FINANCIAL MANAGEMENT - 14th Edition Chapter #23 - Mini Case Assume you have just
ID: 2752344 • Letter: F
Question
FINANCIAL MANAGEMENT- 14th Edition Chapter #23 - Mini Case
Assume 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 companies to institute enterprise risk management programs. Because no one at Tennessee Sunshine is familiar with the basics of enterprise 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 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 to 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?
c. What is COSO? How does COSO define enterprise risk management?
d. Describe the eight components of the COSO ERM framework.
e. Describe some of the risks events within the following major categories of risk:
o (1) strategy and reputation,
o (2) control and compliance,
o (3) hazards,
o (4) human resources,
o (5) operations,
o (6) technology, and
o (7) financial management.
f. What are some actions that companies can take to minimize or reduce risk exposures?
g. What are forward contracts? How can they be used to manage foreign exchange risk?
h. Describe how commodity futures markets can be used to reduce input price risk.
i. It is January, and Tennessee Sunshine is considering issuing $5 million in bonds in June to raise capital for an expansion. Currently, the firm can issue 20-year bonds with a 7% coupon (with interest paid semiannually), but interest rates are on the rise and Stooksbury is concerned that long-term interest rates might rise by as much as 1% 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% .
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.
Explanation / Answer
a. If volatility in cash flows is not caused by systematic risk, then stockholders can eliminate the risk of volatile cash flows by diversifying their portfolios. Stockholders might be able to reduce impact of volatile cash flows by using risk management techniques in their own portfolios.
b.
Risk management allows firms to:
1) Have greater debt capacity, which has a larger tax shield of interest payments.
2) Implement the optimal capital budget without having to raise external equity in years that would have had low cash flow due to volatility.
3) Avoid costs of financial distress.
4) Utilize comparative advantage in hedging relative to hedging ability of investors.
5) Reduce borrowing costs by using interest rate swaps
6) Minimize negative tax effects due to convexity in tax code.
f.
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 which 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 financial risk. Fourth, companies can take actions to reduce the probability of occurrence of an adverse event, such as replacing old wiring to reduce the possibility of fire. Fifth, actions can be taken to reduce the magnitude of the loss associated with adverse events, such as installing automatic sprinkler systems. Finally, companies can simply avoid the activities that give rise to risk.
h.
Essentially, Purchase Of A Commodity Futures Contract Will Allow A Firm To Make A Future Purchase Of The Input Material At Today's Price, Even If The Market Price On The Good Has Risen Substantially In The Interim
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.