Swaps for Managing Risk

Some company cash flows are fixed. Others vary with the level of interest rates, rates of exchange, prices of commodities, and so on. These characteristics may not always result in the desired risk profile. For example, a company that pays a fixed rate of interest on its debt might prefer to pay a floating

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How to Set Up a Hedge

There can be many ways to hedge a risk exposure. Some hedges are zero maintenance: Once established, the financial manager can walk away and worry about other matters. Other hedges are dynamic: They work only if adjusted at frequent intervals. The forward contract between Northern Refineries and Arctic Fuels, which we described in Section

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Is “Derivative” a Four-Letter Word?

Our wheat farmer sold wheat futures to reduce business risk. But if you were to copy the farmer and sell futures without an offsetting holding of wheat, you would increase risk, not reduce it. You would be speculating. Speculators in search of large profits (and prepared to tolerate large losses) are attracted by the

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The Foreign Exchange Market

An American company that imports goods from France may need to buy euros to pay for the purchase. An American company exporting to France may receive euros, which it sells in exchange for dollars. Both firms make use of the foreign exchange market. The foreign exchange market has no central marketplace. Business is conducted

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Some Basic Relationships for Managing International Risks

You can’t develop a consistent international financial policy until you understand the rea­sons for the differences in exchange rates and interest rates. We consider the following four problems: Problem 1. Why is the dollar rate of interest different from, say, the rate on Ruritanian pesos (RUPs)? Problem 2. Why is the forward rate of

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Hedging Currency Risk

Sharp exchange rate movements can make a large dent in corporate profits. To illustrate how companies cope with this problem, we look at a typical company in the United States, Outland Steel, and walk through its foreign exchange operations. EXAMPLE 27.1 ● Outland Steel Outland Steel has a small but profitable export business. Contracts

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Exchange Risk and International Investment Decisions

Suppose that the Swiss pharmaceutical company, Roche, is evaluating a proposal to build a new plant in the United States. To calculate the project’s net present value, Roche forecasts the following dollar cash flows from the project: These cash flows are stated in dollars. So to calculate their net present value Roche discounts them

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Political Risk

So far, we have focused on the management of exchange rate risk, but managers also worry about political risk. By this they mean the threat that a government will change the rules of the game—that is, break a promise or understanding—after the investment is made. Of course political risks are not confined to overseas

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Financial Ratios

Financial ratios are usually easy to calculate. That’s the good news. The bad news is that there are so many of them. To make it worse, the ratios are often presented in long lists that seem to require memorization rather than understanding. We can mitigate the bad news by taking a moment to preview

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Financial Statements

Public companies have a variety of stakeholders, such as shareholders, bondholders, bankers, suppliers, employees, and management. All these stakeholders need to monitor the firm and to ensure that their interests are being served. They rely on the company’s financial statements to provide the necessary information. Public companies in the United States report to their

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Home Depot’s Financial Statements

Your task is to assess the financial standing of Home Depot, the home improvement company. Perhaps you are a mutual fund manager trying to decide whether to allocate $25 million of new money to Home Depot stock. You could be an investment banker seeking business from the company or a bondholder concerned with its

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Measuring Home Depot’s Performance

You want to use Home Depot’s financial statements to assess its financial performance and current standing. Where do you start? At the close of fiscal 2017, Home Depot’s common stock was priced at $204.92 per share. There were 1,170 million shares outstanding, so total market capitalization was 1,170 X $204.92 = $239,756 million. This

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Measuring Efficiency

We began our analysis of Home Depot by calculating how much value the company has added for its shareholders and how much profit it is earning after deducting the cost of the capital that it employs. We examined the company’s rates of return on capital, equity, and total assets and found that its return

Analyzing the Return on Assets: The Du Pont System

We have seen that every dollar of Home Depot’s assets generates $2.35 of sales. But a com­pany’s success depends not only on the volume of its sales but also on how profitable those sales are. This is measured by the profit margin. Profit Margin The profit margin measures the proportion of sales that finds

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Measuring Leverage

When a firm borrows money, it promises to make a series of interest payments and then to repay the amount that it has borrowed. If profits rise, the debtholders continue to receive only the fixed interest payment, so all the gains go to the shareholders. Of course, the reverse happens if profits fall. In

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Measuring Liquidity

If you are extending credit to a customer or making a short-term bank loan, you are interested in more than the company’s leverage. You want to know whether the company can lay its hands on the cash to repay you. That is why credit analysts and bankers look at several mea­sures of liquidity. Liquid

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Interpreting Financial Ratios

We have shown how to calculate some common summary measures of Home Depot’s per­formance and financial condition. Now you need some way to judge whether they are high or low. In some cases, there may be a natural benchmark. For example, if a firm has negative economic value added or a return on capital

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Links between Short-Term and Long-Term Financing Decisions

Short-term financial decisions differ in two ways from long-term decisions such as the purchase of plant and equipment or the choice of capital structure. First, they generally involve short-lived assets and liabilities, and, second, they are usually easily reversed. Compare, for example, a 60-day bank loan with an issue of 20-year bonds. The bank

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Tracing Changes in Cash

Table 29.1 shows the 2018 income statement for Dynamic Mattress Company, and Table 29.2 compares the firm’s 2017 and 2018 year-end balance sheets. You can see that Dynamic’s cash balance increased from $20 million to $30.4 million in 2018. What caused this increase? Did the extra cash come from Dynamic’s issue of long-term debt,

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Cash Budgeting

Table 29.3 showed why Dynamic’s cash balance rose in 2018. But its financial manager also needs to forecast the company’s cash needs in 2019 and ensure that the company will be able to pay its upcoming bills. These forecasts are set out in the firm’s cash budget and are then used to draw up

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