immediately, then
this represents a loss of $5,000,000 - $4,505,181 = $494,819. TS can hedge this risk
by selling T-bond futures contracts.
T-bond futures contracts are priced off of a hypothetical 20-year, 6 percent coupon,
semiannual payment bond, and the 111’25 futures price translates to a $1,117.81 for
each $1000 face value bond. The implied yield can be caluclated with a financial
calculator to be (N = 40; Pmt = 30; FV = 1000; PV = -1117.81; calculate I/Y =
2.5284% semi-annually, which is an annual rate of about 5.057%. If interest rates
represents a decrease of $111,781 – $99,344 = $12,437 for each contract. Since TS
has sold futures contracts, this represents a profit to TS. The total profit from the
futures contracts is 45($12,437) = $559,665.
TS will lose $494,819 on the bonds it issues but gain $559,665 on its futures
Mini Case: 23 - 13
j. What is a swap? Suppose two firms have different credit ratings. Firm Hi can
borrow fixed at 11% and floating at LIBOR + 1%. Firm Lo can borrow fixed at
11.4% and floating at LIBOR + 1.5%. Describe a floating versus fixed interest
rate swap between firms Hi and Lo in which Lo also makes a “side payment” of
45 basis points to Firm L.
Answer: Hi wants fixed rate, but it will issue floating and “swap” with Lo. Lo wants floating
Transaction
Hi
Lo
CF to lender
-(LIBOR+1%)
-11.40%
CF Hi to Lo
-11.40%
11.40%
CF Lo to Hi
+(LIBOR+1%)
-(LIBOR+1%)
CF Lo to Hi
0.45%
-0.45%
Net CF
-10.95%
-(LIBOR+1.45%)
