Question

Case Study

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.

A 'Business Case' is needed 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

Outline and explain the risks associated with the fixed income security the company has

purchased. Use examples of possible scenarios that may occur for SSP to illustrate the nature of these risks.

Question

Present some alternatives the company may look into to protect itself against interest rate rises

associated with debt funding for the new investment project.

Answer 1

Risks associated with fixed income securities:

Interest Rate Risk: If the interest rates go up, the price of the security will come down.

Credit Risk: The company may not be able to pay principal repayments and interest in future due to lack of income. The credit rating will decline in case of default by the company.

Inflation Risk: Inflation risk will lower the purchasing power of the investors.

Put Risk: The investors may exercise their option of put. If interest rates go up, investors will exercise such option and invest in high interest paying schemes.

Liquidity Risk: The investors may not be able to buy or sell the security at a price closer to the true underlying value of the security.

Company should not provide the put option to the investors on its securities. However, it should retain the call option on the securities.