Enterprise Risk Management Analysis for Tennessee Sunshine Inc. Case Study

Introduction

The report is prepared by a financial analyst hired by Tennessee to fulfill Chief Executive Officer’s (CEO) request to aid him/her in understanding the basics of enterprise risk management. The firm specializes in the creation of exotic sauces using imported vegetables and fruits. The analysis is geared towards enhancing in-depth understanding of embracing enterprise risk management programs for the organization.

Analysis

Enterprise risk management is an important aspect for contemporary organizations operating in business environments with high uncertainties. Therefore, from the fundamental knowledge on the topic, it is important to develop strategic programs for ensuring the success of the organizations. The analysis saw gathering of materials related to risk management and derivatives essential for drafting pertinent questions. The question-answer criteria were utilized to develop answers for the questions drafted. The questions were as follows:

1. Why might stockholders be indifferent to whether or not a firm reduces the volatility of its cash flows?
2. What are six reasons risk management might increase the value of a corporation?
3. What is COSO? How does COSO define enterprise risk management?
4. Describe the eight components of the COSO ERM framework.
5. Describe some of the risk’s events within the following major categories of risk: (1) strategy and reputation, (2) control and compliance, (3) hazards, (4) human resources, (5) operations, (6) technology, and (7) financial management.
6. What are some actions that companies can take to minimize or reduce risk exposures?
7. What are forward contracts? How can they be used to manage foreign exchange risk?
8. Describe how commodity futures markets can be used to reduce input price risk.
9. It is January, and Tennessee Sunshine is considering issuing $5 million in bonds in June to raise capital for an expansion. Currently, the firm can issue 20-year bonds with a 7%coupon (with interest paid semi-annually), but interest rates are on the rise and Stooksbury is concerned that long-term interest rates might rise by as much as 1%before June. You looked online and found that June T-bond futures are trading at 111’250.What are the risks of not hedging, and how might TS hedge this exposure? In your analysis, consider what would happen if interest rates all increased by 1%.
10. What is a swap? Suppose two firms have different credit ratings. Firm Hi can borrow fixed at 11%and floating at LIBOR + 1%. Firm Lo can borrow fixed at 11.4%and floating at LIBOR + 1.5%. Describe a floating versus fixed interest rate swap between firms Hi and Lo in which Lo also makes a “side payment” of 45 basis points to Firm L.

Solution

Tennessee Sunshine Inc. will gain more insight into enterprise risk management by looking at the answers provided below.

1. Financial distress becomes higher if the cash flow of a firm is extremely volatile. Cash flow volatility, which reduces the likelihood of bankruptcy, is achievable through risk management. Hedging would be necessary since it smoothens the performance of an organization leading to the low volatility of cash flows. Hedging of finances by a risk-averse firm mitigates product price risk while polishing the supply of cash flows within a given timeframe and helps the organization avoid negative costing. However, slight mistake when handling cash flows may cause a negative setback in cash flows, exposing the organization to financial anguish (Wang, Zhao & Huchzermeier, 2020). Therefore, stakeholders may not be certain as to whether they should reduce the organization’s volatility of cashflow or not.
2. Risk management of a firm incorporates several strategies and policies relating its financial capabilities. However, the performance of a risk management action requires the managerial leaders to possess relevant financial skills. The reasons for risk management boosting corporation’s value include:
   1. derivatives aspects such as swaps are essential for corporates and minimize corporate performance’s volatility;
   2. hedging is essential since it maximizes a firm’s value by surpassing market imperfections made up of borrowing costs associated with aggressive tax areas, bankruptcy risks, high capital cost, and underinvestment issues;
   3. risk management is essential for firms facing price uncertainty in both output and input markets since it maintains optimal capital over time;
   4. identification of optimal financial arrangement is necessary in reducing volatility cashflow and enhancing a firm’s performance (Gherghina, 2021);
   5. risk management is critical when leveraging a firm’s environmental, social, and governance-associated risks assessment of materials relieving it from financial deterrence;
   6. data collected during the hedging process provides an opportunity to have the unmistakable active design of understanding effects of taxation.
3. The Committee of Sponsoring Organizations of the Treadway Commission (COSO) seeks to elevate a firm’s governance and performance. The main goals are the provision of leadership to deal with enterprise risk management (ERM), fraud deterrence, and internal control. COSO defines ERM as capabilities, practices, and culture integrated with strategic and executable settings relied on by organizations for risk management in the creation, preservation, and realization of value (Brigham & Ehrhadt, 2020). COSO sought to improve a corporate institution’s leadership, success, and operation in a market.
4. The eight COSO’s ERM framework include:
   1. The firm’s code of conduct framework, defining the capability of leaders being risk-averse while adopting managerial skills to avoid overlooking underlying risks;
   2. setting objectives and goals framework as well as vision and mission of a firm while considering risk appetite and maintaining tolerance to achieve high-level of management plan catering for strategic goals;
   3. opportunities and risks in event identification essential in avoiding disruptive aspects that restrict the firm from attaining its tangible benefits;
   4. assessing risks and their associated categorization which assists in the identification of the different forms of arising threats essential in assisting the CEO in risk prioritization and decision-making;
   5. the risk mitigation and response framework responsible for reducing, accepting, avoiding, and transferring threats by use of the strategic process of planning;
   6. balances and checks framework granting a platform for ensuring that responsive activities are done according to laid down policies and ethical values of the firm;
   7. communication and information framework which prevents overlooking threats since training programs on risk assessment and identification are in place; and
   8. monitoring and calling to action framework essential for ensuring interval checks to ascertain whether things are working or they are not (Brigham & Ehrhadt, 2020).
5. Below are some of the risk events that may be encountered within various categories of risk.
   1. Strategy and reputation entail risk management practices for integrating and setting performance aspects practical for mitigating the exposures such as legal issues, the action of competitors, perception of the public and corporate social responsibilities;
   2. Control and compliance are a requirement seeking to ensure transparency in governance policies essential to gain control over the regulatory needs, intellectual property rights, litigation threats, internal control arrangements, and survive uncertainties;
   3. Hazards such as earthquakes, fire, floods, and terrorism acts create barriers to production flow in a firm;
   4. Human resources sometimes create difficulty in its management while automated systems are consistent and accurate implying, they possess painless, speedy, and less costly recovery aspects to minimize errors and sluggish processes such as recruitment, planning succession, evaluate staff health and safety;
   5. Operations such as chains of supply, manufacturing units, and business chains are essential in ensuing continued processes while risk events associated with system failures, product recalling, changes in consumers’ demand, and supply chain disruptions deter the firm processes;
   6. Technological disturbances may occur unexpectedly, breaking the chain of operations in a firm; therefore, technological reliability and security is necessary;
   7. Financial management is faced with risk events emanating from witnessed risks associated with interest rates, commodity price, customer credit, project selection, and portfolio.
6. Firms should incorporate hedging of finances to minimize the substitution of effective risk reduction while efficiently interacting with their respective capacity portfolios. Similarly, derivatives dynamically tilt in replicated portfolios aiming at eliminating errors. Capital financing, if adopted will minimize the information and sponsoring costs. Profitable firms have a minimized likelihood of facing bankruptcy risks since indebtedness capacity has been increased. Less incorporation of human efforts indirectly reduces possible human risks. Lastly, performing risk assessments exposes risks likely to deter an organization’s operations (Brigham & Ehrhadt, 2020). Therefore, taking necessary actions is essential in identifying existing risks likely to affect the success of a firm.
7. Forward contracts refer to a discipline exercising its market powers possessing an agreement where one party agrees to purchase an item at a certain price in the future. In contrast, another agrees to sell an entity at the settled-on terms (Miller & Podwol, 2019). Foreign exchange risk is affected by counterparty risk since the seller, and the buyer must be financially and morally upright. Therefore, if one party defaults, then a forward contract would minimize the associated risk with the contact (Brigham & Ehrhadt, 2020). Forward contracts are applicable in minimizing foreign exchange risks which can lead to losses.
8. Future commodity markets are filled with various risks for the products’ prices for producers and consumers. Porter’s decision to trade and purchase copper from Chilean miners requires fulfillment of the contract despite borrowing funds for payment and purchases. Therefore, hedging against raising the prices for copper in future markets becomes necessary (Brigham & Ehrhadt, 2020). Commodity futures markets are financial tools for managing input price risk. They are crucial in the reduction of risks from input prices.
9. Failure by a company to hedge exposes it to the problem of underinvestment while drawing the association between a firm’s investment and cashflows. Hedging is instrumental in reducing the expected tax liability by smoothening taxable income (Brigham & Ehrhadt, 2020). Tennessee Sunshine will be required to hedge since a 1% increase in the interest rate exposes the costs to drop. However, hedging would be costly since extra resources are required if the rate of interest remains similar.
10. A swap refers to a derivative tool permitting the exchange of cash flows within a particular period by counterparties. It requires an agreement involving both parties and pertaining terms of the entity (Brigham & Ehrhadt, 2020). A fixed rate paid by Hi to Lo is tied to the period the swap entered into the contract while depending on creditworthiness and agreement made. For instance, Hi’s appropriate fixed-rate swap to Lo will be 11.4%. Lo would pay LIBOR+1% rate to Hi with an assumption of their existing agreement and creditworthiness elements.

Conclusion

Tennessee Sunshine Inc. would grasp the aspects of enterprise risk management through the question-answer criterion. Similarly, the questions above are instrumental in enhancing financial insight regarding the organization’s risk management. The answers are essential eye-openers that can aid in the management over the subsequent financial periods. Having a better understanding of addressing uncertainties in the future is an essential strategy for steering the firm towards success.

References

Brigham, E., & Ehrhardt, M. (2021). Financial management: Theory & practice (16th ed.). Cengage Learning.

Gherghina, Ș. (2021). Corporate Finance. Journal of Risk and Financial Management, 14(2), 44.

Jorrigala, V. (2021). Business Continuity and Disaster Recovery Plan for Information Security (Masters). Saint Cloud State University.

Miller, N. H., & Podwol, J. (2017). Forward contracts, market structure, and the welfare effects of mergers. SSRN Electronic Journal.

Wang, J., Zhao, L., & Huchzermeier, A. (2020). Operations‐finance interface in risk management: Research evolution and opportunities.Production and Operations Management, 30(2), 355-389.

Yang, S., & Onur, E. (2017). Interest Rate Swap Market Complexity and Its Volatility Implication. SSRN Electronic Journal, 2(1), 1-24.