Baker Adhesives

Case 37 Baker Adhesives

Background/Facts
This case is about Baker Adhesives which is a small company that
manufactures specialty adhesives in Newark, NJ. The setting is June of
2006. Baker Adhesives was a modest company founded by Doug
Bakers father who was a chemist and believed in flexible production
systems. Baker Adhesives had recently forayed into international
markets with a sale to Novo, a Brazilian toy manufacturer. Alissa Moreno
was a sales manager and needed to meet with Doug to discuss the
recent results. Going into the meeting Doug is excited at the prospects of
finding new markets. As U.S. manufacturing continues to migrate
overseas, he is under intense pressure to find new markets. This recent
sale to Novo had been a financial boost to Baker Adhesives. The
company was able to easily meet the order and in fact it freed up some
raw material the company had in inventory. The purpose of the meeting
was to finalize details on a new order from Novo that was to be 50%
larger than the original order.
When the meeting started, Moreno hit Baker with the bad news
immediately. The problem was that since Novo order was denominated
in Brazilian, the payment from Novo had to be converted into U.S.
dollars at the current exchange rate. Exchange rates had changed since
the time Baker Adhesives and Novo had agreed on a price, the value of
the payment was now substantially lower than anticipated. This was
going to hurt profit. So obviously Baker was concerned and wanted to
know what could be done, so they could continue to do business
internationally.
Analysis/Decision
This deal was initially thought to be a good financially for Baker
Adhesives. Although, after factoring in exchange rates, this was not the
case. In the original order, Novo was charged 104,338.30 BRL for their
purchase. After the exchange of currency from BRL to U.S. dollars,
Baker Adhesive was estimated to receive $48,371.24 (104,338.30 * .
4636). This means that Baker Adhesive brought in $55,967.06 less from

their deal with Novo than was expected. Baker Adhesives should have
researched exchange rate risk.
To manage the exchange-rate risk of their deal with Novo, Baker
Adhesive could have hedged in the forward market or hedged in the
money market. In order to hedge in the forward market, Baker Adhesive
would have to make a deal in which the bank would provide Baker
Adhesive a guaranteed exchange rate for the future exchange of
currencies (forward rate). These contracts specified a date, an amount to
be exchanged, and a rate. The bank fee would be built into the rate.
Then by securing a forward rate for the date of a foreign-currencydenominated cash flow, Baker Adhesive could eliminate any risk due to
currency fluctuation. For Baker Adhesive, this meant that the anticipated
future inflow from the sale to Novo could be converted at a rate that
would be known today. The second way to manage risk is hedging in the
money markets. This would allow Baker Adhesive to make any currency
exchanges at the known current spot rate. To do this, Baker Adhesive
would need to convert future expected cash flows into current cash
flows. This is done on the money market by borrowing today in a
foreign currency against an expected future inflow or making a deposit
today in a foreign account to be able to meet a future outflow. By
hedging one of these two ways, Baker Adhesive could continue to do
business and expand internationally.

Baker Adhesives
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BAKER ADHESIVES In early June of 2006, Doug Baker met with his
sales manager Alissa Moreno to discuss the results of a recent foray into
international markets. This was new territory for Baker Adhesives, a
small company manufacturing specialty adhesives. Until a recent sale to
Novo, a Brazilian toy manufacturer, all of Baker Adhesives sales had
been to companies not far from its Newark, New Jersey, manufacturing
facility. However, as U.S. manufacturing continued to migrate overseas,
Baker would be under intense pressure to find new markets, which
would inevitably lead to international sales. Doug Baker was looking
forward to this meeting. The recent sale to Novo, while modest in size at
1,210 gallons, had been a significant financial boost to Baker Adhesives.

The order had used up some raw-materials inventory that Baker had
considered reselling at a loss a few months before the Novo order.
Furthermore, the company had been running well under capacity and the
order was easily accommodated within the production schedule. The
purpose of the meeting was to finalize details on a new order from Novo
that was to be 50% larger than the original order. Also, payment for the
earlier Novo order had just been received and Baker was looking
forward to paying down some of the balance on the firms line of credit.
As Baker sat down with Moreno, he could tell immediately that he was in
for bad news. It came quickly. Moreno pointed out that since the Novo
order was denominated in Brazilian real (BRL), the payment from Novo
had to be converted into U.S. dollars (US$) at the current exchange rate.
Given exchange rate changes since the time Baker Adhesives and Novo
had agreed on a per-gallon price, the value of the payment was
substantially lower than anticipated. More disappointing was the fact that
Novo was unwilling to consider a change in the per-gallon price for the
follow-on order. Translated into dollars, therefore, the new order would
not be as profitable as the original order had initially appeared. In fact, it
would not even be as profitable as the original order had turned out to be
due to a rise in some of Baker Adhesives costs!
This case was prepared by Associate Professor Marc Lipson. It was
written as a basis for class discussion rather than to illustrate effective or
ineffective handling of an administrative situation. Copyright 2007 by
the University of Virginia Darden School Foundation, Charlottesville, VA.
All rights reserved. To order copies, send an e-mail to
sales@dardenpublishing.com. No part of this publication may be
reproduced, stored in a retrieval system, used in a spreadsheet, or
transmitted in any form or by any meanselectronic, mechanical,
photocopying, recording, or otherwisewithout the permission of the
Darden School Foundation.

-2Adhesives Market
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The market for adhesives was dominated by a few large firms who
provided the vast bulk of adhesives in the United States and in global
markets. The adhesive giants had international manufacturing and
sourcing capabilities. Margins on most adhesives were quite slim since
competition was fierce. In response, successful firms had developed
ever more efficient production systems which, to a great degree, relied
on economies of scale. The focus on scale economies had left a number
of specialty markets open for small and technically savvy firms. The key
to success in the specialty market was not the efficient manufacture of
large quantities, but figuring out how to feasibly and economically
produce relatively small batches with distinct properties. In this market a
good chemist and a flexible production system were key drivers of
success. Baker Adhesives had both. The business was started by Doug
Bakers father, a brilliant chemist who left a big company to focus on the
more interesting, if less marketable, products that eventually became the
staple of Baker Adhesives product line. While Bakers father had retired
some years ago, he had attracted a number of capable new employees
and the company was still an acknowledged leader in the specialty
markets. The production facilities, though old, were readily adaptable
and had been well maintained. Until just a few years ago, Baker
Adhesives had done well financially. While growth in sales had never
been a strong point, margins were generally high and sales levels
steady. The company had never employed long-term debt and still did
not do so. The firm had a line of credit from a local bank, which had
always provided sufficient funds to cover short-term needs. Baker
Adhesives currently owed about $180,000 on the credit line. Baker had
an excellent relationship with its bank, which had been the companys
bank from the beginning. Novo Orders The original order from Novo was
for an adhesive Novo was using in the production of a new line of toys
for its Brazilian market. The toys needed to be waterproof and the
adhesive, therefore, needed very specific properties. Through a mutual
friend, Moreno had been introduced to Novos purchasing agent.
Working with Doug Baker, she had then negotiated the original order
(the basis for the pricing of that original order is shown in Exhibit 1).
Novo had agreed to pay shipping costs, so Baker Adhesives simply had
to deliver the adhesive in 55-gallon drums to a nearby shipping facility.

The proposed new order was similar to the last one. As before, Novo
agreed to make payment 30 days after receipt of the adhesives at the
shipping facility. Baker anticipated a fiveweek manufacturing cycle once
all the raw materials were in place. All materials would be secured within
two weeks. Allowing for some flexibility, Moreno felt it would be about
three months from when the order was agreed upon to the receipt of
payment from Novo. That was, in fact, about the length of time it took for
the original order. For this reason, Moreno expected
.

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receipt of payment on the new order, assuming it was agreed upon
immediately, somewhere around September 5, 2006. Whereas a third of
the raw materials continued to be materials Baker Adhesives had in
excess supply (those the company had considered selling off) and the
rest were on hand, about a quarter of the materials needed to be
purchased, and their cost had recently risen by 10%. Exchange Risks
With her newfound awareness of exchange rate risks, Moreno had
gathered additional information on exchange rate markets before the
meeting with Doug Baker. The history of the dollar-to-real exchange rate
is shown in Exhibit 2. Furthermore, the data in that exhibit provided the
most recent information on money markets and an estimate of the
expected future (September 5, 2006) spot rates from a forecasting
service. Moreno had discussed her concerns about exchange rate
changes with the bank when she had arranged for conversion of the
original Novo payment.1 The bank, helpful as always, had described two
ways in which the bank could mitigate the exchange risk from any new
order: Hedge in the forward market Banks would often provide their
clients with guaranteed exchange rates for the future exchange of
currencies (forward rates). These contracts specified a date, an amount
to be exchanged, and a rate. Any bank fee would be built into the rate.
By securing a forward rate for the date of a foreign-currencydenominated cash flow, a firm could eliminate any risk due to currency
fluctuations. In this case, the anticipated future inflow of real from the
sale to Novo could be converted at a rate that would be known today.
Hedge in the money markets Rather than eliminate exchange risk
through a contracted future exchange rate, a firm could make any
currency exchanges at the known current spot rate. To do this, of course,
the firm needed to convert future expected cash flows into current cash
flows. This was done on the money market by borrowing today in a
foreign currency against an expected future inflow or making a deposit
today in a foreign account so as to be able to meet a future outflow. The
amount to be borrowed or deposited would depend on the interest rates
in the foreign currency since a firm would not wish to transfer more or
less than what would be needed. In this case, Baker Adhesives would
borrow in real against the future inflow from Novo. The amount Baker

Though Baker Adhesives had a capable accountant, Doug Baker had

decided to let Alissa Moreno handle the exchange rate issues arising
from the Novo order until they better understood the decisions and
tradeoffs that needed to be made. .
1

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would borrow would be an amount such that the Novo receipt would
exactly cover both principal and interest on the borrowing. After some
discussion and negotiation with the bank and bank affiliates, Moreno
was able to secure the following agreements: Baker Adhesives bank
had agreed to offer a forward contract for September 5 at an exchange
rate of 0.4227 US$/BRL. An affiliate of the bank, located in Brazil and
familiar with Novo, was willing to provide Baker with a short-term real
loan, secured by the Novo receivable, at 26.5% (annual effective rate).
Moreno was initially shocked at this rate, which was more than three
times the 8.5% annual effective rate on Bakers domestic line of credit.
However, the bank described Brazils historically high inflation and the
recent attempts by the government to control inflation with high interest
rates. The rate they had secured was typical of the market at the time.
The Meeting It took Doug Baker some time to get over his
disappointment. However, if international sales were the key to the future
of Baker Adhesives, Baker realized he had already learned some
important lessons. He vowed to put those lessons to good use as he and
Moreno turned their attention to the new Novo order.

-5Exhibit 1 BAKER ADHESIVES Novo Price Calculation on Initial Order

Labor Materials Manufacturing overhead Administrative overhead Total
costs Markup (8%) Cost plus markup in dollars Conversion (US$/BRL)
Cost plus markup in reals Amount (gallons) Quoted price per gallon
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6,000 32,500 4,000 2,000 44,500 3,870 48,370 0.4636 104,335 1,210
86.23
Notes: The exchange rate used in the calculation was obtained from the
Wall Street Journal. Overhead was applied based on labor hours. The
raw materials expense was based on the original cost (book value) of
the materials. The rounded price of BRL 86.23 per gallon was used in
negotiations with Novo. Thus, for the final order Novo was billed a total
of 86.23 1,210 = BRL104,338.30.
.

-6Exhibit 2 BAKER ADHESIVES Exchange Rate and Money Market

Information Exchange Rates for Real as of June 5, 2006 (US$/BRL) Bid
on real Ask for real Consensus forecast bid for September 5, 2006
Consensus forecast ask for September 5, 2006 Standard Deviation of
Monthly Exchange Rate Changes 2005 Year to date 2006 Interbank
Rates Brazil U.S.
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0.4368 0.4380 0.4232 0.4246
3.36% 6.53%
17.40% 5.00%
Bid on Real
Dollar Value of Real (US$/BRL) 0.5000 0.4800 0.4600 0.4400 0.4200
0.4000 0.3800 0.3600 0.3400 0.3200 0.3000 1/1/2005 2/1/2005
3/1/2005 4/1/2005 5/1/2005 6/1/2005 7/1/2005 8/1/2005 9/1/2005
1/1/2006 2/1/2006 3/1/2006 4/1/2006 5/1/2006 10/1/2005 11/1/2005
12/1/2005 6/1/2006