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BAKER ADHESIVES

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In early June 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. As U.S. manufacturing continued to migrate overseas, however,

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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 significant loss a
few months before the Novo order. Furthermore, the company had been running well under
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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 firm’s line of credit.

As Baker sat down with Moreno, he could tell immediately that he was in for bad news.
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It came quickly. Moreno pointed out that since the Novo order was denominated in Brazilian
reais (BRL), the payment from Novo had to be converted into U.S. dollars (USD) at the current
exchange rate.1 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
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profitable as the original order had initially appeared. In fact, given further anticipated changes in
exchange rates the new order would not even be as profitable as the original order had turned out
to be!

1
The Brazilian currency is referred to as real in the singular (as in “the Brazilian real”) and reais in the plural
(as in “sales are denominated in reais”).
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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@dardenbusinesspublishing.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 means—electronic, mechanical, photocopying,
recording, or otherwise—without the permission of the Darden School Foundation.

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Adhesives Market

The market for adhesives was dominated by a few large firms that provided the vast bulk
of adhesives in the United States and in global markets. The adhesives giants had international
manufacturing and sourcing capabilities. Margins on most adhesives were quite slim since

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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

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production system were key drivers of success. Baker Adhesives had both. The business was
started by Doug Baker’s 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 Baker’s 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
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maintained.

Until just a few years earlier, 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
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Adhesives presently owed about USD180,000 on the credit line. Baker had an excellent
relationship with the bank, which had been with the company from the beginning.

Novo Orders

The original order from Novo was for an adhesive Novo was using in the production of a
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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 Novo’s purchasing agent. Working with Doug Baker, she had then negotiated the original
order in February (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
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payment 30 days after receipt of the adhesives at the shipping facility. Baker anticipated a five-
week manufacturing cycle once all the raw materials were in place. All materials would be
secured within two weeks. Allowing for some flexibility, Moreno believed payment would be
received about three months from order placement; that was about how long the original order

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took. For this reason, Moreno expected receipt of payment on the new order, assuming it was
agreed upon immediately, somewhere around September 5, 2006.

Exchange Risks

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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.

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Moreno had discussed her concerns about exchange-rate changes with the bank when she
had arranged for conversion of the original Novo payment.2 The bank, helpful as always, had
described two ways in which Baker could mitigate the exchange risk from any new order: hedge
in the forward market or hedge in the money markets.

Hedge in the forward market

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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-currency-denominated cash flow, a firm could eliminate any risk due to
currency fluctuations. In this case, the anticipated future inflow of reais from the sale to Novo
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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
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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
because a firm would not wish to transfer more or less than what would be needed. In this case,
Baker Adhesives would borrow in reais against the future inflow from Novo. The amount the
company would borrow would be an amount such that the Novo receipt would exactly cover
both principal and interest on the borrowing.
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2
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.

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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, 2006, at an exchange rate of 0.4227 USD/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%.3 Moreno was initially shocked at this rate,

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which was more than three times the 8.52% rate on Baker’s domestic line of credit; however, the
bank described Brazil’s 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

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It took Doug Baker some time to get over his disappointment. If international sales were
the key to the future of Baker Adhesives, however, 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.
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3
Note that the loan from the bank affiliate was a 26% annual percentage rate for a three-month loan (the bank
would charge exactly 6.5% on a three-month loan, to be paid when the principal was repaid). The effective rate over
three months was, therefore, 6.5%. The 8.52% rate for Baker’s line of credit was an annual percentage rate based on
monthly compounding. The effective monthly rate was, therefore, 8.52% ÷ 12 = 0.71%, which implies a (1.0071)3 –
1 = 2.1452% effective rate over three months.

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Exhibit 1
BAKER ADHESIVES
Novo Price Calculation on Initial Order
(figures in U.S. dollars unless otherwise specified)

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Labor 6,000
Materials 32,500
Manufacturing overhead 4,000
Administrative overhead 2,000
Total costs 44,500

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Profit margin (12%) 6,068
Cost plus profit margin in dollars 50,568
Conversion (USD/BRL) 0.4636
Cost plus markup (BRL) 109,077
Amount (gallons) 1,210
Quoted price per gallon (BRL) 90.15
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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 BRL90.15 per gallon was used in negotiations with Novo. Thus, for the final order,
Novo was billed a total of BRL90.15 × 1,210 = BRL109,081.50.
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Source: Created by case writer.

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Exhibit 2
BAKER ADHESIVES
Exchange Rate and Money-Market Information

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Exchange Rates for the Real as of June 5, 2006 (USD/BRL)
Bid on real 0.4368
Ask for real 0.4371
Consensus forecast bid for September 5, 2006 0.4234
Consensus forecast ask for September 5, 2006 0.4239

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Standard Deviation of Monthly Exchange-Rate Changes
2005 3.36%
Year to date 2006 6.53%

Interbank Rates (annual effective rates)

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Brazil 19.47%
United States 5.08%
Data source: Wall Street Journal.
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Bid on Real
Dollar Value of Real (US$/BRL)

0.5000
0.4800
0.4600
0.4400
0.4200
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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

10/1/2005

11/1/2005

12/1/2005

1/1/2006

2/1/2006

3/1/2006

4/1/2006

5/1/2006

6/1/2006
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Date

Source: Created by case writer.

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Permissions@hbsp.harvard.edu or 617.783.7860