How can you insulate a business from sudden changes in the company's cost structure?

Answer 1

Yes, a company can attempt insulate itself from some sudden changes in its cost structure. Like your own personal budget, a company's costs are a function of prices. Some examplies: o A company must finance itself. Therefore its debt is a function of changes in the broader market, such as interest rates, market conditions, investor demand, and its own credit quality. o A company pays for shelter and utilities. Again, changes in these markets may impact a company's costs. o A company is subject to fluctuations in prices and labor. o A company is subject to regulatory, compliance, and tax costs. Any changes to legislation or tax code may impact a company's cost structure. Some of these changes can be hedged. For example, a corporation concerned about rising costs from its supplier may agree in advance to future prices (generally called a "forward" contract). Additionally, in the capital markets, using instruments such as derivatives can help a corporation know its future costs. Derivatives derive their value from an underlying commodity or reference, such as the oil price or an interest rate. The derivative's usually value begins at 0, and rises and falls with changes in the underlying. If the company knew last year that it planned to issue bonds this year, and wanted to know the cost in advance, the company could have entered an interest rate derivative effective on their bond issue date. The company would enter a contract with a financial institution that paid them if interest rates rose. Should interest rates fall, however, the company would pay the financial institution the difference. A company can therefore hedge changes to its cost structure via the capital markets. Commodities, metals, foreign exchange, interest rates, and credit are just a few examples of the derivatives available in the capital markets to corporations that want to know their future costs. Let's look at an example. Assume XYZ Corp plans to issue $100mm of 10y bonds in January 2007. Assume 10y interest rate effective Jan 07 is 6.00%. The company enters an interest rate derivative to hedge the debt issuance. It is now January 2007, and the company is ready to issue its bonds. o Case 1: Higher Rates The 10y rate has risen to 7.00%. The corporation must issue its bonds at 7.00% (because investors demand the market rate), meaning they pay 1.00% or $1mm per year more, on their debt! However, because they entered a derivative contract, they settle it with the financial institution for the equivalent amount, meaning they receive the 1.00% or $1mm per annum more on a net present value basis. Therefore, the company has an effective interest rate of 6.00%, the rate they locked in through their hedge. o Case 2: Lower Rates The 10y rate has fallen to 5.00%. The corporation must issue its bonds at 5.00% (because investors demand the market rate), meaning they pay 1.00% or $1mm LESS per year. However, when they settle the derivative with the financial institution, they PAY the 1.00% or $1mm per annum on a net present value basis. Therefore, the company has an effective interest rate of 6.00%, the rate they locked in through their hedge. As this example illustrates, there is no such thing as a free lunch. Knowing costs in advance, via forward or derivatives or other contracts, may be positive or negative for the corporation. If the future cost is higher, the company benefits, but if the future cost is lower, the company pays a higher than market price! This is the cost of certainty.