Identifying Risk Drivers in the Macdougal Farm - Literature review Example

Introduction

Engaging in international trade gives firms several growth and expansion advantages (Tiwana & Keil, 2004). This is however not to suggest that such international opportunities do not come with any challenges for the firms involved. According to Baba (2009), the levels of exposure to risk for firms become greater when they begin to engage in international trade, including exports. This assertion cannot be denied, given the fact that firms going international may find themselves doing business in countries and with other partners who may have their own trade and operational challenges, most of which are not known till contracts have been signed (Baglioni & Monticini, 2008). It is in the wake of this that MacDougal Farm Machinery Limited can be said to have a lot of responsibility on its hand when it comes to risk management. In this paper therefore, possible risks associated with the proposed contract with the government of Yoobovian are considered with particular emphasis on finance related risk such as credit risk. By so doing, risk mitigation strategies that can help the company fulfil the requirements of Yoobovian government while eliminating credit risk will be explored. An action plan to roll out the identified risk management strategies will also be developed to give clear guidelines on how MacDougal Farm can fully benefit from the contract without a cause suffer any financial setbacks.

Identifying risk drivers in the case

There are aspects of the case between MacDougal and the government of Yoobovian that are of prime importance in the identification of risk, as well as the management of the same. As posited by Baba (2009), risks management is a process rather than an event and as a process, involves many different tasks that include the need to have a comprehensive understanding of all factors that can act as forces for the prevalence and management of risk. First, it would be noted that the state of Yoobovian as a developing country, and the region in which the country is located acts as a risk factor that MacDougal cannot ignore. Particularly, it is noted in the case that Yoobovian has the problem of chronic lack of foreign exchange, creating a situation where foreign creditors are paid in local currency. It would therefore be said that Yoobovian as an international trade partner exposes the company to lots of risks, some of which will be considered in the next section. Another risk factor is the fact tnhat MacDougal accepts many types of payment mechanisms. This situation could either be a positive or negative factor, depending on how it is viewed. That is, Gallanis (2009) lamented that there are a number of payment mechanisms that fail to guarantee reduced credit risk in international trade. MacDougal’s liberal payment system opens it up to suffering from such a situation.

Another risk force, which can be said to be a positive one is the issue of an offshore account by MacDougal, which is used to manage sales of agricultural produce exported mainly by cooperative farmers in Yoobovian. In the management of currency risk, Shenhar (2001) notes that such an offshore account is necessary for ensuring that international companies avoid the need to be transferring funds from one currency to the other, across different international borders. Again, the case makes it clear that ECA will not be giving any insurance cover in Yoobovian. This is a situation that exposes MacDougal to credit risk but the counter situation where the broker is ready to offer $5m and a 3 year credit term should be seen as a possible window for overcoming the emerging credit risk. Another big aspect of the case which would help with the development of practical operational plan and financing structure is the fact that the insurance broker is ready to cover MacDougal from performance of its contract, which may come in the forms of being frustrated and non-payment by the contracting partner. As will be seen in latter part of the paper, this is expected to be the fulcrum around which the risk mitigation plan will revolve. What is more, the fact that the tractors proposed by the government is equal to the value of the insurance is a positive phenomenon, coupled with the fact that the Central Bank Guarantee will also be available.

Types of risks in current contract

The current case is coupled with several types of risks. The first type of risk that can be identified is political risk. As explained by Vose (2008), political risk arises when there is major political instability in the country of destination for the exports or any other forms of international trade. Meanwhile, even though the case was not emphatic about the presence of political instability in Yoobovian, it would be noted that the frequency of such political instabilities in developing countries, of which Yoobovian is one is very high (Baglioni&Monticini, 2008). What is more, such developing countries get exposed to political instability as there is change in governments, where new governments fail to continue the policies of the previous government, leading to possible abrogation of existing international contracts (Chatterji&Toffel, 2009). Such political risk is very important for MacDougal to consider, given the fact that the eventual effect of such risk could be non-payment of its contract sum, especially as the government wants the insurance to start from 1st batch when in actual fact, the delivery cycle for MacDougal is between 8 and 9 months. Currency risk is another risk that MacDougal stands to face due to differences in currency with Yooovian. Particularly so as the government prefers making payments in local currency, this could have a lot of negative effect on the currency earnings of the company.

As with all other international trade contracts, it would be argued that the most serious form of risk in the current contract is credit risk or non-payment risk. Credit risk refers to a situation where a partner in a contract does not get paid for goods or services, especially in export (Tiwana&Keil, 2004). This means MacDougal could be faced with credit risk, if for any reason, the Yoobovian government fails to pay the company for the agreed number of tractors to be exported to it. Meanwhile, it has already been noted that there is a direct relationship between political risk and credit risk, where the presence of political risk can be a possible cause of credit risk. Currently, one other important risk MacDougal could be exposed to is legal risk. As noted by Eisenschmidt and Tapking (2009), each country has its own set of laws, most of which are different between the host country and the country doing business with the host country. When such differences exist, it exposes the foreigner to legal risk as there could be tendencies of breaching important trade regulations and laws. Gallanis (2009) found that there is always a direct relationship between legal risk and financial losses, as breaches in trade laws could result in the payment of heavy funds, which could put a toll of financial loss on the foreign partner in the trade arrangement.

Workable plan and financing structure for risk mitigation

It is interesting to find that both the Yoobovian government and the insurance broker are asking for workable plans and financing structure that can give them the needed trade confidence. As such demands are being made, it is also important that MacDougal positions itself in a way that ensures that all possible forms of risks as identified are eliminated. Below, a workable plan and financing structure is provided on how to mitigate risk for MacDougal so that it can meet the requirements of the broker to get the needed insurance cover. At the same time, the plan seeks to put the company at a safe position where it will eliminate risk for itself because if the credit insurance works, it would be a huge risk mitigation policy for the company.

Workable risk mitigation plans

It is expected that three major workable risk mitigation plans will be rolled out by MacDougal, aimed at ensuring that while fulfilling the government requirement of starting the insurance from hand-over of all completed tractors in a single delivery, the company will not be embattled with risks.

Political risk insurance

As explained by Crockett (2000), political risk insurance is a type of insurance taken by firms engaged in international trade with the aim of covering up against any losses that may arise from political risk. It is expected that while exporting the kits for assembly in three batches over a six-month period, MacDougal will take a political risk insurance that will protect it against all forms of political risk that could occur during the period. This political risk insurance will be taken to extend beyond the six month period to cover all the time required for the assembling process to be finished for all three batches till the official hand-over to the government in single delivery. This lengthy durable for political risk insurance is suggested as a way of meeting the government requirement, while ensuring that the exportation and assembling processes are not hit by any setbacks that would render them abruptly abrogated. In other words, it is important that the company does not only consider the period it will require for assembling individual batches of tractors but the overall time. While making reference to political risk insurance, this will be liaised with a new form of insurance service which gives access to legal risk counsel. With this done, it is expected that the insurance company will get the needed assurance of credit risk being avoided.

Hedging against currency fluctuations

The second risk mitigation plan to be rolled out is the use of hedging against currency fluctuations. This is an important risk mitigation plan that will put MacDougal at an advantage of making needed profits, while giving sufficient assurance to the insurance broker that it is in a position to consolidating its proposed earnings from the contract. As the amount involved in the contract is the same as the insurance cover which is $5m, it is important that possible financial losses from exchange rate risk be avoided. As far as the insurance broker is concerned, a formidable exchange rate risk mitigation plan will ensure they have the confidence that MacDougal will not lose out the contract to other competitors who will be willing to take payment in local currency if MacDougal insists on being paid in a foreign currency. Again, the plan to hedge against currency fluctuation by accepting local currency payment means the risk of not being paid because the government will not be able to raise enough foreign exchange to make payment will be avoided (Chatterji&Toffel, 2009). Specifically on the hedging against currency, the practical plan to use is forex forward hedge. This is considered a direct method of hedging, where the exporter sells a set of foreign currency at an exchange rate, pre-agreed for a delivery date into the future (Shenhar, 2001). Normally, this may work from three days up to a year and so it is expected that it will not be started early but delayed till the single delivery to the government is pending.

Use of prepayment or irrevocable letter of credit

The Central Bank has given guarantee to offer £100,000 line of credit to MacDougal to ship the completed tractors to Yoobovia but this line has been inactive with no assurances for its revival in the near future. Even if this is revived, it would be noted that the benefactor would be MacDougal and it will not be done as a payment assurance for the government. It is therefore important that plans be made to protect MacDougal against credit risk. To do this, it is planned that there will be the use of prepayment or irrevocable letter of credit. As noted by Thiry (2002), a letter of credit is a document issued by a bank, giving assurance to a seller that the bank will give out payment to the seller to the tune of the amount on the letter of credit. But in order to meet this requirement, MacDougal will also be expected to fulfil certain documentary conditions. The lines of duty for MacDougal to meet the conditions for benefiting from the letters of credit will be explained later. It is however expected that once the letter of credit is secured, the issue of credit risk will be avoided because as long as the tractors are delivered as planned, the company will receive payment.

Financing structure

In order to meet the requirements for the letter of credit to be paid, it is important that MacDougal will effectively deliver the work as planned and agreed with the Yoobovian government. Financing is an important element to get this responsibility accomplished. In the light of this, a financing structure is presented to capture how the proposed project is expected to be financed. The financing structure basically is an indication of where all monies to be used for the project will come from, as well as how much is expected from each targeted source. This is not expected to be a comprehensive budget for the project but the financial structure is expected to give stakeholders in the project, including the insurance broker a fair idea of the ability of the company to raise capital to finance the project.

BP £

%

Total budget

4,300,000

100

Central bank

100,000

2.33

UK agriculture council

500,000

11.63

Internally generated funds

2,800,000

65.12

Capital Bank loan

400,000

9.32

Barclays bank loan

500,000

11.63

Total

4,300,000

100

From the financing structure above, it would be noted that greater part of the total budget, which is actually as much as 65.12% of it is expected to be generated internally from MacDougal. This is expected to be a positive development to get the necessary insurance support for the project. The reason for this assertion is that with such an amount being raised internally, it is a strong indication of formidable the company is, in funding more than half of the project. With that half funded, even though the Yoobovian government has given an indication to take all tractors in a single delivery, giving evidence of more than half of the work done could be a motivation for the government to internally support the company to raise funds to complete it, when other targeted sources fail.

Taking decision on the credit insurance to MacDougal

A major aspect of the entire contract between the Yoobovian government and MacDougal will be to get a credit insurance cover for the project. As hinted by the insurance broker, such an insurance cover will protect MacDougal in an event where in the performance of its contract, it is faced with frustration or non-payment from the Yoobovian government. Given the fact that the proposed insurance cover has a lot of similarities with the contract such as the fact that it is of the same value as the tractors demanded and the fact that it is to be run for three years, this is expected to be used as the major credit insurance for MacDougal. Consequently, even though other risk management plans have been put in place to check all forms of risks including credit risk, the major risk mitigation policy to be used by MacDougal will be the credit insurance.There are a number of literature works that have supported the benefits companies can derive from the use of credit insurance.

Thiry (2002) observed that credit insurance is necessary to protect the assets or balance sheet of the debtor. With the issue of credit rating of international firms and governments continuing to be considered important requirements in international trade, Crockett (2000) also opines that where there is a credit insurance, it gives the producing partner access to information about what the credit rating of the foreign buyer is. Even though currently there may be indication to show that the Yoobovian government is in good standing to pay its debt, it must not be overemphasised that the issue of political risk can easily be a contributing factor to negatively affect this current position. Another particularly important point raised by Eisenschmidt andTapking (2009) is the fact that when there is a credit insurance, it will become an avenue to access trade finance. Much of the financing structure given might have been done to convince the insurance broker but it could only be a method to get the insurance cover, after which access to the funds will be made easier. In the light of the factors described about the relevance of the credit insurance, it would be posited that MacDougal has to see the insurance proposal from the broker as a necessity in keeping it checked up against credit risk, which can currently be said to be the most serious form of risk that can confront the company.

Conclusion

From the discussions so far, it would be concluded that the need to meet the government requirements and also eliminate risks for MacDougal is a multifaceted responsibility that the company must roll out effectively. This responsibility is considered multifaceted because it involves different but interrelated tasks that the company must undertake. Particularly, the company has a responsibility of identifying all possible risks inherent with the proposed contract. With this, it has been noted that there are risks that have to do with political risk, legal risk, exchange rate risk, and credit or non-payment risk. With the risks identified, there is also the task of assigning a risk management plan to each of them. With such risk management plans, it would be expected that the level of impact associated with each risk on the company will be minimised to the barest minimum. With the involvement of the credit broker and his requirement for contract worthiness to be exhibited by MacDougal for it to get the $5 million insurance cover, it would be said that fulfilling the provisions of the risk mitigation plan will be more or less a means of killing two birds with one stone. This is because the benefits of receiving the insurance cover will in itself be a means of minimising credit risk. Finally, it will be admonishedthat MacDougal fulfils all its part of the contractual agreements so as to ensure that it qualifies for the credit of letter in case the government is not able to pay.