Dr. P.V. Viswanath



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Fall 2013


Lubin School of Business
MBA 673: Applying Financial Theory to Strategic Decision Making
Prof. P.V. Viswanath
Fall 2013


  • The exam is closed book except for one sheet of formulas containing _only_ Dupont Analysis formulas. No worked out examples, nothing else.
  • Time allowed is 2 hours.
  • Explain all your answers; correct answers without explanations may not be given any credit at all.
  • Make sure that your answer is clear and concise. Confused and rambling answers will lose points.
  • If you answer a question, I have the discretion to award you some points, even if you are completely wrong. If you don't attempt the question at all, I can give you no points! So attempt every question.

    1. Read the following article from the website http://www.law360.com, and answer the following questions. (If this sounds like an interesting case, you may want to investigate another case that Sun Capital was involved in 2012, resulting from its acquisition of Friendly Ice Cream Company in 2007; see http://en.wikipedia.org/wiki/Friendly%27s#Bankruptcy):

    1. (7 points) An employer is supposed to pay an employee's wages and, where the contract so provides, is required to pay into a pension fund. In the case of Scott Brass Inc., the hedge fund management firm (Sun Capital Advisors) investing in Scott Brass through two separate funds (Sun Capital Partners III with a stake of 30% and Sun Capital Partners IV holding the remaining 70%) argued, in part, that it was not liable to pay outstanding pension fund contributions because they were only investors and not engaged in a "business or trade" and ERISA (Employee Retirement Income Security Act) imposes such liability only in the case of a business or trade. The First Circuit court agreed that the hedge funds were indeed engaged in a business because they had effective management control of Scott Brass Inc. Nevertheless, the court found that the two funds may not be liable for the pension fund contributions. What was the reason for this?
    2. (7 points) If you were buying a business whose employees had a pension fund with defined benefits (as in the case of Scott Brass), how might you structure it so that you wouldn't be liable for pension fund contributions if and when you declared bankruptcy?
    3. (7 points) Assuming that you had structured your transaction so as to avoid pension liabilities in case of bankruptcy, would your decision to declare bankruptcy under these circumstances be influenced by the ability to walk away from pension liabilities? Why or why not?
    4. (7 points) Assuming that you had structured your transaction so as to avoid pension liabilities in case of bankruptcy, would you have to pay your workers higher wages than if you had not structured the transaction in this way? Explain.

    Sun Capital PE Funds Count As Businesses, 1st Circ. Says (http://www.law360.com/articles/459905/sun-capital-pe-funds-count-as-businesses-1st-circ-says)

    Law360, San Francisco (July 24, 2013, 9:28 PM ET) -- The First Circuit found Wednesday that two Sun Capital Partners Inc. private equity funds qualified as businesses, reviving a case over whether the funds became liable for a $4.5 million debt bankrupt Scott Brass Inc. owed a trucking-union pension fund after Sun Capital bought the metals manufacturer.

    The dispute dates back to 2008, when Scott Brass declared bankruptcy and the New England Teamsters and Trucking Pension Fund demanded a $4.5 million payment from it and the Sun Capital funds. According to the Teamsters, the funds had entered a partnership or joint venture in common control with Scott Brass and were jointly liable for Scott Brass' withdrawal liability to the fund.

    On Wednesday, the three-judge panel agreed with the Teamsters that under the Employee Retirement Income Security Act, Sun Capital's funds functioned as businesses or trades and therefore couldn't escape responsibility for Scott Brass' withdrawal liability. However, the appeals court affirmed a Massachusetts federal judge's ruling that the court couldn't impose liability on the funds on the basis that they allegedly split ownership in a joint Scott Brass investment vehicle in order to avoid liability.

    The panel remanded the case to the lower court, ordering it to decide the issues of common control. However, it found that Sun Capital's funds qualified as businesses because they were actively involved in managing Scott Brass after the 2007 acquisition, and because that management was intended to help the funds turn a profit.

    The panel's opinion, written by U.S. Circuit Judge Sandra Lynch, acknowledged “these are fine lines.” However, “The various arrangements and entities meant precisely to shield the Sun funds from liability may be viewed as an attempt to divvy up operations to avoid ERISA obligations.”

    The judges rejected Sun Capital's argument that because the activities of the agents and businesses at issue couldn't be attributed to Sun Capital's funds, liability couldn't be proven. Instead, they found that under the law in Delaware, where the funds are organized, “it is clear that the general partner of Sun Fund IV, in providing management services to [Scott Brass], was acting as an agent of the fund,” Judge Lynch wrote.

    The ruling didn't entirely side with the Teamsters fund, which had also argued that Sun Capital was liable for the debt under the Multiemployer Pension Plan Amendments Act of 1980 because of how it divided ownership of investment vehicle Sun Scott Brass LLC. At first, Sun Capital planned to purchase 100 percent of Scott Brass, but later divided the ownership of Sun Scott Brass to avoid common-control issues and related liabilities, the Teamsters argued.

    However, disregarding the divided-ownership agreement “would not result in Sun Fund IV being the 100 percent owner of [Scott Brass],” Judge Lynch wrote. “In essence, the [Teamsters fund] requests that we create a transaction that never occurred — a purchase by Sun Fund IV of a 100 [percent] stake in [Scott Brass].”

    Representatives for the parties did not respond to requests for comment late Wednesday.

    In June 2010, Sun Capital sued the union seeking declaratory judgment that it was not responsible for the debt because it didn't meet the common-control requirement under federal statutes and because neither of the funds was a trade or business. But the court granted summary judgment to the Sun Capital funds in October.

2. Here is some financial statement information for Tiffany and Company. Use them to answer the questions below:

Here is the Balance Sheet as of January 31, 2013.

    Cash & cash equivalents $504,838 Short-term borrowings $194,034
    Accounts receivable, net $173,998 Accounts payable & accrued liabilities $295,424
    Inventories, net $2,234,334 Other short-term liabilities $97,134
    Other Current Assets $238,419 Total current liabilities $586,592
    Total current assets $3,151,589 Long-term debt $765,238
    Fixed Assets $818,838 Pension or postretirement benefit obligations $361,246
    Other assets $660,423 Other long-term liabilities $306,456
    Total stockholders' equity $2,611,318
    Total assets $4,630,850 Total Liabilities $4,630,850

Here is the Income Statement for Tiffany and Company, for the year ended January 31, 2013.

    Net Sales $3,794,249
    Cost of sales $1,630,965
    Gross profit $2,163,284
    Selling, general & administrative expenses $1,466,067
    Earnings from continuing operations $697,217
    Other income, net $5,428
    Interest expense & financing costs $59,069
    Earnings  from continuing operations before income taxes $643,576
    Provision for income taxes $227,419
    Net earnings from continuing operations $416,157
    1. (5 points) Compute the NOPAT Margin.
    2. (5 points) Compute the Operating Asset Turnover.
    3. (10 points) Use your answers from a. and b. above to compute Operating Return on Assets. How does your answer differ from the traditional Return on Assets number? Why is there a difference, if any?
    4. (5 points) Compute the Spread. You may assume that taxes paid equals provision for income taxes.

3. In his article, "Leveraging profitability in low-margin markets," in the Journal of Product and Brand Management, Gerald Smith suggests various marketing strategies to leverage profitability.

    1. (10 points) What are some strategies that Smith suggests for high-margin product markets? Why do they work?
    2. (10 points) What are some specific examples that could work for low-margin product markets? (You can give Smith's examples, but your own examples will get more credit).

4. Answer the following questions:

    1. (15 points) Name three distinct ways in which capital structure decisions could cause a firm to operate in a way that reduces firm value (as opposed to stockholder value). Explain briefly.
    2. (15 points) Why might a highly-levered firm neglect its reputation? Name two distinct ways in which this indifference to reputation might manifest itself?

Solution to Midterm


  1. The court found that the two funds may not be liable for the pension fund contributions because neither fund had sufficient ownership of the Scott Brass firm. As the article says: "At first, Sun Capital planned to purchase 100 percent of Scott Brass, but later divided the ownership of Sun Scott Brass to avoid common-control issues and related liabilities." The Teamsters argued that since the intent in the division of ownership was to avoid pension liability and not for a legitimate business purpose, the division should be thrown out. Nevertheless, the court disagreed. In other words, the divided ownership did help the company to avoid pension liability. In fact, according to other articles, an entity owning 80% of a company could be liable under ERISA. OnPoint (Dechert LLP) said: "The recent decision by the U.S. Court of Appeals for the First Circuit in the Sun Capital Partners case may be of concern to private equity funds and other investment funds that acquire or invest in portfolio companies with significant ERISA liabilities. Under Sun Capital Partners, an investment fund that owns 80% or more of a portfolio company could effectively be aggregated with the portfolio company for ERISA purposes and share its ERISA liabilities, depending on the fund's compensation arrangements and other relevant facts and circumstances."
  2. You would try and make sure that you didn't own more than 79% of the business. Alternatively, you'd make sure that you did not have control of the business. Then you could argue that you weren't involved in a "trade or business."
  3. If you were only looking to maximize your monetary gains, presumably this would be important. Declaring bankruptcy can be costly, both in terms of monetary cost, in terms of disruption of business, and in terms of loss of control. If it allowed you to walk away from pension obligations, then you would be more likely to accept these costs of declaring bankruptcy.
  4. If your workers realized that the structure of your purchase transaction would lead them to depend on the Pension Benefit Guaranty Corporation for their promised defined pension benefits, then they would demand higher wages. Even though the PBGC is obligated to compensate employees for their pension benefits, the PBGC may not have enough money to pay out in full, or it might not pay out on a timely basis.


  1. NOPAT = Net Income + Interest expense x (1-tax rate). Since the tax rate can be computed as Provision for IT/EBIT or 227419/643576 or 35.34%, NOPAT = 416157+(1-0.3534)(59069) = 454353. The NOPAT Margin = NOPAT/Sales or 454353/3794249 = 12%.
  2. Operating Asset Turnover = Sales/(Net Operating Assets). Operating Long-term assets = Long-term assets less Pension liabilities = 818838+660423-361246 = 1118015. Net Operating Working Capital = (Current Assets – Cash and Marketable Securities) – (Current Liabilities – Short term debt and current portion of long-term debt) = (3151589-504838)-(586592-194034) = 2254193. Net Operating Assets is the sum of the two, viz. 1118015 + 2254193 for a total of 3372208. Hence Operating Asset Turnover = 3794249/3372208 = 1.12515.
  3. Hence Operating Return on Assets = (0.12)(1.12515) or 13.5%. The traditional Return on Assets would be Net Income/Total Assets = 416157/4630850 = 8.99%, which is much lower than the Operating ROA. The reason is that pension liabilities count for almost 8-9% of total assets; once this is netted out of total assets, the resulting number for net operating assets is much lower and yields a much higher return on operating assets. Furthermore, we only use the net working capital figure in total assets, thus offsetting short-term operating liabilities against short-term operating assets. In addition, cash is not considered an operating asset.
  4. Net Debt is Total interest bearing liabilities – Cash and Marketable Securities. Total Interest bearing liabilities equals (765,238+306,456)+(194034+97134) = 1,362,862, assuming that other long-term and short-term liabilities are interest-bearing. Subtracting out cash, we get $858,024. The implied interest rate is 59069/858024 = 6.88% and the Net Interest Rate after Taxes is 6.88(1-0.3534) = 4.45%. Hence the Spread is 13.5% - 4.45% = 9.05%.


  1. For high gross margin products, Smith suggests the use of "intensive advertising to drive product sales volume across the entire market, regardless of the varying price sensitivities of different market segments" and to "aggressively use sales promotions and price discounting to stimulate sales volume" because initial margins are large enough to permit discounting. Obviously, the price discounting strategy only works in market segments where there is greater price sensitivity, although typically price sensitivity is low for such products.
    Most customers in this segment are likely to have low price sensitivity and might even have low cost-to-serve because product differentiation has converted them into a loyal group of buyers. For either group, though, advertising, loyalty programs, innovation and distribution activities can be used to reduce price sensitivity and to increase the likelihood of repeat purchases. Such repeat purchases also reduce the cost-to-serve, since marketing investments can be amortized over larger volumes. When profit margins are high, "discount trial incentives, repeat purchase incentives, loyalty programs and pricing latitude can be used to penetrate and develop loyalty among many customer segments of varying price sensitivity."
  2. For low-gross margin products, Smith suggests leveraging incremental profits not by driving volume, but by bundling and driving many gross profit opportunities through the customer base in a way that surrounds and serves the customer account in valuable ways. Rather than think of the product as the unit of analysis, the manager should be looking at the customer as the unit of analysis. Profit can be obtained by aggressively cross-selling additional services that complement a main product at premium margins; bundling or selling higher margin accessories and related products; and engaging customers in deeper and more extensive supplier-customer relationships with multiple products, services and points of contact. One example of such a strategy that Smith gives is that of Cardinal Health, a pharmaceutical distributor with low margins. Smith used its customer base to develop an ancillary service of hosting information systems for hospital pharmacies.
    The basic principle, here, is similar to that of a loss-leader. Thus, for example, a photographer might sell cheap photographs, but then use the relationship to sell expensive picture frames. An undertaker might sell cheaper coffins, but make it up in other funeral services, such as music or a religious service.


  1. A leveraged firm could take on excessive risk because leveraged equity works like a call option and its value is increasing in the volatility of the underlying assets. A leveraged firm could reject profitable investments and underinvest because some of the value of the investment would go to existing debtholders and equityholders may not get enough of a return to make it worth their while, even though such an investment might be firm value-increasing. Finally, a leveraged firm tends to be more myopic because debt that needs to be repaid demands refinancing which, in turn, benefits existing debtholders more than equityholders (the underinvestment problem); to avoid this problem, firms go in for short-term projects which reduce the need to go back to the marketplace for new financing.
  2. A highly levered firm might neglect its reputation because reputation tends to be a long-term investment. This could occur through neglect of product quality or through bad customer service. A firm may also scrimp on institutional advertising that keeps a firm's reputation in the public eye.

Lubin School of Business
MBA 673: Applying Financial Theory to Strategic Decision Making
Prof. P.V. Viswanath
Fall 2013


  • The exam is closed book. No worked out examples, nothing.
  • Time allowed is 2 hours.
  • Explain all your answers; correct answers without explanations may not be given any credit at all. Make sure you do not use more space than the question allows you.
  • Make sure that your answer is clear and concise. Confused and rambling answers will lose points.
  • If you answer a question, I have the discretion to award you some points, even if you are completely wrong. If you don't attempt the question at all, I can give you no points! So attempt every question.

1. Read the article below from the Economist of June 18th, 2009 and answer these questions, using no more than three-quarters of a page for each answer:

  1. (10 points) What are some of the benefits of hedging described in the article. Name and briefly explain at least three.
  2. (10 points) "(B)anks are normally more willing to lend to firms that have reduced their risks by hedging." Why should that be so?
  3. (10 points) Immediately following the statement in the previous question, the article goes on to talk about buying "cheap assets from ailing rivals." Why does the article juxtapose these two issues? A firm that can get cheap bank finance can do lots of things. Why does the article focus on buying cheap assets from ailing rivals?
  4. (10 points) Why are paper losses causing problems for firms that hedge using derivatives? Presumably these firms are using these derivatives to offset their exposure to commodity prices. The paper loss in the derivatives position should be offset by the lower price at which these firms can buy those commodities for their operations.
  5. (10 points) According to the article, banks are charging more to sell derivatives to companies. Why? Explain.
  6. (10 points) "Rolls-Royce, a British aerospace company, is active on foreign-exchange markets because most of its revenues are in dollars but many of its costs are paid in pounds." What kind of derivative can Rolls-Royce use to hedge its risk? Explain what position the company should take and why.
  7. (10 points) How might Rolls-Royce reduce this currency risk operationally (as opposed to using financial contracts)? Why, in your opinion, does Rolls-Royce not use these operational risk reduction strategies?

The credit crunch has made it much more difficult and expensive for firms to hedge their risks

Warren BUFFETT, one of the world's most famous investors, once called derivatives “financial weapons of mass destruction”. Central bankers worry that those sold “over the counter”, meaning outside exchanges, threaten the stability of the whole financial system. Yet firms that rely on derivatives to limit their exposure to swings in commodity prices, interest rates or exchange rates cannot get enough of them—literally.

Several firms using derivatives in an attempt to manage such risks have suffered huge losses of late, on paper at any rate. Among the hardest hit have been airlines, many of which paid to protect themselves from higher fuel prices last year when the oil price peaked at $147 a barrel. Because oil now costs much less, many have had to write down the value of those contracts, even if they are not due to be settled for years. The losers included Cathay Pacific Airways, which made paper losses of close to $1 billion, Ryanair, Air France-KLM and Southwest.

Nonetheless, firms seem as keen to hedge as ever. According to a study by Greenwich Associates, a consultancy, big American, European and Asian firms hedged 55% of their exposure to fuels last year, up from 45% the year before. Even some of the airlines that posted large losses on derivatives tied to the oil price are buying more of them. Ryanair recently said that it has entered contracts to fix the price of 90% of its fuel for the first nine months of this year, almost twice the proportion it had hedged in January. Cathay Pacific, meanwhile, is buying instruments that will protect it from falling as well as rising fuel prices.

The main reason for this enthusiasm, says David Carter, an academic at Oklahoma State University and one of the authors of several papers studying fuel hedging in the airline industry, is that banks are normally more willing to lend to firms that have reduced their risks by hedging. That in turn allows them, for instance, to buy cheap assets from ailing rivals.

 Far from suppressing firms' appetite for derivatives, the turmoil in the world's financial markets has increased it. Of the big corporations Greenwich surveyed last year, 38% used options to manage currency fluctuations, up from 28% a year earlier, and the volume of currency options they bought had increased by about a third. In general, the use of interest-rate and currency options has risen dramatically in recent years (see chart).

But in the second half of last year, such hedging declined for the first time since 2001, according to the International Swaps and Derivatives Association, an industry group. Thanks largely to the credit crunch, banks are selling fewer derivatives at a higher cost. Many firms, especially those with weaker credit ratings, have simply been frozen out of the market for derivatives by banks' reduced willingness to carry risk. Bankers say that only the few airlines with the highest credit ratings have been able to add to their hedge books in recent months to take advantage of lower oil prices.

The bankers' reluctance stems from the nature of hedging contracts which, although not officially loans, nonetheless create liabilities between banks and their customers which grow or shrink as the underlying variable changes. Thus many of the airlines that had hedged their fuel consumption when oil prices were higher built up huge notional debts to banks, even though no money was due to change hands until the contracts reached the end of their lives, by which time oil prices could have risen again. The amounts concerned can easily grow to exceed the internal limits that banks place on their exposure to particular clients or even industries, preventing them from extending additional credit or writing new contracts.

It is not just airlines that are affected. Indian textile exporters, for instance, complain that their banks are not allowing them to take on new currency hedges because of paper losses on contracts tied to the dollar. Pension funds are being affected too, mainly because some specialised derivatives, including certain types of hedges against inflation, completely dried up for a time last year.

Those hedges that are available have become much more expensive. That is partly because markets are less liquid and less competitive since the collapse of Lehman Brothers last September. But banks are also now explicitly charging for the credit risk that they assume when writing a derivative contract. Estimates of the additional cost that companies are paying to hedge risks vary from firm to firm and product to product, particularly as they depend on the creditworthiness of those who are buying them. But some in the industry talk of bank fees rising from less than 0.1% of the value of a deal to as much as 2%.

For many firms, such costs are prohibitive. The main victims are big exporters of manufactured goods. ThyssenKrupp, a German industrial firm, hedges its currency exposure each time it signs a large export order, for example. Similarly Rolls-Royce, a British aerospace company, is active on foreign-exchange markets because most of its revenues are in dollars but many of its costs are paid in pounds.

Ever since the collapse of Lehman Brothers last year, firms have been worrying about whether they will ever be able to collect on the hedging contracts they have bought if their bank collapses. John Grout of the Association of Corporate Treasurers, an industry group, says that some perfectly solvent banks have wriggled out of derivative contracts by invoking obscure break clauses that they had previously promised their customers they would never use.

Banks, meanwhile, fear that some of their cash-strapped customers may default. The result, says one banker involved in advising firms, is that many of them are asking firms to post collateral for the money they owe on derivative contracts. In effect many are edging towards the sorts of arrangements that regulators are thinking about imposing more broadly: moving most derivatives onto exchanges and having them centrally cleared.

Yet such arrangements, too, are deeply troubling for many big firms. By turning paper losses into real ones they represent, in effect, a massive withdrawal of credit. Timothy Murphy, the foreign-currency risk manager for 3M, a large manufacturing company, gave warning in testimony before a subcommittee of America's Congress earlier this month that mandatory clearing of derivatives would “add significant capital requirements for end-users, adding significant costs, discouraging hedging, and diverting scarce capital”. The only thing more dangerous than having too many derivatives floating around the financial system, it seems, may be having too few of them.

2. (15 points) On November 19th, 2013, Prof. James Nish gave a talk in the MBA 673 class on the joint venture and eventual acquisition of a Mexican glassware company called Crisa, by Libbey, a US firm. In this talk, Prof. Nish talked about the reasons why Libbey initially chose a joint-venture format for its investment in Crisa. Discuss at least two different operational implications of this format. Use no more than one page for your answer.

3. (20 points) According to a document published by the Reserve Bank of India on February 29, 2012, "(a) freight derivative is a financial instrument whose value is derived from the future levels of freight rates, such as "dry bulk" carrying rates and oil tanker rates. Freight derivatives are used mainly by end users such as ship owners and large warehouses, suppliers such as oil refining and marketing companies to manage risk and hedge against price volatility in the supply chain." According to Wikipedia, Freight derivatives include Forward Freight Agreements (FFA), container freight swap agreements and options based on these, which depend on future levels of freight rates, for dry bulk carriers, tankers and containerships. These instruments are settled against various freight rate indices published by the Baltic Exchange (for Dry and most Wet contracts) & Platt's (Asian Wet contracts). This notion of settling refers to the fact that these derivatives are settled in cash based on the change in the value of the contract; the hedger offsets this amount against the gain or less in the actual shipping contract.

Again, according to Wikipedia, one of these indices, the Baltic Dry Index (BDI) is issued daily by the London-based Baltic Exchange, and provides "an assessment of the price of moving a range of commodities including coal, iron ore, grain and other dry raw materials by sea, taking in 23 shipping routes.

Suppose your firm regular ships oil to customers in Japan from Norway; the price you quote includes freight costs. Explain what problems you might encounter in using freight derivatives based the Baltic Dry Index in hedging your transportation costs. Begin your answer with a summary in bullet point format. Then use no more than the rest of one side to explain your bullet points in more detail.

4. (15 points) Answer any one of the following questions. Keep in mind that you won't get any credit if you answer a question pertaining to your own project. Use no more than one side of a page.

  1. In the paper, "The Reflexivity Between the Capital Structure Change of Detroit Three, Market Competition, and the Capital Structure Change of Asian Four," the authors say that the Detroit Three's deteriorating financial situation led them to decrease leverage, which in turn helped them to regain market share from the Asian Four. According to the authors, the Asian Four reacted to the Detroit Three's strategy by increasing leverage. How might one justify the Asians reacting to their competitors' leverage decrease by themselves increasing leverage?
  2. What was the conceptual basis behind the thesis of the paper, "Leverage and Employment Levels" that firms that increase leverage decrease employment expenditure? What was their finding?
  3. According to the authors of the paper, "The Impact of Capital Structure on Marketing Efforts In the Drug Manufacturing Industry," is advertising in the pharmaceutical industry short term in nature or long-term? What is their basis for this assertion? How does this explain their regression result?
  4. In the paper, "Impact of Capital Structure on Advertising Competition: Automotive Study," the authors study the impact of leverage changes on advertising expenses and R&D expenditures. In order to do this, they naturally regress Advertising expenditures and R&D expenditures (separately) on leverage changes. However, they include an additional independent variable in their regression. What is this variable and why do they include it?

Solutions to Final


  1. Here are some of the advantages to hedging mentioned in the article:
    1. Banks are more willing to lend to firms that have reduced their risks by hedging
    2. Firms that have hedged are less strapped for funds and can, therefore, buy from rivals assets on the cheap.
    3. Firms that use derivatives can limit their exposure to commodity price swings.
  2. Firms that have reduced their risks by hedging are less likely to go bankrupt. As a result, the chances of the loan being repaid are higher.
  3. The reason is that if there is a negative economic shock in an industry, firms will want to sell off assets to raise funds to tide them over. Since all firms in that industry will be similar hit, the supply of such assets will be high and the price will be low. Under these circumstances, firms in that industry that have hedged will not need to sell off assets, on the one hand. On the other, banks will be willing to lend them money so that they can buy assets from ailing rivals on the cheap. In other words, the juxtaposition is due to the fact that it is precisely the availability of the bank loan that will allow the firm to buy the assets.
  4. The reason the paper loss is relevant is that, even though the paper losses on the derivatives are offset by the potential gains from being able to buy oil (or foreign currency) cheaply, the bank is still subject to a loss if the firm does not pay up. For example, if for some reason the counterparty firm goes out of business, the bank will lose money on the hedge. As a result, the bank will often demand additional collateral or margin from the counterparty firm, as is mentioned later in the article. At the very least, as the article mentions, the bank will not want to extend itself further.
  5. Banks are charging more to sell derivatives because the market is less liquid; as a result the banks cannot offload or offset their positions easily. Also, as mentioned in the earlier article, with general uncertainty increasing and the likelihood of contagion greater, default risk becomes more important. Firms, in general, all want to go short commodities or all take similar positions in currency contracts; this increases the bank's exposure. As a result, banks are charging both for the commodity price risk, as well as for the default risk, making for more expensive derivatives.
  6. Rolls-Royce can sell dollars forward or sell dollar futures (equivalent to buying pounds on a US exchange) to hedge. If it only wants to protect against the downside risk that the dollar might fall, it could buy dollar puts on a UK exchange or buy pound call options on a US exchange.
  7. Rolls-Royce could move some of its manufacturing operations to the US or to other locations whose currencies are pegged to the dollar. Presumably, this is too difficult and costly for the company.

2. Some of the operational implications of choosing a joint-venture format were:

  1. Not having to provide details of the venture on the firm's financial statements
  2. Keeping a low profile with respect to financial reporters who would otherwise press the company for details.
  3. Keeping a low profile with respect to the firm's unions, who would otherwise be worried about the diversion of jobs to low-cost Mexican labor.
  4. Keeping pricing and other strategically sensitive information out of the hands of competitors.


  1. The prices of the derivatives based on the Baltic Dry Index would track freight rates for dry commodities like coal, iron ore, grain etc. Hence these prices would not be well correlated with the freight rates for shipping oil.
  2. The Baltic Dry Index is an average of the costs of moving commodities over 23 different routes. However, our firm is interested in one specific route; again there is a basis risk problem.
  3. The BDI is probably specified in dollars; my firms freight rates may not be payable in dollars.
  4. My firm may not be be able to specify precisely the amount of tonnage it will use; as a result, the firm may be under- or over-hedged.


  1. It is possible that the Asians were able to obtain bank debt more easily than the Americans, since Japan and Korea having financial systems that rely more on banks whereas the US system depends more on financial markets -- as a result, Japanese and Korean firms have more long-term relationships with their lenders.
  2. The idea was that firms with increased leverage would be more subject to the underinvestment problem -- since the benefits of any investment would go to their bondholders, such firms would tend to cut back on their hiring in bad times rather than raise new funds and maintain operations. To the extent that they had debt coming due, they would prefer to pay them off by cutting back on expenses rather than raising new funds for the same reason. The paper found that this was indeed the case; the authors also found that their results were stronger in bad times than in good times.
  3. The authors state that advertising could have short-term and long-term implications. However, they state that a lot of the advertising expenditures for pharmaceutical firms are intended to promote drug prescription and would bring in revenue in the near term. Hence they focus on the short-term benefits of cash inflows from advertising. And, in fact, they find that whereas for healthy firms, leverage is negatively correlated with advertising expenditures (implying that the underinvestment motive is more important), for firms in financial distress, advertising may be positively related with leverage (suggesting that the myopic motive is more important).
  4. The additional variable that the authors of the paper, "Impact of Capital Structure on Advertising Competition: Automotive Study" include is the change in the amount of capital available to the firm. The reason this is important is that a greater availability of capital could encourage advertising and R&D expenditures, while a greater leverage (i.e. if more of this capital is available in the form of debt) could lead the firm to underinvest (especially since the authors argue that advertising in the automobile industry is long-term oriented) and therefore point to less advertising. And, in fact, the authors find that total capital availability is positively related to advertising and R&D, while increased leverage leads to less advertising and R&D (which, almost definitionally, is long-term.



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