7/31/2019 FINANCIAL RISK MANAGEMENT TEST 1 Answers.doc

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FINANCIAL RISK MANAGEMENTTEST 1

Question 1 7 marks

Company A sells a range of 20 consumer product lines to supermarkets. Five ofthe lines are seen to be long term product lines well known to the public. The otherproduct lines have an average life of between one and three years.

What strategies should Company A employ to minimize financial risks for thecompany for :

a. Its long term product lines ?b. Its 1 to 3 year product lines ?

ANSWER

a. Long term lines It should continue to develop new products to keep the product line

fresh and new Make sure it receives a fair share of the R & D budget Fair share of Marketing budget Monitor sales at the retail level Ensure good sell through

b) Its 1 to 3 year product lines Develop several new product lines each year, some will do well, some

OK, and others badly Advertise the new lines Monitoring will be done by watching orders and retail sales As a result of the above monitoring, cut back, or increase production

as required. Objective being to minimize excess inventory at year end at the

company and in the distribution/retailers good sell through

Question 2 3 marks

What are the three categories of risk that can diminish the wealth of a company ?

ANSWER Business operational risk Personnel risk Environmental risk

Question 3 6 marks

Company B has a 10 year option to open a potentially very profitable copper minein a country that currently has a civil war.

The cost of the option is USD 10 million on signature and an annual payment ofUSD 1 million annually.

The sales of the company are USD 3 billion and annual net income is around USD120 million.

It is estimated that the potential profitability of the mine, if it is ever opened, couldhelp the company to increase its annual profit by a factor of 50%.

The civil war has been going on for the last five years. The situation is at astalemate for the belligerents. Both warring sides have suffered high human andmaterial losses.

7/31/2019 FINANCIAL RISK MANAGEMENT TEST 1 Answers.doc

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What decision would you take and explain in detail your reasoning for making yourdecision.

ANSWER

The company is profitable and has the financial resources to pay the moneyshould it decide to.

The potential is high. A plus 50% net income will easily cover the option

costs. This 50% is after depreciation of investment in the plant The option is for 10 years; a lot can happen in 10 years Both sides have been at war for five years and with high human and

material cost. The situation is a stalemate neither side can win so there is a possibility of

compromise ie peace. There will be structural problems in the country after a war so the time

estimated to open the mine may take longer than anticipated.To summarise:

The company can afford it Reasonable hopes for peace Project has high potential profitability Go for it !

Question 4 4 marks

Company C pays annual insurance premiums of USD 30 million for twenty factoriesit has around the world. The premium covers all risks (fire, water damage etc.)except terrorism. The average value of each factory is about USD 100 million.

Over the past ten years there was one major fire in the factory in the Philippineswith a loss of USD 65 million of which the company had to cover USD 3 milliondeductible.

The company is considering creating its own captive insurance company. You havebeen asked to provide the arguments for and against the creation of this captiveinsurance company.

What arguments would you give ?

ANSWER

The company has paid 10 x $30 million in premiums over 10 years. It has had one fires and recovered $62 million Risk that if a fire or other incident occurs before the end of two years

company will have to pay additional cost However the 10 year history very favourable to opening captive After two years may be possible to reduce at least by the 35% taken by

current Insurance company for its own costs and profit

TOTAL 20 marks

(The total marks earned in this and the other tests will be prorated to 30% of thetotal assessment)