Question

You have just been hired as the new treasurer of an Australian firm called Sun Solar Panels (SSP). SSP produces commercial solar panels. It is a well established brand in both the UK and
New Zealand. In fact, it distributes (sells) its entire output to UK and New Zealand retailers. These sales are made through SSP’s UK and New Zealand subsidiaries which act as distributors of the product. Each wholesale transaction in the UK is settled in GBP and each wholesale transaction in New Zealand is settled in NZD. SSP's board is made up of seven directors. Four of these directors are family members who founded the business. Three are from outside the family but also from solar panels’ sales backgrounds. None have any finance or accounting education or experience. The raw materials used to make the solar panels are sourced from Indonesia. The solar panels are manufactured in Australia.
About 30% of manufacturing costs can be attributed to labour, 50% to raw material costs and 20% to other expenses (factory space, electricity etc.). Based on current exchange rates and
cost structures, the average wholesale price of a commercial solar panel is AUD$10 000 and the cost to manufacture such a panel is AUD$5,000. SSP strives to maintain this margin.
Average order size is 20 solar panels. The manufacture and sales processes work as follows:
Step 1: a UK or New Zealand retailer enters into a sales contract with SSP's local subsidiary (ie.
SSP's New Zealand or UK subsidiary). The sales contract stipulates that delivery will occur in
three months. The price in local currency (ie. GBP or NZD) is also stipulated in the contract.
Step 2: After the sales contract is executed, SSP immediately orders raw materials from
Indonesia. This order stipulates a six week delivery of raw materials and the price of the raw
materials which is denominated in IDR.
Step 3: After receiving the raw materials and settling the account with the Indonesian supplier
in IDR, the company manufactures the product as per the sales contract and ships the product
off to the UK or New Zealand.
Step 4: After receiving the finished product, the UK or New Zealand customer pays for the
goods. SSP is about to engage in a new investment project which it will fund through a debt
facility of AUD$100 million and wants protection against increases in interest rates over the next
five years. SSP also has purchased 10 fixed income securities using retained earnings each with
a face value of AUD$1 million with five years to maturity and a coupon rate of 10% paid once
per annum. The issuer has a call provision which enables them to prepay the debt at any time.
Currently the Company has no definitive strategies on managing financial risk.
Your task (Report Part I):
Your mandate (task for this assessment item) is to prepare a ‘Business Case’ with recommendations for your board that pitches the need for a systematic financial risk management strategy and the financial derivatives and tools that could be used as part of this strategy. The business case should focus on the next 12 month period. This business case should be
prepared as a report. The structure of the report should be appropriate to your audience, include an executive summary and address each of the following questions.

Question 1
Clearly outline the reasons why SSP’s board should have a financial risk management strategy in place.

Question 2
For risks associated with the ordering and sales process described above:
1. Identify and explain the financial risk that SSP is potentially exposed to. Use examples of possible scenarios that may occur for SSP to illustrate the nature of these risks.
2. Using examples, explain how the risk can be managed using futures.
3. Aside from a futures based risk management strategy, you should identify and explain three additional risk management strategies using three alternative Over-The-Counter
(OTC) derivatives.

Answer 1

Question 1

Reasons are;

• SSP has exchange rate risk as their revenue is in GBP and NZD and costs are in AUD and IDR. 50% manufacturing cost is raw material cost, which is sourced from Indonesia (IDR) and 50% is labour and other expenses which is to be paid in AUD. The sales contract stipulates revenue in GBP or NZD and sales happen after 3 months, at the time of delivery. So if the GBP or NZD depreciates against AUD in 3 months, their revenue decreases.

   Also purchase contract of raw material is in IDR and payment is in 6 weeks. If IDR appreciates    against AUD in 6 weeks, the raw material cost increases. So profit margin gets affected.

• Interest rate risk: SSPs new investment is to be funded by AUD$100 Mn debt and since the case mentions protection against increase in interest rate, it must be a floating rate loan and interest payments are floating. As interest rate increases in Australia which can be due to increase in demand for credit or due to inflation, the payment obligation of company increases So need to protect against interest rate risk.
• Also the company has invested in AUD$10 Mn callable bonds. As interest rate decreases, the probability of excercising call option by the issuer ie the probability of prepayment increases.This is because the issuer can prepay the debt and issue new bonds with lower coupon rate.So there is a risk of prepayment and decrease in expected income from coupon.

Therefore due to the above reasons, the company requires financial management startegy

Question 2

* The question clearly mentions the risks associated with sales and ordering. So answer is based on that only. $100 Mn debt and investments in fixed income securities are not considered.

1.

SSP is exposed to exchange rate risk/ currency risk. The explanation is given in point 1 in the above answer for question 1. Examples are given below with scenarios

Scenario 1

GBP depreciates

The Company had received a sales order of 1 solar panel from UK on 1 Jun 2018 and the product is to be delivered on 1 Sep 2018. The contract price was GBP 5000.

GBP/AUD on 1 June 2018 was 2.00 ( 1GBP=2 AUD). So AUD10000 equivalent was GBP5000

GBP/AUD on 1 Sep 2018 is 1.8 (1 GBP= 1.8 AUD)

Revenue expected = AUD10000

Cost Expected = AUD5000

Operating Margin expected = (10000-5000) / 5000

   = 100%

Actual Revenue = GBP5000

   = AUD9000    ---------------------------- ( 5000*1.8=9000 )

Actual Cost = AUD 5000    ---------------------------------- ( Assuming IDR/AUD rate to be constant)

Actual operating margin = (9000-5000)/5000

   = 90%

Scenario 2

IDR Appreciates

Suppose on 1 Jun'18 , SSP enters into a purchase order of raw materials for 10 solar panels from Indonesia. The contract mentions IDR312.50 Mn

IDR/AUD on 1 Jun'18 is 0.00008

Cost of raw materials is 50 % of manufacturing costs ie AUD2500 per unit. For 10 units it is AUD25000

Equivalent IDR on June 1 is 25000/0.00008 = 312.50 Mn

Suppose IDR/AUD after 6 weeks is 0.00009

Then

Cost of raw materials = IDR 312.5 Mn

   = 312500000 * 0.00009 AUD

   = AUD 28,125

The cost was expected to be AUD25000. This will reduce the profit margin given all other exchange rates are constant.

2.

In scenario 1 above, if SSP had sold a 3 months currency future , a GBP FX future at GBP/ AUS 2 , the company could have obtained its expected revenue. This future means right to sell GBP for AUD at rate 2 at expiry ( ie after 3 months). So the loss in the sales would have been compensated by the gain from futures.

Loss in revenue = AUD 1000

Gain from futures = (2-1.8) * 5000 = AUD 1000

In scenario 2, SSP should have bought 6 weeks IDR futures on June 1st for IDR/AUD 0.00008 . It is the right to buy IDR at this rate at expiry ( after 6 weeks). Any loss in the increased costs would have been compensated by the gain from futures.

3.

Currency Forwards

Forwards are like futures , it is the right and obligation to buy or sell particular currency in exchange of another currency for the current exchange rate at a futurespecified expiry date. Unlike futures , they are not exchange traded hence the position cannot be closed before expiry.

Currecy option

It is the right but not the obligation to buy/sell currencies at expiry date for the current exchange rate. With options , the risks are hedged plus gains are obtained if the exchange rate moves in favourable direction. A call option can be used instead of buying futures and put option instead of selling futures.

Currency Swaps

For exapmle in scenario 1, A customised swap can be arranged between another company with home currency as GBP and sales in AUD. They can agree to swap their cash flows in AUD with SSP's cash flows in GBP.