BUSI 685 Week 6 DB Forum 4 Example

Discussion Board Forum 4: Thread and Replies

BUSI 685 Financial Management, Discussion Board Forum 4 (thread and two replies)

Thread by [Student Name]

The forum prompt, the company and the classmates are composites standing in for the course's own; the exchange rates come from Federal Reserve Economic Data, and the textbook, Scripture and research cited are real; the requirements follow Liberty's public course guide for BUSI 685.

Thread

The prompt describes a composite U.S. maker of imaging equipment that sells about €400 million of systems a year in Europe and pays nearly all its costs in dollars. According to Federal Reserve Economic Data, the euro averaged about $1.04 in January 2025 and $1.17 by September 2025, and it averaged about $1.15 in September 2026. The same €400 million was worth about $414 million at January 2025's rate and about $470 million at September 2025's, a swing of more than $55 million in dollar revenue with no change in sales. The board asks whether to hedge next year's euro sales.

Brealey et al. (2017) note that hedging does not add value in a world where shareholders can manage risk as cheaply as the firm, since investors can diversify currency exposure themselves. Froot et al. (1993) explain why hedging can still add value: if outside financing costs more than internal funds, a drop in cash flow forces a firm to cut good investments, and hedging protects the internal cash that funds them. The company plans to spend $60 million next year on a new scanner platform. A euro decline that cut revenue by $40 million could put that program at risk, which is the situation their framework describes.

Hedging decisions are not always made for shareholders, though. Tufano (1996), studying gold mining firms, found little support for value-maximizing theories of hedging but found that firms whose managers held more stock hedged more and those whose managers held more options hedged less. The board should therefore ask whether a proposed hedge protects the investment program or management's bonus. In this company, the executives' pay is tied to annual earnings per share, which a currency swing can move sharply, so management has a personal reason to favor a large hedge. A policy written by the board, stating the purpose of hedging and the share of sales to be covered, keeps that incentive in view and makes the program easier to judge after the fact.

Jesus describes a builder who sits down first to count the cost and a king who considers whether ten thousand can meet twenty thousand before going to war (English Standard Version Bible, 2001/2016, Luke 14:28-32). Both plan for what could go wrong before committing. Hedging is counting the cost of a currency move before the move arrives.

I would recommend hedging about half of next year's expected euro sales, enough to protect the $60 million investment, using forward contracts for the most certain orders and euro put options for the rest so the company keeps some upside if the euro rises.

Reply to Owen

Owen, you argued that the company should hedge all of its euro revenue so that currency moves never affect earnings. Stability has value, but a full hedge goes further than the reasons for hedging justify. Froot et al. (1993) locate hedging's value in keeping enough internal cash for the firm's investment plans, which implies hedging enough to cover those needs, not necessarily every euro. Guay and Kothari (2003) reported that, among big nonfinancial companies using derivatives, the positions usually covered only a modest share of the risks the firms faced, which suggests most firms do not attempt full hedges. A full hedge also requires forecasting sales that may not occur; if orders fall, the company would hold forward contracts with nothing to offset them. Hedging forecast sales the company is not confident of could add risk rather than remove it, and a forward contract that must be settled without matching euro receipts becomes a speculative position. Would you hedge contracted orders fully and forecast orders only in part, revisiting the share each quarter as the order book fills?

Reply to Mei

Mei, you made the textbook point that shareholders can diversify currency risk themselves, so the company should not spend money on hedging. Brealey et al. (2017) present exactly that argument, and in perfect markets it holds. But Froot et al. (1993) show that it depends on the firm being able to raise outside funds cheaply whenever internal cash falls short. If borrowing or issuing stock in a bad year is expensive, a currency shock can force the firm to cut its investment budget, and shareholders cannot undo that loss by diversifying. The company in our prompt is planning a $60 million product launch funded from operating cash flow, so the conditions for hedging to add value are present. Tufano (1996) is a fair caution on your side, since hedging may reflect managers' preferences, but that argues for clear board policy, not for no hedging at all. A written policy limiting hedges to the investment need would answer your concern about wasted premiums and still protect the launch. Would you support a hedge limited to the amount of the launch budget?

References

Brealey, R. A., Myers, S. C., & Allen, F. (2017). Principles of corporate finance (12th ed.). McGraw-Hill Education.

English Standard Version Bible. (2016). Crossway. (Original work published 2001)

Froot, K. A., Scharfstein, D. S., & Stein, J. C. (1993). Risk management: Coordinating corporate investment and financing policies. The Journal of Finance, 48(5), 1629-1658. https://doi.org/10.1111/j.1540-6261.1993.tb05123.x

Guay, W., & Kothari, S. P. (2003). How much do firms hedge with derivatives? Journal of Financial Economics, 70(3), 423-461. https://doi.org/10.1016/S0304-405X(03)00179-X

Tufano, P. (1996). Who manages risk? An empirical examination of risk management practices in the gold mining industry. The Journal of Finance, 51(4), 1097-1137. https://doi.org/10.1111/j.1540-6261.1996.tb04064.x