How profitable will the follow-on order be? Would you make this new sale?
Novo’s first order to Baker Adhesives case solution consisted of 1210 gallons of adhesive. Their second order increased in size by 50% to result in an order of 1815 gallons of adhesive. Baker also faced an increase in costs of their materials by 10%. Baker only had to buy 25% of the products needed to create the order Novo requested because they had the other 75% on had so the 10% increase in cost only applied to the new 25% of materials.
Novo’s price per gallon of adhesives for their first order was 86.23 in Brazilian real. To find the new price per gallon for the adhesives we need to take into account the change in material cost. We then come up with the following equation: 86.23*(.25*.1) =2.16+86.23=88.39 New price per gallon.
The component (.25*.1) comes from the increase in material cost and the amount of materials that increase applies to being that only 25% of the materials needed for the order had to be purchased because the other 75% was already on hand.
Baker Adhesives case pdf solution for Novo’s new order are as follows (given the 50% difference in size order between the first order and the new order): Labor| 9000| Materials (with 10% increase in costs)| 52000|
- Manufacturing Overhead| 6000|
- Administrative Overhead| 3000|
- Total Costs| 70000|
Now, to find the price of the sale in real for Novo and the revenue for Baker we have the equation: 1815*88.39 = 160,430 1815 is the amount of gallons Novo needs, 88.39 is the price per gallon we found above.
Next, we will convert this price to United States dollars to determine the revenue stream coming from this sale for Baker in terms of dollars: Sep 160,430*0.4234 = $67,926 this is the revenue that Baker will receive from Novo without using any form of hedging in their sale.
If Baker chooses to use a forward hedging strategy, we will use the same formula to find the revenue for Baker Adhesives case ppt in dollars however, we will use the exchange rate determined for the forward hedge, and this exchange rate is 0.4227. 160,430*0.4227 = $67,814 Baker revenue with forward hedge
Lastly, we will look at how profitable a money market hedge would be for Baker. To do this we first have to find the loan amount if Baker takes out a Brazilian loan to hedge their deal with Novo using the rate given in the case, 26%. However, this annual rate needs to be converted to a three month rate because Novo’s payment will be paid three months after the order is placed so the loan will only be for three months, so in three months this rate would be 6.5% so this is the rate we will use to find the loan amount for Baker. 160,430/ (1+.065) = 150,640 this loan amount is in Brazilian real Now to convert the loan amount to dollars, we use the exchange rate given for June of 2006 because that is when the loan would be taken out. This exchange rate is 0.4368. 150,640*.04368 = $65,800 loan amount in dollars
If Baker chooses a money market hedge, their loan will be put into a money market account where it will yield 5.08% annually or 1.27% for three months. 65,800*(1+.0127) = $66,635 revenue Baker will receive if they choose a money market hedging strategy To convert this to Brazilian real, we use the exchange rate forecast for September to find what the loan will be worth in real in September of 2006 because the exchange rate will be different than it was at the time of the deal for the loan in June of 2006: 66,635*(1/0.4234) = 157,380 final revenue for Baker with money market hedge in real
As we can see, Baker would receive the most amount of revenue from not using a hedging strategy and simply selling at the agreed upon price. The Baker Adhesives case study analysis will receive without hedging is $67,926, with forward hedging they will receive $67,814 in revenue, with a money market hedging strategy Baker will receive $66,635 in revenue, so although the revenue is close with each strategy we can see that it would be most profitable for Baker to take the sale with Novo without using a money market hedging strategy or a forward hedging strategy. This shows us that the sale is profitable for Baker because they will make more money from the sale than they would using a lower exchange rate or taking out a loan with a high interest rate. Baker should take the sale with the original terms agreed upon.
Is Baker current hedging strategy protecting the company from adverse exchange rate changes? Will it work in the long run and short run, why or why not? Explain few other strategies that may work for the firm.
Hedging is defined by Investopedia as, “Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract”. In the case of Baker Adhesives, in order for the company to make a profit, hedging was completely necessary. During the sale of adhesives to Novo, a Brazilian toy company, a price was agreed upon. After further review, Baker’s sales manager, Alissa Moreno, realized that the price that they agreed on would not be sufficient when converted from the exchange rates. After the initially agreement on price was made, Novo was unwilling to renegotiate the price causing Baker to be less profitable on the deal. In order to make this deal worthwhile, hedging is needed. There were two options for Baker; hedge in the forward market or hedge in the money markets.
Hedging in the forward market would mean that Baker Adhesives would have to be guaranteed exchange rates for future exchanges of currencies. A specific date would be set up by a contract, a specific rate and an amount to be exchanged. By securing a forward rate for the date of a foreign-currency-dominated cash flow, a firm could eliminate any risk due to currency inflations. Below is a diagram of cash flows for the forward market hedge. Forward Market Hedge Hedging in the money markets would mean that Baker Adhesive could make any currency exchanges at the known current spot rate. This relies upon borrowing and investing funds via the money markets and using the spot rate to lock-in the amount we will receive from the receivable.
Overall, it seems that hedging will be good for Baker Adhesives for the long-term because they will be receiving full payment however, it will take them up to 3 months before receiving that payment because Novo agreed to make payment 30 days after receipt of the adhesives at the shipping facility. Moreno believed that payment would be received about three months from order placement, as calculated above. It appears that Baker will receive full payment of their product given the exchange rates based on the process of hedging.
If hedging seems unattractive to the company, Baker has other options when operating with international companies. Since they were unaware of the exchange rate, they could now learn from their mistakes and take that into consideration when negotiating with future firms. Before negotiations start, they would be wise to convert the exchange rate and take into consideration all of the costs that will be incurred from doing business overseas to avoid a similar situation that occurred with Novo, their unwillingness to consider changing the per-gallon price.
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Baker Adhesives Case 