MEMORANDUM
From:
To: The Board of Directors, CMC Co
Date: xx/xx/xxxx
Subject: Discussion of the proposal to manage foreign exchange and interest rate exposures, and the proposal to move operations to four branches and consequential agency issues
This memo discusses the proposal of whether or not CMC Co should undertake the management of foreign exchange and interest rate exposure, and the agency issues resulting from the proposal to locate branches internationally and how these issues may be mitigated. Each proposal will be considered in turn.
(i) Proposal One: Management of foreign exchange and interest rate exposure
The non-executive directors are correct if CMC Co is in a situation where markets are perfect and efficient, where information is freely available and where securities are priced correctly. In this circumstance, risk management or hedging would not add value and if shareholders hold well diversified portfolios, unsystematic risk will be largely eliminated. The position against hedging states that in such cases companies would not increase shareholder value by hedging or eliminating risk because there will be no further reduction in unsystematic risk. Furthermore, the cost of reducing any systematic risk will equal or be greater than the benefit derived from such risk reduction. Shareholders would not gain from risk management or hedging; in fact, if the costs exceed the benefits, then hedging may result in a reduction in shareholder value.
Risk management or hedging may result in increasing corporate (and therefore shareholder) value if market imperfections exist, and in these situations, reducing the volatility of a company's earnings will result in higher cash inflows. Proponents of hedging cite three main situations where reduction in volatility or risk may increase cash flows – in situations: where the rate of tax is increasing; where a firm could face significant financial distress costs due to high volatility in earnings; and where stable earnings increases certainty and the ability to plan for the future, thus resulting in stable investment policies by the firm.
Active hedging may also reduce agency costs. For example, unlike shareholders, managers and employees of the company may not hold diversified portfolios. Hedging allows the risks faced by managers and employees to be reduced. Additionally, hedging may allow managers to be less concerned about market movements which are not within their control and instead allow them to focus on business issues over which they can exercise control. This seems to be what the purchasing director is contending. On the other hand, the finance director seems to be more interested in increasing his personal benefits and not necessarily in increasing the value of CMC Co.
A consistent hedging strategy or policy may be used as a signalling tool to reduce the conflict of interest between bondholders and shareholders, and thus reduce restrictive covenants.
It is also suggested that until recently CMC Co had no intention of hedging and communicated this in its annual report. It is likely that shareholders will therefore have created their own risk management policies. A strategic change in the policy may have a negative impact on the shareholders and the clientele impact of this will need to be taken into account.
The case of whether to hedge or not is not clear cut and CMC Co should consider all the above factors and be clear about why it is intending to change its strategy before coming to a conclusion. Any intended change in policy should be communicated to the shareholders. Shareholders can also benefit from risk management because the risk profile of the company may change, resulting in a reduced cost of capital.
(ii) Proposal Two: International branches, agency issues and their mitigation
Principal–agent relationships can be observed within an organisation between different stakeholder groups. With the proposed branches located in different countries, the principal–agent relationship will be between the directors and senior management at CMC Co in Switzerland, and the managers of the individual branches. Agency issues can arise where the motivations of the branch managers, who are interested in the performance of their individual branches, diverge from the management at CMC Co headquarters, who are interested in the performance of the whole organisation.
These issues may arise because branch managers are not aware of, or appreciate the importance of, the key factors at corporate level. They may also arise because of differences in cultures and divergent backgrounds.
Mitigation mechanisms involve monitoring, compensation and communication policies. All of these mechanisms need to work in a complementary fashion in order to achieve goal congruence, much like the mechanisms in any principal–agent relationship.
Monitoring policies would involve ensuring that key aims and strategies are agreed between all parties before implementation, and results monitored to ensure adherence with the original agreements. Where there are differences, for example due to external factors, new targets need to be agreed. Where deviations are noticed, these should be communicated quickly.
Compensation packages should ensure that reward is based on achievement of organisational value and therefore there is every incentive for the branch managers to act in the best interests of the corporation as a whole.
Communication should be two-way, in that branch managers should be made fully aware of the organisational objectives, and any changes to these, and how the branch contributes to these, in order to ensure their acceptance of the objectives. Furthermore, the management at CMC Co headquarters should be fully aware of cultural and educational differences in the countries where the branches are to be set up and fully plan for how organisational objectives may nevertheless be achieved within these differences.
(Note: Credit will be given for alternative, relevant approaches to the calculations, comments and suggestions/recommendations)
