Corporate Treasury Management

1.0. The Key Arguments For and Against Hedging of the Exchange and Interest Rate Risks

It is evident that Zapple PLC faces a number of foreign rate risk and interest rate risks. As such, the management in the company can consider hedging. There are a number of arguments for and against hedging.

1.1. Arguments against Hedging

There are times when a company’s shareholders are better at managing risks as compared to the management (Megginson & Smart 2009). This occurs when the quality of management is questionable. Under such circumstances, a company should avoid hedging. According to the Modigliani-Miller Theorem, it defeats the logic of increasing the value of a company through financial transactions that stockholders can make on their own. Essentially, the management of a company is likely to fail in increasing the value of a firm through hedging (Megginson & Smart 2009).

In the same regard, according to Megginson and Smart (2009), hedging does not add any value to a company. If anything it only consumes the resources of the company in question in this case Zapple PLC. In most cases, the reduction or mitigation of the risk is never large enough to compensate the reduction in cash flow. This implies that the cost of hedging outweighs the benefits. Specifically, the company will spend a lot on hedging only to realize a few or no benefits. In line with the agency theory, managers are normally risk averse as compared to stockholders. As such, they may not be in a position to a take the necessary steps that will lead to sufficiency in risk reduction (Nawalkha, Soto, & Beliaeva 2005). Similarly, the theory also stipulates that managers are driven by self-interests. As such, the hedging decision may only benefit them as opposed to the entire company.  The management at Zapple must be able to do a cost benefit analysis before making the decision on whether or not to hedge. Basically, the decision to hedge should only be arrived upon when the benefits of outweigh the cost. In the event of the cost outweighing the benefits, the company should not engage in the practice as it will end up spending more and gaining less (Megginson & Smart 2009).

Greiner (2013) argues that the expected returns of currency as a result of hedging are zero. Managers normally worry a lot about accounting cosmetics. For example, they are willing to report accounting losses while leaving out hedging costs. In the event of market efficiency (forward and sport), there is no way the management can be better or superior than the market. There are times when the management in a company views hedging especially when trading in derivatives as an extra source of income. This is common when a company’s cash flow in considerably low. As a result, they engage in additional risk taking with an aim of increasing their income. This sometimes results into great losses. Essentially, according to Nawalkha, Soto and Beliaeva (2005), hedging can be viewed as a way of solving one problem by creating another. With this being the case, the management at Zapple should consider the expected return of hedging interest and exchange rate risks. This is because the reasons to hedge become the reasons not to hedge (Nawalkha, Soto, & Beliaeva 2005).

 1.2. Arguments for Hedging

Nawalkha, Soto and Beliaeva (2005) maintain that hedging of the exchange and interest rate risk enables a company or organization to reduce risk. Risk reduction goes a long way in improving a company’s planning as well as investment decisions. This can be attributed to the fact that the management will be confident that it has mitigated financial risks. For example, it is able to avoid points when the company may face financial distress. According to Mathieson and Schinasi (2010), this also enables the company in question in this case Zapple to avoid indirect costs as well as direct costs. For instance, a company is able to avoid direct costs such as filing for bankruptcy as it will have come up with strong strategies on how to avoid the same. Financial distress can result into the shareholders of the company being reluctant to provide more equity that can be used in funding new projects or investments (Megginson & Smart 2009). Ultimately, this can lead to underinvestment, hence creating a barrier to a company achieving a competitive edge. Financial disruptions caused by changes in interest and interest rates are also avoided. Zapple will be in a great position to handle both business and strategic risks through hedging (Abdel-Khalik 2013).

As argued by Megginson and Smart (2009), there are also times when the management is in a better position to effectively manage risks as compared to stockholders. As such, it is best to give them the chance to evaluate and manage exchange and interest rates risks (Fabozzi, Institutional Investment Management: Equity and Bond Portfolio Strategies and Applications 2009). One way through which they can be able to achieve the same is through hedging.  Megginson and Smart (2009) argue that markets are normally in disequilibrium. This can be attributed to constant shocks associated with them. As such, the management in a company can be able to recognize the shocks, hence its ability to do selective hedging (Helliar 2005).

As stated by Fabozzi, Mann and Choudhry (2013), hedging of the exchange and interest rate risk can also aid in eliminating the conflict of interest among different claimants to a company’s cash flows. This also results into the reduction in the cost of capital while at the same time increasing a company’s debt capacity.  Helliar (2005) argues that managers cannot hedge their future wealth. There are times when one individual owns a large share in the company. Such an individual may not be in a position to hedge all the risks. Hedging is likely to benefit the investor. If such an individual is active and committed to the going concern of the company, other shareholders may also benefit from his or her decisions (Abdel-Khalik 2013).

Megginson and Smart (2009) contend that increased volatility in the market affects the normal running of a business. For example, this can reduce customer satisfaction, trade credit, and employee training among other effects. Changes in foreign exchange and interest rates can affect the capital available to a company that can enable it to engage in practices that will lead to high levels of customer satisfaction (Mathieson & Schinasi 2010). Hedging such risks enables managers to anticipate risks aversion. In the same regard, hedging of the exchange and interest rate risk not only makes stockholders comfortable but also customers, employees, suppliers, as well as the broader community. Comfortable employees are more than willing to engage in activities that will lead to the continued success of their company or organization. According to Abdel-Khalik (2013), employees will have a glimpse of the future, hence high levels of motivation. This is unlike the case when the future is not in any clear.

2.0. What Factors Will Influence the Rating of the Planned Bond

It is clear that Zapple intends to issue a long term bond with a maturity date of 2020. The company is looking to raise approximately 500 million pounds with a target coupon of 7 percent. There are a number of factors that will influence the rating of the planned bond.

Madura (2009) argues that that one of the major factors that influences the rating of a bond is interest rates. Generally, an increase in interest rates leads to a fall in the price of a bond. On the contrary, a fall in interest rates leads to an increase in the bond price. For example, if the company’s bond pays the 7 percent interest while the interest rates are lower, for instance, 5 percent then its interest rates is higher than the market or going rate. As such, its bond will be more attractive to investors. This implies that investors will give it a higher rating as compared to other bonds. On the contrary, if the going rate is at 10 percent, this will imply that the company’s interest rate is low. As a result, it will be less attractive to investors. Essentially, investors will give it a lower rating. This also implies that they will be unwilling to purchase the bond making it hard for the company to raise the targeted funds.  Zapple will only be able to realize or even surpass the target amount if its interest rates remain high or at par with going interest rates (Brigham & Houston 2007).

According to Ramaswamy (2004), inflation rates also affect the rating of a bond. Basically, a general increase in inflation rate leads to a decrease in bond prices. On the other hand, a decrease in inflation rate leads to an increase in bond prices hence improved rating. Generally, rising inflation affects the purchasing power an individual is likely to earn on his or her investment. Specifically, when the bond matures, the return on investment will have a lesser value as compared to today’s pound value. This renders a bond less attractive to investors. As such, Zapple is likely to achieve its target if inflation rates remain considerably low. Essentially, high inflation rates will create a major barrier to the achievement of the same goal. Inflation rate is something the company cannot control (Madura 2009). It can only hope that the government will take the necessary actions to keep the rates down. However, the company can capitalize on other factors that affect the rating of bonds to improve the chances of realizing its target.  For example, it can manipulate the interest rates to attract more investors even when the level of inflation is high.

Consistent with Fabozzi (2009), credit ratings also affect the rating of a bond. Credit rating agencies normally assign rating to bond issuers as well as specific bonds. For instance, they provide information on an issuer’s ability to make interest payments. Equally, they can also provide information on whether or not an issuer will be able to repay the principal bond. Investors normally use the same information when making the decision on whether or not to take a bond. Basically, according to Negrila (2007), high credit ratings affect investors’ decisions. This can be attributed to the fact they prove that the company in question has the ability to meet payment obligations. Low ratings communicate the message that the company many not be able to meet payment obligations. This in turn leads to low rating of the bond in question.  A rise in the credit ratings leads to an increase in the price of the bond offered by a company. Equally, a fall in the ratings also leads to a fall in the prices (Brigham & Houston 2007). Companies that have been able to establish good relationships with credit rating agencies are able to achieve high rating as compared to those that have bad relationship. A credit rating agency can easily give a company a low rate as a result of having a personal vendetta with it. In really sense, a company’s ratings may be high. However, investors may make decision based on the rating offered by the agencies, hence the need for organizations to establish good relationships with the agencies (Elton & Gruber 2011).

The demand for bonds also affects their rating. The market demand of bonds normally fluctuates with the performance or the changes in the stock market (Negrila 2007). A fall in stock results into an increase in bond prices. This in turn lowers interest rates. A fall in interest rates results into a reduction in the demand until the stock prices start to increase or are priced attractively. This in turn leads to a repeat of the whole cycle. Basically, according to Besley and Brigham (2011), an increase in the demand for bonds may lead to an increase in the ratings and vice versa. In the same regard, the supply can also affect the ratings of bonds. Increased competition among companies offering bonds can lead to some being given higher rates than others. This may not be the case when Zapple in enjoying monopoly. Essentially, the company may be up against better performers in terms of credit ratings. As such, investors will consider the bonds offered by the competition as opposed to its bond (Elton & Gruber 2011).

Langohr and Langohr (2008) argue that the length of the issue has a great effect on the interest charged. Companies that offer bonds that mature after a long period of time are expected to offer high interest rates. This can be attributed to the fact that the risk of possible rate changes is high. Essentially, longer issues are more sensitive in terms of rate changes. This renders them more volatile as compared to bonds that mature after a short period of time (Elton & Gruber 2011).

Bibliography

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